Theorist is dead, long live the theory


‘INFLATION IS always and everywhere a monetary phenomenon.” I can think of few sentences in economics that have engraved themselves more deeply in my memory than Milton Friedman’s famous line in his Encyclopedia Britannica entry for “Money.”

Even before I went to university, I had become fascinated by the problem of inflation. No wonder: In 1975, when I was 11, the annual rate hit 27% in Britain. At Oxford, however, I was prescribed John Maynard Keynes and John Kenneth Galbraith. I discovered Friedman only when I began work on my doctoral dissertation on the German hyperinflation of 1923. Suddenly all became clear. I just needed to figure out why the Weimar Republic printed such an insane quantity of banknotes. And, sure enough, it turned out that socialist politicians had been trying, among other things, to spend their way to full employment.

In 1920s Germany, however, just like in 1970s Britain, the notion of a trade-off between inflation and unemployment proved to be illusory -- precisely as Friedman argued in his celebrated 1967 address to the American Economic Assn. Gradually, people got wise to what was happening, prices soared sky high and the economy collapsed.


It wasn’t just that Friedman rehabilitated the quantity theory of money. It was his emphasis on people’s expectations that was the key, because that was what translated monetary expansion into higher prices. In this, as in all his work, Friedman combined skepticism toward government with faith in individual rationality and therefore freedom. He was a libertarian across the policy board.

Nevertheless, the question is: Do people still believe in monetarism, Friedman’s most important theory, which argues that inflation can be defeated only by targeting the growth of the money supply and thereby changing expectations? Not too many. From all the host of tributes from politicians, central bankers and economists on both sides of the Atlantic last week, of which the most vivid (“an intellectual freedom fighter”) came from Lady Thatcher, you’d never know that Friedman’s monetarism seemingly predeceased him by a decade or more.

The death of monetarism is usually explained as follows: In the course of the 1980s, pragmatic politicians and clever central bankers came to realize that it was difficult to target the growth of the money supply. Margaret Thatcher’s ministers preferred to raise interest rates or to target the exchange rate. At the Federal Reserve too, Friedman’s rules -- once zealously applied by Paul Volcker -- gradually gave way to Alan Greenspan’s discretion. And, for all the praise he heaped on Friedman last week, Greenspan’s successor, Ben Bernanke, is dismissive of monetarism. Earlier this year, the Fed ceased to track and publish the M3 money supply number (the broadest monetary aggregate). It is the inflation rate that today’s central bankers want to target, not the supply of money.

Anti-monetarists point out that the relationship between monetary growth and inflation has broken down. Inflation is low nearly everywhere. The latest figure for the annual growth in core consumer prices is just 2.3% in the United States, down from 3.8% in May. But the annual growth rate of M3 -- which diehard monetarists have continued to track unofficially -- is just under 10%.

Yet simply because consumer price inflation has remained low does not mean that money is irrelevant. On the contrary, it is the key to understanding the world economy today. For there is nothing in Friedman’s work that states that monetary expansion is always and everywhere a consumer price phenomenon.

In our time, unlike in the 1970s, oil-price pressures have been countered by the entry of low-cost Asian labor into the global workforce. Not only are the things Asians make cheap and getting cheaper, competition from Asia also means that Western labor has lost the bargaining power it had 30 years ago. Stuff is cheap. Wages are pretty flat.

As a result, monetary expansion in our time does not translate into significantly higher prices in shopping malls. We don’t expect it to. Rather, it translates into significantly higher prices for capital assets, particularly real estate and equities.

No one can say for sure what the consequences will be of this new variety of inflation. For the winners, one asset bubble leads merrily to another; the key is to know when to switch from real estate to paintings by Gustav Klimt. For the losers, there is the compensation of cheap electronics. Why worry when China is willing to buy any amount of U.S. dollars the Fed cares to print in order to keep its currency from appreciating and its exports cheap?

Last week, the People’s Bank of China announced that its international reserves had reached the dizzying figure of $1 trillion, 70% of which is held in dollar notes and bonds. If you were wondering where all the money went, that’s part of the answer. Unnerving, isn’t it?

No, the theorist may be dead, but long live the theory.

“Inflation is always and everywhere a monetary phenomenon.” It’s true, no matter what is inflating.