Monetarism is not dead.
That is certainly the view of one of the founders of modern monetarism, Anna J. Schwartz. She, along with Milton Friedman, wrote “A Monetary History of the United States, 1867-1960.” Published in the mid-1960s, that book revived the economic idea that growth in the money supply is the key both to the ups and downs of the business cycle and to the level of inflation.
“I don’t see any indication that monetarism isn’t alive and well,” Schwartz said from the New York office of the National Bureau of Economic Research.
The authors concluded that a change in the growth rate of the nation’s money supply produced a similar change in the growth rate of the economy after “a long and variable lag” averaging nine months. Schwartz says the theory has withstood the test of time.
A recent example, she says, is that, between July and November, 1984, the Federal Reserve kept a tight rein on M1, the nation’s basic money supply. To Schwartz, it was thus quite normal that the pace of the economy slowed in the first seven months of this year.
Since November, however, the Fed has been creating money at an extremely rapid rate. Therefore, she expects a pickup in economic activity later this year--or maybe early in 1986.
The nine-month lag, Schwartz emphasizes, is only an average. So the renewed recovery could take as long as five quarters from November, 1984--or it could be sooner.
Schwartz is sharply critical of the Fed for its rapid changes in monetary growth rates. “There is nothing unusual in the way the Fed has been operating--fast, slow, fast, slow--and the economy responds.” She would prefer the Fed to feed money to the economy at a steady, moderate pace.
The National Bureau economist concludes: “Irregularities or contradictions to monetarist doctrine aren’t so obvious.”
However, two factors have prompted recent challenges to monetarism.
One is the fact that inflation has not reignited, as some monetarist economists forecast last year. Schwartz says the flood of relatively cheap imports has been helping to hold down prices.
The other factor is a slump in “velocity.” This will undoubtedly be discussed by the members of the Fed’s policy-making Federal Open Market Committee when it meets.
The velocity of new money can be thought of as a measure of the amount of money required to produce a given volume of nominal gross national product--the nation’s output of goods and services in current dollars. It indicates the number of times that cash and the funds in checkable deposits move from one pocket to another pocket each year.
Reducing it to a formula, the percentage change in GNP equals the percentage change in M1 plus the percentage change in V (velocity).
From the mid-1950s through the late 1970s, the behavior of velocity was relatively stable and thus more predictable. Between 1956 and 1979, the velocity of M1 grew at a fairly steady 3% annual rate. In other words, people were finding ways to use their money for consumption or investment more rapidly.
So far during the 1980s, velocity has grown, on average, only 0.5% a year. And its growth rate has been more volatile. That means there is less economic bang for each buck created by the Fed. The volatility makes it tougher for the Fed to decide how much money to supply the economy.
Volcker Emphasizes Judgment
Fed Chairman Paul A. Volcker told Congress last month: “The uncertainties surrounding M1, and to a lesser extent the other (monetary) aggregates, in themselves imply the need for a considerable degree of judgment rather than precise rules in the current conduct of monetary policy.”
To monetarists like Schwartz, the Fed is to a considerable degree the creator of its own velocity problem. When it pumps out money so fast, people don’t have time to figure out how to use it right away. Their “money balances” are higher than they would normally hold. Velocity thus slumps.
Schwartz expects that, a couple of quarters “down the line,” people will have found a way to use their new money and velocity will accelerate. If she is right, economic growth will bounce back, helping reduce both unemployment and the federal deficit and boosting business profits. That’s why velocity is a critical measure to economists in and out of government.
During the Depression, economists argued over the same issue, talking about a “liquidity trap.” They said: “You can lead a horse to water, but you can’t make him drink.” Consumers and businessmen were the horse in this analogy, supposedly refusing to use new money supplied by the Fed.
Contrast to Keynes
Enthusiasts for the teachings of British economist John Maynard Keynes maintained that the government should step in by boosting government spending as a sort of pump-priming of the economy.
Monetarists contend that most people have holes in their pockets: They will spend money if given a little time. Extra government spending is therefore unnecessary to remedy a recession.
With the massive deficits of today, not even neo-Keynesians are arguing for more government spending. They are just pleased that the Fed has stepped on the monetary gas.
The monetarists aren’t quite sure what to think. Some suspect that the Fed was right to correct its past slow money growth with faster money growth. Others say the Fed’s loose monetary policy is too risky.
Allan H. Meltzer, an economist at Carnegie-Mellon University, figures the Fed’s fast-money-growth policy is going to catch up with it; he would rather see the Fed use the velocity slump to trim inflation further.
Michael W. Keran, chief economist at Prudential Economic Research and a former Fed economist, figures that, because of lower inflation and more modest interest rates, the longer-term trend in velocity growth has slipped back to about 1% per year rather than 3%.
Michael J. Hamburger, another ex-Fed economist, has an econometric model that uses changes in long-term interest rates to explain the slump in velocity. He supports the Fed’s action as appropriate and does not expect the extra money to boost inflation much this year or early next year.
Schwartz is skeptical. She notes that economists have devised at least two other models to explain changes in velocity. And, although different in their bases, they also work. “I would be happier if there was only one,” she says.
Her prediction: a revived American economy and more inflation.