Monday, February 1, 2010

Monetarism, a Simple Description

Monetarism is an economic theory that is relatively new. It is a theory that sprung up in the 1970's as a new way to fight inflation. It is widely attributed to Milton Friedman who modified Keynesian theory into something different, Monetary theory. There are several popular economic beliefs that can be identified with monetarism. One is the belief that excess money is the definition of inflation.

The fundamental theory of Monetarism is that price stability is its primary focus, using supply of money as its greatest tool, implemented in the form of Federal Reserve policy, monetary policy. Milton Friedman made the now famous claim of monetarism that 'inflation is always and everywhere a monetary phenomenon'. At first, to many economists whose perceptions had been set by Keynesian ideas, it seemed that the Keynesian vs. monetarist debate was merely about whether fiscal or monetary policy was the more effective tool of demand management. By the mid-1970s, however, the debate had moved on when monetarists presented a more fundamental challenge to Keynesian orthodoxy.

Many monetarists sought to resurrect a pre-Keynesian view that market economies are inherently stable in the absence of major unexpected fluctuations in the money supply. Because of this belief in the stability of free-market economies they asserted that active demand management (e.g. increasing government spending) is unnecessary and likely to be harmful. The basis of this belief is that there will be equilibrium between fiscal spending (government stimulus) and future interest rates. In effect, Friedman's model argues that fiscal spending creates as much of a drag on the economy by increasing interest rates as it creates present consumption. As a result, it has no real effect on total demand, merely that of shifting demand.

Naturally, when a new economic theory is created, it is done so in the midst of other theories. Keynesians and Austrians were in the debate during the 70's formation of Monetarist theory. They each used their observations of the policy used in the period of the Great Depression to describe the beliefs that distinguish them. Austrians distinguished themselves with their conclusion that incorrect central bank policy is at the root of large swings in inflation and price instability. Monetarists argued that the primary motivation for excessive easing of central bank policy is to finance fiscal deficits by the central government. Hence, restraint of government spending is the most important single target to restrain excessive monetary growth. Friedman was not a supporter of the Federal Reserve System. In his book, Capitalism and Freedom, he describes the Fed action during the Great Depression this way. "The Great Depression in the United States, far from being a sign of the inherent instability of the private enterprise system, is a testament to how much harm can be done by mistakes on the part of a few men when they wield vast power over the monetary system of a country." He describes his idea of monetary control as course between two popular theories, neither of which is totally acceptable. One "is the belief that a purely automatic gold standard is both feasible and desirable and would resolve all the problems of fostering economic co-operation among individuals and nations in a stable environment." The other idea "is the belief that the need to adapt to unforeseen circumstances requires the assignment of wide discretionary powers to a group of technicians, gathered together in an "independent" central bank, or in some bureaucratic body. Neither has proved a satisfactory solution in the past; and neither is likely to in the future."
Since 1990, the classical form of monetarism has been questioned because of events which many economists have interpreted as being inexplicable in monetarist terms, namely the unhinging of the money supply growth from inflation in the 1990s and the failure of pure monetary policy to stimulate the economy in the 2001-2003 period. Austrian economists criticize monetarism for not recognizing the citizens' subjective value of money and trying to create an objective value through supply and demand.

Something surprising occurs to me as I learn more about the influential economists and the theories they teach. They are all experiments! Some rationalize their validity by using formulas that are provable. But they are still experiments to anybody else. And as is the case of the Austrian School, the Monetarists are not supporters of a Federal Reserve System!