Monetarists Fail History, Time and Again

MonetaristsFailHistory, Time andAgain

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.

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