Monetarism - Practice

Practice

A realistic theory should be able to explain the deflationary waves of the late 19th century, the Great Depression, and the stagflation period beginning with the uncoupling of exchange rates in 1972. Monetarists argue that there was no inflationary investment boom in 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.

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.

With the failure of demand-driven fiscal policies to restrain inflation and produce growth in the 1970s, the way was paved for a new policy of fighting inflation through the central bank, which would be the bank's cardinal responsibility. In typical economic theory, this would be accompanied by austerity shock treatment, as is generally recommended by the International Monetary Fund: such a course was taken in the United Kingdom, where government spending was slashed in the late '70s and early '80s under the political ascendance of Margaret Thatcher. In the United States, the opposite approach was taken and real government spending increased much faster during Reagan's first four years (4.22%/year) than it did under Carter (2.55%/year).

In the ensuing short term, unemployment in both countries remained stubbornly high while central banks raised interest rates to restrain credit. These policies dramatically reduced inflation rates in both countries (the United States' inflation rate fell from almost 14% in 1980 to around 3% in 1983), allowing liberalization of credit and the reduction of interest rates, which led ultimately to the inflationary economic booms of the 1980s. Arguments have been raised, however, that the fall of the inflation rate may be less from control of the money supply and more to do with the unemployment level's effect on demand; some also claim the use of credit to fuel economic expansion is itself an anti-monetarist tool, as it can be argued that an increase in money supply alone constitutes inflation.

Monetarism re-asserted itself in central bank policy in western governments at the end of the 1980s and beginning of the 1990s, with a contraction both in spending and in the money supply, ending the booms experienced in the US and UK.

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.

In the late 1980s, Paul Volcker was succeeded by Alan Greenspan, a leading monetarist. His handling of monetary policy in the run-up to the 1991 recession was criticized 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.

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, just as the early 1970s had represented a fiscal policy bind, and that while asset inflation had crept into the United States (which demanded that the Fed tighten the money supply), 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 irrationally high valuations.

In 2000, Alan Greenspan raised interest rates several times. These actions were believed by many to have caused the bursting of the dot-com bubble. In late 2001, as a decisive reaction to the September 11 attacks and the various corporate scandals which undermined the economy, the Greenspan-led Federal Reserve initiated a series of interest rate cuts that brought the Federal Funds rate down to 1% in 2004. His critics, notably Steve Forbes, attributed the rapid rise in commodity prices and gold to Greenspan's loose monetary policy, and by late 2004 the price of gold was higher than its 12 year moving average; these same forces were also blamed for excessive asset inflation and the weakening of the dollar. These policies of Alan Greenspan are blamed by the followers of the Austrian School for creating excessive liquidity, causing lending standards to deteriorate, and resulting in the housing bubble of 2004-2006.

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.

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 of the European Union under the Maastricht Treaty to support the euro. This more orthodox monetary policy followed credit easing in the late 1980s through 1990s to fund German reunification, which was blamed for the weakening of European currencies in the late 1990s.