On monetarism
Communication and risk in the monetarism controversy
October 2011
IN THE TWENTIETH CENTURY, ACADEMICS AND POLITICIANS DEBATED THE
controversy over monetarism—the theory that economic growth is best promoted by keeping
inflation low, and by controlling the supply of money in the economy. Monetarism is a freemarket
school of thought that prioritises the ‘fight against inflation’ over other economic
goals, even if there are negative impacts on unemployment, the currency level, consumer
demand or the savings rate. The controversy is about what the causes of inflation are, and the
relationship between inflation and wealth. For a whole century, monetarists and antimonetarists
have debated the topic, all the while trying to prove the other side wrong.
Originally, the controversy occurred among academics, but inflation in the 1970s made it a
public and political one (De Long 2000). It was heavily influenced by how the debate was
framed and how risks were communicated. It was framed within the confines of a particular
economic paradigm, which focused on a narrow array of risks, while ignoring others. The
debates featured esoteric concepts that excluded competing economic paradigms.
In the words of former US President Gerard Ford in 1974: ‘Whip inflation now … It is public
enemy number one.’ (Ford 1974)—a strange comment to make during the Cold War.
This essay examines the role of communication in the academic and public debates about
monetarism. It begins by seeking to resolve the actual arguments about monetarism, in order
Jade Connor—Communication and risk in the monetarism controversy, October 2011 2
to make them plain for the reader. It then describes the history of the controversy, before
analysing its political aspects and why it was so prolonged.
The subject of this essay is important to ongoing debates. America continues to debate how
to stimulate its economy when interest rates are already at zero. Europe continues to debate
how to respond to competing pressures, now that it has a common currency. Australia
continues to debate the best way of ‘managing a two-speed economy’.
Katter’s Australian Party has proposed reducing Australia’s cash rate (the wholesale rate at
which banks can borrow cash) from 4.75 per cent to 1 or 2 per cent (www.ausparty.org.au).
However, the reader may ask whether this would be an unduly risky policy. This essay will
answer that question (in the negative), show how the past monetarism controversy continues
to influence the current debate, and draw communication lessons for the Australian Party and
others.
MONETARISM ARGUES THAT THE BEST WAY FOR GOVERNMENTS TO SUPPORT
economic growth is to keep inflation low (keep prices stable). Further, the best way of doing
this is by controlling the money supply.
There are three primary alternative views. Keynesians argue that economic growth is
influenced by fluctuations in the level of investment, and economic growth should be
encouraged by ‘a comprehensive socialisation of investment [decisions]’ (Boreham et al
1999). Anti-liberal conservatives argue that the money supply is too hard to measure and
control efficiently (Tavlas 1997). The Marxist view is that inflation is primarily caused by
conflict between business owners and employees over the distribution of income (Jessop
2002).
In the last decade, a strict adherence to the monetarist approach has fallen out of favour
(Hafer 2001). New Zealand, famous for following the monetarist approach, has now
increased its official inflation target from 0-2%, to 1-3% (Brook et al 2001). Its central bank
Jade Connor—Communication and risk in the monetarism controversy, October 2011 3
is now less dogmatic about inflation, and also considers other impacts of policy, such as
impacts on aggregate demand or the currency level.
Economic circumstances have challenged classical monetarist theories, which had posited
that inflation should be avoided at all costs. In the last decade, many central banks have tried
to cause inflation (OECD 2010). Inflation risks are now a lower order priority. There is also
uncertainty about what level of inflation is problematic: should inflation be kept to 2, 3 or 8
per cent? (Brook et al 2001).
Many economists now also invoke the concept of ‘overheating’ (see, for example,
Ayilavaraparu 2003). It is argued that short-term consumption at the expense of saving and
investment creates economic growth levels that are unsustainable. Inflation is a sign of
overheating, but not itself considered a concern.
In the 1970s, it was obvious that high inflation was related to oil price shocks, not the money
supply. It is now accepted that inflation has many causes, including shortages of products,
skills shortages, wages conflict, expectations of inflation, the ease of access to credit,
speculatory activities that push up prices, and other real-world factors (Reserve Bank of
Australia 2011).
If it is considered that inflation has many causes, it does not make sense to attempt to control
inflation by influencing only one possible cause. The better solution to inflation—if inflation
is a problem—would be to more directly address all causes. Policies could focus on
promoting product substitutes (such as ethanol and other fuels), training more tradespeople,
institutionally setting wages (for example by arbitration), inflation level expectation
management, or reducing the incentives for speculatory activities. Post-Keynesians (or
'Marxist Keynesians') such as Joan Robinson (1973) recommend controlling wage levels
politically or institutionally, as well as directly encouraging investment (Boreham et al 1999).
There is also insufficient evidence to demonstrate a clear causation between inflation and
lower economic growth (see, for example, Brook et al). A typical error is made by presuming
causality between inflation and economic growth levels. Inflation in Australia and New
Zealand has been allowed to remain above 3% for a sustained period (in Australia it is
Jade Connor—Communication and risk in the monetarism controversy, October 2011 4
currently 3.6%, and in New Zealand it is 5.3%), yet neither economy has collapsed as a
result.
THE CONTROVERSY STARTED IN THE EARLY 20TH CENTURY AS AN INTERNAL
controversy within academia. There were competing schools of thought that reflected broader
controversies over economic theory, including Cambridge, Austrian, and University of
Chicago economists (De Long 2000).
Classical economists from the 19th and early 20th century, such as Irving Fisher, developed
theories about money, how it worked, and how it impacted price levels (De Long 2000).
Much of this was commensurate with theories about market tendencies towards equilibrium,
and how markets distributed resources. This version of monetarism established the quantity
theory of money (Friedman 1963).
In the 1920s, John Maynard Keynes and others questioned monetarism’s ability to explain
business cycles and the causes of the Great Depression (Keynes 1936, Robinson 1973).
Keynes’s call for ‘a comprehensive socialisation of investment’, to prevent recessions, was a
direct threat to free-market theories. In response to monetarists’ claim that economies tend
towards equilibrium ‘in the long run’, Keynes famously riposted that ‘In the long run we are
all dead’ (De Long 2000). He argued that economies fluctuated in cycles and did not
necessarily tend towards equilibrium in the medium term.
In the 1940s, the ‘Old Chicago School’ monetarism, represented by academics such as Jacob
Viner, sought to improve monetarist theory in response to Keynesian criticisms (Warburton
1981). In this period, monetarism developed theories about the velocity of money, and about
the sources of monetary instability.
After the second world war, Keynesian economic theories were politically influential—
although Robinson (op cit) argues the policies that were popular were a limited or ‘bastard’
form of Keynesianism. Milton Friedman (op cit) sought to further address identified
weaknesses in monetarist theory, in order to challenge the Keynesian dominance. Friedman
Jade Connor—Communication and risk in the monetarism controversy, October 2011 5
recommended regulating the level of money reserves that banks had to hold, to ‘control the
monetary causes’ of business cycles. Momentum developed for the introduction of an
‘inflation tax’ to control inflation (which developed into the use of the interest rates policy
tool). Friedman thus represented a more limited form of counter-cyclical policy than Keynes
(Chait 2011). Keynes argued that monetary policy was akin to trying to stop a gale by
holding up a feather (Dow 1993).
In the 1970s, monetarism became politically influential. According to De Long, ‘Everything
that went wrong with the macroeconomy had a single, simple cause: the central bank had
failed to make the money supply grow at the appropriate rate.’ The zenith of monetarism’s
influence occurred in Australia in the late 1980s, when the Australian Government and
Reserve Bank of Australia sought to control inflation by increasing interest rates to very high
levels (Hawke 1994).
De Long argues that political monetarism was an oversimplification of the earlier, refined
monetarism. He argues that many theories about the velocity of money, and presumptions
that the monetary supply would be easy for banks to control, proved empirically false in the
1990s. However, the basic tenets of classical monetarism continue to be influential; for
example, the view that inflation can be cured by increasing interest rates. Most economists
still consider these tenets to be important theories explaining how economies function (Abid).
TODAY, THE COMMUNITY IS MORE AWARE OF THE IMPACTS OF MONETARY
policy decisions. Home owners with mortgages want interest rates to be low. Any business
that has debts also likes interest rates low. According to monetarist doctrine, exporters should
want to keep inflation low relative to other countries because, in theory, this increases the real
value of export products. However, high relative interest rates usually increase the value of
the currency, so exporters such as farmers prefer interest rates to be low, even if inflation
increases.
Jade Connor—Communication and risk in the monetarism controversy, October 2011 6
Banks and lending institutions that lend money mostly from their own reserves prefer interest
rates to be higher. Individuals who are net lenders, for example most retirees and
superannuation investors, will prefer interest rates to be higher.
The business community generally prefers policy aimed at keeping inflation as low as
possible. The future value of investments and money deposits is higher when inflation is low.
It is also important to business that inflation is stable and predictable, so that it can predict
future prices when making investment and other decisions. For the business community,
monetary policy should keep inflation low, even if it means increasing interest rates.
One of the reasons why the debate over monetarism is so controversial is that government
policy responses based on the theory of inflation have such widespread impacts. They also
disproportionately affect low- and middle-income earners. Even when the debate about
monetarism remained within academia, there were nonetheless political aspects to the debate.
For example, Milton Friedman (1962) broadly supported the case for free market economics,
and preferred the use of monetary policy tools rather than highly interventionist fiscal or
‘Keynesian’ policy tools.
IN COMMUNICATING RISK, MONETARISM FOCUSED ON RISKS FACED BY
investors and the business community. What is interesting is the motivations of its two mostoften
cited participants: Friedman and Keynes. Keynes was by no means a socialist: he was
an aristocrat and government official who sought to ‘rescue capitalism from itself’ (Robinson
1973). De Long notes the following about Friedman’s motivations:
John Maynard Keynes's exasperation with the way that the First Monetarism was used
by economists in works like, say, Lionel Robbins's (1934) The Great Depression led
him on the intellectual journey that ended with the non-Monetarist John Maynard
Keynes, Mark II, and The General Theory of Employment, Interest and Money.
Most economists would agree with Keynes. Milton Friedman certainly does. In his
1956 "The Quantity Theory of Money--A Restatement," Friedman sets out that one of
Jade Connor—Communication and risk in the monetarism controversy, October 2011 7
his principal goals is to rescue monetarism from the "atrophied and rigid caricature"
of an economic theory that it had become in the interwar period at the hands of
economists such as Robbins and Joseph Schumpeter (1934), who argued that
monetary and fiscal policies were bound to be ineffective—counterproductive in
fact—in fighting recessions and depressions because they could not create true
prosperity, but only a false prosperity that would contain the seeds of a still longer
and deeper future depression.
According to Friedman, it was the inadequacies of this framework that opened the
way for the original Keynesian Revolution.
Monetarism, therefore, was always a slave to broader arguments seeking to establish the
legitimacy of capitalism and its superiority to socialism. There are lessons in this for
contemporary debates about macroeconomic policy, because the same motivations to protect
free-market theoretical dominance still exist. For example, when communicating the need to
reduce interest rates, the Reserve Bank of Australia will typically blame low levels of
consumer demand; if the need is to increase rates the bank will blame overheating, high
consumer spending, high private debt, or low savings rates. The bank does not often cite
causes that would seem to delegitimise free-market principles, such as low levels of business
investment in the domestic economy, or poor investment strategies.
Brook et al (op cit) also provides another interesting example of how risks are considered.
Four studies of the relationship between inflation and economic growth above and below a
certain ‘threshold level’ of inflation were examined. Above the threshold, it is argued that
inflation causes low economic growth. Below the threshold, evidence does not find a
correlation between inflation and economic growth. Although the studies could not establish
whether inflation should be kept below 3%, or merely below 8%, Brook et al conclude that
the correct approach is the precautionary one, and the inflation target should be below 3%.
This conclusion ignores whether there are opposing risks resulting from keeping inflation low
(below 3%), for example risks that low inflation could lead to low economic growth or higher
unemployment. Studies do not find any correlation between low inflation and strong
economic growth. Taking the precautionary approach is not reasonable without a valid reason
based on evidence.
Jade Connor—Communication and risk in the monetarism controversy, October 2011 8
In controversial science, debates are often narrowed down to arguments about specific
phenomena or areas of theory (Collins & Pinch 1993). It is often counterproductive to limit
debates in this way: because it reduces the debate to within the confines of a particular
paradigm, it can lead to the controversy not being resolved. Indeed, debates about
monetarism were often contained within a paradigm formed between Keynesians and
monetarists that focused on markets, or analyses of the supply of money, and ignored other
possible causes of inflation.
During the 20th century, the main possible alternative paradigm—Marxism—remained
underdeveloped, esoteric and unengaged in the monetarism debate (Dow 1993). The Marxist
paradigm, were it more engaged, would have examined the risks of monetary policy to others
besides the business community; however, Marxism tended to ignore the state and public
policy in favour of studying the sociological aspects of the free-market economy (Connor
2005). Unfortunately, both monetarists and Marxists tended not to observe empirical data.
The lesson here is that, to solve the controversy, those with alternative views must engage
with the debate. The debate should not be reduced to a narrow argument over specific
theoretical points within a closed paradigm. This remains a lesson yet to be learned by the
political left of the 21st century. The main political party of the left in Australia, the Greens,
focuses almost exclusively on environmental and social policies. The left does not engage in
economic debates; therefore, the debate takes place within a paradigm shaped by students and
academics with a liberal (free-market) bias.
The second lesson is to understand which risks are being communicated, and whose risks
those are. Katter’s Australian Party, or others concerned about high interest rates, should
point out that economists tend to communicate only the risks to big business. Attention
should be refocused towards impacts on unemployment, the prices of exports, and the level
of domestic investment.
A third lesson is that assumptions about risk must be challenged. It is now accepted that the
money supply is not the cause of all inflation; however, a legacy from the monetarist theory
is that economists argue inflation may get out of control if interest rates are lifted—even if
only lifted marginally. There is a case for more research in this area. The current risk in
Jade Connor—Communication and risk in the monetarism controversy, October 2011 9
Australia that inflation will get out of control is minimal, yet there are no significant
organisations in Australia that are challenging this claim.
AFTER A CENTURY OF RESEARCH INTO THE CAUSES OF INFLATION, THERE
is still no definitive empirical evidence that controlling the money supply is a sound policy
response. A survey of the literature by Brook et al found only four recent empirical studies
on the topic—despite the widespread impacts of monetary policy levers.
The reason for such a prolonged controversy is political. The non-engagement of
competing paradigms meant that the debate occurred within a restrictive paradigm that
only researched the money supply, while ignoring other possible causes of inflation. Two
opposing contributors to economic theory in the 20th century, Keynes and Friedman, were
seemingly motivated by the same objective: to save capitalism from itself. An important
political factor in this was the perceived imperative, at the time, to save capitalism from the
threat of communism.
Participants in the macroeconomic debate should refocus arguments on the range of monetary
policy risks that are traditionally not communicated to the public: the impacts on
employment, investment levels, the level of the currency, speculation and instability of the
currency level, the price of exports, the balance of payments, and the cost of living for
borrowers. Another point to communicate is the relatively low risk from inflation levels
increasing slightly. The challenge is to avoid esotericism, and speak plainly. Ultimately there
will be opposition to this, because most economists are still within a money-supply-focused
paradigm. Many economists still seek to defend a free-market vision for economic policy,
where government intervention is vehemently opposed, even when evidence shows that it is
warranted.
Jade Connor—Communication and risk in the monetarism controversy, October 2011 10
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