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The Fault Lines
of Monetarism

The following is excerpted from Chapter 8 of the book The Death of Inflation by Roger Bootle.

The mainstream position on inflation is a mixture of monetarism -- the doctrine that inflation is always caused by increases in the money supply -- and the belief in the so-called natural rate of employment -- that there is only one level of unemployment at which inflation is stable.  Both of these positions are riddled with dogma.  Neither finds room for historical and institutional factors.

The Appeal of Monetarism

Given any economic problem, economists feel an urge to find a single and complete answer that will apply to all circumstances, a sort of grand unifying theory.  Monetarism is just such a temptation, and economists have fallen for it.  It provides a link with monetary inflations of the past, and with more recent hyperinflations that always involve massive printing of money. 

There is no doubt that monetary expansion plays a dominant role in hyperinflation.  Yet Philip Cagan found in a classic study of seven hyperinflations that in all cases there were substantial declines in the demand for money in real terms, such that the rise in prices substantially exceeded the rise in the money supply. 

The Causes of Hyperinflation

To the monetarist, creeping inflations are really the same as hyperinflations, differing only in degree.  But underlying hyperinflation is almost always a huge budget deficit which the government is unwilling or unable to finance in the ordinary way by borrowing in the capital markets.  Rather than cut the deficit, the government prints money or borrows it from the central bank, which amounts to the same thing.  However, it is striking that mature and developed economies do not normally suffer from such inflation.  When they do, there is a distinctly real cause - such as war, a revolution, or a sharp political change.

Monetary Policy Errors and Inflation

In virtually all cases of moderate inflation in the West, the literal printing of money or government borrowing from the central bank has played a minor role.  If expansion of the (credit) money supply is involved in the moderate post-war inflation, it is due to the commercial banks lending to the private sector, and the businesses and consumers who seek to borrow money from them.  And if governments and central banks are ultimately to be held responsible for this inflation, it must be from their encouragement of the lending behavior of the banks by failing to set interest rates high enough -- presumably for fear of the consequences of unemployment and lost votes.

Correlation is Not Causation

Traditional monetary theory teaches that the money supply can be thought of as an exogenous act of policy.  Thus if you observe a strong link between money and income (or prices), the causation inevitably runs from money to income and not the other way around.  But in a modern monetary system the money supply is not under the direct control of the authorities.  It is determined by the lending criteria of the banks, the demand for credit in the economy as a whole, and the attractions of bank credit compared to other forms of finance. 

Even if you observe a strong correlation between changes in the money supply and changes in national income or the price level, this does not necessarily tell you much.  You do not know whether a change in the money supply is the cause of events in the economy or a response to them.

Why Monetarist Theory Persists

For professional economists, monetarism's simplicity and certainty enables them to believe in a fundamental law or rule of economics, which thereby lends status to the subject.  It saves them from the messy world of historical analysis and institutional studies.  Today, long after monetarism has passed its high-water mark, it lingers on as the conventional wisdom, partly because a whole generation of economists, journalists, bank officials, and market practitioners have been trained in Friedmanite economics.  And partly because so many economists have poured so much intellectual capital into it that they cannot bear to write it off.

A Basic Cause of Moderate Inflation

There is no philosopher's stone that gives all the answers about inflation.  However there is one all-embracing framework that has some appeal:  Inflation is caused by the struggle between different groups within society over their share of national income.  Classic monetary inflation fits into this framework.  Governments caused inflation when they tried to secure more of the national income than they were willing or able to finance openly through taxation.  In an inflation driven by private credit creation, borrowers lay claim to more resources than are currently available without others in society giving up some of their claims.

Post World War II Inflation

The sort of inflation we have experienced in the post-war period reflects the upsurge of producer power that led to battles between producer groups for shares of the cake in which monetary factors were secondary.  In the largely agricultural society of previous eras, the power of producers to affect the general price level was limited.  Small units of production and poor communication made collusive behavior difficult.  When circumstances demanded that prices and wages should fall, they fell almost as easily as they rose on other occasions.

Industrialization changed all this.  The price of industrial output was something to be decided by the producers.  Mass production technology limited the number of firms that could viably operate in an industry.  The conditions of mass production favored mass organization of labor into unions, mirroring the cartelization of the employers.  The tension between services and manufacturing sectors played a major role in the tendency toward rising prices.  The attempt by both capital and labor employed in manufacturing to bag all the benefits of increased productivity was resisted by other groups, and the real income gains spread throughout society.

A Broader View of Inflationary Forces

Inflation will still be caused when aggregate demand runs at too high a level relative to the aggregate supply.  But there is no unique link between the money supply and aggregate demand or inflation.  And across wide variations in the rate of unemployment there will be no systematic relation between the level of demand and the rate of inflation.

At present, the change in the general price level is being driven by two opposing forces.  On the one hand, there is the continuing process of cost and price rises produced by the struggle for income shares, inherited from the past.  On the other hand, there are the cost and price reductions originating from technological advances, the organizational revolution within companies, the development of new producers world-wide, and the intensification of the competitive climate.  This is an unequal struggle.  The former is dissipating while the latter is burgeoning.  It now appears the problem of perpetual inflation is yesterday's story.

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