Today I’d like to take an abridged look at perhaps the biggest economic debate of them all, the conflicting views of Keynesian economics versus those of monetarism.
I’ve looked before at Keynes’ General Theory and his belief that left unaided economies which have sunk into recession may never escape, falling into a downward spiral of unemployment and lower productivity.
Keynes’ central points noted that governments need to fight unemployment and spend their way out of recessionary periods.
The conflicting viewpoint was drawn up Milton Friedman, particularly in his key work A Monetary History of the United States 1867-1960.
Friedman instead believed that ‘inflation is always and everywhere a monetary phenomenon’ and therefore the way to control inflation was through controlling the money supply.
He suggested that the Keynesian theory of pumping cash into an ailing economy would eventually lead to high inflation.
The monetarist theory was that if prices and the money supply could be controlled by central banks, then unemployment and economic growth would eventually take care of themselves.
Thus in an economic downturn more cash should be pumped into the system so that spending is increased, or so the theory goes.
The 1970s and 1980s
Initially, monetarism didn’t seem to get much credibility. Essentially there didn’t seem to be a need for it because up until the 1960s inflation had remained under control and thus Keynesian economics seemed to be working.
However, the 1970s brought a series of economic crises, oil shocks, anaemic growth, unemployment…all mixed in with the pain of very high inflation.
Keynes’ theory suddenly seemed to have no effective answer to this – simply spending more money wasn’t working and only served to send inflation higher than it already was.
Thus key political leaders, including Margaret Thatcher in the UK and Ronald Reagan in the US, embraced monetarism, and the theory found favour with among others central bankers at Germany’s Bundesbank and the Federal Reserve in the US.
The one key problem with monetarism
I remember that the introduction of monetarist policies was controversial in Britain.
Initially we got very high unemployment but eventually sentiment and the economy did turn around after the Falklands War reinstated Margaret Thatcher’s popularity.
So, in theory at least, it seemed that monetarism was a reasonably sound economic theory.
However, the great problem with monetarism is that it is so darned hard to measure what the amount of money in circulation actually is.
The Reserve Bank of Australia measures the money supply, like other central banks, using a range of definitions and aggregates, thus:
- M1: currency bank + current deposits of the private non-bank sector
- M3: M1 + all other bank deposits of the private non-bank sector
- Broad Money: M3 + borrowings from the private sector by NBFIs, less the latter’s holdings of currency and bank deposits
- Money Base: holdings of notes and coins by the private sector plus deposits of banks with the Reserve Bank of Australia (RBA) and other RBA liabilities to the private non-bank sector
Another great difficulty in controlling the money supply is that, quite apart from it being extremely difficult to measure, the supply of money can be affected by events outside the control of the central bank.
One cited example is that of when banks introduce new financial instruments – this effectively increases the supply of ‘money’ in circulation without the central banks having had input or any such intention.
These perhaps unsolvable problems have caused some central banks to stop publishing money supply figures, and some have concluded that focussing only on the money supply is therefore not enough.
In 1993, Australia introduced the target range of inflation.
Today’s targeted range of inflation is 2-3%.
In a recent blog post I explained why moderate inflation is considered preferable to the risk of a deflationary spiral, which can severely impact confidence and thus stilt economic growth.
If prices are expected to fall then consumers become disinclined to spend, and debtors are also severely punished if the value of properties continue to slide over time.
Of course, this the exact reverse of what we typically experience in times of inflation, where consumers remain inclined to spend (as the cost of goods next year will inevitably be higher) and owners of real estate are rewarded as rents and property prices increase but the effective value of mortgage debt is inflated away.
The future for Australia
While the future can never be predicted with any certainty, the most likely outcome seems to be that we will continue to have inflation, but it will be more moderate than was send in the 1970s and 1980s.
As is so often the case with two directly conflicting ideologies, the future seems likely to embrace a mesh of the two.
The target range of inflation, for now at least, seems to have brought inflation under control.
Governments and central banks are painfully aware of the risks of deflation, particularly after the experiences of Japan, and therefore we might expect that the governing bodies will do everything within their powers in order to maintain a moderately inflationary economy.
The implication of individuals is to focus on acquiring assets which represent an inflation hedge.