On last week’s Question Time two people in the audience angrily condemned the “monetarist” policies apparently being pursued by the British and German governments. I groaned. It seems that the only people who use the phrases ‘monetarist’ or ‘monetarism’ anymore are people who haven’t got a clue what they mean.
Monetarism was at its height around thirty years ago. With double digit inflation in Britain, the United States, and elsewhere, and the failure of Keynesian policies to deal with it (indeed, they were the cause of it) the search was on for a set of policies which would. As the chaos grew in the late 1970s many fixed on monetarism as the answer. It went where few economic theories had gone before; debated in Parliament, the front pages of national newspapers, and TV current affairs shows. Rarely has a reasonably technically involved economic concept achieved such widespread discussion among non-economists.
Though it had roots deep in the history of economic thought monetarism was popularized in the 1970s by Milton Friedman, a Nobel Prize winning economist from Chicago University. Friedman was on a roll at the time. In 1953 he had argued for floating exchange rates and in the 1970s these had come about. In 1968 he had predicted the breakdown of the Phillips Curve relationship between unemployment and inflation and, again, in the 1970s this had come about.
His theory was really very simple and was based around one of the oldest, and certainly one of the very few useful, equations in economics, the equation of exchange
MV = PT
Here M stands for the amount of money in an economy and V stands for velocity of circulation; how many times in a given period a unit of currency is spent. Thus, if M was, say, £50 and V was 3 then MV would equal £150 which would be the total amount of spending in that economy in that given period.
P stands for the price level, a statistical aggregate of prices in the economy like the inflation figure reported monthly in newspapers. T stands for the real value of aggregate transactions in the economy in a given period. If that sounds like a slippery concept don’t worry, Freidman swapped it for y, or income in the economy in a given period, to give a refined equation
MV = Py
So far we have a truism; an equation which is true by its very definition. It simply says that spending (MV) will equal income (Py) in the economy in the given period which, when you think about it, is obvious.
Freidman took the truism and made it into a theory by holding V and y constant. V would depend on people’s habits which would change little over the short and medium term. Y was fixed by the economy’s capacity; given a set amount of capital and labour in the economy in a given period production could not be expanded in the short and medium term.
The conclusion that followed utterly logically from this was that increases in P, the very inflation which was plaguing economies, must have been caused by increases in M. Indeed, in his mammoth 1963 book A Monetary History of the United States 1867 – 1960 (written with Anna J Schwartz) Freidman claimed to have found conclusive empirical proof of this theory.
The policy prescription that followed was equally utterly logical; if you wanted to lower and control inflation you had to lower and control increases in the money supply. Freidman argued that the aim should be for price stability, that the money supply should grow at a fixed, pre announced rate which would be calculated to match the trend growth rate of the economy.
That, and nothing else, was monetarism. Its supporters might have argued for and its practitioners might have enacted a raft of other policies such as lower taxes, lower public spending, and privatization which could crudely be labelled ‘right wing’ but these were not part of monetarism which was a narrow theory of monetary management. It would have been perfectly possible for a left wing government to have raised taxes, raised spending and nationalized and still committed itself to monetarism. Indeed, the first monetarist government in Britain was the Labour government of Jim Callaghan in 1976.
And plainly not Britain, Germany, nor anyone else today is following anything which could be called a monetarist monetary policy. Monetarism prescribed control of the money supply to control inflation; it said nothing about interest rates which it left to the market. By contrast Britain and the German controlled European Central Bank follow the monetary management method which replaced monetarism when it fell out of favour towards the end of the 1980s. Nowadays the control of interest rates is the chosen tool in the fight against inflation. It is the money supply, central to monetarism, which is left to the market.
This isn’t necessarily to praise monetarism or even to bury it. It is simply to wash off of it some of the mud thrown at other ideas.