Monetarism: a reply to the critics
Last week Professors Frank Hahn and Robert Neild of Cambridge launched an attack on monetarism. Today the foremost theoretician of that school of economics responds
The article by Professors Frank Hahn and Robert Neild (The Times, February 25) is an egregious example of misleading labelling. The leading word in the title is "monetarism", yet the article has essentially nothing to say about the central propositions of the quantity Theory of money-a classical term I much prefer, to the un-lovely word monetarism.
Instead it deals rather obliquely with a different though related question: whether the widely celebrated "Phillips Curve ", which postulated a stable trade-off between inflation and unemployment, deserves the internment that it has increasingly received from the economics profession over the past dozen years as embodying a confusion between nominal and real magnitudes, a "'money illusion" that is necessarily temporary.
The quantity theory of money is a scientific doctrine about the relation between the quantity of money, on the one hand, and various aggregate economic variables, on the other, especially, total spending (or income) in pounds, the price level, and the rate of inflation.
It is not a new doctrine. David Hume's two mid-eighteenth-century essays "Of Money" and "Of Interest", which presented its central core, can be read today with pleasure and profit. Those like myself who are labelled "monetarists" have revived Hume's theory after Keynes's attack on it and have refined and improved it, incorporating some of Keynes's ideas. Mostly, however, our contribution has been to subject, the theory to empirical tests and to give it empirical content.
As a scientific doctrine, the quantity theory of money (like the law of gravity) is ideologically neutral. In so far as it is valid, it informs policymakers about the consequences of their actions. But how they use it depends on their objectives. Hahn and Neild do not examine the central proposition of the quantity theory of money at all. Rather, taking off in part from a definition of the "natural rate of unemployment "which I gave in my 1967 presidential address to the American Economic Association on "The Role of Monetary Policy", they present an interesting survey of the present state of the mathematical theory of the dynamic adjustment of output, employment, and prices in an economy characterized by a mixture of competitive and monopolistic elements. They conclude that the current theory is incomplete and unsatisfactory.
I entirely agree. Indeed, I have repeatedly emphasized this point in my own writings, citing it as a major reason for my opposition to "fine-tuning" and my support of a steady monetary and fiscal policy announced long in advance and strictly adhered to. However, the unsatisfactory character of the dynamic theory does not rehabilitate the discredited "Phillips Curve" and does not justify the Hahn-Neild conclusion that "there are neither theoretical foundations nor empirical support for the monetarist's proposition that ... activity and employment can be relied upon to recover automatically from the present fiscal and monetary squeeze". We can know that a bird flies and have some insight into how it is able to do so without having a complete understanding of the aerodynamic theory involved. Similarly, we know from the experience of many countries over many centuries [footnote] that:
- When the quantity of money increases at a decidedly faster rate than output over anv extended period, the result is inflation. The more rapidly the quantity of money in- creases, the higher is inflation.
- The relation between monetary growth and inflation is neither perfect nor instan- taneous. It takes time for monetary growth to affect inflation and the time it takes varies from episode to episode.
- In the United Kingdom and the United States, it takes about six months on the average for more rapid monetary growth to produce more rapid growth in spending. Initially; accelerated spending is reflected primarily in output and employment rather than in inflation.
- It takes about another 18 months on the average for accelerated spending to be translated into higher inflation. As that occurs, output and employment decelerate Stagflation or an inflationary recession sets in.
- These effects work also in reverse with roughly the same time lags. Reduced monetary growth produces a subsequent slowdown in spending, reflected first in output and employment, later in inflation. As inflation slows down, output and employment begin recovering. The phase of withdrawal from the drug of inflation is coming to an end.
- There is no dependable -trade-off between inflation and unemployment. On the con- trary, over any but very short periods, higher inflation has been accompanied by higher unemployment. Britain's experience in this respect is typical.
- There is a trade-off between unemployment now and unemployment later. A deliberate acceleration of monetary growth may reduce unemployment temporarily, but only at the cost of still higher unemployment later. Conversely, reduced monetary growth, such as Mrs Thatcher's government is trying to achieve, may increase unemployment temporarily, to be rewarded by a much sharper reduction in unemployment later.
Unfortunately, given the past mismanagement of the British economy, Britain has no soft options. (I regret to say, that this is equally true for the United States).
I challenge Professors Hahn and Neild to offer empirical evidence contradicting these well-established propositions.
May I conclude by stressing that while monetary restraint is a sufficient condition for con- trolling inflation, it is necessary but not sufficient condition for improving Britain's productivity - the fundamental requirement for restoring Britain to full economic health. That requires measures on a broader front to restore and improve incentives, promote product investment, and give a greater scope for private enterprise and initiative.
[Footnote]: A small sample of the empirical evidence and a non-technical presentation of its theoretical interpretation is given in Chapter 9 of Free to Choose by Milton and Rose Friedman (published by Secker and Warburg 1980).
Milton Friedman is professor of economics at the University of Chicago and a senior research fellow at the Hoover Institution, Stanford University. He won the Nobel Prize for Economics in 1976