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In this exchange over monetarism, I fear that in terms of policy, which
iswhat really counts in the end, the questions are perhaps being too
narrowly set. It is not just monetarism in the sense of using control of
the money supply to influence other variables that is at issue, but the
general belief within central banks that they actually know something
useful that can be employed to manage economies.
Thinking about monetarism, whether rising or falling, may therefore only be
thinking about half the problem, if even that. It is the application of
economic theory to central bank policy which is at the centre of the issues
raised. Rob Leeson noted that every central bank across the developed world
has been focusing on such matters and has been employing some variant
monetary theory to manage their own domestic economies. The relationship
between theory and policy sorely needs major investigation because it is
central bank actions which have had the most destabilising consequences.
The past decade and a half have provided a fresh episode in what is a very
long history of monetary misdiagnosis and mismanagement.
The issue lying behind discussion of monetarism and the quantity theory of
money has been inflation control. Monetarism, as in the application of the
quantity theory to policy questions, is only one of the ways in which
keeping prices within an acceptable band has been attempted. It is the
crossover between theory and policy which has raised crucial questions
about applied economic theory that are now in need of serious answers.
The point about monetarism was that in theory anyway it gave policy makers
in the present useful knowledge about the inflation rate at some stage in
the future. What it also theoretically gave them was a tool with which they
could modify the rate of inflation. If one could reliably make estimates of
a future inflation rate by looking at today's rate of money supply growth,
and if one could actually adjust the rate at which the money stock grew,
then one could bring inflation under some kind of control by reducing the
growth rate in money. In quantity theory terms, this required predictable
movements in V and Q which would allow one to relate the growth in M to the
future growth in P.
Whether it was because it was intrinsically impossible to do, or because
the theory was never properly applied, the fact of the matter was that the
attempts to put the quantity theory at the core of anti-inflation policy
was ultimately discarded because, firstly, it did not seem to work, and
then secondly, because of the serious side effects its application appeared
to cause. But towards the end of the 1980s, the process was anyway
superseded by the application of the NAIRU which supposedly provided a
different relationship between something one could know in the present -
this being the rate of unemployment - and a future rate of inflation. Once
a NAIRU had been calculated for an economy, variations in the rate of
unemployment could be used to adjust the rate of inflation. That too has
now been discarded, in this case only because of the phenomenal fall in the
unemployment rate in the United States following which there was not a hint
of inflation. The use of the NAIRU to control inflation was therefore
largely discredited by what had happened in the real world and its use in
policy formation has been quietly fading from view.
Where we now seem to be is in the most extraordinary muddle in
counter-inflationary policy. We seem to have at the core of policy nothing
more than the rate of economic growth which is of itself taken to be the
main cause of inflation. It is "excessive" rates of growth that are seen by
central banks as the cause of inflation and maintaining a tight grip on
inflation appears to mean little more than keeping a tight grip on GDP
growth. The policy of central banks, from the Federal Reserve in the US
outwards, is merely to prevent economies from expanding too rapidly so that
inflation can be kept under wraps. The key concern is to prevent economies
from "overheating".
In terms of the quantity theory, what we seem to be doing is discarding the
MV side of the equation altogether and relying on PQ alone. We are
attempting to control prices by controlling output growth. If there is
anyone in the policy setting area at the moment who pays anything other
than perfunctory attention to the growth in any particular money supply
measure, they have not bothered to mention it in public. The quantity
theory, in the sense of a relationship between the growth in the money
stock and the growth in the price level, seems to be, in policy terms,
virtually dead.
The result of this form of inflation control has been that even as the
price of imported crude oil was rising throughout the developed world,
central banks were raising interest rates to cool off economies that were
seen to be under some sort of inflationary threat. We now have the
spectacle of interest rates being lowered in the United States at an
unprecedented rate to head off a potential economic recession that is
clearly related to the previous application of monetary policies aimed at
slowing growth.
The issue is therefore much larger than monetarism as such. It now relates
to the role of central banks in managing economies and the instability they
have been creating in their anti-inflation crusades.
Steve Kates
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