Jude Wanniski
March21, 1997

Supply-Side Economics Lesson No. 16

Memo To: Website Students
From: Jude Wanniski
Re: 'Monetarism'

Michael Zilkowsky of Saskatoon, Saskatchewan says he met a Canadian Reform Party candidate recently who said his party supports "a monetary policy which promotes a slow, non-inflationary and steady growth in the money supply." He says: "To me, this sounds suspiciously like the Volcker experiment of targeting the aggregates. Perhaps you can explain to me what constitutes 'steady growth.'" Another question comes from Joe Armstrong, who read "Golden Polaris" in Lesson No. 13 (in our archive) and wondered why I define deflation as well as inflation as "a decline in the monetary standard." He can see how it applies to inflation, but "I am somewhat perplexed as to how this could also apply to a deflation. Can you clarify this for me in a future lesson?"

First, let me deal with Joe's question, because it is critical to understanding why monetarism, as defined and developed by Milton Friedman, does not and can not work. A standard is a universally agreed upon rule that enables all people to understand the same concept. Everyone knows an inch or a meter is a precise unit of measure. They also know an inch today will be an inch 30 years from now. A monetary standard should have the same utility, measuring value today and 30 years from now. This enables people to make long-term contracts with the smallest risk to the creditor or the debtor. The creditor is protected against an inflationary decline in the monetary standard a precise weight of gold or silver or basket of commodities. The debtor is protected against a deflationary decline in the monetary standard. Because risks of windfall gains or losses are sharply reduced by strict adherance to the agreed-upon monetary standard, more people are willing to make long-term contracts with each other, either man-to-man, or through financial intermediaries like the stock market, credit unions, insurance companies, banks and thrifts. As risks increase to borrower or lender, the level of economic production decreases on the margin. On the margin means that borrowing and lending will continue even with higher levels of risk, but those contracts which had previously made it just under the line will not longer proceed. Capital is formed when unutilized time, energy and/or talent can be put to work in the marketplace, which almost always requires a financing over time and space.

The creditor who finances economic activity does so either through his own surplus time, energy or talent, or his monetary claims on the surplus time, energy or talent of someone else. A young man can extend me credit by cutting my lawn with my promise to pay him back in the future. An old man can extend me credit by paying a young man to cut my lawn with my promise to pay him back in the future. In either case, there are risks to the creditor and the debtor, depending upon which way the unit of account changes over the contract period. A decline in the monetary standard means the standard has less worthiness and utility in reducing risk.

Monetarism is a system built around the idea that economic growth can be facilitated by having the money supply grow at a slow, steady rate. The observations of Milton Friedman and his colleague, Anna Schwartz, were that over long periods of time the economy grew at about 2 1/2% a year, which meant it would need 2 1/2% 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 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 heydey 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.