Monetarism today is mainly associated with the work of Milton Friedman, who was among the generation of economists to accept Keynesian economics and then criticize it on its own terms. Friedman and Anna Schwartz wrote an influential book, Monetary History of the United States 1867-1960, and argued that "inflation is always and everywhere a monetary phenomenon." Friedman advocated a central bank policy aimed at keeping the supply and demand for money at equilibrium, as measured by growth in productivity and demand. The monetarist argument that the demand for money is a stable function gained considerable support during the late 1960s and 1970s from the work of David Laidler. The former head of the United States Federal Reserve, Alan Greenspan, is generally regarded as monetarist in his policy orientation. The European Central Bank officially bases its monetary policy on money supply targets.
Critics of monetarism include both neo-Keynesians who argue that demand for money is intrinsic to supply, and some conservative economists who argue that demand for money cannot be predicted. Joseph Stiglitz has argued that the relationship between inflation and money supply growth is weak when the inflation is low.
Monetarism is an economic theory which focuses on the macroeconomic effects of the supply of money and central banking. Formulated by Milton Friedman, it argues that excessive expansion of the money supply is inherently inflationary, and that monetary authorities should focus solely on maintaining price stability.
This theory draws its roots from two almost diametrically opposed ideas: the hard money policies that dominated monetary thinking in the late 19th century, and the monetary theories of John Maynard Keynes, who, working in the inter-war period during the failure of the restored gold standard, proposed a demand-driven model for money which was the foundation of macroeconomics. While Keynes had focused on the value stability of currency, with the resulting panics based on an insufficient money supply leading to alternate currency and collapse, then Friedman focused on price stability, which is the equilibrium between supply and demand for money.
The result was summarized in a historical analysis of monetary policy, Monetary History of the United States 1867-1960, which Friedman coauthored with Anna Schwartz. The book attributed inflation to excess money supply generated by a central bank. It attributed deflationary spirals to the reverse effect of a failure of a central bank to support the money supply during a liquidity crunch.
Friedman originally proposed a fixed monetary rule, called Friedman's k-percent rule, where the money supply would be calculated by known macroeconomic and financial factors, targeting a specific level or range of inflation. Under this rule, there would be no leeway for the central reserve bank (money supply increases could be determined "by a computer"), and business could anticipate all monetary policy decisions.
The rise of monetarism within mainstream economics dates mostly from Milton Friedman's 1956 restatement of the quantity theory of money. Friedman argued that the demand for money depended predictably on several major economic variables. Thus, were the money supply expanded, people would not simply wish to hold the extra money in idle money balances; i.e., if they were in equilibrium before the increase, they were already holding money balances to suit their requirements, and thus after the increase they would have money balances surplus to their requirements. These excess money balances would therefore be spent and hence aggregate demand would rise. Similarly, if the money supply were reduced people would want to replenish their holdings of money by reducing their spending. Thus Friedman challenged the Keynesian assertion that "money does not matter"; he argued that the supply of money does affect the amount of spending in an economy. Thus the word 'monetarist' was coined.
The rise of the popularity of monetarism in political circles accelerated when Keynesian economics seemed unable to explain or cure the seemingly contradictory problems of rising unemployment and inflation in response to the collapse of the Bretton Woods system in 1972 and the oil shocks of 1973. On the one hand, higher unemployment seemed to call for Keynesian reflation, but on the other hand rising inflation seemed to call for Keynesian deflation. The result was a significant disillusionment with Keynesian demand management: a Democratic President Jimmy Carter appointed a monetarist Federal Reserve chief Paul Volcker who made inflation fighting his primary objective, and restricted the money supply to tame inflation in the economy. The result was the most severe recession of the post-war period, but also the creation of the desired price stability.
Monetarists not only sought to explain present problems; they also interpreted historical ones. Milton Friedman and Anna Schwartz in their book A Monetary History of the United States, 1867-1960 argued that the Great Depression of 1930 was caused by a massive contraction of the money supply and not by the lack of investment Keynes had argued. They also maintained that post-war inflation was caused by an over-expansion of the money supply. They coined the famous assertion of monetarism that 'inflation is always and everywhere a monetary phenomenon'. At first, to many economists whose perceptions had been set by Keynesian ideas, it seemed that the Keynesian vs. monetarist debate was merely about whether fiscal or monetary policy was the more effective tool of demand management. By the mid-1970s, however, the debate had moved on to more profound matters when monetarists presented a more fundamental challenge to Keynesian orthodoxy.
Many monetarists sought to resurrect the pre-Keynesian view that market economies are inherently stable in the absence of major unexpected fluctuations in the money supply. Because of this belief in the stability of free-market economies they asserted that active demand management (e.g. by the means of increasing government spending) is unnecessary and indeed likely to be harmful. The basis of this argument is an equilibrium between "stimulus" fiscal spending and future interest rates. In effect, Friedman's model argues that current fiscal spending creates as much of a drag on the economy by increased interest rates as it creates present consumption: that it has no real effect on total demand, merely that of shifting demand from the investment sector (I) to the consumer sector (C).
The crucibles of economic theories are the cataclysmic events which reshape economic activity. Hence, major economic theories which aspire to a policy role must explain the great deflationary waves of the late 19th Century with their repeated panics, the Great Depression which began in the late 1920s and peaked in early 1933, and the stagflation period beginning with the uncoupling of exchange rates in 1972.
Monetarists argue that there was no inflationary investment boom in the 1920s, in contrast to both Keynesians and to economists of the Austrian School, who argue that there was significant asset inflation and unsustainable GNP growth during the 1920s. Instead, monetarist thinking centers on the contraction of the M1 during the 1931-1933 period, and argues from there that the Federal Reserve could have avoided the Great Depression by moves to provide sufficient liquidity. In essence, they argue that there was an insufficient supply of money. This argument is supported by macroeconomic data, such as price stability in the 1920s and the slow rise of the money supply.
The counterargument is that microeconomic data support the conclusion of a poorly distributed pooling of liquidity in the 1920s, caused by excessive easing of credit. This viewpoint is argued by followers of Ludwig von Mises, who stated at the time that the expansion was unsustainable, and at the same time by Keynes, whose ideas were included in Franklin D. Roosevelt's first inaugural address.
From their conclusion that incorrect central bank policy is at the root of large swings in inflation and price instability, monetarists argued that the primary motivation for excessive easing of central bank policy is to finance fiscal deficits by the central government. Hence, restraint of government spending is the most important single target to restrain excessive monetary growth.
With the failure of demand-driven fiscal policies to restrain inflation and produce growth in the 1970s, the way was paved for a new change in policy that focused on fighting inflation as the cardinal responsibility for the central bank. In typical economic theory, this would be accompanied by austerity shock treatment, as is generally recommended by the International Monetary Fund. Indeed in the United Kingdom, government spending was slashed in the late 70s and early 80s with the political ascendance of Margaret Thatcher, whereas in the United States, real government spending increased much faster during Reagan's first four years (4.22%/year) than it did under Carter (2.55%/year) [ref: 2006 Economic Report of the President, Table B-78 and B-60]. In the ensuing short term, unemployment in both countries remained stubbornly high while central banks raised interest rates to restrain credit. However, the policies of both countries' central banks dramatically brought down the inflation rates (e.g. the United State's inflation rate fell from almost 14% in 1980 to around 3% in 1983), allowing the liberalisation of credit and the reduction in interest rates which paved the way for the ultimately inflationary economic booms of the 1980s. Some claim that the use of credit to fuel economic expansion is itself an anti-monetarist tool, as it can be argued that an increase in money supply alone constitutes inflation.
Monetarism re-asserted itself in central bank policy in western governments at the end of the 1980s and beginning of the 1990s, with a contraction in spending and in the money supply ending the booms experienced in the US and UK.
With the crash of 1987, questioning of the prevailing monetarist policy began. Monetarists argued that the 1987 stock market decline was simply a correction between conflicting monetary policies in the United States and Europe. Critics of this viewpoint became louder as Japan slid into a sustained deflationary spiral and the collapse of the savings-and-loan banking system in the United States pointed to larger structural changes in the economy.
In the late 1980s, Paul Volcker was succeeded by Alan Greenspan, a leading monetarist. His handling of monetary policy in the run-up to the 1991 recession was criticized from the right as being excessively tight, and costing George H. W. Bush re-election. The incoming Democratic president Bill Clinton reappointed Alan Greenspan, and kept him as a core member of his economic team. Greenspan, while still fundamentally monetarist in orientation, argued that doctrinaire application of theory was insufficiently flexible for central banks to meet emerging situations.
The crucial test of this flexible response by the Federal Reserve was the Asian financial crisis of 1997-1998, which the Federal Reserve met by flooding the world with dollars, and organizing a bailout of Long-Term Capital Management. Some have argued that 1997-1998 represented a monetary policy bind—as the early 1970s had represented a fiscal policy bind—and that while asset inflation had crept into the United States, demanding that the Fed tighten, the Federal Reserve needed to ease liquidity in response to the capital flight from Asia. Greenspan himself noted this when he stated that the American stock market showed signs of irrationally high valuations.
In 2000, Alan Greenspan raised interest rates several times; these actions were believed by many to have caused the bursting of the dot-com bubble. In autumn of 2001, as a decisive reaction to September 11th attacks and the various corporate scandals which undermined the economy, the Greenspan-led Federal Reserve initiated a series of interest cuts that brought down the Federal Funds rate to 1% in 2004. His critics, notably Steve Forbes attributed the rapid rise in commodity prices and gold to Greenspan's loose monetary policy which is causing excessive asset inflation and a weak dollar. By late 2004 the price of gold was higher than its 12 year moving average.
Alan Greenspan is blamed by the followers of the Austrian School for creating excessive liquidity which caused lending standards to deteriorate resulting in the housing bubble of 2004-2006. Currently the American Federal Reserve follows a modified form of monetarism, where broader ranges of intervention are possible in light of temporary instabilities in market dynamics. This form does not yet have a generally accepted name.
In Europe, the European Central Bank follows a more orthodox form of monetarism, with tighter controls over inflation and spending targets as mandated by the Economic and Monetary Union of the European Union under the Maastricht Treaty to support the euro. This more orthodox monetary policy is in the wake of credit easing in the late 1980s and 1990s to fund German reunification, which was blamed for the weakening of European currencies in the late 1990s.
Since 1990, the classical form of monetarism has been questioned because of events which many economists have interpreted as being inexplicable in monetarist terms, namely the unhinging of the money supply growth from inflation in the 1990s and the failure of pure monetary policy to stimulate the economy in the 2001-2003 period. Alan Greenspan, former chairman of the Federal Reserve, argued that the 1990s decoupling was explained by a virtuous cycle of productivity and investment on one hand, and a certain degree of "irrational exuberance" in the investment sector. Economist Robert Solow of MIT suggested that the 2001-2003 failure of the expected economic recovery should be attributed not to monetary policy failure but to the breakdown in productivity growth in crucial sectors of the economy, most particularly retail trade. He noted that five sectors produced all of the productivity gains of the 1990s, and that while the growth of retail and wholesale trade produced the smallest growth, they were by far the largest sectors of the economy experiencing net increase of productivity. "2% may be peanuts, but being the single largest sector of the economy, that's an awful lot of peanuts."
There are also arguments which link monetarism and macroeconomics, and treat monetarism as a special case of Keynesian theory. The central test case over the validity of these theories would be the possibility of a liquidity trap, like that experienced by Japan. Ben Bernanke, Princeton Professor and current Chairman of the US Federal Reserve, has argued that monetarism could respond to zero interest rate conditions by direct expansion of the money supply. In his words "We have the keys to the printing press, and we are not afraid to use them." Another popular economist, Paul Krugman, has advanced the counterargument that this would have a corresponding devaluationary effect, like the sustained low interest rates of 2001-2004 produced against world currencies.
David Hackett Fischer, in his study The Great Wave, questioned the implicit basis of monetarism by examining long periods of secular inflation that stretched over decades. In doing so, he produced data which suggests that prior to a wave of monetary inflation, there is a wave of commodity inflation, which governments respond to, rather than lead. Whether this formulation undermines the monetary data which underpins the fundamental work of monetarism is still a matter of contention.
Monetarists of the Milton Friedman school of thought believed in the 1970s and 1980s that the growth of the money supply should be based on certain formulations related to economic growth. As such, they can be regarded as advocates of a monetary policy based on a "quantity of money" target. This can be contrasted with the monetary policy advocated by supply side economics and the Austrian School which are based on a "value of money" target. Austrian economists criticise monetarism for not recognizing the citizens' subjective value of money and trying to create an objective value through supply and demand.
These disagreements, along with the role of monetary policy in trade liberalization, international investment, and central bank policy, remain lively topics of investigation and argument.