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April 18, 2014

Money-isms: Monetarism

Welcome back to our week of looking at different financial theories, to see what insight we can gain about the interaction of fiscal policy, political philosophies, and the economy.  Yesterday, we looked at Keynesianism, one of the more interventionist money policies, so it’s only fair that we take a look at the policy that’s considered its biggest rival.  That’s right, today’s economic theory is


Founded By

Milton Friedman is the founder of the Monetarism school of economics, much as Keynes created the Keynesian school several decades earlier (the two men never met, but Friedman noted that he received two correspondences from Keynes, both rejection letters).  In his younger years, Friedman worked for the Federal Government and was an advocate for Keynesian policies.

Another Famous Economist, Another Time Cover

Another Famous Economist, Another Time Cover

His most important work, A Monetary History of the United States, 1867-1960 (co-written with Anna Schwartz), set forth the principles of monetarism.  During the sixties, his ideas came to prominence, winning him a Nobel prize in 1976 and inspiring numerous financial leaders over the past several decades.

The Theory

Monetarism, as you might guess, is primarily concerned with controlling the money supply.  In contrast to Keynesian theory, where the government was viewed as having an important job stabilizing the economy, Monetarism tasked the government with simply maintaining the money supply, and allowing the rest of the economy to take care of itself.  By controlling prices via the amount of money available, Friedman and other Monetarists maintained that most other aspects of the economy would take care of themselves.

Another major tenant of Monetarism is the need to fight against inflation.  Inflation is viewed as a monetary phenomenon, the result of too much money being added to the economic system (frequently the result of attempts by government to increase the productivity of the system).  The goal under Monetarism should be to keep the amount of money in the system from growing too fast, leading to inflation and causing a great deal of pain for the economy at large.

For Monetarists, the role of government in economic life should be fairly small.  The control of the money supply, the basis for most Monetarist economic influence, should be left to independent central banks (with strict governing their behavior), rather than in government hands.  These banks should pump more money into the system in the event of a downturn, to prevent deflation; in this view, the failure to do so in the 1930s was one reason that the Great Depression lasted so long and was so severe.

Criticism of Monetarism

Obviously, most of the principles of Monetarism are in conflict with Keynesian principles, as already mentioned.  Keynes and others who followed his economic views downplayed the role of money supply in the economy, encouraged the government to take on deficits to spread money in the event of a downturn, and had a high focus on unemployment and economic growth as opposed to the less interventionist Monetarists.  Some Neo-Keynesians have argued that demand for money is intrinsic to the available supply, in contrast to Monetarist principles.

There are also disagreements between Monetarists and followers of the Austrian School regarding several principles.  Austrian School economists stress the individual’s subjective valuation of money, and reject the attempts of Monetarists to create an objective valuation of money.  This disagreement between the ‘quantity of money’ thinking of the Monetarists and the ‘value of money’ views of the Austrian school provide one source of friction between the two groups.

Since the 1990s, there have been several events in the economic world that have called Monetarist principles into question.  The separation of money supply growth from inflation in the 1990s, the economic trouble in Japan during that same period, and the inability of Monetarist policies to revive the economy in the wake of the 2001-2003 all have caused doubt for the once firm believers in Monetarism.  Add in differing explanations from a variety of quarters regarding issues like the cause of the Great Depression, and the theory of Monetarism is far from unassailable.

A Brief History

The publication of Friedman and Schwartz’s book didn’t attract much attention at first, but during the 1970′s, it began to draw more attention.  When Keynesian economics seemed unable to combat the economic stagnation and high inflation rates that dominated the latter half of that decade, Monetarism was embraced by politicians and economists alike.  The message of fighting inflation, not unemployment was widely enacted.

During the Reagan years in the US (and with corresponding action in the UK and Germany), actions were taken to control the impact of inflation, causing inflation levels to drop and leading to other Friedman policies to be passed.  Financial markets were allowed to operate more freely and inflation and money growth were slowed.

In the 1990s, as already mentioned, events started to occur that changed the perception of Monetarism, decreasing its popularity.  Even among its followers, the monetary policies recommended by Monetarism are difficult to time correctly and put into policy.  Add in the recent downturn and the potential link between some Monetarist policies and the downturn, and Monetarism is in considerable decline (as Keynesianism is on the rebound).

Three Sentence Summary

Monetarism suggests that the most important thing for the government (or rather, a central bank) to do to the affect the economy is to control the money supply.  By restricting the growth of available money, the government can keep inflation under control and allow the rest of the economy to fall into place.  Although very popular in the late seventies and eighties, the last two decades have raised some major concerns about Monetarist policies, though they still remain quite influential.

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