The Limitations of Monetarism

It seems to me that the current economic recession and the financial crisis that precipitated it are distinguished by the extent to which they were created by conservative ideology and created by misguided conservative economic policy. The events of the past year have also laid bare the limitations of monetarism, the economic credo which holds that the most important instrument of economic policy is monetary policy, and that the objectives of monetary policy are best met by targeting the growth rate of the money supply. Monetarists (most famously Milton Friedman and Alan Greenspan) advocated a central bank policy aimed at keeping the supply and demand for money at equilibrium, as measured by growth in productivity and demand. Neo-Keynesians such as Jospeh Stiglitz and Paul Krugman have argued that the relationship between inflation and money supply growth is weak when inflation is low; and, as Lord Keynes himself pointed out, monetary policy is bound to be less effective (and fiscal policy correspondingly more important) when interest rates are low. While monetarism gained credibility in the 1970s and 1980s, when inflation appeared to be the biggest problem (and high interest rates were deemed to be part of the solution), its limitations have been made all-too-apparent in the past year.

In the first place, the attitude of monetarist central bankers that they should concentrate on getting the money supply right and controlling inflation and otherwise be non-interventionist played right into the hands of financiers bent on leveraging more and more money in an ever-expanding speculative bubble that was bound to burst.

In the second place, exclusive reliance on monetary stimulus while keeping budgets balanced when interest rates are near zero would guarantee a much worse recession.

Clearly, right-wing monetarists have as much reason for humility in the face of this crisis as Keynesians did in the inflationary crisis of 25-30 years ago.

An Expert Agrees With Me (Sort of):

Hi Mark,

I’d more or less agree. The term Monetarism is used in the profession to describe monetary targeting. As there are no central banks that do that, the term isn’t used much anymore. Inflation targeting is the new approach. However, it is “monetarist” in the sense that central banks have concentrated on inflation and have advocated that it should be the only goal of monetary policy. In the abstract, this is a compelling position provided there are in place other mechanisms for controlling credit. David Dodge at the Canadian meetings argued for an umbrella institutional structure for dealing with the various dimensions of credit. In the absence of such a structure, the Bank should have been cognizant of asset price targeting.

---M.E. (UVIC Economics Department)