The return of monetarism


In the early years of the Thatcher administration, monetarism ruled. Taking their cue from the economist Milton Friedman, the government took the view that inflation was caused by too much money being in circulation. The more of something there is, the less value it has, and money is no exception.

But this kind of monetarism fell victim to Goodhart's Law. Various things can be included in the definition of 'money' – notes, coins, instant-withdrawal bank accounts, but maybe short-notice bank accounts and lots of other things too. Whatever sort of money the government tries to control, those clever people in the City come up with some new kind, and things carry on regardless. So the government's anti- inflation policy changed. Instead of trying to limit the supply of money, it turned to trying to limit the demand for it. High interest rates would reduce the demand for loans, people would cut back their expenditures, and prices would be bid back down again.

That's pretty well where we have been for the last twenty years. Milton Friedman didn't like it. He said that trying to control prices by changing interest rates was like trying to control the output of cars from Detroit by changing the price of steel. It has some effect, right enough, but a very crude one, and one that messes up other things too. But now the Federal Reserve has set interest rates at 0%-0.25%. They can't go lower than 0% – that would mean people would actually be paying to have cash in the bank – at least, not for very long. So what's the answer? Well, the problem now is not inflation but deflation, so the Fed has let it be known that it's very happy to start printing money again. (It will do it electronically through something called quantitative easing, but it amounts to dropping dollar bills from helicopters across the US economy, in the hope that folk will rush out and spend, and prices will turn up again.)

So Milton Friedman, and monetarism, are back. It's a funny old world.