There is a consensus that monetarism, as applied in the English speaking economies in the early 1980s, was a failure, and criticism of the attempts to apply it has led monetarists to distance themselves from the actions taken in their name. Many opponents of monetarism would argue that the costs incurred by the reduction of inflation in the early 1980s were exceptionally high and that the policy should not have been tried. In this essay, however, I intend to concern myself more with the criticism made by policy-makers, not that monetarism was too costly, but that it proved impracticable because the relationships on which monetarism relied turned out to be unstable. In their turn, monetarists replied that their policies had not been implemented as they had advised. In this essay, I will describe that debate, focussing on both the choice of targets and the instruments used.
In order to implement a monetarist policy, the government must set a target for some measure of the money supply and pursue this target through some policy instrument interest rates, monetary base operations or regulation of the financial sector. It is necessary that there should exist (i) a stable relationship between the measure of money chosen and the price level, and (ii) a predictable relationship between the monetary aggregate in question and the instrument used to influence it. Most of the debate between monetarists over the means of controlling inflation reduces to finding instruments and aggregates which obey these two criteria.
Particular debate has taken place over point (i): which monetary aggregates have a stable relationship with the price level? Instability of this relationship can be attributed to three main causes. Firstly, the relationship is stochastic and when implementing such a policy one must allow for errors in an individual year. Secondly, even in the long term V may be unstable due to institutional changes which affect the money demand function. Thirdly, some monetary aggregates may not cause changes in the price level and may in the past only have exhibited a stable relationship with PY because the causality went the other way. The problem in implementing monetarism is to trade off the instability caused by institutional change, which mainly affects broader measures of money, against the instability caused by the absence of causality, which mainly affects narrower measures. Many of the failures of supposedly monetarist policies in Britain and the US in the 1980s can be attributed to one or other of these problems.
A broadly stable velocity was observed for [[sterling]]M3 through the 1960s and 1970s, rising slightly over time. It was thought to have a predictable relationship with inflation. However, it turned out not to have when tried for policy. The target was overshot in every year except 1982-3, and yet inflation turned out to have fallen dramatically. In the early 1980s, narrower monetary indicators were showing that policy was far tighter than [[sterling]]M3 indicated. By 1983, it was clear that the velocity of circulation had fallen rapidly as soon as policy began to be applied. Many conservatives, who had hoped for a more gradual approach to the reduction of inflation, blamed the breakdown in stability for the overtightness of policy. Unemployment in Britain rose from 1.3m to 2.2m in 1980. But monetarists had always warned there would be short-term costs and output and employment would recover later. A more serious criticism, from their point of view, was advanced by the monetary authorities: that monetarism was impossible to apply.
In the US, the Federal Reserve attempted to implement monetarism between 1979 and 1982. They targeted the narrow monetary aggregate M1 through a form of Monetary Base Control (MBC). MBC entailed controlling the money supply through the non-borrowed reserve base rather than short-term interest rates. Although the year-on-year M1 targets were met, this policy was unsuccessful, since (i) the volatility of different measures of the money supply actually increased and (ii) as in Britain, the velocity of circulation fell. Inflation was thus reduced more quickly than expected and monetarists were blamed for the resulting recession. The theme of this essay, however, is to focus on the debate within monetarism. The Federal Reserve concluded that monetarism was impracticable and reverted to controlling borrowed reserves. In Britain, Canada, the US and Austrailia previously stable velocities all broke down in the early 1980s. The reason for this breakdown is the source of the controversy between policy-makers and theorists.
Why did such instability not show up in Friedmans and Schwartzs work; on which the assumption of the stability of V was based? Did money demand functions only begin to be unstable in the early 1980s? An explanation is provided by Laidler. He notes that Friedman and Schwartz used definitions of monetary aggregates which incorporated institutional changes, rather than representing them as a separate term in the model they were testing. So stability of V in the face of money demand changes depends on the definition of monetary aggregates. It should be said, however, in Friedmans defence, that velocity of circulation changed far more slowly over the period he tested than when monetarism was applied.
The monetarists also blame the Fed for shifting the relationship between M and P. They claim that intervention by the Federal Reserve, in the form of deposit rate ceilings, shifted the money demand function. In addition, they claim that the instability of the money supply growth, which they attribute to the Fed (see above), caused uncertainty among the public and induced them to demand more of M1. Both these effects on M1 imply increases in speculative demand but not in transactions demand, and so the relationship between inflation and the monetary aggregate in question was shifted.
American monetarists regard the British experiment with incredulity. The choice of instrument was the biggest difference between monetarism as espoused in Chicago and as practised in Britain. Friedman said that when one does not know the interest-rate sensitivity of money demand, MBC is a more precise instrument than the interest rate. The Americans did not recognise as monetarism the use of interest rates to control inflation. The instrument is a very ambiguous one theoretically. If one is using the interest rate, it can be argued that one is controlling the money stock through reducing money demand not money supply, which is not a monetarist policy since it assumes that the money stock is supply-determined.
The second criticism made by the monetarists of policies used in Britain and the US was the choice of aggregate. Friedman claimed that the Feds M1 target was broader than, and thus conceptually different from, the M1 used in his empirical work with Anna Schwartz. As a result it contained much money not used for transactions purposes, and did not have a stable link with inflation. In general, broader aggregates are more subject to shifts in money demand. He says the Feds M2 was conceptually equivalent to his M1, and its M1 to his M0.
Likewise in Britain the choice of aggregate was condemned by US monetarists as being too broad. A narrower measure would have been stabler. Friedman, testifying to a British Treasury Committee, said he had little hope for monetarism as it was being practised in Britain. In his memoirs, Nigel Lawson records the contempt of the Swiss-American monetary expert Karl Brunner for your M3. It was because [[sterling]]M3 was so ill-defined conceptually that its velocity of circulation is unreliable. The uncertain effect of interest rates on [[sterling]]M3 was due not to financial innovations but to the choice of an aggregate which contained a lot of money used for savings and with no clear link to transactions. Many of the effects of high interest rates on [[sterling]]M3 could have been predicted, claimed monetarists.
Is the monetarists defence plausible? Friedman can reasonably argue that what was applied in Britain was nothing like monetarism as he knew it. The aggregate was far different conceptually from anything he had recommended targeting and the use of the interest rate had never been advocated at all. (British monetarists, of course, like Alan Waters and Patrick Minford, have no such defence, since they initially supported the policy). In the United States the targeted aggregate was a lot narrower, and the criticism here looks a bit weak. Whether the American breakdown was the monetarists fault depends on the technicalities of MBC, and a conclusive answer to this question will only come if full MBC is applied. However, we can conclude from this debate that the reformulated monetarist position is as follows: to target a narrow aggregate and to use MBC to do so.
Lawson is aware of this criticism, but in his memoirs rejects it in terms which make one doubt whether he believes in monetarism at all. He claims that M0s value was as an indicator of movements in nominal GDP. But such policy rests on the assumption that causality runs from PY to M, and this is not monetarism, but Keynesianism. The essence of monetarism is that changing the money supply changes nominal income and not the other way around. To summarize, either Lawson was using M0 as a target or he was targeting nominal income directly through interest rates. The former would inevitably fail, and targeting of M0, say Pearse and Tysome, may have impaired its efficiency as a predictor of inflation. ( Lawson himself records that a ... serious shortcoming was the failure of M0 to give a true picture...in early 1988 the beginning of the boom.) The latter policy conflicts with the basic tenets of monetarism, of which the raison detre is that the authorities cannot know in time what is happening to output.
MO was mistakenly used as a narrow aggregate because British monetarists had followed American monetarists in advocating a narrow target. However, the Americans were advocating that the target should be the monetary base itself (either reserves or reserves plus cash in circulation) which, unlike MO in the British financial system, has a clear causal relationship with nominal income through the multiplier.
In my opinion, the monetarists place far too much importance on excluding discretion from government policy. The argument that discretion reduces agents confidence in the policy is flawed. It seems clear that what changed inflationary expectations in Britain and the United States was the recession, not the perception that the authorities were adhering to rules for monetary growth. Only the financial markets would have the sophistication to make the esoteric distinction between voluntarily committing oneself to rules and changing those rules to allow for changing circumstances. What matters to wage-setters is whether or not the authorities mean business on inflation.
The second monetarist argument in favour of fixed rules is that the authorities do not have the knowledge or the timing to offset shocks. The expectation of income is its trend value and there having been a shock to income in a previous period does not affect its expected value in the next period. Therefore, there is no point in the government reacting one period late. But although this is true of shocks to income, it does not hold for changes in money demand. Institutional change does not fluctuate around a certain value. Once a change is made, it applies to money demand in the future as well as the present. Therefore it may be possible for the government to react after the change has taken place and for this reaction to be of some use. When it comes to government action to correct for institutional change, lags are a nuisance but not at all fatal.
I believe the example of the Swiss and German authorities is the most hopeful for the future prospects of monetarism. They have often made important changes of target once they observed shifts in velocity, but they have successfully pursued monetary growth rules since the 1970s. The Swiss have varied between Monetary Base Control and short term interest rates as instruments; the Germans changed from a narrow to a broad aggregate; both changed the targeted growth rates frequently. Yet because it was done responsibly and credibly, it worked.
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