Friedman is dead, monetarism is dead, but what about inflation?

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". It was a kind of mantra for the Thatcher generation. The question is: Does anyone still believe it?

Friedman's death last Thursday 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 per cent. 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 Friedman. Instead I was directed to John Kenneth Galbraith, the pre-eminent populariser 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.

In 1920s Germany, however, just as in 1970s Britain, the notion of a trade-off between inflation and unemployment proved to be illusory, precisely as Friedman 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 Friedman 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, Friedman combined scepticism towards government with faith in individual rationality and therefore freedom.

The list of libertarian reforms he urged is an impressive one: the abolition of the 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 Friedman will be best remembered.

Why then has this, his most important idea, ceased to be honoured, even in the breach? Friedman outlived Keynes by half a century. But the same cannot be said for their respective theories. Keynesianism survived its inventor for at least three decades. Monetarism, by contrast, predeceased Milton Friedman by nearly two.

The death of monetarism is usually explained as follows. In the course of the 1980s, pragmatic politicians and clever central bankers came to realise that it was difficult to target the growth of the money supply. As Chancellor of the Exchequer, Geoffrey Howe preferred to raise interest rates and reduce public sector borrowing. His successor Nigel Lawson targeted the exchange rate of the pound against the deutschmark.

At the Federal Reserve, too, Friedman's rules, once zealously applied by Paul Volcker, gradually gave way to Alan Greenspan's discretion. And, for all the praise he heaped on Friedman last week, Greenspan's successor Ben Bernanke is dismissive of monetarism. Earlier this year the Fed ceased to track and publish M3 (the broadest monetary aggregate). It is the inflation rate that today's central bankers want to target, not money (though the President of the European Central Bank, Jean-Claude Trichet, recently came out as a neo-monetarist).

Anti-monetarists point out that the relationship between monetary growth and inflation has simply broken down. Inflation is low nearly everywhere. The latest figure for the annual growth in American core consumer prices is just 2.3 per cent, down from 3.8 per cent in May. Yet the annual growth rate of M3, which diehard monetarists have continued to track unofficially, is just under 10 per cent. Last year, according to the IMF, M2 increased by nearly 13 per cent in the UK. In some emerging markets the figure was higher. Russia's money supply grew 25 per cent.

Yet simply because consumer price inflation has remained low, money has not become irrelevant. On the contrary: it is the key to understanding the world economy today. For there is nothing in Friedman's work that states that monetary expansion is always and everywhere a consumer price phenomenon.

In our time, unlike in the 1970s, oil price pressures have been countered by the entry of low-cost Asian labour into the global workforce. Not only are the things Asians make cheap and getting cheaper, competition from Asia also means that Western labour has lost the bargaining power it had 30 years ago. Stuff is cheap. Wages are pretty flat.

As a result, monetary expansion in our time does not translate into significantly higher prices in shopping malls. We don't expect it to. Rather, it translates into significantly higher prices for capital assets, particularly real estate and equities. The people who find it easiest to borrow money these days are hedge funds and private equity firms. Through leveraged buy outs, the latter can easily acquire companies and, by improving their cashflow, boost their valuations. These guys then buy houses in Chelsea with the millions they make.

It makes sense. Consumer goods are plentiful: the supply of computing power has grown even faster than the supply of credit to consumers. But shares in Chinese banks and houses with Chelsea postcodes are scarce, while the supply of credit to their potential purchasers seems almost infinite.

No one can say for sure what the consequences will be of this new variety of inflation. For the winners, one asset bubble leads merrily to another; the key is to know when to switch from real estate to paintings by Gustav Klimt. For the losers, there is the compensation of cheap electronics. Why worry, when China is willing to buy all the US dollars the Fed cares to print in order to keep its currency from appreciating and its exports cheap?

Last week the People's Bank of China announced that its international reserves have reached the dizzying figure of $1 trillion, 70 per cent of which is held in dollar notes and bonds. If you were wondering where all the money went, that's part of the answer. Unnerving, isn't it?

No, the theorist may be dead, but long live the theory. "Inflation is always and everywhere a monetary phenomenon." It's true, no matter what is inflating.

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