Philip Pilkington: The New Monetarism Part II – Holes in the Theory

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By Philip Pilk­ing­ton, a writer and jour­nal­ist based in Dublin, Ire­land. You can fol­low him on Twit­ter at @pilkingtonphil

In the first part of this piece we looked at the Thatch­er government’s mon­e­tarist exper­i­ment in the ear­ly 1980s. It did not end well. So we must ask: did the Thatch­er gov­ern­ment and the mon­e­tarists believe in what they were doing or were they cyn­i­cal­ly using mon­e­tarist pol­i­cy as a device to destroy large parts of British indus­try in order to destroy the trade union move­ment?

We turn to the British econ­o­mist Nicholas Kaldor who was deeply engaged in mon­e­tarism as it emerged as a pop­u­lar dog­ma in the 1970s and 1980s. Occa­sion­al­ly in his book ‘The Scourge of Mon­e­tarism’ Kaldor does seem to say that the pol­i­cy is sim­ply a ruse:

[Mon­e­taris­m’s] real effect depends on the shrink­age of effec­tive demand brought about through high inter­est rates, an over­val­ued exchange rate, and defla­tion­ary fis­cal mea­sures (main­ly expen­di­ture cuts), and the con­se­quent diminu­tion is the bar­gain­ing strength of labour due to unem­ploy­ment. Con­trol over the ‘mon­ey sup­ply’ which has in any case been inef­fec­tive on the government’s own cri­te­ria, is no more than a con­ve­nient smoke­screen pro­vid­ing an ide­o­log­i­cal jus­ti­fi­ca­tion for such anti-social mea­sures.

On oth­er occa­sions, Kaldor did sug­gest that the major prac­ti­tion­ers actu­al­ly believed in mon­e­tarism. And cer­tain­ly, giv­en the buzz sur­round­ing it at the time it at least appeared that they did.

This ques­tion is not sim­ply one posed to tick­le our his­tor­i­cal curios­i­ty. It remains rel­e­vant today as cen­tral banks in many coun­tries ini­ti­ate ‘quan­ti­ta­tive eas­ing’ (QE) pro­grams which are thought to func­tion due to a the­o­ry of the mon­ey sup­ply that is close­ly relat­ed to mon­e­tarism. So, the ques­tion of belief is one of utmost impor­tance. Many sup­port­ers of QE will deny any con­nec­tion between the two poli­cies, of course, but it is no coin­ci­dence that Mil­ton Fried­man him­self advo­cat­ed the use of QE poli­cies in Japan back in 1997:

The surest road to a healthy eco­nom­ic recov­ery is to increase the rate of mon­e­tary growth, to shift from tight mon­ey to eas­i­er mon­ey, to a rate of mon­e­tary growth clos­er to that which pre­vailed in the gold­en 1980s but with­out again over­do­ing it. That would make much-need­ed finan­cial and eco­nom­ic reforms far eas­i­er to achieve.

The Bank of Japan can buy gov­ern­ment bonds on the open mar­ket, pay­ing for them with either cur­ren­cy or deposits at the Bank of Japan, what econ­o­mists call high-pow­ered mon­ey. Most of the pro­ceeds will end up in com­mer­cial banks, adding to their reserves and enabling them to expand their lia­bil­i­ties by loans and open mar­ket pur­chas­es. But whether they do so or not, the mon­ey sup­ply will increase.

There is no lim­it to the extent to which the Bank of Japan can increase the mon­ey sup­ply if it wish­es to do so. High­er mon­e­tary growth will have the same effect as always. After a year or so, the econ­o­my will expand more rapid­ly; out­put will grow, and after anoth­er delay, infla­tion will increase mod­er­ate­ly. A return to the con­di­tions of the late 1980s would reju­ve­nate Japan and help shore up the rest of Asia.

This is why the ques­tions sur­round­ing the mon­e­tarist doc­trine are direct­ly applic­a­ble to our world. They shine light on why cer­tain econ­o­mists and cen­tral bankers believe that QE poli­cies are effec­tive and why they con­tin­ue to hold this belief despite the over­whelm­ing evi­dence to the con­trary.

An aside: I should clar­i­fy my posi­tion. I am not equat­ing Thatcher’s vicious mon­e­tarist poli­cies with the cur­rent QE. QE prob­a­bly has some pos­i­tive, albeit sec­ondary effects – like giv­ing bor­row­ers some breath­ing room; but these are prob­a­bly can­celled out by its neg­a­tive effects – like remov­ing inter­est income from savers and pen­sion funds and the like (not to men­tion the com­modi­ties bub­bles it has prob­a­bly stoked).

How It Works…or Doesn’t

Mon­e­tarism arose large­ly because Mil­ton Fried­man found what he thought to be strong cor­re­la­tions between the amount of mon­ey in exis­tence and the nation­al income. At the time the Key­ne­sian ortho­doxy had pos­tu­lat­ed that the stock of mon­ey was indeed fixed but the veloc­i­ty – that is, the speed at which this stock of mon­ey turns over in the econ­o­my – was vari­able. Keynes thought that people’s desire for mon­ey respond­ed to the pre­vail­ing rate of inter­est and, giv­en that Keynes still sub­scribed to the quan­ti­ty the­o­ry of mon­ey, he assumed that adjust­ments must be made to nation­al income by peo­ple speed­ing up or slow­ing down the out­stand­ing stock of mon­ey in exis­tence by spend­ing faster or slow­er.

Fried­man was con­vinced that if he could prove that Keynes was wrong by show­ing that the veloc­i­ty of mon­ey was rel­a­tive­ly fixed and that there was thus a fair­ly sim­ple mechan­i­cal rela­tion­ship between the mon­ey sup­ply and nation­al income, the Key­ne­sian the­o­ry would large­ly fall apart. If Fried­man was cor­rect he would also be able to explain infla­tion as sim­ply being due to the cen­tral bank allow­ing too much mon­ey flow into the econ­o­my rel­a­tive to the size of that econ­o­my and that all they had to do was tar­get a giv­en mon­ey sup­ply to bring the infla­tion under con­trol. This, of course, was pre­cise­ly what the Thatch­er and oth­er gov­ern­ments tried to do in the 1970s and 1980s.

Inter­est­ing­ly – and much less talked about – is that Friedman’s mon­e­tarism also implied that if the econ­o­my had under­gone a strong shock or finan­cial cri­sis and was oper­at­ing with large amounts of unem­ploy­ment and excess capac­i­ty, all the cen­tral bank had to do was inject more mon­ey into the sys­tem. Since, pace Fried­man, this extra mon­ey would con­tribute direct­ly to increas­ing nation­al income – that is, it would be spent and invest­ed – unem­ploy­ment would come down. Fried­man had pos­tu­lat­ed that it was the fail­ure of the cen­tral bank to under­take mon­e­tary stim­u­lus that had led to the Great Depres­sion and this was why Fried­man was an ear­ly advo­cate of Japan’s QE pro­gram (which actu­al­ly began in 2001 and was a dis­mal fail­ure).

Relat­ed to this Fried­man believed that finan­cial crises, such as the 1929 stock bub­ble, were sim­ply due to the cen­tral bank pump­ing too much mon­ey into the econ­o­my. The cur­rent Fed chair­man is, or at least was, an adher­ent of this view. In a speech hon­our­ing Mil­ton Fried­man in 2002 Bernanke said:

Let me end my talk by abus­ing slight­ly my sta­tus as an offi­cial rep­re­sen­ta­tive of the Fed­er­al Reserve. I would like to say to Mil­ton and Anna [Schwartz, Fried­man’s coau­thor]: Regard­ing the Great Depres­sion. You’re right, we did it. We’re very sor­ry. But thanks to you, we won’t do it again.

Of course, if we assume that Bernanke was not mere­ly pos­tur­ing, accord­ing to his own log­ic the Fed­er­al Reserve did indeed “do it again”. A mon­e­tarist would blame the recent hous­ing bub­ble in the US on an over-easy mon­ey sup­ply. How­ev­er, whether Bernanke believed this state­ment or not, he cer­tain­ly act­ed in line with Friedman’s mon­e­tarist treat­ment when he under­took the QE pro­grams in the wake of the crash.

So, what was wrong with Friedman’s basic the­o­ry? Well, first of all the cor­re­la­tions he thought he found were not the same across time and space. If the data for many coun­tries is com­pared across time we see strong fluc­tu­a­tions in the veloc­i­ty of mon­ey. Indeed, even with­in sin­gle coun­tries the veloc­i­ty of mon­ey fluc­tu­ates quite aggres­sive­ly in line with over­all eco­nom­ic growth. Here, for exam­ple, is the veloc­i­ty of the M2 mon­ey sup­ply in the US chart­ed togeth­er with the employ­ment-pop­u­la­tion ratio – an indi­ca­tor of eco­nom­ic health that is used to deter­mine the abil­i­ty of the econ­o­my to pro­duce jobs:

Clear­ly the veloc­i­ty of the M2 is not at all con­stant and moves in rough cor­re­la­tion with the employ­ment-pop­u­la­tion ratio and, hence, with the health of the econ­o­my. So, Fried­man was wrong on even the sim­plest mea­sure. The veloc­i­ty of mon­ey does, in fact, vary over time.

Does this mean that Keynes was cor­rect and large-scale unem­ploy­ment could not be cured by mon­e­tary stim­u­lus due to a falling veloc­i­ty? No, not real­ly. Keynes’ idea that the veloc­i­ty of mon­ey would move togeth­er with the lev­el of eco­nom­ic activ­i­ty (and the inter­est rate) was sim­ply a mod­i­fi­ca­tion of the old quan­ti­ty the­o­ry of mon­ey. Thus all Fried­man had to do was show a con­stant veloc­i­ty and he could debunk Keynes. But in actu­al fact, both Fried­man and Keynes were using a mori­bund the­o­ry that had no basis in real­i­ty (albeit Keynes’ ver­sion was far clos­er to the truth than Friedman’s).

It is on this point that both Fried­man­ite the­o­ry and Fried­man­ite pol­i­cy must be debunked today. Because nei­ther Keynes nor Fried­man – nor most econ­o­mists today, some of whom still pour over mon­e­tary data as if it were goat entrails – under­stood how the exist­ing mon­ey sys­tem actu­al­ly oper­at­ed. In actu­al fact, nei­ther veloc­i­ty nor the out­stand­ing stock of mon­ey have any real bear­ing on eco­nom­ic activ­i­ty. As Keynes knew well, but could not artic­u­late with­in the out­mod­ed frame­work he was using, only the inter­est rate set by the cen­tral bank has any effect on econ­o­my activ­i­ty – and this is through the saving/lending chan­nel, not through some mon­ey supply/velocity mys­ti­cism.

This the­o­ry is called the ‘endoge­nous the­o­ry of mon­ey’ and while there are many ways of approach­ing it, per­haps we should con­tin­ue in our his­tor­i­cal inves­ti­ga­tion and look at it through the prism of the Rad­cliffe Com­mis­sion which was set up in Britain after the war to deter­mine the true role of mon­e­tary pol­i­cy. We shall inves­ti­gate this fas­ci­nat­ing his­tor­i­cal event in the third and final chap­ter of this series.


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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.