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BANKING
BUNKUM
Part 1: Monetary
theology
By Henry C K Liu
Central bankers are like librarians who consider
a well-run library to be one in which all the books are
safely stacked on the shelves and properly catalogued.
To reduce incidents of late returns or loss, they would
proposed more strict lending rules, ignoring that the
measure of a good library lies in full circulation.
Librarians take pride in the size of their collections
rather than the velocity of their circulation.
Central bankers take the same attitude toward
money. Central bankers view their job as preserving the
value of money through the restriction of its
circulation, rather than maximizing the beneficial
effect of money on the economy through its circulation.
Many central bankers boast about the size of their
foreign reserves the way librarians boast about the size
of their collections, while their governments pile up
budget deficits. Paul Volcker, the US central banker
widely credited with ending inflation in the early 1980s
by administering wholesale financial blood letting on
the US economy, quipped lightheartedly at a Washington
party that "central bankers are brought up pulling legs
off of ants".
Central banking insulates monetary
policy from national economic policy by prioritizing the
preservation of the value of money over the monetary
needs of a sound national economy. A global finance
architecture based on universal central banking allows
an often volatile foreign exchange market to operate to
facilitate the instant cross-border ebb and flow of
capital and debt instruments. The workings of an
unregulated global financial market of both capital and
debt forced central banking to prevent the application
of the State Theory of Money (STM) in individual
countries to use sovereign credit to finance domestic
development by penalizing, with low exchange rates for
their currencies, governments that run budget deficits.
STM asserts that the acceptance of
government-issued legal tender, commonly known as money,
is based on government's authority to levy taxes payable
in money. Thus the government can and should issue as
much money in the form of credit as the economy needs
for sustainable growth without fear of hyperinflation.
What monetary economists call the money supply is
essentially the sum total of credit aggregates in the
economy, structured around government credit as
bellwether. Sovereign credit is the anchor of a vibrant
domestic credit market so necessary for a dynamic
economy.
By making STM inoperative through the
tyranny of exchange rates, central banking in a
globalized financial market robs individual governments
of their sovereign credit prerogative and forces
sovereign nations to depend on external capital and debt
to finance domestic development. The deteriorating
exchange value of a nation's currency then would lead to
a corresponding drop in foreign direct or indirect
investment (capital inflow), and a rise in interest cost
for sovereign and private debts, since central banking
essentially relies on interest policy to maintain the
value of money. Central banking thus relies on domestic
economic austerity caused by high interest rates to
achieve its institutional mandate of maintaining price
stability.
Such domestic economic austerity
comes in the form of systemic credit crunches that cause
high unemployment, bankruptcies, recessions and even
total economic collapse, as in the case of Britain in
1992, the Asian financial crisis in 1997 and subsequent
crises in Russia, Turkey, Brazil and Argentina. It is
the economic equivalent of a blood-letting cure.
A national bank does not seek independence from
the government. The independence of central banks is a
euphemism for a shift from institutional loyalty to
national economic well-being toward institutional
loyalty to the smooth functioning of a global financial
architecture. The international finance architecture at
this moment in history is dominated by US dollar
hegemony, which can be simply defined by the dollar's
unjustified status as a global reserve currency. The
operation of the current international finance
architecture requires the sacrifice of local economies
in a financial food chain that feeds the issuer of US
dollars. It is the monetary aspect of the predatory
effects of globalization.
Historically, the term
"central bank" has been interchangeable with the term
"national bank". In fact, the enabling act to establish
the first national bank, the Bank of the United States,
referred to the bank interchangeably as a central and a
national bank. However, with the globalization of
financial markets in recent decades, a central bank has
become fundamentally different from a national bank.
The mandate of a national bank is to finance the
sustainable development of the national economy, and its
function aims to adjust the value of a nation's currency
at a level best suited for achieving that purpose within
an international regime of exchange control. On the
other hand, the mandate of a modern-day central bank is
to safeguard the value of a nation's currency in a
globalized financial market of no or minimal exchange
control, by adjusting the national economy to sustain
that narrow objective, through economic recession and
negative growth if necessary.
Central banking
tends to define monetary policy within the narrow limits
of price stability. In other words, the best monetary
policy in the context of central banking is a
non-discretionary money-supply target set by universal
rules of price stability, unaffected by the economic
needs or political considerations of individual nations.
The theology of monetary economics
Inflation, the all-consuming target of central
banking, is popularly thought of as too much money
chasing too few goods, which economists refer to as the
Quantity Theory of Money (QTM). QTM is one of the oldest
surviving economic doctrines. Simply stated, it asserts
that changes in the general level of commodity prices
are determined primarily by changes in the quantity of
money in circulation. But the theology of monetary
economics has a long and complex history, an
understanding of which is necessary for forming any
informed opinion on the validity and purpose of central
banking. Below is a brief summary of the stuff dinner
conversation is made of among the gods of monetary
theory.
Jean Bodin (1530-96), a French
social/political philosopher, attributed the price
inflation then raging in Western Europe to the abundance
of monetary metals imported from the newly opened gold
and silver mines in the Spanish colonies in South
America. Though he held many aspects of mercantilist
views, Bodin asserted that the rise of prices was a
function not merely of the debasement of the coinage,
but also of the amount of currency in circulation.
Bodin's religious tolerance in a period of fanatical
religious wars drew upon him the accusation of being a
"freethinker", a label as damaging as being called a
communist sympathizer in the United States in modern
times. In his Les Six Livrers de la republic
(1576), Bodin replaced the concept of a past golden age
with the concept of progress. He foreshadowed Thomas
Hobbes (1588-1679: The Leviathan, 1651) by
stating the political necessity of absolute sovereignty,
subject only to the laws of God (morality) and nature
(reality). Bodin also anticipated Baron Montesquieu
(1689-1755: De l'esprit des lois, 1748) by
highlighting environment as a determinant of laws,
customs, beliefs and the interpretation of events, a
view that influenced the US constitution, a view since
rejected by current US moral imperialism.
John
Locke (1632-1704) and David Hume (1711-76) provided
considerable refinement, elaboration and extension to
the QTM, allowing it to be integrated into the
mainstream of orthodox monetarist tradition. Locke
developed the right of private property based on the
labor theory of value and the mechanics of political
checks and balances that were incorporated in the US
constitution. Locke, in 1661, asserted the
proportionality postulate: that a doubling of the
quantity of money (M) will double the level of prices
(P) and half the value of the monetary unit.
Hume, in 1752, introduced the notion of
causation by stating that variation in M (money
quantity) will cause proportionate changes in P (price
level). Concurrently with Irish banker Richard Cantillon
(1680-1734), Hume applied to the QTM two crucial
distinctions: 1) between static (long-run stationary
equilibrium) and dynamic (short-run movement toward
equilibrium); and 2) between the long-run neutrality and
the short-run non-neutrality of money. Hume and
Cantillon provided the first dynamic process analysis of
how the impact of a monetary change spread from one
sector of the economy to another, altering relative
price and quantity in the process. They pointed out that
most monetary injection would involve non-neutral
distribution effects. New money would not be distributed
among individuals in proportion to their pre-existing
share of money holdings. Those who receive more will
benefit at the expense of those receiving less than
their proportionate share, and they will exert more
influence in determining the composition of new output.
Initial distribution effects temporarily alter the
pattern of expenditure and thus the structure of
production and the allocation of resources. Thus it is
understandable that conservatives would be sympathetic
to the QTM to maintain the wealth distribution status
quo, or if the QTM is skirted, to ensure that the
maldistribution tilts toward those who are more likely
to engage in capital formation, namely the rich. Thus
developing economies in need of capital formation would
find logic in first enriching the financial elite while
advanced economies with production overcapacity would
need to increase aggregate demand by restricting income
disparity.
Hume describes how different degrees
of money illusion among income recipients, coupled with
time delays in the adjustment process, could cause costs
to lag behind prices, thus creating abnormal profits and
stimulating optimistic profit expectations that would
spur business expansion and employment during the
transition period. These non-neutral effects are not
denied by the adherents of QTM, who nevertheless assert
that they are bound to dissipate in the long run, often
with great damage if the optimism was unjustified. The
latest evidence of the non-neutral effects of money is
observable in expansion of the so-called New Economy
from easy money in the past decade and the recent
collapse of its bubble.
The QTM formed the
central core of 19th-century classical monetary
analysis, provided the dominant conceptual framework for
interpreting contemporary financial events and formed
the intellectual foundation of orthodox policy
prescription designed to preserve the gold standard. The
economic structure in 19th-century Europe led analysts
to acknowledge additional non-neutral effects, such as
the lag of money wages behind prices, which temporarily
reduces real wages; the stimulus to output occasioned by
inflation-induced reduction in real debt burdens, which
shifts real income from unproductive creditor-rentiers
to productive debtor-entrepreneurs; the so-called
"forced saving" effect occasioned by price-induced
redistribution of income among socio-economic classes
having structurally different propensity to save and
invest; and the stimulus to investment imparted by a
temporary reduction in the rate of interest below the
anticipated rate of return on new capital.
Yet
classical quantity theorists tended persistently to
minimize the importance of non-neutral effects as merely
transitional. Whereas Hume tended to stress lengthy
dynamic disequilibrium periods in which money matters
much, classical analysts focused on long-run equilibrium
in which money is merely a veil. David Ricardo
(1772-1823), the most influential of the classical
economists, thought such disequilibrium effects
ephemeral and unimportant in long-run equilibrium
analysis. Gods, of course, enjoy longer perspectives
than most mortals, as do the rich over the poor. As John
Maynard Keynes famously said: "In the long run, we will
all be dead."
As leader of the Bullionists,
Ricardo charged that inflation in Britain was solely the
result of the Bank of England's irresponsible overissue
of money, when in 1797, under the stress of the
Napoleonic Wars, Britain left the gold standard for
inconvertible paper. At that time, the Bank of England
was still operating as a national bank, not a central
bank in the modern sense of the term. In other words, it
operated to improve the English economy rather than to
strengthen the sanctity of international finance.
Ricardo, by focusing on long term-equilibrium,
discouraged discussions on the possible beneficial
output and employment effects of monetary injection on
the national level. Like modern-day monetarists,
Bullionists laid the source of inflation, a decidedly
evil force in international finance, squarely at the
door of the national bank. As Milton Friedman declared
some two centuries after Richardo: inflation is
everywhere a monetary phenomenon. Friedman's concept of
"money matters" is the diametrical opposite of Hume's.
The historical evolution in 18th-century Europe
from a predominantly full-metal money to a mixed
metal-paper money forced advances in the understanding
of the monetary transmission mechanism. After gold coins
had given way to banknotes, Hume's direct mechanism of
price adjustment was found lacking in explaining how
banknotes are injected into the system.
Henry
Thornton (1760-1815), in his classic The Paper Credit
of Great Britain (1802), provided the first
description of the indirect mechanism by observing that
new money created by banks enters the financial markets
initially via an expansion of bank loans, through
increasing the supply of lendable funds, temporarily
reducing the loan rate of interest below the rate of
return on new capital, thus stimulating additional
investment and loan demand. This in turn pushes prices
up, including capital good prices, drives up loan
demands and eventually interest rates, bringing the
system back into equilibrium indirectly.
The
central issue of the doctrines of the British classical
school that dominated the first half of the 19th century
was focused around the application of the QTM to
government policy, which manifested itself in the
maintenance of external equilibrium and the restoration
and defense of the gold standard. Consequently, the QTM
tended to be directed toward the analysis of
international price levels, gold flow, exchange-rate
fluctuations and trade deficits. It formed the
foundation of mercantilism, which underpinned the
economic structure of the British Empire via
colonialism, which reached institutional maturity in the
same period.
Bullionists developed the idea that
the stock of money, or its currency component, could be
effectively regulated by controlling a narrowly defined
monetary base, that the control of "high-power money"
(bank reserves) in a fractional reserve banking regime
implies virtual control of the money supply. High-power
money is the totality of bank reserves that would be
multiplied many times through the money-creation power
of commercial bank lending, depending on the velocity of
circulation.
In the 1987 crash when the Dow
Jones Industrial Average (DJIA) dropped 22.6 percent in
one day (October 19) on volume of 608 million shares,
six times the normal volume then (current normal daily
volume is about 1.6 trillion shares), the US Federal
Reserve under its newly installed chairman, Alan
Greenspan, created US$12 billion of new bank reserves by
buying up government securities. The $12 billion
injection of high-power money in one day caused the Fed
Funds rate to fall by three-quarters of a point and
halted the financial panic. If the government had been
running a balanced budget and there were no government
securities to be bought, the economy would have seized
up. This shows that government deficits and debt are
part and parcel of the modern financial architecture.
In the three decades after Britain returned to
the gold standard in 1821, the policy objective focused
on the maintenance of fixed exchange rates and the
automatic gold convertibility of the pound. But the
Currency School (CS) versus Banking School (BS)
controversy broke out over whether the "Currency
Principle" of making existing mixed gold-paper currency
expand and contract in direct proportion to gold
reserves was sufficient to safeguard against note
overissuance, or whether additional regulation was
necessary. This controversy grew out of the expansion
pressure put on the supply of pound sterling by the
rapid expansion of the British empire.
Members
of the CS argued that even a fully, legally convertible
currency could be issued in excess with undesirable
consequences, such as rising domestic prices relative to
foreign prices, balance-of-payment deficits, falling
foreign-exchange rates, gold outflow resulting in
depletion of gold reserves and ultimately forced
suspension of convertibility. The rate of reserves drain
often accelerated when the external gold drain coincided
with internal domestic-panic conversion of paper into
gold in fear of pending depreciation. Thus the CS
promoted full convertibility plus strict regulation of
the volume of banknotes to prevent the recurrence of
gold drains, exchange depreciation and domestic
liquidity crises.
The apprehension of the CS was
fully justified by past actions of the Bank of England,
which had been perverse and destabilizing by
international finance standards. The destabilizing
argument stressed the time lag on the Bank's policy
response to gold outflow and to exchange-rate movements.
The inevitably too little, too late measures taken by
the national bank, instead of protecting gold reserves,
merely exacerbated financial panics and liquidity crises
that inevitably followed periods of currency-credit
excess. The famous Bank Charter Act of 1844, in modern
parlance, imposed a 100 percent reserve requirement,
with an unabashed bias toward wealth preservation over
wealth creation. The CS also asserts that money
substitutes cannot impair the effectiveness of monetary
regulation. Thus if banknotes could be controlled, there
would be no need to control deposits explicitly, on the
ground that money substitutes have low velocity and are
of declining substitutional value in times of crisis.
Keynesians argue that the QTM is invalid because
it assumes an automatic tendency to full employment. If
resource under-ultilization and excess capacity exist, a
monetary expansion may produce a rise in output rather
than a rise in prices, as in the case of the 1930s
Depression. Money is not a mere veil. Monetary changes
may have a permanent effect on output, interest rates,
and other real variables, contrary to the neutrality
postulate of the QTM. Post-Keynesians also contend that
the QTM erroneously assumes the stability of velocity
and its counterpart, the demand for money. Velocity is a
volatile, unpredictable variable (technically known as
exogenous - due to external causes), influenced by
meta-rationality and by changes in the volume of money
substitutes, not to mention hedges in the form of
derivatives. The erratic behavior of velocity makes it
impossible to predict the effect of a given monetary
change on prices.
John Law (1671-1729), a
contemporary of Bodin, elaborated in 1705 on the
distinction drawn by Bernardo Davanzati (1529-1606)
between "value in exchange" and "value in use", which
led Law to introduce his famous "water-diamond" paradox:
that water, which has great use-value, has no
exchange-value, while diamonds, which have great
exchange-value, have no use-value. Contrary to Adam
Smith, who used the same example but explained it on the
basis of water and diamonds having different labor costs
of production, Law regarded the relative scarcity of
goods in demand as the generator of exchange value.
Davanzati showed how "barter is a necessary
complement of division of labor amongst men and amongst
nations"; and how there is easily a "want of coincidence
in barter", which calls for a "medium of exchange"; and
this medium must be capable of "subdivision" and be a
"store of value". He remarked "that one single egg was
more worth to Count Ugolino in his tower [prison] than
all the gold of the world", but that on the other hand,
"ten thousand grains of corn are only worth one of gold
in the market", and that "water, however necessary for
life, is worth nothing, because superabundant". That was
of course before International Monetary Fund (IMF)
conditionality requiring the poor in the indebted Third
World to pay for water through privatization of basic
utilities to service foreign debt.
Davanzati
observed that in the siege of Casilino, "a rat was sold
for 200 florins, and the price could not be called
exaggerated, because next day the man who sold it was
starved and the man who bought it was still alive". Of
course, modern economists would call that a market
failure. Davanzati viewed all the money in a country as
worth all the goods, because the one exchanges for the
other and nobody wants money for its own sake. Davanzati
did not know anything about the velocity of money, and
only recognized that every country needs a different
quantity of money, as different human frames need
different quantities of blood. The mint ought to coin
money gratuitously for everybody; and the fear that, if
the coins are too good, they should be exported is
simply illusory, because they must have been paid for by
the exporter.
Law's "Real Bills Doctrine" of
money applied the "reflux principle" to the money
supply. Money, Law argued, was credit and credit was
determined by the "needs of trade". Consequently, the
amount of money in existence is determined not by the
imports of gold or trade balances (as the Mercantilists
argued), but rather on the supply of credit in the
economy. And money supply (in opposition to the Quantity
Theory) is endogenous (growing from within), determined
by the "needs of trade".
Post-Keynesians have
drawn on the Real Bills Doctrine, which asserts that the
money supply is an endogenous variable that responds
passively to shifts in the demand for it. Thus monetary
changes cannot affect prices. Being demand-determined,
the stock of money cannot exceed or fall short of the
quantity of money demanded. In short, there is no
transmission mechanism running from money to prices.
Analysts should look instead for the source of economic
dislocations in real rather than monetary causes.
Inflation creates a corresponding increase in the money
supply, not the other way around. Yet QTM theorists
exposed the Achilles' heel of the Real Bills Doctrine by
demonstrating that as long as the loan rate of interest
is below the expected yield on new capital projects, the
demand for loans will be insatiable. Thus the "real
bills" criterion as an automatic regulator of the money
supply is inoperative unless central banks intervene to
raise interest rates in concert with expected return on
capital.
The attack on the QTM from the Banking
School (BS) also supported modern Keynesian views, by
pointing out that new money may simply be absorbed into
idle balances (gold hoards, a liquidity trap) without
entering the spending stream, while the supply of money
is determined by the need of trade and thus can never
exceed demand (in modern parlance: pushing on the credit
string). The BS went farther than the "Real Bills"
argument that even if the real-bills criterion of
restriction of loans to self-liquidating paper were
violated, the law of reflux would prevent overissue.
Holders of excess papers would simply redeposit them in
banks rather than spending them. The BS asserts that
prices are determined by income and not by the quantity
of money. For national economies, factor incomes earned
from overseas investment, rather than money, are the
sources of expenditure that act on prices, unless
neutralized by imports. This income-expenditure approach
was later developed by Keynes and became a
characteristic feature of Keynesian macro-economic
models.
The BS also disputed the quantity-theory
view of money as an exogenous or external independent
variable by arguing that the stock of money and credit
is a passive, endogenous demand-determined variable. The
stock of money and credit is the effect, not the cause,
of price changes. The channel of causation runs from
prices to money, not the opposite direction as contended
by the CS. What determines the volume of currency in
circulation is the active initiation of the non-bank
public (borrowers) with the banks playing only a passive
accommodating role. Implicit in the BS view of massive
money are three anti-quantity theory propositions: 1)
changes in economic activities precede and cause changes
in the money supply (the reverse causation argument); 2)
the supply of circulating media is not independent of
the demand for it and 3) the central bank does not
actively control the money supply, but instead
accommodates or responds to prior changes in the demand
for money. Against the CS emphasis on a narrowly defined
money supply, the BS emphasized the overall structure of
credit.
The BS advocates more free banking
against regulated banking, favoring the discretion of
bankers over regulation by government or fixed rules,
and, most important, the BS regards attempts to regulate
prices via monetary control as futile, since the money
supply, especially notes, is an endogenous variable
independent of exogenous control. BS views fighting
inflation via the supply of money and credit as putting
the cart before the horse, since it is prices that
determine the quantity of money and credit, and not vice
versa.
Despite the BS's criticism, the QTM
emerged victorious from the mid-19th century
Currency-Banking Debate to command wide acceptance until
the 1930s. The CS policy of fixed exchange rate, gold
standard, convertibility and strict control of banknotes
became British monetary orthodoxy in the second half of
the 19th century within the context of the triumph of
British imperialism. But the rigorous mathematical
restatement of the QTM by neo-classical economists
around the dawn of the 20th century was the crowning
factor to QTM's success in intellectual circles.
Irving Fisher (1876-1947) in his classic The
Purchasing Power of Money (1911) spelled out his
famous equation of exchange: MV=PT, where M is the stock
of money, V is the velocity of circulation, P is the
price level and T is the physical volume of market
transaction. This and other equations, such as the
Cambridge cash balance equation, which corresponds with
the emerging use of mathematics in neo-classical
economic analysis, define precisely the conditions under
which the proportional postulate is valid.
Yet
these conditions include constancy of the velocity of
money and of real output. Neoclassical economics assumed
that velocity was a near constant determined by
individuals' cash-holding decisions in conjunction with
technological and institutional factors associated with
the aggregate payment mechanism. Today, with
interest-bearing cash accounts, electronic payment
regimes and cashless credit-card transactions, such
assumptions are less valid. Money velocity, like wind
velocity in a weather pattern, fluctuates widely and
suddenly, caused by complex factors feeding back on each
other.
Fisher and other neo-classical
economists, such as Arthur Cecil Pigou (1877-1959) of
Cambridge, demonstrated that monetary control could be
achieved in a fractional reserve banking regime via
control of an exogenously determined stock of high-power
money. Underlying their argument that the total stock of
money and bank deposits would be a constant multiple of
the monetary base is the claim that the stock of money
is governed by three proximate determinants: 1) the
high-power monetary base, 2) the banks' desired reserve
to deposit ratio and 3) the public's desired
cash-to-deposit ratio, and with the the monetary base
dominating determinants 2) and 3). Again the financial
reality today is very different. Banks routinely borrow
through the repos window to bypass reserve requirements.
Banks, to reduce the capital requirement based on their
balance sheets, also sell their loans regularly as
securitized financial products in the credit markets.
Yet QTM continues to exercise a strong hold on monetary
theory.
Neo-classical quantity theorists stress
the long-run non-neutrality of money, a topic not well
developed in classical analysis. They integrate the QTM
into their analysis of business cycles, identifying the
quantity of money as a major cause of booms and busts
and monetary effects on price as a prerequisite to the
stabilization of economic activity.
It was not
until the 1930s that the QTM encountered serious
criticism and was discredited, replaced by the Keynesian
income-expenditure model. Notwithstanding Keynes'
earlier support for QTM in A Tract on Monetary
Reform (1923), Keynes' General Theory (1936)
launched a frontal attack on QTM by observing that if
the economy were operating at less than full employment,
with idle resources to draw from, changes in spending
would affect output and employment rather than prices.
Keynes reversed the QTM assumption by treating
prices as rigid and output flexible, a situation any
businessman could recognize. Keynes criticized the QTM
equations as tautological and that QTM erroneously
treated the circulatory velocity of money as a near
constant. Keynes pointed out that the velocity variable
in Fisher's equation was in reality extremely unstable
by showing that any change in M (money stock) might be
absorbed by an offsetting change in V (circulation
velocity) and therefore would not be transmitted to P
(price level). Likewise, any change in income or the
volume of market transaction might be accommodated by a
change in velocity without requiring any change in the
money supply.
Keynes revived the BS conclusion
that economic disturbances arise from exogenous shocks
originating in the real economy rather than from erratic
behavior of the money supply, and the futility of using
monetary policy to regulate economic activity to cure
unemployment and recession. The conclusion was based on
Keynes' theory of an absolute preference for liquidity
at low interest-rate levels - the case for the liquidity
trap. Keynes argued that either a liquidity trap or
interest-insensitive investment draught could render a
monetary expansion ineffective in a depression. Keynes
stressed a new non-monetary adjustment mechanism - the
income multiplier. The chief policy implication of the
Keynesian income-expenditure analysis was that fiscal
policy would have a more powerful impact on income and
employment than would monetary policy.
Post-Keynesian economists added to Keynes'
contra-QTM arguments by pointing out that inflation is
predominantly a cost-pushed phenomenon associated with
non-monetary institutional forces, such as union wage
inelasticity, monopoly pricing, etc. Cheap money,
Post-Keynesian advocates assert, from expansionary
monetary policy could be used to keep interest rates at
low levels, minimizing the burden of both private and
public debt, helping to keep unemployment at permanently
low levels. These positions depart from the neutrality
proposition. The Radcliffe Committee on British monetary
reform in 1959 declared that 1) money is an
indistinguishable component of a continuous spectrum of
financial assets; 2) the velocity of money is devoid of
economic content; and 3) attempts to regulate spending
via monetary control are futile in a financial system
that can produce a limitless array of money substitutes.
The Radcliffe Committee declaration is in fact an update
of the Banking School.
Then came Milton
Friedman, who remodeled the QTM into a theory of the
demand for money. It was based on the wealth effect, or
the theory of real balance effect, which argues that
prices would fall in a depression, thereby raising the
purchasing power of wealth held in money from. The
price-induced rise in the real value of cash balances
would then stimulate spending directly until full
capacity utilization had been attained. As the wealth
effect operates independently of changes in interest
rates, closure of the indirect channel could not prevent
the restoration of full employment. It follows that a
rise in the real balances and hence spending could be
accomplished just as easily via a monetary expansion,
validating the potency of monetary policy even in a
depression.
This argument offered an escape from
the Keynesian liquidity trap and a way of thwarting the
interest inelasticity of the investment-spending
draught, thus contradicting the Keynesian doctrine of
underemployment equilibrium. Friedman suggested that the
Keynesian view of the monetary transmission mechanism
was seriously incomplete. In denying that the quantity
theory was a theory of income determination, Friedman
freed it from the Keynesian criticism that it assumes
full employment. In their A Monetary History of the
United States, 1867-1960, Friedman and Anna Schwartz
showed that a rapid and large reduction in the money
supply played the dominant causal role in the Great
Depression of the 1930s. Their observation led to
criticism of the Keynesian attribution of the Depression
to a collapse of demand.
Monetarists argue that
the quantity of money, rather than the level and
channels of interest rates, is the appropriate variable
for the monetary authority to regulate. Greenspan in
essence applied this theory to prolong economic
expansion in the United States after 1997 and produced
the biggest bubble since the 1920s.
Monetarists
regard monetary policy as having a powerful long-run
impact on nominal income as contrasted with fiscal
policy. They regard income policy as having a perverse
long-term impact on economic activity. Despite lip
service paid to the notion of the direct effect of
monetary changes on commodity expenditure, modern
monetarists acknowledge that the transmission mechanism
operates primarily through a complex portfolio or
balance-sheet adjustment process involving various
interest-rate channels and affecting a wide range of
assets and expenditures, generating shifts in the
composition of asset portfolios, thereby inducing prices
and yields of existing financial and non-financial
assets relative to prices of current services and new
assets, albeit that the portfolio approach is not of
monetary origin, having been first developed by Keynes
and J R Hicks in the mid-1930s and subsequently
elaborated by James Tobin and others. These asset price
and yield changes, in turn, generate changes in the
demands for service flows and new asset stocks and hence
in the prices and output of latter items.
The
question of the appropriate range of assets and interest
rates to be considered in the analysis of the
transmission mechanism is a key point in the
monetarist-Keynesian controversy over the spending
impact of monetary changes. Keynesian models tended to
concentrate on a narrower range of assets and interest
rates, forcing the transmission process through a narrow
channel, thus choking off some of the spending impact of
a monetary change.
Of course, in Keynes' days,
the financial architecture was primarily a two-asset
world: cash and bonds, fundamentally different from
today's infinite range of financial assets in the brave
new world of structured finance. Modern monetarists
generally favor flexible exchange rates without exchange
control, whereas the Currency School advocated fixed
rates with exchange control.
Next: The European experience
Henry C K Liu is chairman of the New York-based Liu Investment
Group.
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