Is Monetarism Really Dead? : Its Priorities Were Reversed, but Its Common Sense Remains

Monetarism is dead, or so it’s said. But before the obituaries are written, monetarism’s virtues and vices need to be separated.

In its essentials, monetarism has been correct. In the 1960s it warned that the dogmatic pursuit of economic growth would result only in rising inflation, and in the 1970s that to bring inflation under control would require tighter Federal Reserve policies. Where monetarism faltered was on technical details--trying to make the money supply the supreme guide for economic policy.

Monetarism is common sense. It’s the idea that inflation ultimately is too much money chasing too few goods. It holds that because the government controls money creation, it also controls inflation. The fact that the theory is being ridiculed doesn’t refute these central ideas.

Put simply, monetarists want the Federal Reserve to increase the money supply by a predictable annual amount--enough to permit real economic growth, but not enough to fuel inflation. Superficially, this approach seems sensible, but in the past decade it has proved unworkable. Defining the money supply has become more difficult as banking deregulation has created new types of deposits. There are at least three major money-supply definitions, and these definitions and these different “money supplies” don’t always act the same. In a narrow sense, money is what we use to purchase things. Every definition includes cash, but after that what to include isn’t clear. For example: You have a NOW account to pay bills, but because it pays 5.25% interest you also use it for savings. The funds used to pay bills are money, but what about the savings? If they are included, why not include other savings--say, in stocks or even in housing? And if they are not included, how can savings in checking accounts be separated from spending money?

Another problem disrupting the predictability of the money supply is that the desire to hold money changes as inflation changes. In the 1970s, when checking accounts paid no interest and inflation was rising, leaving money in a checking account was tantamount to giving it away. There were huge incentives to minimize checking-account deposits. In the 1980s, low inflation and interest-bearing checking accounts changed the incentives. Finally, the demand for money is affected by the role of the dollar as the major international currency for global trading and investment.

Just how badly these practical difficulties have wounded money-supply arithmetic can be found in figures showing the relationship between increases in the basic money supply, defined as cash plus checking deposits, and inflation for three periods: During 1950-85 the money supply rose 397% while inflation rose 367%; for 1978-80 the increases were 15% and 19%; for 1983-85 they were 17% and 8%.

What the comparison shows is that over a long period large and continuous increases in the money supply result in inflation. But over shorter periods the relationship is inexact. Based on money-supply statistics, a monetarist economist would have expected inflation in the 1980s to be worse than in the late 1970s. Even now the cause of the 1980s’ unexpectedly large rise in the money supply is unclear. Is it lower inflation, new types of deposits or something else? It is this dramatic breakdown in the connection between the money supply and inflation that inspired monetarism’s obituaries.

But, broadly speaking, the monetarist framework has been vindicated. Almost no one disagrees that in the 1980s inflation subsided because the Federal Reserve adopted stringent anti-inflationary policies. Money-supply numbers may not show the change, but interest rates do. When adjusted for inflation, they rose substantially. Nor is there much dissent that Federal Reserve policies in the 1960s and 1970s were inflationary. The experience of the past decade has confirmed (just as monetarists argued) the Federal Reserve’s awesome economic powers.

The mistake of the monetarists has been to emphasize the trivia of their theory at the expense of the fundamentals. It is true that the bewildering behavior of the money-supply statistics creates problems for managing monetary policy. Just what is the Federal Reserve to watch? The money supply? But which money supply? Interest rates? These are notoriously difficult to gauge, because to be judged--the actual rates to borrowers and lenders--they need to be adjusted for inflation and tax considerations.

These are the kinds of problems that worry monetarist economists. They are not irrelevant, but the details of how the Federal Reserve conducts its policy--whether by watching interest rates or some definition of the money supply--are much less important than its sense of mission. In the 1960s and 1970s it strove for added economic growth at the expense of slightly higher inflation. What we ought to have learned is that the Federal Reserve’s first responsibility should be to control inflation. Stable prices are a pre-condition for long-term healthy economic growth.

In short, what matters most is politics--the popular consensus of what the Federal Reserve should do--and not the particular technique of economic control. Monetarism had its priorities reversed. But its basic teachings remain: Inflation is destructive, and government creates inflation. If these lessons are forgotten, then we someday will needlessly repeat the wrenching inflation and disinflation of the past quarter-century.