Long Live Monetarism

Monday, October 30, 2006

“Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output.” I can think of few sentences in economics that have engraved themselves more deeply in my memory than Milton Friedman’s famous line in his Encyclopaedia Britannica entry for “Money.”

Milton’s death elicited a host of tributes from politicians, central bankers, and economists on both sides of the Atlantic, of which the most vivid (“an intellectual freedom fighter”) came from Lady Thatcher. Let me humbly add my own.

Even before I went to university (in 1982), I had become fascinated by the problem of inflation. Who in my generation was untouched by it, after all? As a schoolboy, I had overheard my worried parents discussing the impact of a pay freeze on our family finances, at a time when the annual inflation rate was in double figures. In August 1975, it is worth remembering, consumer price inflation in Britain hit 27 percent. I was 11, the age my daughter is today. Hard times beyond her imagining.

At Oxford, an institution overwhelmingly hostile to Thatcherism, I ploughed through John Maynard Keynes’s General Theory of Employment, Interest and Money. No one mentioned Milton Friedman. Instead I was directed to John Kenneth Galbraith, the preeminent popularizer of Keynes’s work. I discovered Friedman—Galbraith’s antithesis in every respect apart from brains and longevity—only when I began work on my doctoral dissertation on the German hyperinflation of 1923 (if you’re going to study inflation, I figured, study the biggest one). And I still recall the thrill of reading that line for the first time: “Inflation is always and everywhere a monetary phenomenon.” Suddenly all became clear. Instead of worrying about the marginal propensity to consume and other arcane Keynesian concepts, I just needed to figure out why the Weimar Republic printed such an insane quantity of banknotes. And, sure enough, it turned out that socialist politicians had been trying, among other things, to spend their way to full employment.

Milton’s work combined skepticism toward government with faith in individual rationality and therefore freedom.

In 1920s Germany, however, just like in 1970s Britain, the notion of a trade-off between inflation and unemployment proved to be illusory, precisely as Milton argued in his celebrated 1967 address to the American Economic Association. Gradually, people cottoned on to what was happening, prices soared sky-high, and the economy collapsed.

It wasn’t just that Milton rehabilitated the quantity theory of money. It was his emphasis on people’s expectations that was the key, for that was what translated monetary expansion into higher prices (with positive effects on employment and incomes lasting only as long as it took people to wise up). In this, as in all his work, Milton combined skepticism toward government with faith in individual rationality and therefore freedom.

The list of libertarian reforms he urged is an impressive one: the abolition of the military draft, the abolition of fixed exchange rates, vouchers to allow parental choice in education, tax credits instead of government handouts. Nevertheless, it will be for monetarism—the principle that inflation could be defeated only by targeting the growth of the money supply and thereby changing expectations—that Milton Friedman will be best remembered.