Does Transparent Monetary Policy Lead to Economic Stability?

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Commentary

In his various writings, the leader of the monetarist school of thought, Milton Friedman, argued that there is a variable time lag between changes in money supply and its effect on real output and prices. Thus, Friedman wrote:

“In the short run, which may be as much as five or ten years, monetary changes affect primarily output. Over decades, on the other hand, the rate of monetary growth affects primarily prices.”

Friedman held that the effect of changes in money supply shows up first in output and hardly at all in prices. It is only after a longer time lag that changes in money start to have an effect on prices. According to Friedman, the main reason why changes in the money supply affect output in the short run is the variability in the time lag between money and output. Consequently, he was of the view that if the central bank were to follow a constant money growth rate rule, this would eliminate fluctuations in output caused by the variability in the time lag between money and the real economy. Therefore, in this way of thinking, the effect money will have is only on prices. Thus, Friedman wrote:

“On the average, there is a close relation between changes in the quantity of money and the subsequent course of national income. But economic policy must deal with the individual case, not the average. In any case, there is much slippage. It is precisely this leeway, this looseness in the relation, this lack of mechanical one-to-one correspondence between changes in money and in income that is the primary reason why I have long favored for the USA a quasi-automatic monetary policy under which the quantity of money would grow at a steady rate of 4 or 5 per cent per year, month-in, month-out.”

In his Nobel lecture, Robert Lucas expressed disagreement with Friedman.

Lucas asked, “If everyone understands that prices will ultimately increase in proportion to the increase in money, what force stops this from happening right away?”

Consequently, Lucas suggested that the reason why money does generate real effect in the short run is not so much the variability of monetary time lags but more whether money changes were anticipated or not.

According to Lucas, if monetary growth is anticipated, then individuals are likely to adjust to it rather quickly, and there will not be any real effect on the economy. Only unanticipated monetary expansion can stimulate production. Moreover, according to Lucas, “unanticipated monetary expansions, on the other hand, can stimulate production as, symmetrically, unanticipated contractions can induce depression.”

Both Friedman and Lucas are of the view, although for different reasons, that it is desirable to make money neutral in order to avoid unstable and therefore unsustainable economic growth. The current practice of Fed policymakers seems to incorporate the ideas of Friedman and Lucas into the so-called transparent monetary policy framework. This framework accepts Lucas’s view that anticipated monetary policy can lead to stable economic growth. It also accepts that a gradual change in the monetary policy in the spirit of Friedman’s constant money growth rule could reinforce the transparency.

Both Friedman and Lucas are of the view that increases in money supply can cause economic growth. (For Lucas, only unanticipated money growth can grow the economy.) But does it make sense that increases in money supply can cause economic growth? Murray Rothbard wrote:

“Money, per se, cannot be consumed and cannot be used directly as a producers’ good in the productive process. Money per se is therefore unproductive; it is dead stock and produces nothing.”

Both Friedman and Lucas—in order to establish that more money can grow an economy—might have followed the Keynesian framework that demand causes supply. According to this, increases in the money supply consequently causes increased demand for goods. This, in turn, is supposed to strengthen the real output. But an individual’s demand is constrained by his ability to produce goods. The more goods that an individual can produce, the more goods he can demand.

If greater demand could cause economic growth by itself, then world poverty would have been eliminated a long time ago. After all, what is lacking in many countries is not the ability to demand but the ability to produce.

Money, Expectations, and Economic Growth

What is required for economic growth is a growing “subsistence fund,” which will support individuals in the various stages of production, including the buildup of capital goods. An increase in money, however, is not of much help here. On the contrary, this increase results in consumption that is not supported by the production of wealth. The increase in money supply sets in motion the exchange of nothing for something. This results in a weakening of savings and a depletion of the subsistence fund, which undermines economic growth. Increases in the money supply cause a redirection of savings, capital, and production from wealth-generating activities toward nonproductive, wealth-consuming activities.

Even Friedman’s scheme to fix money supply growth rate at a given percentage will not generate stability. A fixed percentage growth is still money growth and still involves distortions of the price and production structure, price inflation, wealth redistribution, and boom-bust cycles.

Why is it, then, that we can observe that increases in the money supply are associated with increases in economic indicators such as real gross domestic product (GDP)? In reality, all we observe is an increase in spending. This is what GDP depicts. The more money that is generated, the higher the GDP. The so-called real GDP is merely nominal GDP deflated by a dubious price index. Hence, so-called “economic growth” just mirrors monetary expansion and has nothing to do with true economic growth. It is not possible to establish a meaningful total by adding potatoes to tomatoes.

Monetary growth—irrespective of whether it is anticipated or unanticipated—cannot grow the economy; it definitely produces a real effect by undermining the structure of production and capital formation, thereby weakening the economy. Unanticipated monetary growth and anticipated monetary growth cause the menace of boom-bust cycles. Besides, even if the money growth is fully anticipated, there is always someone who gets it first.

Even if the money is pumped in such a way that everybody gets it at the same time, changes in the demand for money are going to vary as will the time of purchases. There is always somebody who is going to spend the newly received money before somebody else. This results in a transfer of wealth from the late spenders to the early spenders.

Regardless of expectations, tampering with the economy by monetary policy will undermine the foundations of the economy. Hence, it is not possible to make the economy stable through expansionary monetary policy, no matter how transparent it might be. Henceforth, the best monetary policy is not to have any monetary policy.

From Mises.org