Download The Triumph of Monetarism

The Triumph of Monetarism
J. Bradford DeLong
U.C. Berkeley and NBER
[email protected]
http://econ161.berkeley.edu/
(510) 643-4027
August 14, 1999
Why do we today speak of “New Keynesian” rather than “New Monetarist”
economics? A look back at the intellectual battle lines between
“Keynesianism” and “Monetarism” in the 1960s cannot help but be followed
by the recognition that there is a sense in which one of the two leading
schools of business cycle fluctuations macroeconomics today is misnamed.
We may not all be Keynesians now, but the influence of Monetarism on how
we today all think about macroeconomics has been deep, pervasive, and
subtle.
Of today’s two leading schools of macroeconomics, the New Classical
research program is quickly summarized. It holds that the best way to make
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progress in understanding economic fluctuations is to recognize the
stochastic character of economic growth and attempt to understand the
“cycle” using the same models that we use to understand the “trend” (see
Black (1982), Kydland and Prescott (1982)).
But how do we characterize the second school, the one called “New
Keynesian”? The New Keynesian research program is harder to summarize
briefly. But any list of its key ideas and premises would include the
propositions that:
 The key to understanding real fluctuations in employment and output
is to understand the process by which business cycle-frequency
shocks to nominal income and spending are divided into changes in
real spending and changes in the price level.
 Under normal circumstances, monetary policy is a more potent and
useful tool for stabilization than is fiscal policy.
 Business cycle fluctuations in production are best analyzed from a
starting point that sees them as fluctuations around the sustainable
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long-run trend (rather than as declines below some sustainable
potential output level).
 The right way to analyze macroeconomic policy is to consider the
implications for the economy of a policy rule, not to analyze each
one- or two-year episode in isolation as requiring a unique and
idiosyncratic policy response.
 Any sound approach to stabilization policy must recognize the limits
of stabilization policy—the long lags and low multipliers associated
with fiscal policy; the long and variable lags and uncertain magnitude
of the effects of monetary policy.
But all of these propositions saw their origin in or saw a large chunk of their
development take place in the work of Milton Friedman. The importance of
the stochastic effects of policy in imposing limits on stabilization policy
comes from Friedman (1953a). The importance of thinking not just about
what policy would be best in response to this particular shock but what
policy rule would be best in general comes from Friedman (1960). That
policy should be stabilization policy rather than gap-closing policy was the
principal message of Friedman (1968). Friedman and Schwartz (1963) and
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Friedman and Meiselman (1963) are key moments in the recognition of the
power of monetary policy. And a large chunk of the way that New
Keynesians think about aggregate supply saw its development in Friedman’s
discussions of the “missing equation” in Gordon (1974).
Even those New Keynesians who dissent from some of these five
propositions (I, for example, still cling to the belief—albeit without much
supporting empirical evidence—that policy is as much gap-closing as
stabilization policy) have a hard time denying that they structure how the
New Keynesian wing of macroeconomics thinks about the issues. And it is
hard to find prominent Keynesian analysts in the 1950s, 1960s, or early
1970s who gave these points as much prominence in their work as Milton
Friedman did in his (with Brainard ()) being one of a few exceptions).
So why, then, do we speak of “New Keynesians” rather than “New
Monetarists”? I think that to answer this question we need to look at the
history of what has been called “Monetarism,” and to distinguish between
four different subspecies of Monetarism that have been seen in the century
just past.
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The first subspecies of monetarism was the monetarism of Irving Fisher
(1911): the quantity theory of money, the equation of exchange, and the
determination of the price level. But even though the business cycle analysis
of some believers in this first subspecies of monetarism was subtle and
sophisticated (see Fisher (1933)), the business cycle theory of this first
generation was by and large not. It was exasperation with the monetarist
analyses of events made by his colleagues in the immediate aftermath of
World War II that led one of the very best of this first subspecies of
monetarists—John Maynard Keynes—to declare in his Tract on Monetary
Reform (1923) that the standard quantity-theoretic analyses were of no use
whatsoever:
Now ‘in the long run’ this [way of summarizing the quantity theory:
that a doubling of the money stock doubles the price level] is probably
true.... But this long run is a misleading guide to current affairs. In the
long run we are all dead. Economists set themselves too easy, too
useless a task if in tempestuous seasons they can only tell us that
when the storm is long past the ocean is flat again.
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Milton Friedman does not disagree: in “The Quantity Theory of Money—A
Restatement” Friedman sets out that one of its goals is to rescue monetarism
from the “atrophied and rigid caricature” of an economic theory that it had
become in the interwar period at the hands of analysts like Lionel Robbins
(1934) (see Friedman (1974)). According to Friedman, it was the
inadequacies of this framework that opened the way for the original
Keynesian Revolution: a “dismal picture” in contrast to which “Keynes’s
interpretation of the depression and of the right policy to cure it must have
come like a flash of light on a dark night” (Friedman (1974).
Alongside or slightly later than this first subspecies of monetarism is what
Friedman has always called the Chicago School oral tradition—composed of
those who saw deflation as the source of depression—who blamed monetary
and fiscal policies for “permitting banks to fail and the quantity of deposits
to decline,” and who called for both monetary expansion and large
government deficits to fight depression. Don Patinkin (1969, 1972) and
Harry Johnson (1971) denied that this Chicago School oral tradition existed:
they saw Friedman (1956, 1970, 1971a, 1971b) as using “Keynesian” tools
and insights to provide a retrospective post-hoc theoretical justification for
policies advocated by Simons, Mints, Knight, and Viner that were sensible
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but also free-floating and only tenuously connected with their monetary
theory. Friedman does not completely disagree: “after all, I am not
unwilling to accept some credit for the theoretical analysis,” he says, while
insisting that “The Quantity Theory—A Restatement” does give the flavor
of what he and others who contributed to Studies in the Quantity Theory of
Money had learned at Chicago.
My view is that it has long been sterile to debate whether the kind of
analysis carried out by Viner (1933) (and by Keynes (1923)!) is (as Patinkin
would have it) unjustified by their theoretical framework or is (in
Friedman’s (1956) words) a “subtle and relevant version… of the quantity
theory… a flexible and sensitive tool for interpreting movements in
aggregate economic activity and for developing relevant policy
prescriptions.” It depends what you mean by “theory.” What is worth noting
is, as pointed out by Tavlas (), that this second subspecies of monetarism did
not believe in the stability of the velocity of money, and did not believe that
control of the money supply was easy.
It did not believe in the stability of the velocity of money because the phase
of the business cycle and the concommitant general price level movements
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powerfully affected incentives: economic actors had strong incentives to
economize on money holdings during times of boom and inflation, and to
hoard money balances during times of recession and deflation. These swings
in velocity amplified the effects of monetary shocks on total nominal
spending.
It did not believe that control of the money supply was easy because in the
absence of general deposit insurance fear of bank bankruptcy on the part of
consumers could cause substantial swings in the deposit-currency ratio, and
fear of being caught illiquid on the part of banks could cause substantial
swings in the deposit-reserve ratio. The overall level of the money supply
was as much a product of these two as of the stock of high-powered money
itself—the only thing that the Federal Reserve could quickly control. Indeed,
in Friedman and Schwartz (1963) the monetary forces that cause depression
and boom are as often changes in the deposit-currency and deposit-reserve
ratios as changes in the stock of high-powered money.
Then there is post-World War II monetarism, monetarism-subspecies-three,
classic monetarism. It contains the analysis of the limits of stabilization
policy, the stress on the importance of policy rules, the belief that the natural
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rate of unemployment is inevitably close to the average rate of
unemployment, the belief in the relative potency of monetary policy. It
contains much of what the New Keynesian wing of macroeconomics
believes very deeply today.
But there is another component of classic monetarism: a reaction to the
sources of monetary instability as perceived by monetarism version II.
Friedman’s (1960) Program for Monetary Stability, for example, is a
proposal to change institutions to make simple monetarism—with a constant
velocity of money, and a central bank in direct and immediate control of the
money stock—true. The money stock shifts in response to changes in the
deposit-reserve and deposit-currency ratios? Then require 100% reserve
banking. Then shifts in the deposit-reserve ratio are illegal. And in the
absence of any possibility that banks will be caught illiquid there is no
reason for there to be any shifts in the deposit-currency ratio. The velocity of
money moves procyclically because of monetary shocks that temporarily
boost or subtract from the money supply? Then enforce a constant growth
rate of the money stock: without cyclical fluctuations in the money stock and
in inflation, there will be no reason for cyclical fluctuations in the velocity of
money.
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And classic monetarism contains yet a third current. The work of Karl
Brunner and Alan Meltzer, for example, tends to emphasize the political
economy of monetary policy to a greater extent. They see one great
advantage of a fixed nominal money growth rule as its constraining the
government’s ability to confiscate resources via the inflation tax, and in the
process redistribute wealth. One can fear discretionary monetary policy for
two reasons: it can be conducted incompetently, or it can be conducted
competently by a government with its own objectives different from the
public interest. In Friedman’s hands classic monetarism is more likely to
stress the first; in Brunner and Meltzer’s the second (although these are
differences of degree).
But this three-pronged doctrine of classic monetarism—with its institutional
reform side, its analytical side, and its political-economy side—was not the
“Monetarism” that became a powerful political doctrine in the 1970s. That
was the fourth subspecies of Monetarism.
The fourth subspecies of Monetarism argued not that velocity could be made
stable if monetary shocks were avoided, but that velocity was stable: thus
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the money stock became a sufficient statistic for forecasting nominal
demand. It argued not that institutional reforms were needed to give the
central bank the power to tightly control the money supply, but that the
central bank was the source (in its actions or in its failure to neutralize
private actions) of shifts in the money supply. Thus everything that went
wrong in the macroeconomy had a single, simple cause: the central bank had
failed to make the money supply grow at the appropriate rate.
[Figure 1: M2 Velocity, 1950-2000]
And it was this brand of monetarism that crashed and burned in the early
1980s. The velocity of money turned unstable (but as William Poole ()
argued at the time, why should anyone expect velocity to be unstable when
the rate of inflation was varying so much?). Charles Goodhart’s () law made
itself felt: whatever monetary aggregate was being targeted by a central bank
turned out to be the one with the lowest correlation with nominal income:
controlling the money supply relevant for total spending turned out to be
very difficult indeed. And financial innovation began to undermine the
strength of the money-spending correlation (but as Robert Hall () argued at
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the time, why should anyone expect a tight money-income correlation to be
more durable than the institutional setup that had produced it?).
[Figure 2: Breakdown of the Correlation Between the Growth Rates of
Different Monetary Aggregates, 1960-2000]
But even as Monetarism subspecies four was failing its empirical test,
Monetarism subspecies three was expanding its intellectual hegemony.
University of Michigan Professor Matthew Shapiro passed through the
border of its expansion in the summer of 1981, as he moved from
undergraduate economics at Yale to graduate economics at MIT. At Yale, he
said, the first thing he had been taught was that the “Chicago School was in
error because it”—that is, Friedman, Brunner, Meltzer, and company—
“thought that money affected output.” At MIT, by constrast, the first thing
he learned was that the “Chicago School was in error because it”—that is,
Lucas, Sargent, and Prescott—“thought that money didn’t affect output.”
This sudden change in just why the Chicago School was in error struck him
as a considerable surprise. We can see in it an index of the intellectual
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hegemony exercised by post-World War II monetarism: the name may be
largely gone, but the ideas and principles are very much alive.
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References
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Charles Goodhart ()
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15
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