Is monetarism dead?

National Review, Nov 4, 1991 by Allan H. Meltzer, Alan Walters, Warren T. Brookes, Alan Reynolds

Not at all, answers a leading monetarist: all the evidence of the '70s and '80s affirms the importance of controlling the growth of money. Three distinguished economists respond.

IT HAS become common to proclaim: "Monetarism is dead." Yet what does the evidence of recent years show? During the early months of 1990, inflation rates, as reported by the IMF, ranged from negative numbers to an annual rate of more than 1,400 per cent. Countries like Poland, Argentina, Yugoslavia, and Brazil, where the reported annual rate of inflation was above 1,000 per cent, had all experienced high money growth. A few countries like Togo and Ethiopia reported falling prices; they had experienced negative rates of money growth in the recent past.

To the monetary economist, this link between growth and inflation is just additional evidence for one of the principal monetarist propositions: Sustained money growth in excess of the growth of output produces inflation. To end inflation or produce deflation, therefore, money growth must fall below the growth of output. It is especially noteworthy that one country with low or negative money growth, Ethiopia, has reported a falling price level despite civil wars and periodic famines.

What is true across countries is also true across time in a particular country. Countries as diverse as Chile, Israel, Brazil, Argentina, Italy, Japan, Turkey, and the United States have increased or reduced inflation at different times by increasing or reducing the rate of money growth. In some countries, the changes in money growth and inflation have ranged over hundreds or thousands of percentage points. In others, the range has been narrower.

Another monetarist proposition is that where inflation is high, open-market interest rates are also high and market exchange rates depreciate. This proposition too has been validated both across countries and through time. Governments' efforts to hide these effects of past inflation and anticipations of future inflation may succeed for a time, but they do not succeed permanently. Although inflation may not be reflected fully in official measurements, black-market or open-market rates on unofficial markets tell a more correct story.

When inflation increases, output often grows for a time above its trend rate. Reductions of inflation have the opposite effect: output falls, or grows at less than trend rate for a time. These temporary changes in the growth rate of output illustrate a third monetarist proposition: The first effects of changes in money growth are on output; only later does the rate of inflation change. The synchronous reduction in money growth in most of the industrial countries at the beginning of the 1980s produced a severe downturn in many of these countries, though the size and duration of the downturn differed substantially from country to country. The U.S. experienced a sharp contraction of real output; Japan escaped with only a modest reduction in the growth rate of output.

These monetarist propositions about inflation, interest rates, exchange rates, and output are now widely accepted by economists and policy-makers. Conversation with governors of central banks these days finds them more alert to the risks of inflation, more conscious of the costs of restraining inflation once inflation is widely anticipated, and more aware of the long-term relation between money growth and inflation. Many central bankers have, accordingly, adopted targets or guidelines for money growth. The high levels of interest rates in world markets in 1990 partly reflected efforts by Germany, Japan, Great Britain, the United States, and others to bring down the rate of money growth and to avoid a return of the high inflation of the 1970s.

Contrast the response of the American and German governments to the oil shocks of the 1970s, or the response of the Japanese government in 1973-74 and 1979-80 to the same shocks, or the responses of the United States to the oil shocks in 1973 and 1979 and in 1990. A lesson learned from these different experiences is that oil shocks can produce a one-time change in the price level, but that if money growth remains unchanged, the surge in prices will be temporary and short-lived. Once the oil shock passes through the economy, prices then rise at a rate dependent on the maintained growth of money relative to output. Monetarists have emphasized the distinction between onetime price-level changes and the sustained rates of change that are properly called inflation.

Academic and professional opinion has now accepted several of the monetarist propositions that many once regarded as wrong-headed or even heretical. Central bankers in leading countries, including the United States, now see their principal task as the maintenance of price stability. Countries like Italy, France, and Britain, with a history of inflationary policy, tie their currencies to the German Mark in order to borrow credibility from the successful low-inflation policies of the Bundesbank. And the Bundesbank sets targets for the growth rate of the money stock that it achieves much of the time. Just as importantly, the market believes that the directors of the Bundesbank will not persistently exceed their monetary target.