Monetarism - Rise

Rise

Clark Warburton is credited with making the first solid empirical case for the monetarist interpretation of business fluctuations in a series of papers from 1945.p. 493 Within mainstream economics, the rise of monetarism accelerated from Milton Friedman's 1956 restatement of the quantity theory of money. Friedman argued that the demand for money could be described as depending on a small number of economic variables. Thus, where the money supply expanded, people would not simply wish to hold the extra money in idle money balances; i.e., if they were in equilibrium before the increase, they were already holding money balances to suit their requirements, and thus after the increase they would have money balances surplus to their requirements. These excess money balances would therefore be spent and hence aggregate demand would rise. Similarly, if the money supply were reduced people would want to replenish their holdings of money by reducing their spending. In this, Friedman challenged a simplification attributed to Keynes suggesting that "money does not matter." Thus the word 'monetarist' was coined.

The rise of the popularity of monetarism also picked up in political circles when Keynesian economics seemed unable to explain or cure the seemingly contradictory problems of rising unemployment and inflation in response to the collapse of the Bretton Woods system in 1972 and the oil shocks of 1973. On the one hand, higher unemployment seemed to call for Keynesian reflation, but on the other hand rising inflation seemed to call for Keynesian disinflation. In 1979, President Jimmy Carter appointed a Federal Reserve chief Paul Volcker who made inflation fighting his primary objective, and restricted the money supply (in accordance with the Friedman rule) to tame inflation in the economy. The result was the creation of the desired price stability.

Monetarists not only sought to explain present problems; they also interpreted historical ones. Milton Friedman and Anna Schwartz in their book A Monetary History of the United States, 1867-1960 argued that the Great Depression of 1930 was caused by a massive contraction of the money supply and not by the lack of investment Keynes had argued. They also maintained that post-war inflation was caused by an over-expansion of the money supply. They made famous the assertion of monetarism that 'inflation is always and everywhere a monetary phenomenon'. Many Keynesian economists initially believed that the Keynesian vs. monetarist debate was solely about whether fiscal or monetary policy was the more effective tool of demand management. By the mid-1970s, however, the debate had moved on to other issues as monetarists began presenting a fundamental challenge to Keynesianism.

Many monetarists sought to resurrect the pre-Keynesian view that market economies are inherently stable in the absence of major unexpected fluctuations in the money supply. Because of this belief in the stability of free-market economies they asserted that active demand management (e.g. by the means of increasing government spending) is unnecessary and indeed likely to be harmful. The basis of this argument is an equilibrium between "stimulus" fiscal spending and future interest rates. In effect, Friedman's model argues that current fiscal spending creates as much of a drag on the economy by increased interest rates as it creates present consumption: that it has no real effect on total demand, merely that of shifting demand from the investment sector (I) to the consumer sector (C).

When Margaret Thatcher, leader of the Conservative Party in the United Kingdom, won the 1979 general election defeating the incumbent Labour Party led by James Callaghan, Britain had endured several years of severe inflation, which was rarely below 10% and by the time of the election in May 1979 stood at 10.3%. Thatcher implemented monetarism as the weapon in her battle against inflation, and succeeded at reducing it to 4.6% by 1983 — although this was achieved largely by the mass closure of inefficient factories, which resulted in a recession and in unemployment doubling from around 1,500,000 people to more than 3,000,000. This policy was controversial with the public and even some of her own Members of Parliament (MPs) (as well as former Conservative prime ministers Harold Macmillanand Edward Heath), but her success in the Falklands war led to a recovery in her popularity which contributed to the Conservative victory in the 1983 general election. This came at a time of a global recession, and Thatcher's monetarist policies earned her the respect of political leaders worldwide as Britain was a world leader in the fight against the recession and one of the first nations to re-establish economic growth.

Callaghan himself had adopted policies echoing monetarism while serving as prime minister from 1976 to 1979, adopting deflationary policies and reducing public spending in response to high inflation and national debt. He initially had some success, as inflation was below 10% by the summer of 1978, although unemployment now stood at 1,500,000. However, by the time of his election defeat barely a year later, inflation had soared to 27%.