The Retreat from Monetarism

J.R. Shackleton

At the end of the Seventies, having received both a Nobel Prize and the still greater accolade of his own TV series, a diminutive retired professor from Chicago became for the moment one of the most influential private individuals in the world. Fêted by financiers, mobbed by the media, patronised by presidents and prime ministers, Milton Friedman had at last arrived. The doctrine for which he had fought – initially almost single-handedly – for a quarter of a century had become the New Orthodoxy. Monetarism had overthrown discredited Keynesianism, and nowhere was its victory more warmly welcomed than at Numbers 10 and 11 Downing Street.

Yet today things look a little different. Despite more than six years’ declared commitment to monetary discipline (even longer if we include the half-hearted efforts of Denis Healey), the UK inflation rate remains stubbornly above that which the Government wishes to see. Meanwhile unemployment, which was only expected to rise temporarily, has been stuck at pre-war levels for four years or more, and shows no real sign of falling. Moreover measures of the money supply – supposed indicators of the monetary stance of the Government – are all over the place. Some over-predict the inflation rate; some under-predict it. In the United States, on the other hand, a theoretical commitment to monetarism has gone hand-in-hand with a fairly permissive monetary policy and an outrageously lax fiscal policy. This combination should, in Friedman’s framework, have produced disaster. However, the performance of the American economy continues to make those on this side of the Atlantic turn green with envy.

Small wonder, then, that the Chancellor has back-pedalled. In his Mansion House speech this autumn he effectively abandoned the sterling M3 target which had been the central indicator of monetary policy since the Thatcher Administration came to power. And behind the smokescreen of the receipts from privatising everything that isn’t tied down, it is suggested that he intends to produce an old-fashioned reflation timed nicely for the runup to the next election (much to the disgust of his erstwhile supporters at the Centre for Policy Studies, who have recently denounced him as a turncoat).

But this is not simply a case of politicians running away from the task of administering a harsh but necessary medicine to an increasingly fractious and disagreeable patient. For it’s clear that the doctors clustering around the patient’s bedside are less and less confident that the Friedman medicine is the panacea they had been led to expect. Some are muttering that they had always believed monetarism to be a quack remedy anyway and offer their own nostrums instead. Others, while still holding that the medicine is of therapeutic value, now argue that it can only be a part of the recovery regimen.

So what’s it all about then? In order to get some idea of the reasons for this retreat from the pristine certainties of monetarism, we have first to clarify what the doctrine entails.

Friedman’s monetarism, remember, is a modern restatement of a very old idea: the Quantity Theory of Money. This theory, clearly present in the work of David Hume and David Ricardo, was formalised in the work of Alfred Marshall, A.C. Pigou and Irving Fisher at the beginning of this century. With the rise of Keynesianism, however, the primary lesson of the old-time religion – crudely, that price inflation is caused by an increase in the money supply – fell into disfavour. This was because Keynesians thought that the velocity of circulation (the frequency with which money changes hands) would alter in response to interest-rate changes brought about by changes in the money supply. If this occurred, there was no need for the price level to alter. Friedman accepted that changes in the interest rate on bonds could in principle affect the velocity of circulation. But he pointed out that this is also true of the rate of return on all other assets, and that there is no reason to suppose that interest rates alone will have all that significant an impact. In any case, this is an empirical question, and Friedman has always been a keen advocate of testing hypotheses. His econometric work, and that of his colleagues over many years, culminated in his monumental Monetary Trends in the United States and the United Kingdom, co-authored with Anna Schwartz and published in 1982. This body of work suggested that the velocity of circulation, although varying over the business cycle, is in the long run fairly stable. In particular, it is more stable than the value of the Keynesian multiplier. This implies that monetary policy is more powerful than the fiscal policy espoused by Keynesians, and that monetary disturbances are more likely to destabilise the economy than are independent changes in consumption or investment.

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[*] A Guide to UK Monetary Policy by Paul Temperton offers a detailed examination of UK monetary targets (Macmillan, 165 pp., £25, 30 January, 0 333 39280 9).