Reviving the Living Dead

A few days ago Philip Pilkington wrote an utterly bizarre article for the Comment is Free section on the Guardian website. It is titled “Monetarism is the living dead of economic theory – let’s kill it off” but seems to lack an understanding of what monetarism is.

His discussion of the monetarist policies of the Callaghan and Thatcher governments is particularly confusing.

Over the next five years, monetarist policies succeeded in plunging the British economy into the deepest recession it had seen since the great depression. Large sections of British industry disappeared overnight and unemployment soared. Inflation began to subside, not because the money supply stopped growing – it didn’t – but rather because wage growth was contained through high rates of unemployment and the demolition of trade unions.

This seems a strange argument. Pilkington acknowledges that monetarism (ie controlling monetary aggregates) caused the recession. Commonsense would dictate that it was the recession that resulted in higher levels of unemployment. Having missed this elementary step, Pilkington picks up at unemployment resulted in lower inflationary pressure. If X leads to Y and Y leads to Z, then it seems fair to conclude that X leads to Z. Hence control of the money supply did lead to lower inflation. The secular decline in trade union power that had been ongoing since WWII may have had some effect but is probably less important than the impact of tight money. Any decline in upward wage pressure as a result of lower trade union bargaining power can probably be best explained by higher unemployment rather than any of the changes Pilkington believes led to the “demolition” of unions. Of course it is correct that the money supply didn’t stop growing – it just grew a lot less quickly! As Scott Sumner helpfully points out:

In 1969 the UK base was 3618 million pounds.   By 1979 it had soared to 10446 million pounds, up 189%.  Then the BoE stopped printing money at such a furious pace and growth slowed, so that the base reached 17621 million pounds in 1989, up 69%.  That’s certainly a significant slowdown, and largely explains why prices rose only 85% during the 1980s, after rising 222% during the 1970s.

Things then get stranger

Fast forward to March 2014, and the Bank of England has begun to bury its monetarist legacy. In a quarterly report released last week, the Bank admitted it had no ability to control the money supply. Rather, it sets the rate of interest

Pilkington is 29 years late. The BoE suspended its use of M3 targets in October 1985 and dropped it completely in 1987. Due to increased financial deregulation the relationships between monetary aggregates and nominal income had begun to break down. This was when monetarism in the sense of setting growth targets for monetary aggregates was superseded by new policy instruments. It had become increasingly clear that the velocity of circulation was nowhere near stable enough to produce a stable growth path for nominal income in the short-run. However if it were true that “the Bank admitted it had no ability to control the money supply” Mark Carney and every senior member of the BoE would be waiting in the dole queue, just as a fisherman who admitted he had no ability to catch fish would probably not have a job for much longer. As difficult as it is to tell, I think Pilkington means “monetary aggregates” when he says “money supply”. Imagine a man running on a conveyor belt moving at an unknown and potentially variable speed – the man may not know how fast he is moving relative to the ground but can still speed up or down by altering his speed relative to the conveyor belt. Similarly central banks can change the money supply even if there are difficulties in measuring a useful aggregate to target. In practice the easiest way to change the money supply (when not at the ZLB) is to change interest rates – this is obvious, especially given the difficulties we have defining money. Hardly revelatory or any change of direction for the BoE to “admit” this. Old monetarism died years ago – a fact that everyone seems to have realised but Mr Pilkington. That doesn’t mean the money supply is now irrelevant!

The second component [of monetarism], however, is alive and well. That is the idea that the central bank should use unemployment to control inflation. Although the central banks of the world rarely say it in public, since the monetarist era they have used interest rate hikes to generate recessions and increase unemployment any time they fear an uptick in inflation.

It now transpires that Pilkington inhabits a world in which Milton Friedman invented the Phillips Curve. The second part of this is even more baffling. It’s unclear whether he believes that central banks overshoot when engaging in contractionary monetary policy to bring inflation under control thus causing recessions or whether he is stating some sort of grand cover-up where central banks refuse to admit that tight money decreases output. The latter can be shown to be incorrect by glancing at any elementary macro textbook or central bank report. I genuinely have no idea what he is trying to say and think Pilkington genuinely has no idea what New Keynesianism is, as he seems to believe it to be a form of monetarism.

The Bank’s report continues to insist that it should use the interest rate to manage the level of economic activity. This is despite the fact that even the extraordinarily low interest rates of the past five years have failed to produce a sustained recovery.

And yet hidden all the way down on pg 7 of the report Pilkington cites is a good explanation of how the hot potato effect can lead to changes in the level of activity through changes in the money supply – despite no change in the interest rate. The BoE clearly believes that tools other than interest rates should be used by virtue of the fact it is using QE. Interest rates are still naturally a reasonable way of changing the money supply when the ZLB constraint is not active. The argument that interest rates are low and hence money must be loose is one of the most dangerous but thankfully thoroughly rebutted fallacies in modern economics. As Milton Friedman once stated:

“low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy… After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

Interest rates were also high during the German hyperinflation of the early 1920s but it would be crazy to suggest that money was tight at the time!

I’m sorry if my arguments in this post may have come across as piecemeal. It was hard to avoid as a result of the nature of Pilkington’s original post.

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PS: Pilkington also has a blog. He argues that mathematical modelling is so prevalent in economics because of the dominance of male economists. Apparently he believes that making empirical predictions about the world using simplifications is gendered!