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Revising monetary history of the 1970s

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A new article by The Economist on the confused state of macro-economics makes the following claim:

The Keynesian task of “demand management” outlived the Depression, becoming a routine duty of governments. They were aided by economic advisers, who built working models of the economy, quantifying the key relationships. For almost three decades after the second world war these advisers seemed to know what they were doing, guided by an apparent trade-off between inflation and unemployment. But their credibility did not survive the oil-price shocks of the 1970s. These condemned Western economies to “stagflation”, a baffling combination of unemployment and inflation, which the Keynesian consensus grasped poorly and failed to prevent.

The Federal Reserve, led by Paul Volcker, eventually defeated American inflation in the early 1980s, albeit at a grievous cost to employment. But victory did not restore the intellectual peace. Macroeconomists split into two camps, drawing opposite lessons from the episode.

What happened in the 1970s wasn’t simply because of oil shocks and profligate government spending.  People who blame excessive spending conveniently forgot the Fed aggressively expanded the money supply so as to ensure’s Nixon’s re-election:

Still, President Nixon’s primary concern was not dollar holders or deficits or even inflation. He feared another recession. He and others that were running for re-election wanted the economy to boom. The way to do that, Nixon reasoned, was to pressure the Fed for low interest rates.

Nixon fired Fed Chairman William McChesney Martin, and installed presidential counselor Arthur Burns as Martin’s successor in early 1971. Although the Fed is supposed to be solely dedicated to money creation policies that promote growth without excessive inflation, Burns was quickly taught the political facts of life. Nixon wanted cheap money: low interest rates that would promote growth in the short term and make the economy seem strong as voters were casting ballots.

Because I Say So!

In public and private Nixon turned the pressure on Burns. William Greider, in his book “Secrets of the Temple: How the Federal Reserve Runs The Country” reports Nixon as saying: “We’ll take inflation if necessary, but we can’t take unemployment.” The nation eventually had an abundance of both. Burns, and the Fed’s Open Market Committee which decided on money creation policies, soon provided cheap money.

The key money creation number, M1, which is total checking deposits, demand deposits and travelers checks, went from $228 billion to 249 billion between December 1971 and December 1972, according to Federal Reserve Board numbers. As a matter of comparison, in Martin’s last year, the numbers went from $198 billion to $203 billion. The amount of M2 numbers, measuring retail savings and small deposit, rose even more by the end of ’72, from $710 billion to $802 billion.

Milton Friedman, the great father of monetarism would go on to admit in 1994 that inflation is always a monetary pheonomenon.  That later admission didn’t stop him from leading the charge against Keynesian thought in the 1970s that the the violation of the Philips curve meant Keynesian interventionist policies had failed.  Never mind the fact that Keynes himself did not posit an inverse relationship between unemployment and inflation.  Never mind that Keynes himself had warned of monetarist excesses (in 1919 to be exact) and inflation more than a half  century before Friedman did so:

The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent governments, unable or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance. In Russia and Austria-Hungary this process has reached a point where for the purposes of foreign trade the currency is practically valueless. The Polish mark can be bought for about [three cents] and the Austrian crown for less than [two cents], but they cannot be sold at all. The German mark is worth less than [four cents] on the exchanges….

But while these currencies enjoy a precarious value abroad, they have never entirely lost, not even in Russia, their purchasing power at home. A sentiment of trust in the legal money of the state is so deeply implanted in the citizens of all countries that they cannot but believe that some day this money must recover a part at least of its former value…. They do not apprehend that the real wealth, which this money might have stood for has been dissipated once and for all. This sentiment is supported by the various legal regulations with which the governments endeavor to control internal prices, and so to preserve some purchasing power for their legal tender….

The preservation of a spurious value for the currency, by the force of law expressed in the regulation of prices, contains in itself, however, the seeds of final economic decay, and soon dries up the sources of ultimate supply. If a man is compelled to exchange the fruits of his labors for paper which, as experience soon teaches him, he cannot use to purchase what he requires at a price comparable to that which he has received for his own products, he will keep his produce for himself, dispose of it to his friends and neighbors as a favor, or relax his efforts in producing it.

A system of compelling the exchange of commodities at what is not their real relative value not only relaxes production, but [also] leads finally to the waste and inefficiency of barter. If, however, a government refrains from regulation and allows matters to take their course, essential commodities soon attain a level of price out of the reach of all but the rich, the worthlessness of the money becomes apparent, and the fraud upon the public can be concealed no longer.

The effect on foreign trade of price-regulation and profiteer-hunting as cures for inflation is even worse. Whatever may be the case at home, the currency must soon reach its real level abroad, with the result that prices inside and outside the country lose their normal adjustment. The price of imported commodities, when converted at the current rate of exchange, is far in excess of the local price, so that many essential goods will not be imported at all by private agency, and must be provided by the government, which, in re-selling the goods below cost price, plunges thereby a little further into insolvency….

Searching the literature, I found a 1981 paper which debunks the claim that Keynes was concerned a lot less with inflation than unemployment:

The purpose of this article, however, it to show that the foregoing perceptions are wrong: that far from being an inflationist, Keynes deplored inflation, warned repeatedly of its evils, and recommended restrictive demand management policies to prevent it; that far from being an extreme nonmonetarist, he shared the monetarists’ antipathy to inflation, endorsed their policy goal of price stability, and employed at least five monetarist concepts in his analysis of inflation; and, finally, that far from advocating full employment at any cost, he maintained that even at high unemployment rates expansionary aggregate demand policy must be curbed to prevent inflation. More precisely, this article demonstrates (1) that Keynes was always concerned with inflation, (2) that this concern motivated his advocacy of anti-inflationary aggregate demand management policy on at least two occasions (including once in the Great Depression of the 1930s), and (3) that there are enough monetarist elements in his analysis to qualify him as at least a partial monetarist as far as inflation theory is concerned.

In short, given his beliefs about the efficacy of discretionary policy, his advocacy of such policy was perfectly consistent with his antipathy to inflation. That anti- pathy amply justifies F. A. Hayek’s judgment that if Keynes were alive today he would be “one of the most determined fighters against inflation” [4; p. 40, n. 1]

So much for monetarist talking points. Even Cafe Hayek, an online outlet for Austrian non-interventionist fiscal views, acknowledges that Keynes was much more worried about inflation than commonly thought.


Written by defennder

July 19, 2009 at 1:24 PM

2 Responses

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  1. I wonder if this crisis will be monetarism’s Waterloo.

    Perhaps the answer is in Austrian economics almost every single one of them Marc Faber, Ron Paul etc saw this crisis coming. However, their solution is even scarier than the crisis – let everything fall apart then rebuild the financial system…

    Lucky Tan

    July 21, 2009 at 5:27 PM

  2. Hi Lucky,

    Thanks for reading and commenting.

    As a non-economist I can’t offer much. But I’d say I used to diss much of what the Austrians had to say. That changed somewhat when I learned that some Austrians were trumpeting the 1921 recession in America as proof that both monetary and fiscal policies may do more harm than good.

    According to them, the US government in 1921 did essentially nothing and yet the economy rebounded swiftly. At least one monetarist, Professor Scott Sumner of Bentley University who recently debated monetary policy with more tight-fisted economist John Cochrane stumbled somewhat in trying to explain the 1921 recession. You can see his post and counter-arguments in comments on that here.

    Personally my current views (not well articulated) are that monetary policy must be coupled with some form of regulation to prevent over-speculation. Hence a Fed Chair like Greenspan who was both a monetarist and a free-marketeer was I think, a disaster waiting to happen.

    As for myself, I’ll see if I can dig around some more for more information. I should add a notification on my blog as a header: “Warning, views expressed currently may be subjected to future changes” in the mean time ;).


    July 21, 2009 at 11:59 PM

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