Monetarism?

If I understand correctly, Mark is expressing what economists call monetarist theory. I am far from knowledgeable about monetarism, but my guess--Mark please correct me here--is that it bloomed around 1950 with the work of Milton Friedman and Anna Schwartz.

At that time, the primary mediums of exchange in the developed world consisted only of cash that sovereign nations created, and deposits held in their banks. The Federal Reserve and other central banks added these amounts together to determine the "money supply." Over the years other items have been added, so that today there are three successively broader measures of money supply--M1, M2, and M3. 

If I may simplistically describe the monetarist view that arose under these circumstances, it was that the money supply determined the health of the total national economy, a total now measured as Gross Domestic Product (GDP). If the money supply was too small, firms would find it harder to obtain money, they would spend less, unemployment would rise, and a recession would follow. If the money supply was too large, the nominal price of goods and services would rise. With inflation, loans would be repaid in money with less purchasing power. Creditors would adjust their terms, money would be harder to obtain, firms would spend less, unemployment would rise, and a recession would follow. The proper solution, then, was to maintain a steady or “Goldilocks” money supply relative to the economy’s GDP, and by adjusting interest rates prevent undue inflation or deflation.

This theory was very attractive to the more comfortable segment of society because such people were, by and large, the creditors who would suffer immediate losses in purchasing power if inflation occurred, and who would not suffer personally if raising the interest rates to prevent inflation resulted in job losses. It was also attractive in its simplicity: one factor alone, easily measured and controlled, could determine the health of the economy. Moreover, during a prolonged period of American economic growth (not counting the Depression), it seemed an adequate explanation of the economic cycles intellectually validated by Friedman and Schwartz’s massive statistics.

Applying this logic to the current economic situation leads many modern conservatives, such as the Peterson Institute, to something like Mark’s point of view. Since late 2008 the federal government and the Federal Reserve have greatly increased the money supply, and Mark claims this spending did not get us much of a recovery from the Great Recession, and “is about to give way again.”

I have two basic difficulties with this economic theory. First and most importantly, I think finance has greatly changed. Mediums of exchange have expanded well beyond cash and bank credit, and they come from many domestic sources that have grown dynamically, that the authorities do not regulate, and whose impact they cannot really measure. Moreover, a large and growing share of these money supply sources are international. Consequently, a simple effort to regulate the domestic money supply has much less impact than it did a few decades ago, and no longer serves as the simple lever that it once seemed to do.

My second difficulty is based on evidence. It has been seven or eight years since the Obama stimulus and the Fed’s quantitative easing began. Yet inflation has not arisen in the US, and similar stimulus efforts have not produced inflation in Europe. As Krugman likes to say, monetarists have predicted 15 of the last 3 recessions. Moreover, it seems there is a good reason for the lack of inflation: lack of demand. Monetarists see demand as determined by the money supply. But that hasn’t happened now. Nor did it happen in Japan in the early ‘90s. On the contrary, it seems pretty clear that low demand for money has led banks to hoard most of the funds that the Fed so generously provided, and has led to a much slower circulation of money in general—a circulation known as the velocity of money.

I will concede that, to some extent, the lack of demand results from the stifling of Democratic efforts to increase government spending, which could not offset the sharp reductions in spending that States experienced. As a result, the amount of money actually provided to counter the Great Recession has been very limited, far lower than most economists had thought necessary. Although this may be happy news for monetarists, it does mean that employment has been very slow and partial in recovery. But of course the monetarists are not themselves much affected.