Jude Wanniski
June 9, 2000


To: SSU Students
From: Jude Wanniski
Re: ‘Monetarism’

In the very first SSU semester, which began on November 27, 1996, we began with no more than a dozen students. When we ended the “semester” on June 6, 1997, we had 35 students registered and participating. The number of registered students has now seemed to stabilize at around 1800. I’d planned to end the spring term last weekend, but in looking through that first term’s work, I realized I covered “monetarism” back then, in response to a question, and have not really done that intellectual discipline justice in this semester’s focus on money. Here is more or less how I handled the topic in 1997, with a few embellishments added.

Monetarism is an economic system built around the idea that economic growth can be facilitated by having the money supply grow at a slow, steady rate. It is a system wholly associated with Milton Friedman and his work at the University of Chicago in the 1950s and 1960s, as he provided a counterweight to the dominance of the Keynesian economics of that era. The Encyclopedia Britannica edition of 1975 actually had Friedman write its “macropedia” section on money. He opened his discussion of “the monetarist view” by denigrating the Keynesians for having predicted “a great postwar depression if war spending [after 1945] was not replaced by other government spending. But government spending fell precipitously in the U.S. and elsewhere without ill effect. The analysis of the Keynesians had called for ‘cheap money’ policies -- that is, low interest rates -- with a view to stimulating investment and thus mass unemployment. These policies proved in the main to be unnecessary; where they were adopted they were consistently followed by inflation that could be restrained only by abandoning the cheap-money policies.” Friedman, identified at the end of the article only as “M.Fr.,” continued:

A re-examination of the Great Depression of the 1930's demonstrated that, contrary to a general belief, it had been a tragic testament to the great power of monetary policy, not to its impotence. The U.S. Federal Reserve System could have prevented the decline of one-third in the quantity of money that occurred from 1929 to 1933. Had it done so, the evidence indicates, the depression would have been far milder and briefer. Most important of all, extensive empirical research demonstrated that the velocity of money, far from moving to offset changes in the quantity of money, had generally moved in the same direction and reinforced the effect of these changes.

Now don’t you think my eyebrows went up the first time I read these passages, realizing the Britannica editors had permitted Friedman to sit as judge and jury over the work of his adversaries in the demand-side academic community and pronounce it a failure, then sit as judge and jury over his own work, and pronounce it a great success. The entire essay, of course, is practically worthless as a source for serious students of economics. The key flaw in Friedman’s exposition is where he refers to the “velocity” of money as having failed to speed up to offset the decline in the “quantity” of money. In our classical, supply model, there is never any reason for the “velocity” of money to change as long as the “money” is defined as a specific weight of gold -- which it was in the period 1929-1932. On Friedman’s supposition that if the velocity of money would remain constant during the most cataclysmic economic event of the century -- the Crash of 1929 and the Depression that followed -- he built a monetarist model which eliminated “velocity” as a variable. Here is the simple equation that got him and his students into trouble, leading to the great world inflation of the last 30 years and the deflation that began in late 1996 and persists to this day: MV = PT, in which “M” is the quantity of money and “V” is its velocity, the rate at which it travels from hand to hand -- “the average number of times that the money stock is used for making income transactions,” says Friedman in the Britannica, then proceeding to: The right side of the equation then becomes the product of an average price (P) times an aggregate quantity of goods (T).”

You can quickly see that if “V” is assumed to be constant, then the quantity of money “M” controls the national income in constant prices. How simple managing the national economy becomes!! Manage M and you produce the right side of the equation, PT, without inflation, as long as you increase “M” at the “correct rate.” If, as Friedman did, posit that the national economy grows at roughly 2½% or 3% per year, over a stretch of time, then if you have the Fed increase M by that amount year in and year out, the economy will grow at its average rate at all times, with no “booms” or “busts.” Let’s go back to the lecture of March 1997 and read how I handled it then:

The observations of Milton Friedman and his colleague, Anna Schwartz, were that over long periods of time the economy grew at about 2½% a year, which meant it would need 2½% more money supply to serve its needs for monetary liquidity. The reasoning more or less suggested that booms and busts could be tamed by having the Federal Reserve increase the money supply at that slow, steady rate. Instead of the economy overheating in some periods, which would mean it would have to cool down to recession levels, it would avoid the extremes of the business cycle. Much of the impetus for the hypothesis grew out of the assumption that the Great Depression was caused by the Roaring Twenties, when the economy grew rapidly as did the money supply. When the stock market crashed in 1929, it was assumed a bubble had burst, leading to the depths of economic contraction and a collapse of the money supply. It seemed a reasonable demand-side hypothesis, which paralleled the Keynesian idea that the Depression was caused by excessive saving, which led to a fiscal solution to the business cycle -- increasing government spending and lowering taxes in downturns, cutting spending and raising taxes to cool off booms. Both Friedmanites and Keynesians have fought my supply-side hypothesis, first presented in 1977, that it was the Smoot-Hawley Tariff Act that first shocked the financial markets in 1929, followed by a series of income-tax increases by Herbert Hoover and Franklin Roosevelt that deepened the trough.

One of the principal reasons monetarism failed, when tried first in the Carter administration and again in the first Reagan administration, was that it had to downplay the importance of the monetary standard. That is, the dollar's link to gold had to be broken in order for the quantity of money to be stabilized by the Fed, instead of the price of money, with gold as the proxy of money's price. We normally don't think of money as having a price, but we can see it if we ask the question "How much gold do we have to pay in order to buy $35 in currency?" Gold is the proxy for all other goods and services: "How many apples do we have to pay to buy $35?" or "How many hours do we have to work to buy $35 in currency." With an ounce of gold priced at $35, the accounting unit was fixed and so was the monetary standard. Once the link was broken, the price of money was permitted to fluctuate around attempts to fix the quantity of money. (A tricky problem for monetarists has always been the definition of "money," otherwise known as one form or another of monetary aggregates, as the question was put at the top of this lesson. Is money only cash? Or does it include checking accounts? Money-market accounts? Unutilized bank reserves? But that is a whole other story.)

Unhappily, Professor Friedman had assumed there would be very narrow fluctuations of the price of gold and other commodities if the supply of dollars grew at the slow, steady rate. This is because over the course of almost two centuries, he had observed a fairly constant velocity of money. The velocity is simply the rate at which money circulates, doing its work as a transactions medium. If its velocity would double, a dollar could do twice as much work exchanging goods or services in the same amount of time, and there would be need of only half as much money. If the money stock remains the same, there is twice as much as is needed, and prices will have to double. Why would velocity increase? Because people want to exchange the paper for something real before the paper will lose its purchasing power. For the purpose of developing monetarism, Friedman assumed its velocity would remain as reliably constant as it was while the U.S. was fixing the dollar to gold in maintenance of the monetary standard. The monetarist equation, MV=PT, was at the heart of his calculations. The amount of money, M, times the velocity of money, V, would equal the price of all goods, P, times the number of transactions, T. Because PT equals the value of all economic transactions (what we otherwise call the Gross Domestic Product), the economy could then be controlled by controlling M, inasmuch as V was assumed to be constant. V turned out not to be constant as soon as the dollar left its gold anchor. Velocity increased rapidly as people sought to reduce their holdings of cash and other non-interest bearing forms of money, which were losing value relative to gold, the proxy for all things. A 3% increase in M no longer produced slow steady results. PT rose faster, not because the economy was growing faster, but because P was shooting up. Interest rates, which had been increasing as the market saw the political commitment to a gold link weakening, rose more rapidly when President Nixon formally broke the link on August 15, 1971. The $35 gold price quadrupled by 1973 and was followed by a quadrupling of the oil price, as the oil-producing countries of the Middle East found they were selling oil for paper dollars worth one-quarter as much as they had been worth, in terms of gold, the proxy. Through the 1970s, monetarists insisted their ideas were not being faithfully carried out by the Federal Reserve. Disputes arose over the correct definition of money, and various types of monetary aggregates were advanced -- M1, M2, M3, etc. -- depending upon the mixture of cash, checking accounts, money-market accounts, bank reserves, etc. The turbulence in the financial markets increased and the price of gold doubled again, to $240 or so, by 1979. In October of that year, Fed Chairman Paul Volcker agreed to elevate the monetary aggregates as his central monetary rule, which is what the monetarists wanted. The gold price climbed as high as $850 on Feb. 1, 1980, as interest rates on government bond passed 10% and the prime rate rose over 20%. The slow, steady increase in money supply was producing chaos. At the time, I likened the volatility to that which would occur if you drove through the mountains, with a steady pressure on the gas pedal, whether you were going up the mountain or down the mountain.

Monetarism as it had come to be known ended as a serious experiment in the summer of 1982. By following its theorems, the Fed in 1981-82 was climbing one of those mountains, and the steady pressure on the monetary pedal was producing a deflation -- characterized as a steady decline in the price of gold. From its peak of $850 in early 1980 it had fallen to $290 in early 1982. Debtors were unable to pay their loans. Creditors were going bankrupt. I was among those supply-siders pleading with Volcker to add money faster, to halt the deflation. Monetarists insisted that if he did, inflation would be reignited and the bond market would collapse. In the summer of 1982, he was forced to add $3 billion of liquidity to the banking system to prevent collapse, and the bond market boomed. Monetarism's day in the sun ended. As an anachronism, the Humphrey-Hawkins legislation enacted by Congress in the heyday of monetarism still requires the Fed to annually present its M targets to Congress. But nobody expects the Fed to really try to hit them. A few weeks ago, when asked what signals he looks at to determine whether he should ease or tighten, Alan Greenspan says he still takes a look at the money supply, with all its imperfections, but that he really watches gold.

* * *

Unhappily, since this was written, Greenspan decided not to watch gold, as its price fell steadily, a classical signal of monetary deflation. When oil prices and farm prices and other commodity prices fell, where were the monetarists? For the most part, the students of Milton Friedman continue to focus on the “M” quantity of money, and because it has been growing faster than 2½% a year -- Friedman’s preferred number -- the monetarists are forced to conclude that inflation must be close at hand. A number of monetarists on the Federal Reserve Board of governors have been joining with Keynesians, such as Laurence Meyers, in arguing for ever higher interest rates in order to prevent an outbreak of inflation. If the dollar were fixed to gold, the velocity of money would once again be a constant, and there would be no inflation or deflation, but the Fed would also be powerless to manipulate the MV = PT equation to manage the economy to conform to their obsolete theories.