“inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
“Government spending may or may not be inflationary. It clearly will be inflationary if it is financed by creating money, that is, by printing currency or creating bank deposits.”
“There is a great deal of evidence from the past attempts by monetary authorities to do better. The verdict is very clear. The attempts by monetary authorities to do better have done far more harm than good. The actions by the monetary authorities have been an important source of instability.”
“A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth. It will not produce perfect stability; it will not produce heaven on earth; but it can make an important contribution to a stable economic society.”
Milton Friedman, The Counter-Revolution in Monetary Theory, Institute of Economic Affairs 1970.
I was blessed to attend this First Wincott Memorial Lecture delivered at the Senate House, University of London, 16 September 1970. It was the very first time that I saw Milton Friedman weave his spell of monetary magic over an audience. It was the moment when I first truly understood the significance of the monetarist counter-revolution against the Keynesian hegemony that still held sway over the backward, xenophobic British economics profession, of which I was an increasingly disenchanted member.
Ideas, for the most part, like changes in the quantity of money, make their way slowly through a system, with long and variable lags. Monetarism was such an idea. It took 9 years for the idea that inflation is a monetary phenomenon to percolate through British politics into the thinking of the Thatcher administration. It took 10 years, with the election of Ronald Reagan, for it to percolate into the thinking of Paul Volcker, Chairman of the Federal Reserve, who reversed the Fed’s policy of easy money and placed the United States economy into a monetary refrigerator. It would be several more years before monetarism finally squeezed out inflationary expectations and set the British and the US economies on course for 16 years of the splendid Great Moderation.
Certainly, monetarism did not take us to Paradise; but it eased one big worry from our minds. Ordinary people could go about their business and live their lives without concerning themselves about the uncertainties created by high and volatile rates of price inflation. Economic decisions could be registered on the basis of real factors, without undue concern for nominal white noise. The brilliant son of poor Jewish immigrants, who had started out their lives in the United States gladly working in sweatshops, had delivered an enormous benefit to mankind.
Only to be reversed by the inexcusable ignorance of two younger members of his own ethnic group, Alan Greenspan and Ben Bernanke. Now, it is true that neither of these two future Fed Chairmen learned their economics at the feet of the Maestro. Certainly, however, they had more personal exposure to his nonstrums than had I, living through the critical years of the counter-revolution some 4,000 miles away from the capital of Freshwater Economics. In each case, before they assumed high office, they had the spectacular success of Maestro Volcker to guide them in their ministrations.
As a historical fact, both Greenspan and Bernanke failed to understand the message, failed to honor their oaths of office. Jointly and severally, they have returned the United States to its former inflationary path. Jointly and severally, they have abandoned the great monetary counter-revolution and returned the US economy to the dominance of the Keynesian episode. They should be thoroughly ashamed, not just for themselves, and their own monetary ignorance, but more importantly, for all our children and our grandchildren, who now seem to be doomed to the returning misery of stagflation.
For make no mistake about it, Dear Readers, the specter of inflation once again stalks the United States as a consequence of the monetary furnace fired up by Ben Bernanke since September 2008. Because Bernanke misread his own scholarship, and wrongly identified a limited economic contraction in 2008 as a return to the Great Depression, he has debauched the currency of the United States. Because he falsely believed that the United States was teetering on the edge of a deflationary cliff, he poured high-powered money into the financial system, tripling the size of the Fed’s balance sheet, and setting the scene for a potential 96 per cent increase in M2 money, once the income velocity of circulation of money returns to its historical norm.
For the time being the world sleeps, as money exerts its slow influence in the manner identified by Milton Friedman. First, monetary expansion will impact on real output, as already is the case. Then it will impact on the price level, slowly at first, but then with increasing venom. The first signs are already evident: the CPI rose 2.7 per cent in 2009, according to the recent update by the Bureau of Labor Statistics, and it did so against a backcloth of 9.3 per cent unemployment. This is a first green shoot of stagflation. A 2.7 per cent rate of price inflation is above the rate achieved in 5 out of the past 10 years in the United States. It does not signify a nation teetering on the edge of deflation.*
Do you still remember the Misery Index that became such a central feature of economic evaluations during the stagflation era? This Index is the sum of the unemployment and the inflation rates at any point in time. In 2009, the Misery Index is measured at 12.0. This is the highest level of the index over the past 26 years, going right back to 1983, when it was 13.4, immediately before Paul Volcker’s monetary refrigerator conquered inflationary expectations.
Brace yourselves, Dear Readers, for worse that is yet to come. Ben Bernanke is no Paul Volcker; and Barack Obama is no Ronald Reagan. The Fed is still firing up the monetary furnace, would not dare to tighten the economy by reversing course. Barack Obama is still spending the nation’s wealth as though there is no tomorrow. The promise of a new era of Great Moderation lies as far ahead at this moment in time as it did in September 1970, when I attended that eye-opening presentation by Milton Friedman.
Milton Friedman sadly is no longer with us to sound the warning yet again. And almost everyone else is asleep, as the Captain of the Titanic steers his ship full speed ahead onto the silently floating iceberg that will surely destroy his vessel, and all our lives.
* These statistics were reported by Robert Murphy in The Washington Times (February 19, 2010). The monetarist interpetation of these developments is my responsibility. I am usually careful to cite sources. In my initial posting of the column, I regretfully overlooked the source of these statistics, believing that they had been published in an unnamed Editorial. I am now rectifying that omission.
Tags: Bernanke, Greenspan, inflation is a monetary phenemenon, stagflation, the misery index, the specter of inflation, Volcker
February 20, 2010 at 1:11 pm |
In theory, inflation _is_ always a monetary phenomenon. However, it is a phenomenon of the quantity of money _and_ the demand to hold money. It is an error to make the further step of claiming it is a phenomenon of the relationship between the quantity of money and the quantity of goods. It requires the further assumption that the demand to hold money is strictly proportional to the quantity of goods.
While high and persistent inflation could be caused by a falling demand to hold money is possible, it is hardly likely. The rough rule of thumb, that a progressive economy with growing real volumes of output will only have persistent inflation if the quantity of money grows more rapidly is correct.
However, if one advocates a rule for the growth rate of some specific conglomeration of financial assets, like M2, then there are any number of things that could result in low and variable inflation or deflation. Unlike the new classical, real business cycle theorists, Friedman understood that this would also involve fluctuations in real output away from capacity.
And, of course, this is what Friedman meant by a money supply rule not creating heaven on earth. Of course, it wouldn’t come close to ending scarcity, but low inflation or deflation, and fluctuations between as well as disturbances to production from monetary sources would occur.
The _reason_ most economists, including Greenspan and Bermanke have rejected targeting the M2 measure of the money supply is that the demand to hold it has fluctuated more than it has in the past. While high and persistent inflation wouldn’t be likely, the inflation and deflation and fluctuations in real output would likely be much worse than what Friedman would have expected from looking at the demand to hold M2 in the past.
The Fed _is_ much better now than in the past. They are not trying to directly stabilize unemployment or output–they understand that there are market forces impacting these things that monetary policy can’t influence in the long run, and any short run benefits create more harm than good. They understand that nominal interest rate targets must respond to inflation expectations enough to keep real interest rates under control. These are real victories for sound monetary theory.
Still, I am very critical of current Fed policy. I think that the emphasis of the federal funds rate has proven to be an error. I favor an explicit target for a growth path of nominal expenditure. I think the Fed should commit to adjusting the level (and growth) of the monetary base to remain on that growth path, and reverse any deviations. That should be the framework. If the Fed thinks the best method is to offset partially or wholly market driven changes in federal funds, or changes in the growth rate or path of some conglomeration of final assets, that is fine. But these should never be confused with the target. And, of course, targeting nominal expenditure means that market forces will determine output and inflation.
Like Friedman, I see the goal as creating a proper environment for economic activity. But rather than a steady growth path for some measure of the quantity of money (much less M2,) nominal expenditure is the best way to go.
February 20, 2010 at 1:43 pm |
Bill:
As always, your comment is excellent. I do not think that we are very far apart. I learned from your earlier comments not to focus too closely on M2. But I am sure that we both agree with Friedman’s focus on high-powered money. And that is what Bernanke has increased so spectacularly. For whatever reason, the income velocity is down at present, and we can differ on the reason for that, as we do. But eventually, as it adjusts upwards, as it surely will, inflationary pressures will return significantly, if all that high-powered money is still out there. My real fear is that political pressure will be exerted on the Fed to allow the inflation rate to rise (the argument will be to a 4-6 per cent range) in order to inflate away the real burden of the debt (though of course they will not state that explicitly).
But we know that such a choice is not sustainable. Inflationary pressures will then accelerate and additional political pressure will be exerted and will encourage a weak Fed to accommodate them. At this moment in time, I would prefer the misery index weighed more heavily than it already is to unemployment than to inflation, not because I like unemployment, but because I believe that unemployment can be dealt with more effectively than inflation once the latter has really set in.
Thank you for patrolling these borders so well. You and other commentators are providing a real service to our readers at this time.
February 20, 2010 at 3:15 pm |
Professor Rowley,
I agree with your logic and am completely in the monetarist camp as a matter of general principle, but there is one additional factor to take into consideration in our present circumstances. That is the fact that, since October 2008, the Fed has been able to pay interest on bank reserves. Part of the reason that banks have not put their new reserves into circulation is because the Fed is essentially bribing them to hold the money rather than lend it out.
This could go on indefinitely. When I learned about this, it occurred to me that whether or not we get a big inflation is now much more uncertain than I thought it was. If they raise the rate they’re paying banks to hold their reserves when the economy recovers, it could be that that money never makes its way out into the economy.
February 20, 2010 at 4:01 pm |
Adam:
You are correct to bring this strategy to the fore since it is already in place to a small extent. I did review the arguments pro and con for this policy in my column dated February 6, drawing upon some discussion by Allan Meltzer. He concluded, and I agree with him, that if inflationary expectations take off, the interest rates that the Fed would have to pay to buy off the banks would be sufficiently high as to choke off economic recovery. If so, the Fed ultimately would still have to choose between inflation and unemployment. In the current political climate it would allow inflation to take off, especially as this would reduce the real value of the debt.
Thank you very much for your thoughtful contribution.
February 20, 2010 at 5:20 pm |
You’re welcome sir, and thank you for your thoughtful response!
I’ve also been wondering if, when we reach recovery and move into an economic boom, the rate that banks could earn by lending out to the private sector would be higher than the Fed would be willing to raise the rate it pays on reserves to. That could possibly be the cause of the future inflation expectations you mention.
February 20, 2010 at 7:43 pm |
Just a couple of thoughts here regarding the issue of stagflation. This was encountered for the very first time in the 1970s. Australia for example was hard hit during the 1970s and did not fully recover until the 1980s. What preceded the stagflation in Australia was a Govt expansionary budget. The budget that was prior to the election in 1972 was mildly expansionary. At that stage unemployment was on the rise. When Whitlam won the election, his government went mad and instituted a number of expansionary reforms that increased the budget deficit by a wide margin at the time. The stagflation was evident by the end of 1973. Australia was hit by high demands for wage rises, high prices and a rising CPI during that time.
This scenario apparently was repeated in Great Britain and the USA. Great Britain for example had to go to the IMF because of a budget deficit that was out of control. Since there are usually lags involved before inflation, deflation or stagflation shows itself it would be highly likely that the cause of the problem in the USA was the expansionary policies of LBJ, coupled with the fact that he went to war in Vietnam and did not raise taxes at the same time.
I believe that it requires a mix of the Monetarist policies as well as Keynesian to have a balanced economy. What is becoming clear to me is that when Govt strayed from the “prescription” the inflation got worse. Keynesian policy is not suitable today because the variables within the economy are very different. For example, Keynes observed economies where women stayed at home, and now women make up to about 50% of the workforce. This has obvious implications in the jobs market. Other variables such as: childcare, maternity leave, holiday leave loading, govt healthcare, public education etc. were things that did not exist or hardly existed during the period when Keynes was alive. Another variable relates to immigration, and yest the impact of unskilled immigrants who are more like parasites in the economy is important.
At this point in time, I do not know if these variables matter with regard to the emergence of stagflation. I think that perhaps there are other issues that I have not considered, including the fact that manufacturing has been moving offshore and is being set up in China, India and Malaysia instead of in the USA, Australia and Great Britain.