Inflation is always and everywhere a monetary phenomenon.
—MILTON FRIEDMAN (1956)
The Kennedy-Johnson tax cut of 1964 was, as noted in chapter 1, the first deliberate use of fiscal policy to speed up the growth of aggregate demand in the United States. (Such policies had, however, been used in several European countries much earlier.) Its success gave the idea a good name. But that was all about boosting demand and pushing the economy forward.
The first deliberate use of fiscal policy to slow down the growth of aggregate demand came in 1968 in the form of a temporary surcharge on income tax payments. The surcharge was not successful, and it is hard to find many (any?) subsequent examples of fiscal tightening for stabilization purposes in U.S. history.1 There are, of course, obvious political reasons why politicians eschew tax hikes. Nonetheless, the failure of the 1968 surcharge may have had momentous consequences. Why did it fail?
Recall that President Lyndon Johnson’s economic advisers began urging him, pretty much unanimously, to pursue a contractionary fiscal policy in late 1965, and they never relented. But Johnson was unmoved for more than a year. Only by January 1967, with the unemployment rate down to 3.8 percent and the inflation rate up to 3.4 percent, was he persuaded by his Troika (Treasury, the Office of Management and Budget, and the Council of Economic Advisers [CEA]) that a tax increase was in order (Okun 1970, 84–85). Johnson initially spoke of a 6 percent surcharge on both personal and corporate income tax payments, exempting taxpayers in the lowest brackets. But by the time Congress acted, the overheating of the economy had worsened, and the surtax rate was eventually set at 10 percent.
Johnson’s request may have been long overdue, but it nonetheless received a frosty reception on Capitol Hill. To cite just one prominent example, Congressman Wilbur Mills (D-AR), who chaired the powerful House Ways and Means Committee, observed at a hearing in November 1967 that “I have not seen as yet any evidence that we are currently in any demand-pull inflationary situation that requires immediate action” (Okun 1970, 87). If you paid attention to neither theory nor economic forecasts—which was (and is) no doubt the position of most members of Congress—Mills had a point: inflation at the time was stable to falling.
Much more important, elected legislators knew that taxpayers never like higher taxes and that the unpopularity of the Vietnam War made any patriotic appeal for revenue to finance the war a political nonstarter. The war did not grow more popular as time passed, but public and congressional opinion against inflation began to stiffen as the inflation rate crept up from its low point of 2.3 percent in May 1967 to 3.3 percent by December 1967 and 4.2 percent by June 1968 (figure 2.1).2 Where would it stop?
FIGURE 2.1. Consumer Price Index inflation rate, January 1965–December 1969.
Source: Bureau of Labor Statistics.
Interestingly, in view of the cavalier attitudes toward central bank independence at the time, the Federal Reserve explicitly joined the administration’s call for fiscal restraint in early 1968. The February 1968 Economic Report of the President observed that “it has been and remains the conviction of both the Administration and the Federal Reserve System that the Nation should depend on fiscal policy, not monetary policy, to carry the main burden of the additional restraint on the growth of demand that now appears necessary for 1968” (CEA 1968, 84–85).
From a modern perspective, two remarkable—and long-rejected—ideas are packed into that sentence. First, the Fed was ceding to the administration the “main burden” of fighting inflation. Really? When’s the last time the Fed thought that would work? Or when did you last hear an economist voice that view? Second, not only did the CEA speak for the Fed (in its Economic Report), but the Fed explicitly endorsed the administration’s fiscal policy. Did it not occur to Fed Chair Bill Martin that the Johnson administration or future administrations might not return the favor by endorsing the Fed’s monetary policies? Had he forgotten that politicians don’t like to see punch bowls being taken away from parties?
The Revenue and Expenditure Control Act of 1968 was finally signed into law by President Johnson in late June 1968, retroactive to April 1 for individuals and to January 1 for corporations. It was estimated to raise about $10.5 billion per year once fully phased in, which was roughly 1.2 percent of GDP at the time. Notice that the magnitude almost undid the Kennedy-Johnson tax cut of 1964. The act also reduced federal spending by $6 billion. Together, both parts of the acts represented a sizable fiscal contraction, nearly 2 percent of GDP. It was late for sure, but not trivial in size.
FIGURE 2.2. Annualized growth rate of real GDP, quarterly, 1965–1970.
Source: Bureau of Economic Analysis.
Because the historical verdict on the 1968 surcharge—a verdict that came quickly—is so negative, it is worth pointing out that real GDP growth (in today’s data) slowed from 5.5 percent in the four quarters before the 1968 act to 3.1 percent in the four quarters after. Negative growth did not show up until the final quarter of 1969, when a short and shallow recession began (figure 2.2).
Did people at the time expect a faster or sharper slowdown than that? I suppose some did, but the CEA’s January 1969 forecast predicted only “less than 3%” real growth over the four quarters of 1969 (CEA 1969, 56). Modern data show the actual figure to have been 2.1 percent, so the CEA forecast was basically on the mark. Robert Solow and I (Blinder and Solow 1974, 103–15) subsequently noted that the surtax was battling a list of contemporaneous forces that were expanding aggregate demand, such as a surge in spending on automobiles and the lagged effects of the highly expansionary monetary policy that had followed the credit crunch. So, perhaps the surtax was more effective than widely believed. All that said, however, inflation rose after the tax hike from 4.2 percent in June 1968 to 5.5 percent in June 1969 and 6 percent in June 1970 (see figure 2.1). This outcome was not expected, and it seemed perverse. The surtax was branded a failure.
The comparatively weak effect of higher taxes on real demand is not hard to explain, however. The law imposed the surtax for just one year (it was later extended to a second year). As Robert Eisner (1969) observed at the time and as subsequent research confirmed, albeit not without controversy,3 explicitly temporary income tax increases (or decreases for that matter) should pack less punch than permanent ones. Okun (1971) subsequently used four macroeconometric models to estimate that the surcharge on personal income taxes, which averaged $9 billion (at annual rates) over the four quarters of 1969, should have reduced consumer spending by about $4 billion, or less than 0.5 percent of GDP.
Thus, the puzzle, to the extent there is one, is not why consumption did not fall more but rather why inflation continued to rise. The answer is obvious to a modern economist, though it wasn’t to many economists of the day: unemployment remained substantially below its natural rate throughout the period, not reaching even 5 percent until July 1970. But the Keynesian economists of the day, perhaps wed to President John F. Kennedy’s 4 percent “full employment” target, were loath to accept that proposition. Indeed, the natural rate hypothesis itself, though already introduced by Friedman (1968) and Phelps (1967, 1968), was not yet widely accepted (more on this in the next chapter). People looked instead to ephemeral phenomena such as “wage push,” “administered pricing,” “bottlenecks,” and the like.
As the New Frontiersmen were bringing Keynesian policy into mainstream American practice, Milton Friedman and Anna Schwartz were rewriting American economic history in a decidedly non-Keynesian way. The bold opening sentence of their epic 1963 work (from which this book draws its title) is at once accurate and a gross understatement of the book’s intent and achievements: “This is a book about the stock of money in the United States” (Friedman and Schwartz 1963, 3). Yes, it was about the money stock—and a lot more.
Friedman and Schwartz’s A Monetary History of the United States, 1867–1960 rewrote macroeconomic history with a heavy emphasis on fluctuations in the money supply. (Money looked much better as a predictor of nominal GDP and inflation in the 1950s and 1960s than it would later.) Among other things, the pair famously laid responsibility for the length and depth of the Great Depression squarely on the “inept” (their word) policies of the Federal Reserve. They insisted that “though the Reserve System proclaimed that it was following an easy-money policy, in fact it followed an exceedingly tight policy” (Friedman and Schwartz 1963, 699), allowing the money supply to contract. To Friedman and Schwartz, monetary stringency, not credit conditions, had squeezed aggregate demand and turned what might have been a recession into a severe depression.
Nearly four decades later, Ben Bernanke, a Fed governor at the time and later the Fed’s chair, offered a famous apology to Friedman and Schwartz at Friedman’s ninetieth birthday celebration in 2002. “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again” (Bernanke 2002). When Great Depression 2.0 threatened to engulf the U.S. economy in September 2008, Bernanke and the Fed most emphatically didn’t “do it again.” Nor did Chair Jerome Powell in 2020.
In the Friedman and Schwartz view, the Fed’s grievous errors in 1929–1933 not only made the Depression worse—which was bad enough—but also left a damaging intellectual legacy. “The contraction shattered the long-held belief … that monetary forces were important elements in the cyclical process and that monetary policy was a potent instrument for promoting economic stability. Opinion shifted almost to the opposite extreme, that ‘money does not matter’; that it is a passive factor which chiefly reflects the effects of other forces; and that monetary policy is of extremely limited value in promoting stability” (Friedman and Schwartz 1963, 300). Friedman and Schwartz, of course, rejected every aspect of that “shattering”; they favored returning to the “long-held belief.” Notice in particular the quotation marks around the phrase “money does not matter,” suggesting, without citation, that it was a widely voiced notion at the time. But was it? Or was it a straw man?
More the latter, it appears. I am unable to find any American economist at the time who denied that monetary policy mattered. That Heller, Tobin, Ackley, and Okun were not in that camp is on the record. They all said so clearly. Ditto for such other Keynesian luminaries as Samuelson, Solow, and Franco Modigliani. What is true is that a number of U.S. economists, looking back at the Great Depression, had observed that a liquidity trap could conceivably rob monetary policy of its efficacy—something Keynes had pointed out in 1936. None, however, saw the liquidity trap as relevant to the 1960s.4
Looking for extreme “fiscalists” was perhaps a bit more promising in the United Kingdom, where Nicholas Kaldor and Joan Robinson are sometimes offered as examples. But their central complaint against monetarism was not that monetary policy was powerless but rather that the money supply was endogenous, so M should not be looked upon as a control variable (Iša 2006). It is true that the denigration of M as an exogenous policy instrument, which many of the aforementioned American economists shared, is a rather different gestalt than what is found in Freidman and Schwartz. But it is a long way from claiming that “money does not matter.”
Regardless of whether many (or even any) economists ever said that money didn’t matter, there is little doubt that Friedman and Schwartz’s monumental work—bolstered significantly by Friedman’s personal persuasiveness and skill in debate—changed intellectual history. Even though the term monetarism never appears in their volume, there is little doubt that their Monetary History is one of the wellsprings of that doctrine.
A second wellspring that became famous at the time but is mostly forgotten today is Friedman and David Meiselman’s (1963) lengthy paper “The Relative Stability of Monetary Velocity and the Investment Multiplier in the United States, 1897–1958,” written for the Commission on Money and Credit. The commission was established in November 1957 by the Committee for Economic Development to make the first extensive investigation of the U.S. monetary system since the Aldrich Commission of 1908–1911, which turned out to be a step toward founding the Federal Reserve. Although the commission’s report was published in June 1961, a multivolume series of supporting studies, which included Friedman and Meiselman’s soon-to-be-famous paper, appeared only in 1963.
Friedman and Meiselman asked, in an exceedingly simple way, whether velocity was more or less stable (and hence reliable) than the Keynesian multiplier. Specifically, they asked which was the better predictor of consumer spending (C): what we now call M2 or what they classified as “autonomous expenditure” (A), conveniently eliding the facts that M had clearly not been the Fed’s policy instrument over most of this period and that the United States didn’t even have a central bank in 1897–1913.5 Their basic methodology was to run statistical horse races between M and A via univariate regressions—that is, to regress C on either M or A—and see which gave the better statistical fit. In Friedman and Meiselman’s work, M won this horse race with plenty to spare. But evidence as simplistic as that was not very convincing—unless you were already convinced.
Their salvo, however, was just the beginning of what would become a decades-long empirical battle. Very quickly (given publication lags), Albert Ando and Franco Modigliani (1965) disputed both Friedman and Meiselman’s methodology and their conclusions in the pages of the American Economic Review. Friedman and Meiselman (1965) replied at length in that same issue. They started their reply with these modest words: “Because our article ventured into almost virgin territory, it was necessarily tentative, probing, and imperfect. Because it questioned the new orthodoxy, we expected it to provoke controversy” (753). It certainly did!
Under the influence of its hawkish president, Darryl Francis, and its research director, Homer Jones, the Federal Reserve Bank of St. Louis became the hotbed of monetarism within the Federal Reserve System. In 1968, two of the bank’s research economists, Leonall Andersen and Jerry Jordan (1968), published a paper in the Federal Reserve Bank of St. Louis Review that caused a sensation and became a defining event in the monetarist-Keynesian debate.6 That paper evoked, although it did not cite, Friedman and Meiselman’s analysis; indeed, looking back years later, Jordan wrote that “we considered the AJ article to be a sequel to the FM article” (Jordan 1986, 6).
But the Andersen-Jordan approach was considerably more sophisticated than Friedman-Meiselman’s, especially about such matters as allowing for lags in the effects of policy and including both monetary and fiscal variables in the same regression. Using either the money stock or the monetary base as the measure of monetary policy and either the high-employment surplus or its revenue and expenditure components separately as the fiscal policy measure(s), Andersen and Jordan presented a series of multivariate regressions covering the years 1952–1968. These purported to show that monetary policy did a vastly better job than fiscal policy in explaining quarterly movements in nominal GDP.
Keynesians were aghast, and research critical of Andersen and Jordan started to appear everywhere.7 I still remember a visit by Andersen to MIT to present a seminar on their results when I was a graduate student there in 1969–1970. When Andersen made some nonincendiary remark about how both monetary and fiscal policy might matter, Paul Samuelson popped out of his seat to declare, “If you believe that, you’re not a monetarist. You’re a member of the human race!” The fact that the great Professor Samuelson chose to attend the seminar at all indicated how important the Andersen-Jordan results looked in academia, even though they were not published in a peer-reviewed scholarly journal. His not-very-polite remark was indicative of the heat that surrounded the debate.
The term monetarism appears to have been coined by Karl Brunner. Brunner and his frequent coauthor, Allan Meltzer, were perhaps the most prominent monetarists of the day after Friedman himself. Brunner described the core of the doctrine as comprising three propositions. “First, monetary impulses are a major factor accounting for variations in output, employment and prices. Second, movements in the money stock are the most reliable measure of the thrust of monetary impulses. Third, the behavior of the monetary authorities dominates movements in the money stock over business cycles” (Brunner 1968, 9).
Most Keynesians of the day accepted the first of these propositions and perhaps the third as well.8 But they choked on the second. At the time, the Federal Reserve was using “free reserves” as its instrument,9 mostly as a way to control short-term interest rates. It was certainly not targeting the money supply by anybody’s definition. But that just describes how the Fed was actually behaving at the time. It leaves open the question of whether it could have done a better job of conducting monetary policy by targeting the money supply instead. Monetarists insisted that it could—and should.
Notice that Brunner’s list does not include the notion that fiscal policy does not matter, even though the Friedman-Meiselman and Andersen-Jordan results both pointed in that direction. In his then-famous 1968 debate with Friedman, Walter Heller stated that “the issue is not whether money matters—we all grant that—but whether only money matters, as some Friedmanites, or perhaps I should say Friedmaniacs, would put it” (Friedman and Heller 1969, 16). Friedman replied that this is a “straw man.… I do not think that it is a meaningful statement” (46). But a few pages later he stated that “in my opinion, the state of the budget by itself has no significant effect on the course of nominal income, on inflation, on deflation, or on cyclical fluctuations” (51). Isn’t that saying that fiscal policy doesn’t matter?10 Friedman’s explanation then was what we would now call complete crowding out of deficit spending if it is financed by issuing bonds. This became the issue: Does a larger fiscal deficit, not accompanied by increasing the money supply, expand aggregate demand?
Simple versions of the monetarist model—which answered no to that question—required that the demand for money, and hence velocity, be insensitive to interest rates. In the economists’ jargon, the LM curve summarizing the dependence of the demand for money on interest rates and GDP is vertical. But the zero elasticity idea was easily debunked empirically. A famous, or perhaps infamous, paper by Friedman (1959) had claimed to have found a zero interest elasticity, but no one else could. Okun’s (1970, 146–47) book listed twenty-five “articles [that] report empirical results showing a negative relationship between the demand for money and the rate of interest” and only one—Friedman’s 1959 article—showing no relationship.11
However, establishing that the demand for money does in fact depend negatively on the nominal interest rate by no means ended the Keynesian-monetarist debate. One prominent monetarist recalled that “as the decade of the 1960s ended, the lines had been drawn for a prolonged intellectual battle. The Keynesian revolution was still dominant, but the challenge of the monetarist counterrevolution had been initiated” (Jordan 1986, 6). The battle was indeed long, raging on through the 1970s, the 1980s, and even into the early 1990s, which is when Federal Reserve Chair Alan Greenspan officially announced that the Federal Open Market Committee (FOMC) would no longer pay attention to the growth rates of the monetary aggregates.12 By the time he made that statement, attention to the Ms at the Fed, which had been a legal requirement since 1975, had already been reduced to lip service. Greenspan just put an end to the lip service.
But I am getting ahead of the story. The 1968 tax surcharge failed to curb inflation. In retrospect, no one should have expected it to. But the plain—and painful—fact that inflation rose to levels not seen in almost two decades was counted as a failure of Keynesian economics and therefore gave monetarism a strong boost in both intellectual and policy circles.
Perhaps by coincidence, most Keynesian economists tended to be both liberal and a bit dovish on inflation,13 while monetarists tended to be conservative and decidedly more hawkish on inflation. Samuelson and Friedman were quintessential examples of each camp. So, there was an underlying grain of truth to the monetarist charge that Keynesians were soft on inflation—but only a grain. Remember, it was President Johnson’s Keynesian economists who had lobbied for a contractionary, anti-inflation policy as early as 1965. The political aspects of the Keynesian-monetarist divide probably stemmed more from Friedman’s advocacy of fixed policy rules than from anything having to do with money per se. After all, liberals typically look toward government for solutions, while conservatives look away.
In any case, rising inflation certainly gave the rise of monetarism a big assist. In 1969, the Consumer Price Index inflation rate topped 6 percent for the first time since 1951. The proverbial horses were out of the barn. As noted earlier, both fiscal and monetary policy had already turned restrictive by then to fight inflation, and to no one’s surprise, a mild recession began in December 1969. Partly in consequence, the inflation rate tracked down to about 5.5 percent a year later and to about 4.5 percent when President Richard Nixon invoked wage-price controls in August 1971 (more on price controls in chapter 4). Arguably, monetary and fiscal policies were working, albeit slowly, when Nixon, anxious about his 1972 reelection prospects, ran out of patience. But the entire episode was read, especially by monetarists and other conservatives, as discrediting Keynesianism.
To Milton Friedman, the remedy for the disease of inflation was simple: just slow down the growth rate of the money supply. Hence, the genesis of his famous k-percent rule for money growth, which predated the term monetarism by many years.14 The constant k was supposed to be the estimated growth rate of potential GDP plus the target rate of inflation—nowadays 2 percent, though Friedman might have preferred zero or even negative (Friedman 1969). Regarding inflation fighting, he wrote that “I don’t think monetary policy has to be backed up by fiscal policy at all. I think monetary policy can curb inflation” (Nelson 2007, 1). Friedman’s reasoning was simple and familiar: “A budget deficit is inflationary if, and only if, it is financed in considerable part by printing money.”15 Notice that Friedman was once again skating perilously close to the extreme “fiscal policy doesn’t matter” position that he had attacked as a straw man.
Remember also that his policy prescription, the k-percent rule, predated the birth of monetarism by years and was not part of Karl Brunner’s definitional list in 1968. In fact, the Brunner quotation above, taken in isolation, could easily be read as a brief for activist monetary stabilization policy—something that a younger Milton Friedman had once advocated (Friedman 1948).16 Nonetheless, the k-percent rule soon became an essential part of the monetarist policy prescription, if not of monetarist theory. Friedman, a libertarian distrustful of government, naturally believed in elevating rules over human discretion. Many monetarists sympathized with that view. Arthur Burns, though a conservative, did not (more on Burns in chapter 4.)
Milton Friedman (1912–2006) Monetarist Extraordinaire
Few economists who never held a high position in government ever had as extraordinary an influence on public policy as Milton Friedman. He did it all by the force of his intellect, a deft pen, and an amazing talent for debating.17 His book A Monetary History of the United States, 1867–1960 (with Anna Schwartz), published in 1963, is, of course, the inspiration for this book’s title.
Friedman was born in Brooklyn, New York, but raised in New Jersey by parents who were immigrants from what we now call Ukraine. A brilliant high school student, young Milton won a scholarship to Rutgers, which was then private but is now the state university of New Jersey. There, studying economics and mathematics, he encountered a teacher named Arthur Burns, thus starting an association that would prove to be both long-lasting and influential. But Friedman’s original goal was to become an actuary!
Upon graduation from Rutgers, Friedman turned down a scholarship to study mathematics at Brown in favor of one to study economics at the University of Chicago. It was a fateful decision, for “the Chicago school” and “Friedman” subsequently became nearly synonymous. As a graduate student at Chicago, Friedman was influenced by the likes of Jacob Viner, Frank Knight, and Henry Simons. Perhaps more important, Friedman met and fell in love with his wife, Rose Director.
Ironically, given what was to come, Friedman’s first job after obtaining his PhD in 1935 was in Washington, DC, as a bit player in Franklin Roosevelt’s New Deal working for—hold your breath—the National Resources Planning Board. A few years later, he was back in the government as an adviser to the Treasury Department during World War II.
Obviously, this attachment to federal service didn’t stick. Virtually all of Friedman’s fabled career was spent in academia, mostly at the University of Chicago (from 1946 to 1977), and much of it attacking government actions as foolhardy or worse. At the University of Chicago, Friedman published such notable works as A Theory of the Consumption Function (1957), the aforementioned Monetary History, his celebrated 1967 American Economic Association presidential address “The Role of Monetary Policy” (1968), a collection of essays entitled The Optimum Quantity of Money and Other Essays (1969), and much more. He was awarded the Nobel Prize in 1976.
Friedman’s keen intellect and talent for persuasion were evident in a number of popular books (Capitalism and Freedom [1962] and Free to Choose [1979]), in widely read Newsweek columns for about eighteen years, and in advocacy of a number of “crazy” ideas that subsequently became realities such as floating exchange rates, the negative income tax, an all-volunteer army, and school vouchers.
In the realm of monetary and fiscal policy, however, Friedman is clearly most notable for practically inventing the doctrine that Karl Brunner later labeled “monetarism.” That meant both positive monetarism, which argued that the growth rate of the money supply was far and away the most important determinant of inflation, and normative monetarism, which held that the central bank should stabilize the growth rate of the money supply. There aren’t many monetarists left today. But in its heyday monetarism was enormously influential, as was Milton Friedman.
While monetarists insisted on the central importance of monetary policy, often denigrating fiscal policy, they were just as insistent that the Federal Reserve was committing grievous errors by targeting a short-term interest rate rather than the growth rate of (some measure of) the money supply. M, the monetarists argued, was a better control instrument than r. As Allan Meltzer put it years later, “To a monetarist economist, [the simple] view of the transmission process is overly restrictive and mechanical. A monetary impulse that alters the nominal and real stocks of money does more than change a single short-term interest rate or borrowing cost” (Meltzer 1995, 52). Whoever argued with that? Wealth effects, for example, would boost consumer spending. It was another straw man. But it left open the question of whether M or r was a better target for the Fed.
This important practical question was addressed theoretically in a landmark paper by William Poole (1970), a onetime Friedman student who was then a staff economist at the Federal Reserve Board. Poole would later become an academic and, subsequently, president of the Federal Reserve Bank of St. Louis. Like many good ideas, Poole’s original framework was strikingly simple, though it was later complexified by other economists in several dimensions.18 Here is his basic idea.
If the central bank fixes the money supply (M), thus giving rise to the textbook IS-LM system, both output (y) and interest rates (r) will fluctuate in response to stochastic shocks to either the demand for money (“LM shocks” or “velocity shocks”) or real spending (“IS shocks”). If, on the other hand, the central bank fixes r, letting M adjust period by period to achieve the desired interest rate, LM shocks become irrelevant to y, whose variance depends only on IS shocks. But those demand shocks now have larger effects on y than when an upward-sloping LM curve cushions them. So, there is a trade-off. Targeting M rather than r mutes the effects of IS shocks but adds LM shocks to the mix. Depending on which type of shock is more troublesome, the monetary authority might prefer one type of policy or the other.
Poole, who went on to become a prominent monetarist, was relatively agnostic about the choice in that 1970 paper. It was a work of scholarship, not advocacy. He did, however, observe that “it could be argued that much more is known about the monetary sector than about the expenditure sector” (Poole 1970, 206), which if true would push a central bank toward targeting M rather than r. Subsequent events, especially waves of financial innovation in the 1970s and 1980s, spurred both by inflation and Regulation Q restrictions, would demonstrate the power of Poole’s simple (and intuitive) analysis. But they would also prove his hunch wrong. We did not know more about the monetary sector. Rather, huge and recurring velocity shocks gradually led one central bank after another to give up on monetarism. As Bank of Canada governor Gerald Bouey famously quipped, “we didn’t abandon monetary aggregates, they abandoned us” (Bouey 1982).
The Fed’s brief flirtation with monetarism in 1979–1982 will be described in chapter 7. But monetarism’s rise in the late 1960s and early 1970s had enough influence in the real world that financial markets began to dance to the tune of the Fed’s weekly announcements of the money supply (by several different definitions!), even though those high-frequency numbers were mostly statistical noise. The FOMC itself began to specify “ranges of tolerance” for M1 and M2 in 1974. Then in 1975, the Fed received instructions from Congress to include annual growth targets for M1, M2, M3, and bank credit in its semiannual reports. Monetarists rejoiced at this “major change in monetary policy—perhaps the most important change since the banking acts of the 1930s,” in Milton Friedman’s overly exuberant words (Friedman 1975a, 62).
Finally, a 1977 amendment to the Federal Reserve Act directed the Fed to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Modern attention focuses on the last part of that instruction, the Fed’s so-called dual mandate. But reread the first ten words. Congress had enshrined a role for the Ms into law.19 Monetarism had (sort of) been endorsed by Congress.
After the Volcker experiment in 1979–1982, the Fed rapidly backed away from its allegedly monetarist operating procedures. In Ben Bernanke’s words in 2006, “It would be fair to say that monetary and credit aggregates have not played a central role in the formulation of U.S. monetary policy since that time” (Bernanke 2006). That was an understatement. When the statutory reporting requirements lapsed in 2000, the Fed ceased setting target ranges for the monetary aggregates. By then, monetarism was pretty much a dead intellectual doctrine anyway. Empirical realities had trumped theoretical reasoning—not for the first time and not for the last.
But monetarism had left its mark. As early as 2009, inflation hawks were worrying out loud about the potential inflationary consequences of the mountain of reserves the Fed had created to fight the world financial crisis, despite the evident facts that (a) nervous banks wanted to hold enormous volumes of idle reserves and (b) those reserves now paid interest. For example, at a House hearing in July 2009, Congressman Ron Paul (R-TX) criticized the Fed after its massive first round of quantitative easing. “The true definition of ‘inflation’ is when you increase the money supply.… You have doubled the money supply.… So it seems to me that you are in the midst of massive inflation” (U.S. House Committee on Financial Services 2010, 19). Paul’s “true definition” seemed to reverse the roles of horse and cart. But then again, logic is never required in a congressional hearing.
Now, you might write off Paul as an anti-Fed crank—and you would be right to do so. And rising inflation never came. In January 2010, however, with the economy still in the doldrums, Thomas Hoenig, then president of the Kansas City Fed, was dissenting against the Fed’s hyperexpansionary policies partly on the grounds that “the combination of near-zero interest rates with the size of our balance sheet will cause long-term inflation expectations to systematically, over time, become less well anchored” (FOMC 2010a, 188). Not quite monetarism but perhaps a first cousin.
Monetarist-like thinking reemerged even more strongly during the pandemic of 2020–2021. As M2 growth soared by 35 percent during the year and a half from February 2020 to August 2021, more and more voices started pointing to money growth as a harbinger of inflation. And inflation did indeed rise in 2021, although most contemporary observers attributed it more to sectoral supply bottlenecks than to the money supply.
Monetarism rose to prominence on a combination of some hotly disputed scholarly work, Milton Friedman’s singular brilliance and skill in debate, and perhaps most important the rise of inflation in the late 1960s (due to excess demand) and the early 1970s (due mostly to the supply shocks discussed in chapter 5). Keynesianism was unjustly tagged as inherently “inflationary,” and monetarism stepped forward as the replacement.
Monetarist doctrine died in both the academic and policy realms for the same reason, though with different timing in different countries: the behavior of velocity became erratic and unpredictable. That happened, however, only after monetarism had registered substantial influence on policy formulation in the United States, the United Kingdom, Germany, and elsewhere. The policy debate was not, as Friedman and others sometimes claimed, over whether monetary policy mattered. It was about whether fiscal policy not accommodated by monetary policy mattered. As it turns out, it did.
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1. As will be clear in this book, there have been fiscal tightenings for other reasons, such as to reduce the budget deficit.
2. Here, as usual, I use the twelve-month Consumer Price Index inflation rate as recorded in today’s data.
3. See, for example, Okun (1971) and Blinder (1981b).
4. In late 2008, however, the liquidity trap idea made a surprising comeback.
5. In fairness to them, money creation could influence output and spending even without a central bank.
6. Jordan would later become president of the Federal Reserve Bank of Cleveland.
7. A fledgling Princeton economist named Alan Blinder participated in this effort a few years later. See Goldfeld and Blinder (1972). We showed that, for example, perfect fiscal stabilization policy would destroy any statistical correlation between GDP and the fiscal policy variable.
8. Years later, there was a sizable academic literature on endogenous money. It did not, however, grow out of Kaldor’s and Robinson’s objections but instead came from “inside” the monetarist camp. See, for example, King and Plosser (1984).
9. Free reserves were defined as excess reserves minus borrowings from the Fed.
10. In fairness, however, the budget deficit is at least an endogenous as the money supply.
11. Okun’s list included papers by prominent monetarists such as Karl Brunner, Allan Meltzer, and David Laidler.
12. See, for example, his testimony before the Senate Banking Committee (Greenspan 1993).
13. But not all, either then or now. Herbert Stein was a prominent conservative Keynesian back then; Ben Bernanke is today.
14. Friedman had advocated it in his 1960 book (Friedman 1960).
15. From a newspaper interview, as quoted in Nelson (2020, 437n162).
16. His idea there was that with fixed fiscal policies, the business cycle would naturally produce deficits and surpluses that should be financed by creating and destroying high-powered money.
17. Personal note: I debated him once. It was an event for which I prepared more assiduously than I ever prepared for anything else. Debating Milton was frightening.
18. One such extension, by Sargent and Wallace (1975), turned out to be a landmark in the rational expectations revolution. See chapter 6.
19. On the matters in this and the next paragraph, see Bernanke (2006).