Monetarism

Monetarism is a set of views concerning the determination of national income and monetary economics. It focuses on the supply and demand for money as the primary means by which economic activity is regulated. Monetary theory focuses on money supply and on inflation as an effect of the supply of money being larger than the demand for money.

Monetarism in practice

The crucibles of economic theories are the cataclysmic events which reshape economic activity. Hence, major economic theories which aspire to a policy role must explain the great deflationary waves of the late 19th Century with their repeated panics, the Great Depression which began in the late 1920s and peaked in early 1933, and the stagflation period beginning with the uncoupling of exchange rates in 1972.

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Monetarists argue that there was no inflationary investment boom in the 1920s, in contrast to both Keynesians and to economists of the Austrian School, who argue that there was significant asset inflation and unsustainable GNP growth during the 1920s. Instead, monetarist thinking centers on the contraction of the M1 during the 1931-1933 period, and argues from there that the Federal Reserve could have avoided the Great Depression by moves to provide sufficient liquidity. In essence, they argue that there was an insufficient supply of money. This argument is supported by macroeconomic data, such as price stability in the 1920s and the slow rise of the money supply.

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The counterargument is that microeconomic data supports the conclusion of a maldistributed pooling of liquidity in the 1920s, caused by excessive easing of credit. This viewpoint is argued by followers of Ludwig von Mises, who stated at the time that the expansion was unsustainable, and at the same time by Keynes, whose ideas were included in Franklin D. Roosevelt's first inaugural address.

Related Topics:
Ludwig von Mises - Keynes - Franklin D. Roosevelt

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From their conclusion that incorrect central bank policy is at the root of large swings in inflation and price instability, monetarists argued that the primary motivation for excessive easing of central bank policy is to finance fiscal deficits by the central government. Hence, restraint of government spending is the most important single target to restrain excessive monetary growth.

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With the failure of demand-driven fiscal policies to restrain inflation and produce growth in the 1970s, the way was paved for a new change in policy, focusing on inflation fighting as the cardinal responsibility for the central bank. In typical economic theory, this would be accompanied by austerity shock treatment, as is generally recommended by the International Monetary Fund. Indeed in the United Kingdom and the United States, government spending was slashed in the late 70s and early 80s, resulting in stubbornly high unemployment and little growth or productivity improvement, while central banks raised interest rates to restrain credit. It was only from around 1983-1987, with a liberalisation of credit - an anti-monetarist move - that the economic situation improved in the United Kingdom and the United States.

Related Topics:
International Monetary Fund - United Kingdom - United States

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Monetarism re-asserted itself in central bank policy in western governments at the end of the 1980s and beginning of the 1990s, a contraction in spending and in the money supply bringing to an abrupt end the boom that had been experienced in the US and UK.

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With the crash of 1987, questioning of the prevailing monetarist policy began. Monetarists argued that the 1987 stock market decline was simply a correction between conflicting monetary policies in the United States and Europe. Critics of this viewpoint became louder as Japan slid into a sustained deflationary spiral and the collapse of the savings-and-loan banking system in the United States pointed to larger structural changes in the economy.

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In the late 1980s, Paul Volcker was succeeded by Alan Greenspan, former follower of Ayn Rand, and a leading monetarist. His handling of monetary policy in the run up to the 1991 recession was criticised from the right as being excessively tight, and costing George H. W. Bush re-election. The incoming Democratic president Bill Clinton reappointed Alan Greenspan, and kept him as a core member of his economic team. Greenspan, while still fundamentally monetarist in orientation, argued that doctrinaire application of theory was insufficiently flexible for central banks to meet emerging situations.

Related Topics:
Paul Volcker - Alan Greenspan - Ayn Rand - George H. W. Bush - Bill Clinton

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The crucial test of this flexible response by the Federal Reserve was the Asian Financial Crisis of 1997-1998, which the Federal Reserve met by flooding the world with dollars, and organizing a bailout of Long Term Capital Management. Some have argued that 1997-1998 represented a monetary policy bind ?- as the early 1970s had represented a fiscal policy bind ?- and that while asset inflation had crept into the United States, demanding that the Fed tighten, the Federal Reserve needed to ease liquidity in response to the capital flight from Asia. Greenspan himself noted this when he stated that the American stock market showed signs of irrational valuations.

Related Topics:
Asian Financial Crisis - Long Term Capital Management

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In 2000, Greenspan pushed the economy into recession with a rapid and drastic series of tightening moves by the Federal Reserve to sanitize the intervention of 1997-1998, followed by a similarly drastic series of loosenings in the wake of the 2000-2001 recession. It was the failure of these moves to produce stimulus which lead to the wider-spread questioning of the sufficiency of monetary policy to deal with economic downturns.

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Currently the American Federal Reserve follows a modified form of monetarism, where broader ranges of intervention are possible in light of temporary instabilities in market dynamics. This form does not yet have a generally accepted name.

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In Europe, the European Central Bank follows a more orthodox form of monetarism, with tighter controls over inflation and spending targets as mandated by the Economic and Monetary Union under the Maastricht Treaty to support the euro. This more orthodox monetary policy is in the wake of credit easing in the late 1980s and 1990s to fund German reunification, which was blamed for the weakening of European currencies in the late 1990s.

Related Topics:
Economic and Monetary Union - Maastricht Treaty - Euro

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