The Burden of Monetarism Jude Wanniski July 9, 2004

Memo To: Financial Journalists
From: Jude Wanniski
Re: More Reaganomics History

Six months after Ronald Reagan was inaugurated as the nation’s 40th President, the tax cuts he promised the American people were passed by the Democratic Congress and put in place. Instead of celebrating as one of the architects of the policy, I wrote a commentary for the Sunday business section of The New York Times warning that the monetary policies of the Federal Reserve were crippling the economy. It was a broadside attack on the monetarists whose theories had been sold to the Carter administration in October 1979 and were the primary reason that Mr. Carter was not re-elected in 1980.

When Reagan defeated him that year with his tax-cut promise, he chose supply-siders to fill the key posts in the Treasury Department, but picked monetarists for all the important posts bearing on monetary policy. The big problem was that most supply-siders were “fiscalists,” who assumed the tax cuts would generate an immediate economic boom. I knew the same monetarist theories that had created the great inflation which blew up the Carter administration were in a position to overwhelm the supply effects of the tax cuts, and unless I set the record straight before the economic sank further, the supply-siders and their tax cuts would be blamed for the economic decline. I decided to make my case in a personal attack on the father of monetarism, Milton Friedman, in order to bring the most attention to the case I was making. The Wall Street Journal, my alma mater, would never permit such commentary, but the NYTimes was happy to get the piece and run it as is.

When the economy fell apart in the monetary deflation that followed, supply-siders and the tax cuts were blamed by the Keynesian economists and the politicians who employed them. But White House Chief of Staff James Baker III had heard my arguments in person and saw in the Times piece the extent of my conviction. The dollar price of gold had fallen in the deflation from $625 when Reagan was elected to about $450 when the article ran. As the lower tax rates on labor and capital invited an economic expansion, there was an increased demand for liquidity, and when the Fed did not supply it by creating new bank reserves the dollar became scarce relative to gold and the gold price declined, pulling all prices down to one degree or another.

My article did nothing to bring about change, but it did serve its purpose of putting the blame where it belonged. When gold continued its decline, to under $300 oz in the early months of 1982, the stage was set for the abandonment of monetarism in the summer of that year, when Fed Chairman Paul Volcker, who, with Jim Baker, knew all my arguments, avoided widespread bank failures by creating $3 billion in fresh reserves. The price of gold soared, ending the deflation, and both stocks and bonds had enormous rallies, with the Reagan boom finally enjoying both supply-side legs to drive it ahead. The monetarists inside the administration had predicted such an infusion of easy money would reignite inflation and cause a collapse of the bond market. When the economy boomed instead, that was the end of monetarism, once and for all. It took awhile, but Professor Friedman last year acknowledged the flaw in his theory. All that remains is a way to redefine the dollar in terms of gold, which was what Reagan wanted to do all along.

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July 26, 1981, Sunday

Business Forum;
THE BURDEN OF FRIEDMAN'S MONETARISM
By Jude Wanniski

MILTON FRIEDMAN is not a big man, but he is very heavy. His monetarist economic ideas are a deadweight burden on the shoulders of Menachem Begin and the Israeli economy. They crush down on Margaret Thatcher as England riots. They are crippling the Nobel Laureate's old friend, Ronald Reagan, the United States economy and indirectly, all of our trading partners. Professor Friedman is barely five feet tall, but his shadow falls across the last decade of global inflation.

How ironic that ''Reaganomics'' has come to be identified as the twinning of ''tax cuts and tight money,'' a marriage of supply-side fiscal policy and Friedman monetarism. The classical, supply-side movement was revived a decade ago in reaction to the success of Professor Friedman in selling his theories to policymakers.

The monetarists gave two cheers when President Nixon closed the gold window on Aug. 15, 1971. But it was not enough for them. The Nixon White House had bought the Keynesian idea that the dollar had to be devalued in order to make the Japanese and West Germans less competitive and American industry more competitive.

Thus, in the spring of 1973, the monetarist gave their third cheer when Treasury Secretary George P. Shultz, a Friedman disciple and fellow Chicago economist, succeeded in ''floating'' the American dollar. Henceforth, the dollar would not be defined in terms of anything. It would be a managed currency, managed according to the theories of the monetarists.

These developments led Robert Mundell, a Canadian economist now at Columbia University, to predict a global inflation. The Mundell vantage point, which permitted him to view the future so clearly, was classical and simply explained. The individual baker comes into the marketplace with bread, wanting to exchange his surplus production for wine. The vintner comes with a surplus of wine, seeking an exchange for bread. The government, which maintains the marketplace, taxes the exchange, taking some bread and some wine to finance its activities. Fiscal policy generally bears on the baker's and vintner's willingness to produce for current consumption needs. If the government takes too much bread or wine, the baker and vintner are discouraged from coming to the marketplace and the government gets none of their output.

People produce not only for current consumption needs. They produce for the future. The baker wants to save part of his daily output for his retirement, or an illness, or to finance his children's college tuition down the road. For this, he needs a financial asset, a way of saving a loaf of bread without having it spoil. The marketplace provides a bank, which give the baker a dollar asset in exchange for a loaf of bread. It is the government that provides the dollar through its monopoly over official ''money.'' The dollar is a ''unit of account,'' which theoretically permits the baker to keep track of his loaf of bread over time, as the dollar asset remains more or less a loaf of bread.

The supply-side economist is concerned when the government either changes the unit of account purposely or simply loses the ability to maintain it, try as it might. In either case, the baker is discouraged from producing for future consumption. He sees his loaf become half a loaf, then a slice, then a crumb. Why bother? He will direct production as much as possible toward current consumption, in a self-defense against the government's failure to maintain the unit of account, the monetary standard.

National wealth and productivity are enhanced by faithful maintenance of the unit of account. President Kennedy was the last President who really believed this, having had the idea drummed into him not by economists, but by his father. In a July 1963 message to Congress, John Kennedy affirmed: ''This nation will maintain the dollar as good as gold at $35 an ounce, the foundation stone of the free world's trade and payments system.''

THE monetarists do not see the dollar simply as a unit of account, a standard of value, a medium of exchange. They see it as an article of intrinsic wealth. Consumer demand drives the economy, they believe, as do the Keynesians. When the government puts more money into the baker's pocket by printing more, there is less unemployment of winemakers, but a tendency to higher prices. Reducing the amount of money combats ''inflation,'' but the price is lessened economic activity, stagnation.

To experiment with this theory requires that the dollar have no definition, that it be linked to nothing. The currency cannot be managed if it is convertible because an excess of dollars, over and above the number the baker and vintner need for their transactions, will result in a citizen coming to the central bank with the excess and demanding that it be converted into gold, or whatever.

This is what Professor Mundell saw happening. The dollar, which has been maintained as the foundation stone of the free world's trade and payments system, would no longer serve that function. It would be jiggled and wiggled from hour to hour, day to day, month to month, to the monetarist tune, vainly trying to dance toward a money-supply target, thwarted again and again by the market's shifting demand for money.

The bakers and vintners of the world, who had viewed the dollar as a faithful measuring rod of value, reliable tool and instrument, would view it as ever changing, elastic, and they would have to defend themselves against its vagaries.

For a while after 1973, the bureaucrats at the Federal Reserve resisted conforming to monetarist prescriptions, still insisting on using interest rates as a policy guide, not quantity targets. But in October 1979, under pressure from Paul A. Volcker, the monetarists were given almost everything they wanted. Professor Friedman had earlier won over the Israeli central bank, which by 1980 presided over inflation rates of more than 100 percent. Margaret Thatcher bought monetarism in the spring of 1979, and after 26 months of squeeze not only looks at riots and 11.5 percent unemployment, but also at a 19.5 percent rise in consumer prices for the last quarter, at an annual rate.

Now, Professor Friedman has finally come to full flower in Washington. The President even carried him to Ottawa, selling the Summit gang on a six-month dose of global Thatcherism. Inflation is to be whipped with a worldwide going-out-of-business sale. The bond market responded by hitting an all-time low, and the Dow took it on the chin, too.

The baker, the vintner, the automaker and the homebuilder are eager to produce and exchange. Consenting adults across the land are eager to commit commerce because the Government is altering tax policy to let them keep more of their production. But the monetarist model reads this inflationary and must choke it off. And when the Fed whips those producers to their knees, bankrupting them at alarming rates, monetary authorities will then see that it is all right to flood the nation with more dollars, and consumer prices will soar again.

For old times' sake, Ronald Reagan will put up with it. Milton Friedman is an old friend, a certified conservative who faithfully trumpets the doctrine that government bureaucrats are ill-suited to manage anything, except the currency. The only question is how long the President will carry the professor on his back. There, the United States has an advantage over Britain.

Britain has scheduled elections every five years, which means Margaret Thatcher can carry the Nobel Laureate for another two and a half years, unless there is a revolution. The United States has Congressional elections every two years, another coming up in 15 months. Every Republican candidate for the Senate and the House will have Milton Friedman on his or her back. Unless the ''experiment'' ends soon, austerity is ''just around the corner for the G.O.P.''

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Jude Wanniski, president of Polyconomics Inc., a business consulting firm, helped conceive the Kemp-Roth tax-cut legislation.

Copyright 1981 The New York Times Company
The New York Times