Abstract
In the rapidly changing contemporary financial environment, economists generally are reluctant to define money. Instead, they have joined the central bankers in playing a numbers game with “monetary aggregates.” Monetarists presume to stabilize the economy by fixing the growth rate of the money supply they refuse to identify. The contradiction may explain why the success of monetarism has been matched by the apparent inability of central banks consistently to pursue the monetarist monetary rule. The time has come to determine whether contemporary macroeconomic instability is the consequence of adherence to monetarism or failure to pursue it as promised. Ironically, the answer is: both. The attempt to follow an unspecified monetarist rule produces perverse consequences that preclude persistence.
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Endnotes
Supplemented by simultaneous gluts of oil and agricultural markets, the downturn only temporarily moderated (without even temporarily reversing) the upward march of the price level.
Even nonborrowed reserves increased at a 12.7 percent annual rate in the same period.
See Fig. 5 and Benjamin Friedman (1988, pp. 57–58).
Evidence abounded as the Fed played the numbers game with the various measures of money: “Throughout the post-1982 period the Federal Reserve’s official pronouncements continued to emphasize targets for broader monetary aggregates in place of M1, but it is not clear to what extent these measures genuinely guided monetary policy (Benjamin Friedman 1988, p. 56).
Compare, for example, the more healthy behavior of bank reserves and interest rates in the recovery from the Panic of 1907 with the less propitious comportment of both in the business revival of 1980 (see Figs. 6 and 7). It is more than coincidental that the recovery of 1908 lasted two and a half years; whereas the recovery of 1980 aborted in a year. The comparison is restricted to 12 months on each side of each downturn in order to isolate the effects of the monetarist rule from the influence of the “supply-side economics” introduced later by the Reagan Administration.
See the previous two notes.
These systemic deficiencies were actually irrelevant because they antedated October 6, 1979 by many years. In any case, mechanistic remedies would improve the situation without solving the problem. It was correctly predicted, for example, that success of the monetarist approach would not be assured by the return to contemporaneous reserve accounting in 1984 (Kellner 1982). David E. Lindsey’s additional suggested “regulatory changes” take account of the variability in the demand for money that monetarists customarily neglect (1981, pp. 25 ff). His recommendations were intended to improve Fed control of the money stock by targeting the reserve component (nonborrowed reserves) that best offsets fluctuations of the reserve multiplier. This is an ironic reminder of the pre-Friedman Chicago school that endorsed 100% bank reserves and volitional manipulation of the quantity of money to compensate for short-run, cyclical variations in its velocity.
New York bank loans actually increased in this period from $712.17 to $776.9 million, an increase of $64.2 million (Sprague 1910, p. 310).
Comparison of Ml figures for 1907 and 1980 is precluded by the fact that only the totals of demand and time deposits were reported until establishment of the Fed. However, bank reserves of the two periods are comparable (see Fig. 7). Comparison of Figures 2 and 7 appear to compel us to give up either the M2 measurement or the notion of reserve determination of the money stock.
Individual bank liquidity was traditionally considered (until the paternalism of 1980s deregulation) the responsibility of each bank’s management.
The elastic Federal Reserve note was expected to replace bank deposits when depositors feared for the safety of their deposits, and be exchanged for deposits as soon as confidence was restored.
There were four between 1966 and 1981 in contrast to their prior absence in the postwar United States.
Comparison of the introductory chapter of the successive editions of the Fed’s publication, The Federal Reserve System: Purposes and Functions, will reveal a declining interest in the initial purpose of providing an “elastic currency.” Once regarded as the solution (to be provided by the central bank), monetary flexibility is now perceived as the problem. Consequently, instead of providing system liquidity, the modern Fed, like other contemporary central banks, is systematically creating illiquidity. An invariant growth of the money supply despite variations in the demand for money is, as William Nordhaus (1980, p. F-2) has noted, “akin to putting the same amount of fuel in the furnace whether it is June or January.”
The degree of “monetary” elasticity consistent with preservation of the gold standard was always as tricky a question as the related issue of the appropriate size of the fractional goldreserve requirement. Neither was ever resolved. The nineteenth century banking school question of how much less than 100 percent was appropriate for the gold reserve of the gold standard was never answered. Events ultimately proved that whatever the fraction was, was not enough to preserve the standard. In the 1931 debacle it was discovered that gold reserves were adequate where unneeded but inadequate where needed. With abandonment of the gold standard (1931–33, 1971–73) and elimination of central bank reserve requirements of any kind (1960s), the compatibility issues shifted to that between short-run monetary flexibility and long-run price level stability. The question has remained as imponderable as its predecessors. Instead of resolving the dilemma, monetarists have avoided it by abandoning the principle of short-run currency elasticity, and they have apparently persuaded the Federal Reserve Board to ignore (or, at least, minimize) its original basic responsibility.
Even seasonal variations are not as predictable as presumed (Noyes 1981, p. 9).
Greater skepticism of Chicago-style monetarism than the Fed’s may explain the paradox of the Bank of England’s apparent superior independence of government in spite of structural differences that imply the contrary. Charles A. E. Goodhart, a principal advisor of the Bank of England, for instance, recognized that officially controlled measures of money soon lose their significance (Rattner 1982, p. F-8). See infra, Chap. 8, pp. 115–116.
The modern loss of control of the quantity of money was due to a growing ambiguity of the criterion for stabilization of the value of money, which caused the collapse of the gold standard (Mason 1977, pp. 480–487; 1963, pp. 105–107) and the failure to find a replacement. Without a value referent, the essentially endogenous (and relatively costless) money supply grew without ascertainable limits. These are the circumstances that incubated both monetarism and the reactions to its failure in the form of advocacy of a return to the gold standard or enactment of a Constitutional amendment requiring an annually balanced budget. In view of their general denial of the desirability or effectiveness of government regulation, monetarists’ faith in government control of money remains a curiosity (Girton and Roper 1979, p. 234) inconsistent with classical economics, to which they claim allegiance. David Ricardo, for example, saw no way to limit the quantity (and thus maintain the value) of a virtually costless currency (Mason 1977, p. 478). Subsequent history seems to have at least partially validated Ricardo’s skepticism.
Wesley Clair Mitchell established the National Bureau of Economic Research (NBER) to resolve the paradox of the reversing cyclical processes of cumulative expansion and contraction. Some modern theorists attempt to replace the messy empirical fact of cumulative processes with the linearly manageable artifacts of “rational expectations,” continuous as well as instant equilibration, and the “equilibrium model of the business cycle” (see Mason 1990).
Oskar Morgenstern resolved the paradox by concluding that business cycles are cumulative, but not continuously so. Unfortunately, he died too soon to have the influence on the NBER that he should have had.
Friedman’s belief in the stabilizing influence of money survived (without explanation) his acknowledgment of the contrary opinion of Wesley C. Mitchell (Cf. Patinkin 1969, pp. 50–51).
Choosing M2 over M1 obscures this source of the instability of a monetary economy. This was not the initial reason for Friedman’s preference, but it is evidently the semantic rationale for the growing popularity of the choice among monetarists.
Ironically, the monetarist “stability in the demand for money is a reflection of the instability of its supply” (Kaldor 1970, p. 15).
It is curious that the notion of the stability of money should find growing acceptance among economists at a time when physicists are suggesting that all matter may be ultimately unstable. The anticlassical antibullionists tried but failed to make the point that an abstract standard of value would be more stable than a commodity standard because the former would not fluctuate with the supply and demand for it, as “it” had no existence (Mason 1963, p. 24). Are monetarists attempting to exempt money from the spreading recognition of the universality of instability by paradoxically reviving the anti-bullionist argument in the form of “money matters because it isn’t matter”? If so, they are merely resurrecting the venerable confusion of the monetary standard and unit of account (Mason 1963, pp. 33,38–39,47,49,145–146 [n. 141], 156 [n. 216], 169 [n. 56]). Since modern money is essentially immaterial, such a defense of monetarism may be more logical than reasonable.
Maximizing behavior surely is not the same in the general fear of the loss of income and employment characteristic of recession as it is in the optimistic anticipation of the rising income, employment, and prices associated with waxing prosperity.
Monetarism is said to be an inexorable inference from the “natural rate” of unemployment. This hypothesis, known alternatively as the “vertical Phillips curve,” is a veritable truism that simply ignores the short run that Keynes and Phillips, respectively, analyzed theoretically and empirically (Burton 1982, pp. 15,19). Milton Friedman (1968b, p. 11) does not deny a short-run relationship between employment (unemployment) and inflation (deflation), but he is no more interested in temporary phenomena than Ricardo was a century and a half earlier. While Keynes emphasized that life itself is transient, Friedman concentrates on continuity of the species rather than the finite life expectancies of individuals (an interesting role reversal relative to aggregation). Each attitude has its place and its limitations.
The paradox of neomonetarist adherence to the monetarist monetary rule despite relaxation of the static, long-run premises of monetarism (Brunner and Meltzer 1971, pp. 788–789, 791–792, 799–800; Brunner 1982, pp. 16–19) may be resolved by reluctance to abandon the assumption that countercyclical policies are destabilizing in the present institutional environment.
Increases in the money stock during recession are effectively cancelled by the falling velocity of money associated with contraction. In the early and intermediate stages of business revival, the price level effect of the expanding money supply is cushioned by the increased output of goods responding to rising demand. Later in the recovery phase of the cycle the inflationary consequences of incremental money are reinforced by rising monetary velocity and falling unused productive capacity (Fisher 1918, pp. 55–56,60–69).
Reference is made here to the minor (inventory) cycle in contrast to the major cycle (significantly affecting investment in plant and equipment as well as inventories) that Fisher analyzed (supra, Chap. 3, nn. 20–22). Before the Cold War a minor cycle usually intervened between major cycles. The Cold War raised the spending floor enough to preclude major depressions in the Western World. With termination of the Cold War, alternate minor recessions may in the absence of appropriate countercyclical policies again degenerate into major depressions.
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Mason, W.E. (1996). Monetarism and the Disposable Central Bank. In: Butos, W.N. (eds) Classical versus Neoclassical Monetary Theories. Springer, Boston, MA. https://doi.org/10.1007/978-1-4615-6261-0_7
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