monetarism and its critics: why they were both wrong, part I

Gerry Jackson
13 January 2023

Since posting my critique of Keynesianism I’ve had a number of requests to write something on monetarism and why it seems to have failed. Monetarism rests on the basic economic truth that inflation is a monetary phenomenon. From this the Chicago monetarists drew the conclusion that control of the money supply is the means to control inflation and stabilise the economy. The opinions of two Australian critics encapsulates the views of most critics. According to Ross Gittins “monetarism was wrong and didn’t work” and was “built on assumptions that didn’t hold. Moreover, “money was something hard to define and measure in practice.”1 Alex Millmow argued that

[a]part from problems controlling the growth in the money supply, Friedman’s prescription of deflating economic activity to snap freeze the inflation problem meant enduring high unemployment, and was politically untenable2.

In 1568 Jean Bodin’s3 outlined his crude quantity theory of money according to which the price level rose in proportion to the increase in the supply of money. Millmow and Gittins don’t realise, like the great majority of those who criticise monetarism, that the monetarists’ approach, despite their fancy mathematics, does not go much further than Bodin’s monetary analysis. The first question to be asked is what is money. For Bodin and his contemporaries it was silver and gold coins. By the late eighteenth century this situation had changed dramatically. This brings us to the bullion controversy that Walter Boyd initiated in 1801 with his open letter to Prime Minister Pitt in which he gave the following as a definition of money:

By the words ‘Means of Circulation, ‘Circulating Medium’, and ‘Currency’, which are used almost as synonymous terms in this letter, I understand always ready money, whether consisting of Bank Notes or specie, in contradistinction to Bills of Exchange, Navy Bills, Exchequer Bills, or any other negotiable paper, which form no part of the circulating medium, as I have always understood that term. The latter is the Circulator; the former are merely objects of circulation4.

Boyd was saying that money is not merely a medium, it is something that has paying power. As Robert Torrens5 explained to Thomas Tooke6, buying power is that which finalises a transaction, something credit instruments cannot do. This means that money is M1. Therefore it is not something that is “hard to define and measure”.

Now Boyd’s letter set in motion a debate from which our own economists could learn a great deal, this includes critics of monetarism. The definition of money and whether money is neutral were two important elements of this debate. Monetarists like David Ricardo7, who had been heavily influenced by David Hume8 and John Wheatley9, argued that changes in general prices are proportional to changes in the quantity of money. This meant that not only was the quantity of money all that mattered but money was also neutral, meaning that changes in the money supply had little or no effect on individual prices, and therefore a monetary-induced change in the structure of production would not emerge.

Opposing Ricardo et al on this issue was Lord King10 who correctly observed that the demand for money was always uncertain and variable. He then went on to describe how an increase in the quantity of money would alter relative prices and incomes, thus showing why money could not be neutral. (We now call this distributive process the Cantillon effect11). In addition, Lord King and Walter Boyd fully understood that though money factors always predominated real factors also played a role in influencing prices.

There was also Henry Thornton’s12 insight that forcing the rate of interest below its market rate would expand the money supply which in turn would stimulate  the “needs of business”. This results in ‘savings’ exceeding investment, what is now called “forced savings” and what Jeremy Bentham termed “forced frugality”. It is clear that these early economists understood that for ‘savings to exceed investment’ a monetary expansion is necessary. In the words of Malthus:

PWhenever, in the actual state of things, a fresh issue of notes comes into the hands of those who mean to employ them in the prosecution and extension of profitable business, a difference in the distribution of the circulating medium takes place, similar in kind to that which has been last supposed; and produces similar, though of course, comparatively inconsiderable effects, in altering the proportion between capital and revenue in favour of the former. The new notes go into the market as so much additional capital, to purchase what is necessary for the conduct of the concern. But, before the produce of the country has been increased, it is impossible for one person to have more of it, without diminishing the shares of others. [Emphasis added].

This diminution is affected by the rise of prices, occasioned by the competition of the new note, which puts it out of the power of those who are only buyers, and not sellers, to purchase as much of the annual produce as before: While all the industrial classes, — all those who sell as well as buy, — are, during the progressive rise of prices, making unusual profits; and, even when this progression stops, are left with the command of a greater proportion of the annual produce than they possessed previous to the new issues13. [Emphasis added].

These paragraphs amount to a remarkable proto-Austrian analysis, the same one that Keynesians and Milton Friedman and his colleagues rejected, that is heavily pregnant with possibilities. Under the influence of John Bates Clark a great many economists came to treat capital as a timeless self-perpetuating homogeneous fund that reproduces itself. This view clearly denies the existence of stages of production and the role of time in production while treating maintenance and reproduction as an automatic process. This leads to the conclusion that production and consumption are instantaneous. (This is presented in textbook as the circular flow of income). As Böhm-Bawerk pointed out in his 189514, debate with James B. Clark, this model could resurrect the underconsumption fallacy where increased savings are supposed to reduce aggregate demand thereby causing a recession.  This is precisely what has happened.

As Walter Boyd  brilliantly pointed out, credit instruments  are not money. In other words, exchanging credit instruments for money cannot increase the quantity of money. Money consisted entirely of demand deposits and gold and silver coins. Robert Torrens that there were only two characteristics define money.

1. Paying power, meaning the ability to finalise a sale.

  1. Its usefulness as a medium of exchange.

Of the two characteristics paying power is the most important. It is also one that is ignored by our economic commentators.

Monetarists use broad money as a definition of the money supply. This now consists of  currency, demand deposits, time deposits, savings accounts, CDs, travellers cheques, and just about any credit instrument that can be quickly converted into cash. Savings accounts that involve a simple transfer of purchasing power should be excluded from the money supply figures. (Unfortunately, the Federal Reserve now includes these accounts in M1.) Writing in 1873 Walter Bagehot15 noted that the savings’ bank  deposits amounted to £240,000,000. Savings banks did not take demand deposits: what was paid in is what was loaned out to the extent that their

Pcash in ultimate reserve — cash in reserve against a panic — the savings’ banks have not a sixpence. . 

It should now be obvious why genuine savings accounts should not be included in the money stock

I think the monetarists most egregious error was to accept the fallacy of proportionality, the argument that in the long run any per centage increase in the money supply would raise the price level by the same per centage. This mechanistic view ignored the important fact that inflation changes relative prices. If Milton Friedman and his colleagues had taken note of works of  Cantillon, Boyd, Lord King, Thornton, and Torrens etc., they might very well have drawn very different conclusions regarding the power and meaning of money.

1Ross Gittins, Milton got a lot of things right — except monetarism, Sydney Morning Herald, November 18, 2006.

2Alex Millmow, The rivalry of two great economists lives on, The Canberra Times, 21 November 2006.

3Jean Bodin, A Reply to the Paradoxes of M. Malestroit, 1568.

4Walter Boyd, A Letter to the Right Honourable William Pitt on the Influence of the Stoppage of Issues in Specie at the Bank of England, on the Prices of Provisions, and other Commodities, 2nd edition, T. Gillet, London, 1801, p. 2.

5Robert Torrens, The Principles and Practical Operation of Sir Robert Peel’s Act of 1844 Explained and Defended, Longman, Brown, Green, Longmans, and Roberts, 1857, ch. 1


7David Ricardo, The High Price of Bullion: a proof of the depreciation of bank notes ….

The high price of bullion : a proof of the depreciation of bank notes, John Murray, 1810, pp. 6, 16. What is strange is that on page 49 he writes that monetary expansion “may distribute the productive capital in different proportions”. This is what the Austrian school calls malinvestments and the classical economists disproportionalities.

8The Works of David Hume, Vol. I, Henry Frowde, p. 289.

If we consider any one kingdom by itself, it is evident that the greater or less plenty of money is of no consequence, since the prices of commodities are always proportioned to the plenty of money…

9John Wheatly, Essay On The Theory Of Money And Principles Of Commerce Vol I, T. Cadell and W. Davies. p. 12.

10A Selection from the Speeches and Writings of the Late Lord King, Longman, Brown, Green, and Longmans, 1844 p. 67.

11Richard Cantillon, An Essay on the Nature of Commerce in General, written about 1725 but first published in 1755.

12Henry Thornton,  An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, J. Hatchard, 1802, pp. 260-264.

13Thomas Malthus, Edinburgh Review, February 1811, pp. 363-372. I am fortunate in owing the original essay,

14Bohm-Bawerk, The Positive Theory of Capital and Its Critics, Quarterly Journal of Economics, Vol. IX, January 1895, pp. 113-131. Page 123 is of particular interest regarding savings and recessions.

15Walter Bagehot, Lombard Street, Henry S. King & Co., 1973, p. 331.

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