The Monetarist Myth
Originally published December 5, 2004
Page 1
It is a widely held belief that there is a serious theoretical difference between the Keynesians
and the Monetarists. It is commonly assumed that Keynesians are expansionist and inflationary,
while Monetarists are much more fiscally conservative. However, there doesn’t seem to be much
evidence to support this claim. In fact, as I noted in a previous issue, Keynes was one of the
prominent economists who pointed out the futility of blindly pumping money into the banking
system, since under depression conditions it would simply disappear into hoards. This is not to
suggest that Keynes was opposed to adding liquidity to the system under the right circumstances,
but he recognized the limitations of such a policy when the public was disinclined to spend and
invest. Friedman’s argument was potentially more inflationist, since he maintained the
government’s prime error during the Depression was its failure to respond to the early phases of
contraction with a strong dose of easy money. I believe that the perception of conservatism came
about only when his theories were invoked to explain the need to contract the money supply in the
1980s.
Put simply, when considering depression conditions, Keynes and Friedman are both
expansionist. The Keynesians tend to stress the importance of government deficit spending, while
the Monetarists point to the importance of adding liquidity at the right moment to avoid contraction.
I don’t think these are particularly counterposed views. To find viewpoints which are significantly
different, it is necessary to cast a wider net. For the
purposes of this discussion I will focus on the
Austrian school represented by Murray Rothbard.
Rather than arguing over which particular
government policy should be used to prime the pump,
the Austrian school generally argues that no policy
should be used to this end, since it merely puts off the
day of reckoning, ultimately making the collapse that
much more severe. While I don’t advocate policy in
this newsletter, it seems obvious that this school
should be given a hearing given the state of the
international economy.
In this issue I will contrast views of Friedman
with the those of Rothbard as they relate to the so called “Great” Depression. I think this will help
not only to get insights on this crucial period in economic history, but also to challenge the
commonly held view that monetarists are financially conservative.
Friedman and Schwartz’s A Monetary History of the United States, 1867 - 1960 is a dense,
highly focused treatment of US monetary history. By their own admission, the book is restricted in
its scope. While they admit that money has an impact on a wide range of economic and political
phenomena, they point out that the book is not intended to address these broader issues. It is a
purely a monetary history. Though the thesis is simple (roughly that “an adequate stock of money
should be available to the system at all times”) the detail is vast. For whatever criticisms may be
leveled against the work, it certainly can’t be faulted for a lack of breadth.
Friedman points out that the bulk of the ‘twenties was a period of high prosperity and
economic growth. The few recessions which occurred after 1921 were so small that few people
noticed them. The Federal Reserve system was still new, having been created in 1913. There was
a growing public perception that economic fluctuations could be smoothed out using the new
monetary machinery, and there was some basis to believe this was true. The Fed subscribed to the
“inventory” theory in an effort to curb large fluctuations. According to this theory, excessive
inventory liquidation could be mitigated by fostering “slack” toward the end of a contraction while
in boom times, undue inventory expansion could be prevented by tightening the money supply and
resisting the needs of trade (p.297). Other factors which had contributed to “excessive” fluctuations
were also addressed. For instance, gold movements, which traditionally fostered expansion during
inflows and contraction during outflows were “sterilized” by open market operations. As gold
flowed into the system, the Federal Reserve would offset the increase by selling securities in the
open market. This absorbed the “excess” liquidity created by the inflow. Conversely, during
outflows, the Fed would conduct open market purchases offsetting the loss. Seasonal fluctuations
(due largely to the needs of agriculture) were neutralized by similar sales and purchases in the open
market. The net effect of these actions was to iron out smaller fluctuations creating a sense of
confidence and stability. This confidence in the ability to regulate the business cycle may
paradoxically have contributed to the new era mentality.
Toward the end of the decade, Friedman notes, many observers became concerned with the
rampant speculation and high valuations in the stock market. Both the Federal Reserve Bank of New
York and the Federal Reserve Board, centered in Washington, agreed that stock speculation was a
problem but there was a conflict as to how to deal with it. The Board sought to apply
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