Authors: David Smith
Free Lunch (19 page)
Whatever happened to monetarism?
There is plenty more that could be said about money but it is nearly time to move on. There is one more set of guests to entertain us, and we should not keep them waiting too long. Since one of them is Milton Friedman, however, we should briefly address one question. Why is monetarism, so much in vogue in the 1980s, now barely mentioned?
The roots of monetarism go back to the birth of modern economics. Its central tenet is simplicity itself. The faster the growth in the amount of money in circulation the more rapid, other things being equal, the rate of price rises – inflation. David Hume, a contemporary of Adam Smith, wrote in his 1750 essay ‘Of Money’ about the effects of an increase in the quantity of money in circulation: ‘At first, no alteration is perceived, by degrees the price rises, first of one commodity, then of another, till the whole at last reaches a just proportion with the quantity of specie which is in the kingdom.’ The language is a little archaic but the message is relatively clear, although Alfred Marshall, Keynes’s Cambridge teacher, perhaps put it a little more succinctly 150 years later. ‘If everything else remains the same,’ he wrote, ‘then there is this direct relation between the volume of currency and the level of prices, that if one is increased by 10 percent, the other will also be increased by 10 percent.’
Until 1914 few economists challenged the basis of monetarism, the quantity theory of money. The pre-First World War gold standard, under which paper money was backed up by and convertible into gold, both underlined money’s preeminence as an economic lever and institutionalized monetarist-type arrangements. Under the gold standard unreliable politicians and central bankers were constrained from expanding the money supply too rapidly. It was something of a monetarist paradise.
So what happened? Two things – Keynes and the Great Depression. Keynes emphasized the power of fiscal policy and explained how monetary policy could lose its effectiveness – it could be as effective as ‘pushing on a piece of string’. As importantly, there was a real-life example in America during the depression years. Actually, there was a good monetarist explanation for the depression and deflation (falling prices) of the 1930s. America’s Federal Reserve, in a lesson imprinted indelibly on the minds of every subsequent Fed chairman, allowed too many banks to fail, producing a sharp contraction in the money supply. Interestingly, one big debate at the time of writing is on how to rescue the Japanese economy from its long slump and deflation. Having tried the Keynesian remedy, with repeated public works programmes, Japan may have to opt for a monetarist one – a big expansion of money and credit.
In some countries monetarism did not go away at all, in others it did so only temporarily. In the 1950s, when the legendary Bundesbank came into being, it used a combination of a monetarist approach and the German folk memory of two hyperinflations to achieve more than forty years of low inflation. Britain and America were much keener on the Keynesian approach and on ‘fine-tuning’. It took until 1979 and the election of Margaret Thatcher for a British government to embrace monetarism willingly and then, as noted above, with mixed results.
Was monetarism right or wrong? Few economists would dispute that there is a relationship between the money supply and inflation, although many would question whether that relationship could ever be precise. For one thing, the speed money circulates at around the economy (the technical term is ‘velocity of circulation’) will affect the pass-through from money to inflation. For another, the lags between changes in the money supply and inflation are, as monetarists concede, ‘long and variable’. The link between money and inflation can also be affected by changes in the financial system and in the use of money. A rapid shift towards a cashless society would not mean there was no useful message in the rate at which cash is growing, but it would mean that such information would need to be interpreted with care. Others would argue that there is nothing magical about the link between money and inflation. When the economy is picking up, one of the first things to happen is that individuals and companies start to borrow more. Measures of the money supply therefore start rising, ahead of any increase in inflation. The driving force of inflation is faster growth in the economy, not faster money supply growth. Every year there is a big rise in the money supply in the autumn, the critics of monetarism say, which is followed by a frenetic bout of Christmas shopping. Nobody, however, would pretend that the increase in the money supply has ‘caused’ Christmas.
We’ll leave them to argue this out. The point is that, in setting interest rates, most central banks these days take note of what is happening to the money supply but are not slaves to it. The idea that monetary policy could operate on automatic pilot – simply set targets for the money supply and make sure you stick to them – has been discredited. Money matters, but so do plenty of other things.
Time to move on. Readers may have noticed that, with the exception of the occasional sideways glance at the French and the bulky presence of the German-born Karl Marx, British economists have dominated. All that, sadly, is about to change. Britain in 1945 discovered that she had not just lost an empire. She also lost her dominance of economics to the new superpower, America.
Why did economics come to be dominated by America, and Americans, after 1945? With Europe ravaged by war and oppression, America’s universities became a haven for European intellectuals displaced from their homelands. This was not just true in economics, of course, but it provided a significant boost for the subject. America, too, had fewer hang-ups about economics, which perhaps has something to do with the nature of its society. In Britain economics had a long battle against intellectual snobs who insisted that it was not quite a proper subject. Eric Roll, in his
A History of Economic Thought
, sees it as a natural consequence of Britain’s displacement as a global economic power:
It is not surprising that the relative preponderance of English economic thought should decline once England ceased to be the only important capitalist country. Nor is it surprising that the emergence of the United States as the leading capitalist country should have coincided with a very considerable increase of American theoretical activity. Today the accumulated and current output of American economic literature is vast; and it is only barely an exaggeration to say that the study of economics, as we have become accustomed to it over the last hundred years, has its most congenial home in the United States.
America’s modern-day control of economics is not in doubt. The Nobel Prize for economics (strictly, the Swedish Central Bank prize, judged by the Nobel Committee), was instituted in 1969. At the time of writing, forty-nine economists had won it (some sharing with others). America’s dominance is underlined by the fact that thirty-two of these were American. Britain, incidentally, is in second place with seven Nobel laureates in economics, followed by Sweden and Norway, with two each, and Canada, India, France, Russia, the Netherlands and Germany, each with one. Canada’s winner, incidentally, was Robert Mundell, who has plied his trade in US universities and is often thought of as American. America’s prizewinners have included Milton Friedman, Paul Samuelson, Kenneth Arrow, Herbert Simon, Robert Solow, Gary Becker, John Nash and Robert Lucas.
From an early stage in America there were few doubts about the value of economics, although the determination of many practitioners of the subject to turn it into a fully fledged, mathematically based science also meant that it became very different from the ‘political economy’ of most of the classical British economists and even their twentieth-century successors. This is not to say America invented mathematical economics – Alfred Marshall’s approach was highly mathematical – but American economists developed it. It is not to say, either, that there were no great American economists before 1945. One was John Bates Clark (1847–1938), whose work on wages and income distribution, and in other areas, followed the ‘marginalist’ approach of, for example, Britain’s Marshall. Better known these days, however, is one of the greatest of all, Irving Fisher (1867–1947).
Fisher and money
Irving Fisher, to some the best American economist ever, was a fascinating character. He became a millionaire not through economics but through inventing for his own use, and patenting, the index card system we now know as the Rolodex. Fisher set up a company to manufacture it, sold it on, and by the 1920s was sitting on a fortune. Unfortunately, such was his belief in the ‘new era’ for the American economy of the 1920s – something like the new economy of information technology of the 1990s – he failed to see the 1929 crash coming. ‘Stock prices have reached what looks like a permanently high plateau,’ he wrote in mid-October 1929. His reputation and his fortune suffered when the market crashed, and he never really recovered.
Fisher’s two big contributions were on the way we think about the rate of interest and, in particular, money. Two books,
The Rate of Interest
in 1907 and
The Theory of Interest
in 1930, established what became the conventional framework for thinking about interest, which as he put it in the earlier book ‘is an index of the community’s preference for a dollar of present income over a dollar of future income’. The higher the rate of interest, in other words, the more we will be prepared to forgo spending now in favour of spending later. This time aspect was crucial. It explained why, in normal circumstances, real (after-inflation) interest rates have to be positive – otherwise any money saved is eroded in value by inflation. The ‘Fisher equation’ showed that the level of interest rates at any one time was made up of the real interest rate plus expected inflation. Fisher also demonstrated the role of interest rates in investment decisions, and how different rates could alter the ranking of, say, competing projects, depending also partly on the payback period for such projects.
His most famous contribution was, however, what is known as the quantity theory of money (sometimes called the ‘Fisher identity’ or, confusingly, the ‘Fisher equation of exchange’). This may be the point to relax the ‘no equation’ rule of this book just once more. Thinking back to the monetarism of the previous chapter, Fisher turned what had essentially been an often wordy and imprecise description of the relationship between money and prices into something that modern economists can use. The quantity theory is simple enough: MV = PT. In it, M is the amount of money in circulation (the stock of money), V is the speed, or velocity, at which it circulates around the economy. P is the level of prices and T the number of transactions. On the simplifying assumption that V is fairly constant and T does not change much either (assumptions, it should be said, that have caused monetarists a lot of trouble), a change in M – the stock of money – results in a change in P, prices. As Fisher put it: ‘The level of prices varies in direct proportion with the quantity of money in circulation, provided that the velocity of money and the volume of trade which it is obliged to perform are not changed.’ Control money and you will control inflation. This, of course, was the basis both of Margaret Thatcher’s monetarism and the version pursued in America under Ronald Reagan in the early 1980s by Paul Volcker at the Federal Reserve Board.
The Keynesian economist as bestseller – Paul Samuelson
As any author does, I have high hopes for this book, but I can safely predict that it will not sell as many copies as Samuelson’s
Economics
. It was first published in 1948, when he was thirty-three, and has been through numerous editions since. There can be few students of economics, business studies or other related subjects who have not pored over a copy. ‘
Economics
was destined to become the most successful textbook ever published in any field,’ writes Mark Skousen, in his
The Making of Modern Economics
.
Sixteen editions have sold more than four million copies and have been translated into over forty languages. No other textbook, including those of Jean-Baptiste Say, John Stuart Mill and Alfred Marshall, can compare. Samuelson’s
Economics
survived a half-century of dramatic changes in the world economy and the economics profession: peace and war, boom and bust, inflation and deflation, Republicans and Democrats, and an array of new economic theories.
Other textbooks have come and gone. British students of my generation will recall Richard Lipsey’s
An Introduction to Positive Economics
. Later students will have benefited from one of the many editions of Begg, Dornbusch and Fischer’s
Economics
. Samuelson, however, provided the template. He may have been lucky with his bestseller. It emerged when there was a gap in the market, none of the existing textbooks of the time having caught up properly with Keynesian economics. It started life as course notes for students at Harvard and MIT (Massachusetts Institute of Technology), the latter institution being where Samuelson made his name. He was, however, much more than someone who just popularized Keynes. Like other eminent American economists such as Alvin Hansen, one of Samuelson’s teachers, he gave us what became known as the Keynesian framework. This was not just a question of interpretation. In his
General Theory
of 1936, Keynes was often imprecise and contradictory. The American Keynesians, in particular, made it coherent.
They also made it very mathematical. Samuelson was a noted mathematician, like most of the top post-war American economists, and made no secret of his view of the shortcomings of Britain’s ‘literary’ tradition of economic exposition. If economics was to be regarded as a grown-up science, it had to start using the language of science. What this meant, of course, was that academic economics became a closed society with its own in- built restrictive practices – anybody who did not understand the language and code could not hope to enter. Articles in economic journals became impenetrable to even the intelligent layman, although Samuelson would argue, correctly, that this was not the case for his textbook.
Samuelson gave us in diagrammatical and equation form what most would recognize as standard Keynesian analysis, using the national income identity (otherwise known as the most useful equation in economics). This is the one from back in our main course that shows that gross domestic product consists of consumer spending, investment, government spending and net exports (exports less imports), in other words Y = C + I + G + X - M. He also developed the consumption function – consumer spending rises in proportion to income – and other underpinnings of Keynesian economic policy. Keynesian policy was, in essence, that on the many occasions when the market fails to generate full employment, the government should do so. Samuelson advised John F. Kennedy during his 1960–63 administration. A couple of examples of his contributions are worth pulling out. One is the paradox of thrift, referred to in Keynes’s
General Theory
but only properly developed by Samuelson. This was that, while additional savings to fund productive investment would normally be regarded as unequivocally good, that extra saving, if it reduced consumption and therefore aggregate demand, could be damaging, even to investment. If all businessmen see is a slowing economy because people are saving more and spending less, why should they invest?
Another of his contributions, the ‘balanced budget multiplier’, shows the subtlety of Keynesian economics at work. A balanced budget implies that the government is neither adding nor subtracting from demand in the economy. Government policy is neutral. But Samuelson demonstrated that whether or not it was neutral depended on the detail of the government’s fiscal policy. A government that introduced ‘tax and spend’ policies, raising tax to increase public spending by the same amount would, while still sticking to a balanced budget, boost the economy. How so? Because government spending provides the economy with a greater stimulus – it goes directly into extra demand for goods, services and people. Tax, however, is subject to various ‘leakages’, for example into savings or imports. Thus £1 billion spent by government will, through the multiplier, have a bigger impact than £1 billion used for tax cuts. By implication, £1 billion raised through extra taxes and spent on public services will provide a net stimulus.
Such thinking is no longer fashionable, although it still has its followers, not least those who grew up on Samuelson’s textbook. But it was hugely influential in the 1950s, 1960s and much of the 1970s.
Friedman and the backlash
There was a time, not so long ago, when the entire economic debate could be characterized as a battle between monetarists and Keynesians. As bitter as any religious dispute or deep-seated sporting rivalry, there was a schism that ran right through the economics profession. Pragmatism may be the fashionable and appropriate position to adopt now but in the 1980s that was not allowed. Either you were a monetarist or you were a Keynesian, and never the twain did meet. In 1981, famously, 364 Keynesian economists from British universities signed a round-robin letter claiming that Margaret Thatcher’s monetarist policies would result in economic disaster. In America the battle was just as bitter. The Keynesians were seen as smug, prosperous, Ivy Leaguers who did not care that the policies they were advocating would ultimately result in inflation. Critics argued that by promoting a bigger role for government, they were also coloured with a pinkish political tinge. The monetarists, in contrast, came from outside the establishment. They fought a guerrilla campaign against the prevailing Keynesian orthodoxy, with their belief not only in sound money but also in free markets and small government. They were terrier-like, and none more so than Milton Friedman.
Friedman, born in Brooklyn in 1912 to poor, first-generation Jewish immigrant parents, nearly did not become an economist at all, lack of money threatening to cut short his studies. Fortunately he was able to persevere, and fortunately too, he found himself at the University of Chicago. The Chicago school of economics, like the Austrian school associated with important names such as Ludwig von Mises and Friedrich Hayek, to whom there is sadly not enough space in this book to do justice, kept the free market/sound money tradition going at a time when it was in danger of being snuffed out. Half the world was pursuing versions of Marxist economics, while the other half was, to free market thinkers, following a course that was nearly as dangerous, that of far-reaching government intervention. Through economists such as Henry Simons, Lloyd Mints, Frank Knight and Jacob Viner, Chicago in the 1930s and 1940s, stood as a bastion against the Keynesian thinking sweeping the world of economics.
