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Up from Monetarism and Other Wishful Thinking

A case can readily be made that the English-speaking countries, the United Kingdom and the United States in particular, are currently getting the economic policy that they deserve. Theology, wishful thinking, and a modest resort to necromancy have extensively replaced practical judgment on both sides of the Atlantic. The results are in keeping. The British experiment along these lines is more advanced than that in the United States, so the economic consequences in England are much worse. But the administration in Washington has come to office with a powerful promise that it will repeat the British error. It agrees that government should not in these days take instruction from experience—its own or that of others. I do, of course, wish to be even-handed in these sordid matters; there is little to be said for the alternative policies so far being advanced by most of those now out of office.

The problem, stripped of the priestly incantation by which economists in high public or private position assert their superior identification with the occult, is simple. The unrelenting affliction of the modern industrial society is inflation; it is against this affliction that the hard core of economic policy is arrayed. There are only three designs for contending with inflation. The first is by controlling the spending and respending of the proceeds from bank and general lending. Though described in different terms by its advocates, this is the essence of monetary policy. The second design is by the control of private expenditure through taxation and of public expenditure through restraint on governmental spending. This is fiscal policy. The third design involves direct intervention by government on incomes and prices in that part of the economy where wage advances can press up prices and prices can stimulate wage demands, and where the result is a continuing upward spiral that, in turn, sets a pattern for the less organized part of the economic system. These are the only three designs for contending with inflation. There are no others.

I shall have a word presently on the notion now current in the United States that inflation can be quenched by increased productivity and supply. This is a relatively unsophisticated form of fraud. Annual productivity gains are minimal in relation to current rates of inflation. At the very best they will so continue. It is only increased production that is induced by more efficient use of labor and capital that works against inflation. Expansion in output that does not involve cost reduction carries with it the increased purchasing power by which it is bought. This purchasing power sustains prices. Ronald Reagan, we now know, is an activist where economic policy is involved. But even he cannot repeal this application of what is known as Say’s Law, a notably conservative economic proposition, I would also observe.

Thus we come to the sources of the present sorrow and the reason why it is readily explicable and indeed elementary. In modern highly organized economies all three measures, all three, are needed for dealing with the problem of inflation—they are needed if governments are to avoid a crucifying increase in unemployment, idle plant capacity, business failures, and disruption in the international exchanges and capital movements. But in both the United Kingdom and the United States there is an overriding commitment to one, and only one, of these measures—monetary policy. In both countries an incomes and prices policy is rejected on grounds of high market principle except as it involves employees in the public sector. In both countries there is a rhetorical embrace of a conservative fiscal policy—according to terminology, to a small or negative deficit or public-sector borrowing requirement. In both countries the fiscal or budget policy is, in fact, exceedingly weak or, in the American case, will become so. There remains therefore, only monetary policy.

Monetary policy, however, is not just a residual course of action; in both countries it is also an affirmative faith. And it is this faith that combines the wishful thinking and theology. It is wonderful to imagine that the problem of economic management in all its complexity can be solved by leaving everything to the ordered, quiet, subtle, slightly mysterious world of the Bank of England and the Federal Reserve System. How nice, in an otherwise secular matter, to believe that God is securely in support of Professor Milton Friedman, the most eloquent, optimistic, and convinced of economic prophets. Control the supply of money, allow it to increase only as income and output in the economy increase, and you have controlled all. In Britain this rule has been inscribed on the sacred tablets at Whitehall. But with Ronald Reagan in the White House and Beryl Sprinkel in charge of monetary affairs in the United States Treasury, no one can suggest that Professor Friedman is a prophet without honor in his own country. Mr. Sprinkel, a few weeks ago, went so far as to say that the federal deficit was immaterial so long as there was a tight hold on the money supply. It is now the policy in the United States to relive the British travail.

As do other economists, I have a particular penchant for the redundant and the obvious. There are so few things in our discipline that are certain; thus the satisfaction in saying that the British experience shows that monetarism in isolation does not work. This, manifestly, is something Englishmen, the Scots, and Welsh already know. It is also now known that the difficulties are at three levels. There is (1) the uncertainty about what is money; there is (2) the certainty that what the central bank chooses to define as money cannot, either in quantity or velocity, be controlled; and there is (3) the further and demonstrated certainty that efforts at control, to the extent that they are pressed, will substitute for the problem of inflation the alternatives of high unemployment, recession or depression, and disaster for those industries which depend on borrowed money. There are other lesser effects to which I will return.

As to what is to be called money, not even the monetarists agree. That is because in the modern sophisticated economy there are many media of payment and exchange—currency or the money base, deposits subject to check, savings deposits subject to check or readily converted to checking accounts, unused lines of credit, unused overdraft facilities, the purchasing power that lies back of credit cards. The decision on what is to be controlled is largely, though not quite completely, arbitrary. Were it otherwise, the monetarists would not be debating within the cult what should be controlled.

But it is now the revealed experience of both the Bank of England and the Federal Reserve System (I eschew the egregious commitment to an ostentatious familiarity which causes economists and journalists to speak of “The Fed”) that, having decided what will be called money, they cannot control it. They cannot make any pretense to controlling the turnover or velocity which in all the monetarist equations is one dimension of the effect on prices. Reduce the volume of money in the form of checking accounts and a partly offsetting increase in the rate of use is quite conceivable. But neither, with any precision, can the Federal Reserve control the shifts between different kinds of money—some controlled, some beyond reach of control—or the rate at which borrowers come to the banks for the accommodation which, as loans and deposits, then becomes part of the monetary aggregates.

This inability to control the money supply as it is defined is the common experience of the central banks of both countries. It has caused Professor Friedman (and one gathers also the Chancellor of the Exchequer) to accuse the Bank of England of incompetence. And, in an equally forgettable current controversy in Washington, it has caused Mr. Sprinkel of the Treasury to attribute similar fecklessness to the Federal Reserve System. It will occur to most people, although not alas to passionate monetarists, that any policy that relies heavily on a central bank must be with-in the going competence of the central bank. The monetarists are asking the central banks to do what, in the modern economy, they cannot do.

That does not mean that the effort is without consequence. Or that it is without effect on inflation. Monetary policy, as earlier noted, limits expenditure and re-expenditure from borrowed funds. This it accomplishes by rationing their use by high interest rates and tightened loan conditions. (The manipulation of reserve requirements and discount rates by which this is accomplished is not without sophistication, but it can be ignored.) The resort to high interest rates and astringent borrowing conditions in general has an immediately adverse effect on those industries that depend for their operations on borrowed funds—housing being the outstanding case but smaller or weakly financed businesses being also generally vulnerable. Acting as it does on borrowing for investment rather than on consumption, it has an adverse effect on productivity. It has a devastating effect on the bond market, and is far from good for common stocks. It is one of the dubious virtues of the policy that, in a high-minded way, it does not spare its friends. And, as we currently observe, monetarism conduces to large movements in footloose international balances as they try to capture the high interest returns. Thus the policy has a deeply unsettling effect on the international exchanges.

But the truly serious effects are on general macroeconomic performance. The archons of monetarism, I need hardly argue, are men much committed to the market. If you have sufficiently studied the classical market, such can be your affection for this useful institution that you can believe that, in its pristine form, it exists everywhere. In a university this is an amiable and harmless fantasy; in practical application to a world of numerous, diverse, sensitive, and obstreperous unions, strong corporations, farm organizations, OPEC, and a large public sector, it is hopelessly and disastrously in conflict with reality. The consequence of that conflict is the discovery that only a severe restraint on aggregate demand has an appreciable effect on wages and prices.

The astringency must be sufficiently severe so that corporate employers, contemplating their shrinking market, as now in the American automobile industry, are moved to resist union demands. And unions, contemplating their unemployed members, as now at Chrysler, are moved to concede. And OPEC is forced to second thoughts. And (as now) unprotected world commodity prices are forced down. In a highly organized society monetary policy works against inflation. But it works, experience now tells us, both unequally and by producing a high and enduring volume of unemployment and a severe recession in business activity. It is one of Britain’s great, useful, and painful contributions to economic understanding that it has shown that this is not an economist’s construct; it is a matter of practical experience.

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