Up from Monetarism and Other Wishful Thinking

A case can readily be made that the English-speaking countries, the United Kingdom and the United States in particular, are currently getting the economic policy that they deserve. Theology, wishful thinking, and a modest resort to necromancy have extensively replaced practical judgment on both sides of the Atlantic. The results are in keeping. The British experiment along these lines is more advanced than that in the United States, so the economic consequences in England are much worse. But the administration in Washington has come to office with a powerful promise that it will repeat the British error. It agrees that government should not in these days take instruction from experience—its own or that of others. I do, of course, wish to be even-handed in these sordid matters; there is little to be said for the alternative policies so far being advanced by most of those now out of office.

The problem, stripped of the priestly incantation by which economists in high public or private position assert their superior identification with the occult, is simple. The unrelenting affliction of the modern industrial society is inflation; it is against this affliction that the hard core of economic policy is arrayed. There are only three designs for contending with inflation. The first is by controlling the spending and respending of the proceeds from bank and general lending. Though described in different terms by its advocates, this is the essence of monetary policy. The second design is by the control of private expenditure through taxation and of public expenditure through restraint on governmental spending. This is fiscal policy. The third design involves direct intervention by government on incomes and prices in that part of the economy where wage advances can press up prices and prices can stimulate wage demands, and where the result is a continuing upward spiral that, in turn, sets a pattern for the less organized part of the economic system. These are the only three designs for contending with inflation. There are no others.

I shall have a word presently on the notion now current in the United States that inflation can be quenched by increased productivity and supply. This is a relatively unsophisticated form of fraud. Annual productivity gains are minimal in relation to current rates of inflation. At the very best they will so continue. It is only increased production that is induced by more efficient use of labor and capital that works against inflation. Expansion in output that does not involve cost reduction carries with it the increased purchasing power by which it is bought. This purchasing power sustains prices. Ronald Reagan, we now know, is an activist where economic policy is involved. But even he cannot repeal this application of what is known as Say’s Law, a notably conservative economic proposition, I would also observe.

Thus we come to the sources of the present sorrow and the reason why it is readily explicable and indeed elementary. In modern highly organized economies all three measures, all three, are needed for dealing with the problem of inflation—they are needed if governments are to avoid a crucifying increase in unemployment, idle plant capacity, business failures, and disruption in the international exchanges and capital movements. But in both the United Kingdom and the United States there is an overriding commitment to one, and only one, of these measures—monetary policy. In both countries an incomes and prices policy is rejected on grounds of high market principle except as it involves employees in the public sector. In both countries there is a rhetorical embrace of a conservative fiscal policy—according to terminology, to a small or negative deficit or public-sector borrowing requirement. In both countries the fiscal or budget policy is, in fact, exceedingly weak or, in the American case, will become so. There remains therefore, only monetary policy.

Monetary policy, however, is not just a residual course of action; in both countries it is also an affirmative faith. And it is this faith that combines the wishful thinking and theology. It is wonderful to imagine that the problem of economic management in all its complexity can be solved by leaving everything to the ordered, quiet, subtle, slightly mysterious world of the Bank of England and the Federal Reserve System. How nice, in an otherwise secular matter, to believe that God is securely in support of Professor Milton Friedman, the most eloquent, optimistic, and convinced of economic prophets. Control the supply of money, allow it to increase only as income and output in the economy increase, and you have controlled all. In Britain this rule has been inscribed on the sacred tablets at Whitehall. But with Ronald Reagan in the White House and Beryl Sprinkel in charge of monetary affairs in the United States Treasury, no one can suggest that Professor Friedman is a prophet without honor in his own country. Mr. Sprinkel, a few weeks ago, went so far as to say that the federal deficit was immaterial so long as there was a tight hold on the money supply. It is now the policy in the United States to relive the British travail.

As do other economists, I have a particular penchant for the redundant and the obvious. There are so few things in our discipline that are certain; thus the satisfaction in saying that the British experience shows that monetarism in isolation does not work. This, manifestly, is something Englishmen, the Scots, and Welsh already know. It is also now known that the difficulties are at three levels. There is (1) the uncertainty about what is money; there is (2) the certainty that what the central bank chooses to define as money cannot, either in quantity or velocity, be controlled; and there is (3) the further and demonstrated certainty that efforts at control, to the extent that they are pressed, will substitute for the problem of inflation the alternatives of high unemployment, recession or depression, and disaster for those industries which depend on borrowed money. There are other lesser effects to which I will return.

As to what is to be called money, not even the monetarists agree. That is because in the modern sophisticated economy there are many media of payment and exchange—currency or the money base, deposits subject to check, savings deposits subject to check or readily converted to checking accounts, unused lines of credit, unused overdraft facilities, the purchasing power that lies back of credit cards. The decision on what is to be controlled is largely, though not quite completely, arbitrary. Were it otherwise, the monetarists would not be debating within the cult what should be controlled.

But it is now the revealed experience of both the Bank of England and the Federal Reserve System (I eschew the egregious commitment to an ostentatious familiarity which causes economists and journalists to speak of “The Fed”) that, having decided what will be called money, they cannot control it. They cannot make any pretense to controlling the turnover or velocity which in all the monetarist equations is one dimension of the effect on prices. Reduce the volume of money in the form of checking accounts and a partly offsetting increase in the rate of use is quite conceivable. But neither, with any precision, can the Federal Reserve control the shifts between different kinds of money—some controlled, some beyond reach of control—or the rate at which borrowers come to the banks for the accommodation which, as loans and deposits, then becomes part of the monetary aggregates.

This inability to control the money supply as it is defined is the common experience of the central banks of both countries. It has caused Professor Friedman (and one gathers also the Chancellor of the Exchequer) to accuse the Bank of England of incompetence. And, in an equally forgettable current controversy in Washington, it has caused Mr. Sprinkel of the Treasury to attribute similar fecklessness to the Federal Reserve System. It will occur to most people, although not alas to passionate monetarists, that any policy that relies heavily on a central bank must be with-in the going competence of the central bank. The monetarists are asking the central banks to do what, in the modern economy, they cannot do.

That does not mean that the effort is without consequence. Or that it is without effect on inflation. Monetary policy, as earlier noted, limits expenditure and re-expenditure from borrowed funds. This it accomplishes by rationing their use by high interest rates and tightened loan conditions. (The manipulation of reserve requirements and discount rates by which this is accomplished is not without sophistication, but it can be ignored.) The resort to high interest rates and astringent borrowing conditions in general has an immediately adverse effect on those industries that depend for their operations on borrowed funds—housing being the outstanding case but smaller or weakly financed businesses being also generally vulnerable. Acting as it does on borrowing for investment rather than on consumption, it has an adverse effect on productivity. It has a devastating effect on the bond market, and is far from good for common stocks. It is one of the dubious virtues of the policy that, in a high-minded way, it does not spare its friends. And, as we currently observe, monetarism conduces to large movements in footloose international balances as they try to capture the high interest returns. Thus the policy has a deeply unsettling effect on the international exchanges.

But the truly serious effects are on general macroeconomic performance. The archons of monetarism, I need hardly argue, are men much committed to the market. If you have sufficiently studied the classical market, such can be your affection for this useful institution that you can believe that, in its pristine form, it exists everywhere. In a university this is an amiable and harmless fantasy; in practical application to a world of numerous, diverse, sensitive, and obstreperous unions, strong corporations, farm organizations, OPEC, and a large public sector, it is hopelessly and disastrously in conflict with reality. The consequence of that conflict is the discovery that only a severe restraint on aggregate demand has an appreciable effect on wages and prices.

The astringency must be sufficiently severe so that corporate employers, contemplating their shrinking market, as now in the American automobile industry, are moved to resist union demands. And unions, contemplating their unemployed members, as now at Chrysler, are moved to concede. And OPEC is forced to second thoughts. And (as now) unprotected world commodity prices are forced down. In a highly organized society monetary policy works against inflation. But it works, experience now tells us, both unequally and by producing a high and enduring volume of unemployment and a severe recession in business activity. It is one of Britain’s great, useful, and painful contributions to economic understanding that it has shown that this is not an economist’s construct; it is a matter of practical experience.

As has been noted, the American retreat to monetary policy is less advanced than that in Britain. It had, however, gone far enough in the last year of the Carter presidency to combine high interest rates, a sharp recession, increased unemployment, and a continuing high rate of inflation with the date of the election. As I have observed on other occasions, economists can do some things with precision. But the true test is yet to come. The Reagan administration is committed to combining a vigorous supply-side expansion of the economy that is being counted on to expand output and public revenues and reduce the public deficit with an even more exclusive reliance on monetary policy—a policy that works against inflation only as it represses economic activity and enhances idle capacity and unemployment. There are some contradictions in life and experience that can quite possibly be reconciled. The Israelites did manage to walk on dry land across the Red Sea. To combine a vigorous expansion of the economy with a policy of deliberately induced contraction, recession, and unemployment in order to control inflation will be more difficult.

In fact, what is being called supply-side economics in the United States has very little to do with the functioning of the economic system. This everyone with a minimum resistance to bamboozlement and special pleading either realizes or is coming to comprehend. Among the very affluent in the United States there is a strong feeling that upper-bracket taxes are too high. It has always been so. On the merits of this I do not comment; as to the depth of the feeling, few will be in doubt. But, alas, in this day and age the affluent cannot plead for lower taxes merely because they would like to have more money to spend and enjoy. Instead some solemn justification must be found; tax reduction must have some purpose of larger social value.

The reinvigoration of the American economy is the case currently being made on behalf of those who, in a perfectly normal way, would like to have more money at their disposal. No one, whatever the personal pecuniary temptation, should be fooled. It is hopelessly optimistic and a bit fatuous to suppose that there will be some great new burst of energy if personal income taxes are reduced. Business executives, the decisive figures in our time, work about as hard and as intelligently as they can now, a sadly obvious point that I’ve made often before. Investment is made in response to the prospect for profits; income tax reduction does not turn a prospective loss into a profit. The added income after tax reduction, we know, is spent more or less as was that previously received.

In the election last year Mr. Reagan had the support of the visibly and articulately affluent. Politicians regularly reward their supporters. This, not the pompous business about reinvigoration of the system, is the true motivation of the tax (and expenditure) cuts. And it is hard to believe that our natural skepticism in such matters is so trivial, our gullibility so great, that anyone much is being fooled. Most Americans, and all of any experience in public matters, know when they hear the words “needed incentives” that someone in a well-established tradition in our use of the language is yearning to have some money for himself.

An effective macroeconomic policy requires, I have observed, that there be use of all three instruments against inflation. There must be continuing restraint on bank lending; there must be a scrupulous and, indeed, rigorous fiscal policy; and there must be an incomes and prices policy. The three instruments of macroeconomic management are closely interrelated. One of the more dismal consequences of a heavy reliance on monetary policy is a lessened effect of fiscal policy—a higher public-borrowing requirement or deficit. This again is not a matter of theory; in the United Kingdom tight monetary policy has brought weaker industrial firms or those already in public ownership to the government for assistance in great numbers. There is a similar movement in the United States. The automobile industry is a major case in point; if tight money continues, our savings banks and savings and loan associations will be another. They are caught, as all know, between the low yield on their past lending and the very high current costs of money. And there is the very important public cost for those whom tight money and unemployment place on one form or another of public welfare or assistance. A less inclusive reliance on monetary policy allows greater latitude in the use of fiscal policy.

The purpose of an incomes and prices policy is to reduce the reliance on both fiscal and monetary policy. Both of these—to repeat—work against inflation only as they create idle capacity and unemployment. It is the case against an incomes policy that it is not an agreeable instrument of public management. That is wholly correct. It involves negotiation with infinitely disagreeable people, legislation and administration of a deeply inconvenient sort. Its only justification is in being far superior to unemployment and to what, in another assault on the English language, has come to be called stagflation. This brings me to the left—liberals in the United States, social democrats and socialists in Britain. I have been critical of the economic policies of two conservative administrations. Let me now, indeed, prove, against whatever odds, that I am entirely even-handed.

As it is the theological commitment of conservatives in our time that God is in professional association with Professor Friedman and will not let him down, so (with some happy exceptions) it is the faith of liberals or their equivalent, both in the United States and the United Kingdom, that Jehovah is an old-fashioned Keynesian. Allow us to power and we will somehow make monetary and fiscal policy work. It is not the policy that is in question but the political tone of the people who hold and turn the wheel. We who live in close political association with the trade unions cannot advocate anything that could arouse their adverse comment. That the modern corporate price and wage structure bears little relationship to the world of the economic textbook all or nearly all on the liberal left agree. That wages act to shove up prices and prices to pull up wages is a fact visible to everyone. But let us also not risk the condemnation of those whose intellectual and economic interest is committed to the classical and neoclassical market. The monetarists come to monetarism as an affirmative faith. The left in both the United States and the United Kingdom comes to the same result—unemployment as a restraint on inflation—out of refusal to face the facts of modern economic society.

Those who presume to offer an alternative to monetarism have also been insufficiently forthcoming in fiscal policy. Monetary policy, let us remember, cuts demand by cutting back on investment—and productivity. Fiscal policy works against consumption, and it does not so directly affect productivity. It taxes the income of the businessman or farmer, or maybe reduces his public services or more improbably his subsidy. Monetary policy attacks his borrowing for investment in new plant, equipment, or in inventory. I do not, needless to say, join in the condemnation of public consumption, now a ritual in the United States. Both public and private goods and services are part of the living standard; there is no clear evidence that public goods and services are more munificently supplied than those that comprise our private consumption. What is certain is that public goods, services, and transfer payments are of increasing importance as one goes down the income scale. There is something less than wholesome about the current enthusiasm for cutting the public consumption of the poor. Nor is it a wise conservative design. Capitalism has survived in all the industrial countries because of the successful effort to mellow its otherwise harsh impact on the least fortunate and the most easily alienated in the society. Let there be thoughtful regard for the British riots of these last weeks.

On the liberal left there is, indeed, need to be much more concerned with the quality of public administration than we have been in the past. In an age of organization this—the quality of administration—is essential. There is yet greater need for improving on fiscal policy as it concerns what we may call the new socialism. It is now clear that if an industrial firm is large enough and in financial trouble, powerful conservative influences will intervene to keep it from going out of business. In consequence, there is now in all the industrial countries a large and expanding public sector which consists of the failed offspring of private capitalism. Modern American or British socialism, as I’ve elsewhere observed, comes not from socialists but when the banks tell a despairing corporation that its only chance is Washington or Whitehall. As has so often happened in the development of capitalism, Britain is the pioneer case in a developing trend. And the British experience is showing how deep can be the drain on public revenues and borrowing requirements when this happens.

But in the United States we are following in the path. Lockheed, the eastern railroads, Chrysler, perhaps next year Ford and Pan Am—our genius is only that, so far, we are better at concealing the tendency from ourselves. (Chrysler, we agree, was not the victim of its own incompetence; it fell afoul of government regulations and high fuel prices that, unlike the Japanese, it failed, in an innocent way, to foresee.) I am not disposed to be brutal in this matter; the costs, human and otherwise, of closing down the great enterprise are great. There should always be a policy of the second chance. But we must also accept the need to phase out the industrial failures of private capitalism at some stage. This must be accepted on the left. The cost of preserving the corpse must be measured, like all public expenditure, against the opportunity costs—the alternative use of the resources.

Finally there is need on the liberal left for some minimal thought, however unnatural, on the matter of taxes. In the United States we are suffering severely in our public affairs from an excessive past reliance on the general property tax. In both the United States and Britain there has been great reluctance to consider and devise alternatives or supplements to the income tax, the supreme achievement of liberal thought. Washington, as noted, is now contemplating large reductions in the income tax. Some adjustments in lower-bracket rates to offset the effect of inflation apart, this is good policy for neither liberals nor conservatives. Inflation remains at a high rate. Military expenditures are to increase, a step that, for other reasons, requires far more rigorous examination than it has received. The result of an enhanced deficit in the federal budget will be an even greater reliance on monetary policy. On the effect of this and on interest rates I need have no further word. But I would also like to see on the liberal left a more open-minded consideration of indirect taxes than has been the modern habit.

We live, one need not stress, in an age of extraordinarily luxurious and uxorious private expenditure. A substantial part of our literature and an even larger part of our advertising celebrate a notably conspicuous consumption. Instead of taxing so fully the income that sustains this expenditure, it would be better were we to tax the expenditure itself—to graduate sales taxes or the VAT to return revenue from upper-end consumption.

I stress the reference to upper-end consumption; graduation must now be according to the cost of an item and not by its category. Food, automobiles, clothing, cosmetics, housing, and no doubt, even perhaps alcohol can, at their cheapest, be the greatest of necessities and, at their most expensive, the most replete of luxuries. Taxation on luxuries would have no adverse incentive effect. It requires a certain fastidious confidence to argue that there is exploitation or oppression in having to pay more for a Rolls Royce, a Cadillac, a pair of Gucci shoes, or a dinner at one of the social watering places of the loaded New York or London elite. Taxes on upper-end private consumption to support lower-end public consumption has a certain equitable logic that it is not easy to reject. For a century or more any advocacy of indirect taxes or sales taxes has brought the automatic condemnation of liberals, especially in the United States. Some things can do with fresh thought after a hundred years. Underlying circumstances can change—and do.

I cannot feel that I am offering an especially radical program here. Doubtless it would be rewarding to the soul were this so. But the true radicals in our time are those who place all of their chips on one card—who, against the weight of the evidence, assert that monetary policy will serve the whole task of macroeconomic management. I here urge the moderate course—the more modest use of all three of the relevant instruments of public management. And I urge this equally on conservatives and on those on the left who, contemplating the terrible tasks in negotiating with trade unions, corporations, farmers, and civil servants, invent for themselves some benign escape from the realities of the economic world in which we live. It would be wonderful, indeed, were economic policy a matter of faith and hope and high political convenience. Alas, it is not so.