Wednesday, August 7, 2013

Monetarists Fail History, Time and Again

Certain supporters of monetarism are telling me in the comments on my last post that the central bank can indeed directly control the broad money supply.

Well, that was news to Milton Friedman as reported in a 2003 interview:
“... prepare to be amazed: Milton Friedman has changed his mind. ‘The use of quantity of money as a target has not been a success,’ concedes the grand old man of conservative economics. ‘I’m not sure I would as of today push it as hard as I once did.’”
Simon London, “Lunch with the FT – Milton Friedman,” Financial Times, 7 June 2003.
I imagine Friedman had in mind the quasi-monetarist experiments of Paul Volcker and Thatcher. Both attempted to control the growth rate of the money supply – and both failed and resulted in disaster.

In the case of Paul Volcker, he adopted a monetarist policy at the Federal Reserve in October, 1979. He gave up direct targeting of the federal funds rate and instead wanted to control the growth rate of M1 by directly targeting the growth rate of nonborrowed-reserves. According to the quantity theory, the central bank had the power to exogenously set the money supply and thus control inflation. But the result was a catastrophe. The Federal Reserve was utterly unable to achieve its reserve target or M1 target. In October 1982, Volcker abandoned monetarism and returned to a discretionary interest rate policy.

Thatcher’s monetarist experiment involved the Medium Term Financial Strategy (MTFS) from May 1979 to the mid-1980s. The MTFS stressed the monetarist idea that inflation is (supposedly) caused by excessive money supply growth, but the twist in Thatcher’s monetarist thinking (or really that of her advisers) was that the excess money supply growth in Britain was caused by government deficits through borrowing from the banking system.

The first flaw in this ideology was the notion of a straightforward direction of causation from money supply growth to the price level. In fact, money supply growth is, generally speaking, a consequence of real economic variables such as credit growth and the rising prices of factor inputs. Secondly, although there was some British government borrowing from the banking system, bond purchases in the UK tended to be made by the non-bank private sector (Stewart 1993: 49). Michael Stewart notes that the empirical evidence from the last years of the 1970s shows that 98% of government borrowing was from the non-bank private sector and not directly from the banking sector (Stewart 1993: 49–50).

Further proof of the incompetence of the strange form of British monetarism pursued under Thatcher was its focus on the broad money stock M3. The Medium Term Financial Strategy (MTFS) prescribed targets for the growth rates of M3, but, during the first three years of Thatcher’s rule, M3 grew by around 50% per annum, which was twice as much as the government’s targets (Stewart 1993: 50). A further perverse effect of the rise in UK interest rates was to cause the selling-off of long term financial assets and the shift of the money into interest-bearing bank deposits – which of course caused the growth rate of M3 to soar! (Stewart 1993: 50).

But, of course, it would be too much to expect fans of monetarism to learn some history, wouldn’t it.

Stewart, Michael. 1993. Keynes in the 1990s: A Return to Economic Sanity. Penguin, Harmondsworth.


  1. Excellent Lord Keynes! It´s very strange position that Friedman and his followers have.I mean their rather isolated even among
    neo-classicals in their view about Quantity Theory i think.An oddity i guess,i mean the debate about QTM started allready by the controversy between Knut Wicksell and Irving Fisher (and probarly earlier by others essentally) and later with Patemkin cotroversy and the debate between the Keynsians of different flavors and even other schools and monetarists on one side there
    in large the "Keynsian" of different flavors was rooted in some way to Wicksell´s spirit and Friedman et consortes held the more narrow view of Irving Fisher.
    I don´t really now that much of the views of the Market monetarist etc,do you know their position on QTM,Lord Keynes??Interesting to se that Friedman change his mind in old age!
    Well this is something of Wicksellian view and qritique of "Fisherite" position that Friedman more or less followed.

    "Knut Wicksell's theory of the "cumulative process" of inflation is an early decisive swing at the idea of money as a "veil".The start of the Quantity Theory's mechanism is a helicopter drop of cash: an exogenous increase in the supply of money. Wicksell's theory claims, that increases in the supply of money leads to rises in price levels, but the original increase is endogenous, created by the conditions of the financial and real sectors.
    With the existence of credit money, Wicksell claimed, two interest rates prevail: the "natural" rate and the "money" rate. The natural rate is the return on capital - or the real profit rate. It can be considered to be equivalent to the marginal product of new capital. The money rate, in turn, is the loan rate, an entirely financial construction. Credit, then, is perceived quite appropriately as "money". Banks provide credit, after all, by creating deposits upon which borrowers can draw. Since deposits constitute part of real money balances, therefore the bank can, in essence, "create" money.

    Wicksell's main thesis, the disequilibrium engendered by real changes leads endogenously to an increase in the demand for money - and, simultaneously, its supply as banks try to accommodate it perfectly. Given full employment, (a constant Y) and payments structure (constant V), then in terms of the equation of exchange, MV = PY, a rise in M leads only to a rise in P. Thus, the story of the Quantity Theory of Money, the long-run relationship between money and inflation, is kept in Wicksell. Wicksell's main thesis, the disequilibrium engendered by real changes leads endogenously to an increase in the demand for money - and, simultaneously, its supply as banks try to accommodate it perfectly.
    Primarily, Say's Law is violated and abandoned by the wayside. Namely, when real aggregate supply does constrain, inflation results because capital goods industries cannot meet new real demands for capital goods by entrepreneurs by increasing capacity. They may try but this would involve making higher bids in the factor market which itself is supply-constrained - thus raising factor prices and hence the price of goods in general. In short, inflation is a real phenomenon brought about by a rise in real aggregate demand over and above real aggregate supply."

    It´s written lot about it for sure,
    Axel Leijonhufvud,The Wicksell Connection: Variation on a Theme
    and in
    Boianovsky, Mauro, Erreygers, Guido (2005), Social comptabilism and pure credit systems. Solvay and Wicksell on monetary reform, in : Fontaine, Philippe, Leonard, Robert, (ed.), The experiment in the history of economics, London, Routledge.

  2. You really like to flog dead horses, dont you LK? Again, nobody cares about the "old monetarism" anymore. It didnt fail because its impossible for a CB to hit those targets. The CB uses OMP's open market operations) to increase or decrease the monetary base as needed, but we dont care about the MB in itself either. What's important is monetary velocity, or money thats being spent. Again, any central bank can shrink MV, NGDP, or GNP and crush inflation at great cost, which is entirely different than saying its IMPOSSIBLE

    1. Unfortunately the central bank has no more control over monetary velocity than it does over aggregates, unless it has somehow gained the capacity to control tax rates, trade balances and savings desires when I wasn't looking.

  3. And I never said that the CB can DIRECTLY control all money supplies, if i did I misstated myself. What the CB CAN do is to jack up or down interest rates, to use OMP's to increase and decrease the monetary base, which THEN is an INDIRECT lever on the nominal gdp of a certain country

    1. Depending on how the CB's policy is pursued, interest rates and the actual jacking thereof may not precede but rather result from their open market activities. For instance, if the CB doesn't offer interest on reserves, as the U.S. Fed didn't until recently, then even the description you just gave is flawed — if my reading of the above is true to your meaning.

      MB is only a lever in one direction: down. In the other direction, the only pre-emptive action you can take is to continue to raise a ceiling that the economy may not be large enough to reach, anyway. It would still has to grow into it at whatever rate it's bound to. And if you've been raising the ceiling in that fashion, then you'll have to do some backtracking before you get to the point at which the aforementioned downward levering can even happen.

      It's not clear to me that Market Monetarists have a strong understanding of how tightening monetary policy can have the mentioned effect, as all the explanations I've heard from them seem to beg the question wherever possible. It's just an alphabet soup of MV's and PT's, without any clarity as to which M, what V, and why it is that those are taken to be the independent side of the equation, rather than PT.

      V, in particular, is such a nebulous concept. As far as I can see, "measurements" of it are actually derived in the fashion of V = PT/M. So it's just an unstable coefficient drawn from an assumed identity, with no necessary causal value — just like the "money multiplier."

      As if that's not enough of a problem, we also have to consider that most of the money in our economy is credit money, and credit money doesn't "circulate" as such; it operates in an accounting cycle, being generated and extinguished at different points along the continuous sequence of transactions between different bank members. So it's no help at all to speculate about how many times the "total" money supply is spent in a fixed period (as though said supply itself were also somehow fixed). It's just a mess from every angle.

  4. To restate: A CB can hit any target for broad money it wants to. However as the links between broad money and important real variables like inflation and NGDP are weak a sensible CB would not want to target the money supply directly but rather to use control of the money supply to target a real variable (inflation, NGDP, the output gap or whatever.)

    This is precisely what Friedman meant when he said "The use of quantity of money as a target has not been a success,"

    I think the UK experience was not that the monetary targets could not have been hit, but rather that it became evident that hitting them would have been harmful to the real economy (The chosen target was causing NGDP to fall and the economy to move into recession)and so were abandoned.

    1. Statement 1:
      (1) "To restate: A CB can hit any target for broad money it wants to."

      Statement 2:
      (2) This is precisely what Friedman meant when he said "The use of quantity of money as a target has not been a success,"

      How anyone can assert these two propositions as true at the same time, with a straight face, is a mystery.

    2. Just because some thing can be done doesn't mean that that thing will bring desirable results.

      Clearly targeting the money supply directly didn't bring good results , and this is all that Friedman is acknowledging.

      Is that such a complex thing to understand ?

    3. It is generally undesireable when sonething doesn't work, you're correct on that.

  5. On the Volker period:

    Its clear that M1 targets were set during this period and largely missed.

    My take on this is that because there was no clear correlation between the target and observed inflation and GDP growth at the time the target was missed (and eventually abandoned) for pragmatic reasons. Had the fed really wanted to hit the target at all costs it could have done so - however the costs may been bank failures and a deep recession and this was a price not worth paying.

    The fed abandoned monetary targets in 1982 and adopted inflation targets instead. It more or less met its target for the next 25 years. I think it important to understand that a CB could not successfully hit inflation targets if it did not have control over the broad money supply.

    1. That's a circular argument:

      Assertion 1) The Fed can control inflation

      Assertion 2) Inflation is always monetary

      Assertion 3) In an arbitrary period inflation was low

      Assertion 4) Therefore the Fed controls the money supply

      Note this thinking requires us to ignore everything else that was happening in our economy as well as decades of price stability before the inflation targeting of the period you cherry-picked.

    2. You're right Ben, it could be a total co-incidence that a 25-year period of low-inflation just happened to occur during a period when that was the fed's target.

    3. Bob,
      The period of low inflation coincided with the period of insufficient deficits and much higher unemployment than in 1950-1970.

    4. Again you're dodging the point. We had price stability for decades before so-called inflation targeting, yet you chose to leave that data out suggesting inflation only came under control during the "monetarist" period, which is of course absurd. Just about anything can be made to correlate when you cherry pick data sets.

    5. The period of inflation targeting was preceded by 2 decades of rising inflation.

    6. Rob,

      Average inflation 1954-1973 : 2.40%

      average inflation 1983-2013 : 2.89%

      Look also at unemployment, it soared after 1970, no wonder inflation was easier to control. That inflation was as low int he full employment period shows the total failure of the recent paradigm. Most developed countries had unemployment at 2% (!!!!!) prior to 1970.

  6. Although it is quite technical, the book by Urlich Bindseil, head of monetary operations at the ECB is the most thorough and detailed examination of the conduct of monetary policy today and throughout history.

    Obviously it stresses the fact that central banks have an obligation for the smooth functioning of the interbank system and thus run an overdraft monetary system which only allows them to set the price of reserves, not the quantity.

    1. Exactly. No one has less control over quantity than the Federal Reserve because it must necessarily prioritize the short-term interest rate.

  7. My summary:

    1. The private sector’s desire to do business, e.g. borrow, determines the amount of commercial bank created money. That is, commercial banks “lend money into existence” as the saying goes.

    2. Expanding the amount of CENTRAL BANK money is stimulatory (as MMTers have pointed out ad nausiam) if that expansion is effected in such a way as to increase what MMTers call “private sector net financial assets”. That would happen for example if the government / central bank machine simply created new money and spent it into the economy (and/or cut taxes). MMTers actually advocate the latter form of stimulus, as do Positive Money and others.

    3. In contrast, if the amount of central bank money in private hands expands as a result of the central bank buying government debt (as occurs with QE), the effect is far more muted and possibly non-existence. Witness the undramatic effects of QE. The reason is that QE does not change the amount of private sector net financial assets.

    4. Expanding the amount of central bank money, i.e. bank reserves, will influence the amount of commercial bank money where private bank lending is being constrained by shortage of reserves. That would happen if the central bank kept commercial banks short of reserves AND made no attempt to control interest rates. (Have I got No. 4 right?)

    1. On (4), yes, CBs must supply reserves or cause financial system to have shortages. But even here the commercial banks might innovate and find some other asset to act as reserves for interbank clearing, just as pre-1914 commercial banking systems without CBs managed to innovate and accept new reserve assets.

    2. I'm interested in that "pre-1914" stuff. If you've got time, could you cite sources?

    3. Regarding pre-1914, what I mean is that

      (1) in nations with a central bank like the UK the banknotes of the central bank came to be effectively a form of base money and reserves, and

      (2) in systems without a central bank the banknotes or assets of the most powerful or trusted private banks were used *as if* they were base money in final interbank clearing without conversion into gold.

      That is, in nations without a central bank like Canada the banknotes of the “Bank of Montreal” (a sort of de facto central bank, although a private commercial one) were probably being used as reserves.

      More discussion here:

  8. "But, of course, it would be too much to expect fans of monetarism to learn some history, wouldn’t it."

    An otherwise interesting analysis is again ruined by a sneery aside.

  9. Some nice gobbledeegook from monetarist types on here. When a theory like monetarism -- sorry "old monetarism" -- breaks down adherents become incomprehensible and say inconsistent things. You can say what you want about Friedman but he was (mostly) consistent. His modern day followers talk out both sides of their mouths. Very mediocre.

    Here's a nice Wynne Godley quote, by the way:

    "Governments can no more "control" stocks of either bank money or cash than a gardener can control the direction of a hosepipe by grabbing at the water jet."

  10. The monetarists experiment of the early eighties did have one huge positive result - inflation was brought under control in the US and UK during this period.

    However the policy of targeting growth of the money supply directly was not a success as Friedman acknowledged. There is a simple reason for this. The target did not take into account the velocity of money which meant that targeting M1 or M2 had indeterminate results on inflation and GDP, (especially if the target actually had an impact on velocity itself). These variables were very important and closely monitored by the monetary authorities who then tended to fudge the monetary targets in the face of unwanted movements especially in GDP.

    Long before this time monetary theorists including Hayek had recommended stable MV, not stable M and this is what modern monetarists tend to push for.

    I assume that LK and the other post-Keynsian's would be equally sceptically of a CBs ability to hit a NGDP-based target? I think though that there is strong evidence that such skepticism would be misplaced.

    1. Due to a number of factors. One being the massive unemployment that brought down ULCs. No one doubts that unemployment can be created through massive interest rate hikes. Also, move toward natural gas and a falling oil price.

    2. Phillip, I read your post and actually I don't disagree too much with the socio-economic background you described that contributed to the inflation of that time.

      However I'd like to ask you question: If the fed had refused to expand the monetary base during that time do you think the inflation would have occurred anyway to the extent and length of time it did ?

    3. Yes it would have. The Fed do not have control over the money supply. But even if they did new types of credit would have come into existence and velocity would have increased.

    4. The logic of your views appears to be that not only at the ZLB but at all times monetary policy has no effect because whatever policies the CB implements to change the monetary base will be offset by changes in other types of credit and/or velocity.

      Is that a correct understanding ?

    5. No. The central bank has a control over interest rates. Changing the interest rate has effects, albeit ones that are far less linear than what mainstream/Austrian theory applies.

    6. So if the fed had increased interest rates in the 70s would it have reduced inflation ?

    7. To some extent maybe due to the increased unemployment. But a good deal of it would have carried on regardless due to the oil price hikes.

    8. Increased interest rates also mean greater interest incomes to the private sector. The only way to make a case that higher rates must reduce spending is by assuming demand for credit is infinite.

    9. I agree BJ, but you can use high unemployment to destroy worker bargaining power and bring down unit labour costs. The money supply will continue to rise, due to the dynamic you point out, but it may dent inflation (as inflation and money supply growth are not tied in the way the monetarists think).