Monetarism and its critics why they were both wrong, part II

Gerry Jackson
20 February 2023

I ended part I with the observation that if the monetarists had taken note of the work of classical economists they might just have realised how much they had underestimated how insidiously disruptive money is when badly managed. In turn this realisation may have led them to ask why the Austrian school of economics stresses the heterogeneity of capital. That Friedman knew all was not right with his quantity theory was hinted at in the following statement with respect to a secular fall in prices:

[T]he price level fell to half its initial level in the course of less than fifteen years and, at the same time, economic growth proceeded at a rapid rate. The one phenomenon was the seedbed of controversy about monetary arrangements that was destined to plague the following decades; the other was a vigorous stage in the continued economic expansion that was destined to raise the United states to the first rank among the nations of the world. And their coincidence casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible1.

There was a similar price phenomenon in Britain which saw wholesale prices fall by about 47 per cent from 1873 to 18962.

However, 1873 was the peak of an inflationary boom that distorted the price trend, which began for both countries in 1864. During that 32-year period British prices fell by 43 per cent and American prices by about 55 per cent3. Although there are no consumer price indexes for this period, consumer prices would still have followed the same downward trend as wholesale prices. The effect of falling prices on real wages was striking.

Although difference between the cost of living and the wholesale price index can vary significantly it’s safe to presume, given the scale of the fall in the wholesale price index,  that the British cost of living fell by about 25 per cent. This would increase purchasing power by 33 per cent. Hence, if during that period a man’s annual money wage rose from £102 pa to £202 pa then he real wage would £272, 166 per cent increase. Those who criticise the Industrial Revolution for not raising real wages fast enough overlook the fact that this increase in the standard of living was unprecedented in history. Moreover, they do not realise that they are criticising nineteenth century industrialists for not using  21st century machinery4.

Today’s economists make the grave error of attributing this lengthy price fall to deflation, which would make it the longest monetary contraction in monetary history. Therefore, the absurdity of the error should be obvious. Our 32 years of falling prices were produced by a fairly steady increase in productivity that created a downward trend in production costs and prices, a sure sign of a progressing economy. It was by this process the benefits of industrial progress were spread throughout society. Alfred Marshall observed with respect to this productivity-induced fall in prices that

 …its effect is, on the whole good, because it certainly tends to cause a redistribution of wealth better than that which we should other have….the greater part of the redistribution is in the direction of giving higher real wages and real salaries to the employees, and that, I think, is a gain5.

Friedman understood that the Austrian school of economics posed a significant danger to monetarism, particularly with respect to its trade cycle theory. He counter attacked with the assertion that the Austrian explanation of the ‘business cycle’ failed the statistical test and was therefore false. But it was Friedman who was wrong. His mistake was to use GDP data which omits intermediate spending between stages of product. In other words, Friedman’s approach missed the most important element from the Austrian perspective which is total spending and not net spending6.

At the beginning of 1999 America’s unemployment rate was 4.3 per cent, even though manufacturing was shedding jobs. I predicted, using Austrian analysis, that the situation with respect to manufacturing jobs and output signalled that the economy was sliding into recession even though GDP and the demand for labour were rising. This meant that spending between stages of production must have been falling, an important fact concealed by the GDP approach. No wonder Steve Slifer, who was then chief economist at Lehman Brothers, said of the US economy in January 2001:

It’s really an odd-looking slowdown. The manufacturing sector is, in fact, in a recession but not the overall economy. At least not yet.

Keynesians could not recognise the danger signals.

To explain periodic recessions Friedman conjured up the “plucking model7”. Imagine a string stretched between two points. The consistency of the string is such that one can pluck it at various points so that they sag. These are the busts. According to Friedman this merely shows that what goes down must go up. But this is no explanation at all. Yoshio Suzuki, a Japanese economist, certainly thinks so. Moreover he believes that the Austrian analysis fits the bill. According to Suzuki:

 As Hayek teaches us, easy money does not always raise the price of goods and services, but always creates an imbalance in the structure of the economy, particularly in the capital markets. . . . This is exactly what happened in Japan [in the 1980s]8.

The most devastating criticism of the quantity theory of money was made by Benjamin M. Anderson who said that

The formula of the quantity theorists is a monotonous “tit-tat-toe”— money, credit, and prices. With this explanation the problem was solved and further research and further investigation were unnecessary, and consequently stopped — for those who believed in this theory. It is one of the great vices of the quantity theory of money that it tends to check investigation for underlying factors in a business situation. The quantity theory of money is invalid. . . . We cannot accept a predominantly monetary general theory either for the level of commodity prices or for the movements of the business cycle9.

 Those Keynesians who insist that the 1970s was a period of is cost-push inflation. Really?

During the Whitlam years December 1972 to November 1975 the CPI rose by more than 40 per cent. During the same period currency leapt by 75 per cent. February 1975 to December 1975 saw bank deposits jump by21 per cent and M1 by 20 per cent. (Apparently the RBA had no figures for bank deposits and M1 prior to February 1975). The same Keynesian madness infected the UK: from 1970 to 1979 MI leaped from £9.5 billion to £30.5 billion. So much for the mindless Keynesian and post-Keynesian mantra there is such a thing as cost push inflation.

1Milton Friedman and Anna J. Schwartz, A Monetary History of the United States 1867–1960, Princeton, N.J.: Princeton University Press, 1971, p. 15.

 2Samuel Berrick Saul, The Myth of the Great Depression 1873-1896, Macmillan Publishers 1985, 14.

3Historical Statistics of the United States, 1789-1945, pp. 231-232.

421st century machinery

5Alfred Marshall, Official Papers, Macmillan and Co., Limited, 1926, p. 91.

6The Austrian school looks at gross spending which include all intermediate goods. These are the goods that pass through the stages of production. When this spending contracts so does the economy.

7The Austrian theory of booms and busts comes under frequent attacks. I have yet to encounter one authored by someone who actually studied the theory. One particular attack that pops up frequently is that the theory predicts that consumption will fall before the recession emerges. This is rubbish. As Mises said:

 …the  amount  of capital goods available for investment has not increased. Neither does credit expansion bring about a tendency toward a restriction of consumption. [Emphasis added].

Ludwig Von Mises,  Human Action: A Treatise on Economics, Yale University Press, 1949, pp. 546, 553

8Dr. Yoshio Suzuki, Comment on Papers by Benegas Lynch and Skousen, Mont Pelerin Society Meetings, September 27, 1994, Cannes, France.

9Benjamin Anderson, Economics and the Public Welfare, LibertyPress 1979 first published 1949,  p. 56.

One thought on “Monetarism and its critics why they were both wrong, part II”

  1. I Thought I had the basics of monetarism till I read this. It certainly revealed to me how bad the media are when it comes to commentating on economics.

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