Why is it that conservatives like Jack Kemp (R–N.Y.) and liberals like Robert Byrd (D–W. Va.) are united in their dislike of monetarism? For very different reasons, I hope to show, as I try to shed light this month on the controversy surrounding the monetarist experiment.
Put as simply as possible, monetarism is a theory which recognizes that the amount of money circulating in a country must be subject to some constraint or rule if the money is to retain its value over time. For a long time in this country and in others, the money supply was constrained by its convertibility into gold, which in turn was obviously linked to the real economy of labor and production. But after 1933 the links between money and gold were gradually loosened and then completely broken in 1971.
So by 1972 there was nothing to constrain monetary growth. This was the day the liberals and the left had dreamed of. Now only a compassionate Federal Reserve chairman was needed, and then everyone would be able to have lots of money! Poverty could finally be abolished. I think many liberals sincerely believed this. Some of them still do. (Robert Byrd may be one of them.) Well, their compassionate chairman was appointed by President Carter—G. William Miller. And if the truth be told, they had another one before him in Arthur Burns.
Anyway, as we all know, inflation took off once compassionate monetary policies were adopted in the 1970s. Liberals steadfastly refused to believe that inflation was connected with this monetary expansion. They tried to blame OPEC and (old stand-by) "LBJ's refusal to raise taxes to pay for guns and butter." (Such nonsense: fiscal 1969 was the year of the last balanced budget.) Even though they had the press solidly on their side, with the TV networks saying not one word about money supply figures, the liberals lost that war. The connection between monetary aggregates and inflation could not be denied.
Enter monetarism. To have a stable price level, said Milton Friedman and his doughty band, the quantity of money must grow at a slow but steady rate. And here was the quantity rule: the amount of money in the nation could be added up, and the growth rate of this aggregate should be comparable to the growth rate of the real economy—the production of goods and services. Notice that this was obviously superior to the feeble, "compassionate" position of the liberals, with whom Friedman & Co. were sharply at variance. Jimmy Carter eventually realized that he had to get Miller out of the Fed position, and Paul Volcker was appointed. Monetarism—the targeting of aggregates rather than interest rates—became the announced policy in October 1979.
Since that time it has been shown without any shadow of doubt that if you reduce the monetary aggregates, or slow the rate of their increase, then you can and will bring down the inflation rate. I don't think there really was any doubt on this score, in fact. But then a new, and in my opinion serious, criticism of monetarism arose. Enter now Jack Kemp, Irving Kristol, and the supply-siders.
The crucial point may perhaps be seen if one considers the moment in October 1979 when the monetarist experiment was officially launched. At that time the "narrow money supply," M-1, was about $375 billion. (Today it is about $475 billion.) The idea was, then, that this aggregate should grow at a prescribed annual rate (of about 5 percent).
The sophisticated, supply-side criticism (as opposed to the simplistic "compassionate" one) may be expressed in the form of the following question: How does anyone know that the starting level of that prescribed monetary growth rate, $375 billion, was the correct one? Bear in mind that inflation was then soaring into double digits. The gold price was beginning its rapid lift-off. When inflation is high, the demand for money is low. People spend their paychecks as soon as possible when they know things will cost more next month or next week. So money circulates quickly—it has a high velocity when inflation is high and rising. People are forever trying to get rid of money—pass it on to the next guy. Consequently, M-1, which is mainly the sum of checking accounts, is artificially low at such moments.
So in October '79 the Fed took action to tighten up on the growth of money, raising the discount rate, selling government securities (or buying them infrequently). Then what? The inflation rate came down. And as a result, people were more content to let their paychecks sit a while in their checking accounts before spending them. Thus the velocity of money slowed down. In such circumstances there is a natural tendency for M-1 (the total of cash and all checking accounts) to rise at a faster rate than that prescribed by the strict monetarist rule. If the Fed then stubbornly adheres to its rule, at a time when the circulation, or velocity, of money has slowed down, prices will inevitably sag even further, and there is a serious threat, in economies (such as ours) built on debt, of a crash or depression. The Fed, under such circumstances, must abandon its quantity rule and try something else.
Try what? Well, the supply-siders have been suggesting for some time that the most sensitive leading indicator of inflation and deflation is the gold price. Therefore, the Fed should conduct its monetary policy with a view to maintaining the gold price within a narrow range. In short, it must abandon its quantity rule and move to a price rule. Only then will monetary policy be able to steer a course between inflation and depression. And that, of course, takes us back to the point where things began to go wrong in the first place—when the discipline of gold was abandoned.
Tom Bethell is a free-lance writer, a contributing editor of Washington Monthly, and a columnist for National Review.