Central Bankers Have Forgotten The Crucial Monetary Lessons Of The Past

Central Bankers Have Forgotten The Crucial Monetary Lessons Of The Past

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Among his many notable remarks Milton Friedman’s observation that inflation is always and everywhere a monetary phenomenon stands out and teaches us not only of the 1960’s & 1970’ but is a warning to us today. Freedman’s claim was not just that excessive growth of the quantity of money was one of several causes of inflation. He had a more definite and far-reaching conclusion in mind. In his view, excessive growth of the quantity of money at the rate of increase far ahead of that of real output was a necessarily a sufficient condition for inflation. Further once inflation had taken off and become entrenched in business and social expectations, a reduction in the rate of money increase to a figure similar to the trend rate of economic growth was necessarily a sufficient condition for ending it. History tells us that he was right and that the “necessary condition” was painful to the economy, businesses, and people both individually and collectively.

More pointedly, nothing else would work. Politicians and commentators might kid themselves that soft options could be found. Since they argued that alternatives were available including for example interference with wages and prices. They might think such interference, backed by agreement between the so called peak organisations of employers and trade unions would prevent inflation. They might persuade themselves that wages and prices could always be held back by the state powers, regardless of the rate of money growth. But, according to Friedman and other monetarist economists, and a large body of historical evidence showed that this was a complete and utter fantasy. Restraint over money growth might be painful and unpopular, but it was the only valid anti-inflation weapon in the long run.

In the 1970s consumer prices rose in Britain on average by 12.6% a year a rate which would cause the real value of money to fall by 95% in a generation. Margaret Thatcher never mastered the technicalities of monetary policy, but she understood the implacability of the monetarist message. When she insisted at the start of her government in 1979 that there is no alternative on macroeconomic policy and that there must be no turning back to the unsuccessful wage and price controls of the past this was what she had in mind. Any weakening of the monetarist economic would not be successful and the political consequences would be worse.

But isn’t that battle with inflation just ancient history?

The answer is that generations come and go, and nations and their key institutions suffer from institutional amnesia just the same way as individuals. Like the UK, the United States experienced high inflation in the 1970s.

When in the early 1980s it central bank, the Federal Reserve, tried to curb it by limiting monetary growth, its then chairman, Paul Volcker, was explicit in acknowledging Friedman’s intellectual influence. But regrettably neither the anguished recessions of the Volcker chairmanship nor Freedman’s controversial academic work has much resonance with the Federal Reserve nowadays which will assuredly mean that we are destined to repeat the painful experiences of the previous generation.

Last spring the Federal Reserve embarked on extraordinary generous asset purchases or so- called quantitative easing program to ease the macroeconomic part of the Covid-19 pandemic. No doubt the Federal Reserve intended to do good, with the correctly calibrated dosage of stimulus. Unfortunately, it did far more good than it ought to have done with a large dosage of that which was both disproportionate and dangerous. In the year to June 2020 the quantity of money in the USA soared by 26%, far above the 1970s figure and unmatched since the wartime emergency of 1943.

The USA it is now leading a vigorous global boom which, if business surveys are to be believed, continues to gather pace. This boom like every other boom will result in more inflation. In the year to April, the US consumer price index rose by 4.2%, the highest number since 2008. But the strength of the demand at present is such that this is unlikely to be the peak. There was a link between the 1943 monetary explosion and the US price level, which was followed in the year to March 1947 with a US inflation rate of more than 20%.

Will inflation soon drop back towards the norm of 2% or less recorded for much of the 2010’s?

If Friedman was still alive today, he would highlight the quantity of money and its future growth rate as crucial to the outcome. But today the Federal Reserve senior economists never mentioned money and their analysis. They are apparently convinced that expectations of sub 2% inflation are so much part of current business psychology that sub 2% inflation will return regardless of how money monetary policy creates and regardless of whether annual money growth is 4% or 40% or 400%. They resemble the British public figures of the 1960s, who peddled soft options that proved useless in the face of inflation.

The UK had worse inflation than the USA in the 1970s and 1980s and memories of that era may ensure that the money growth access in the UK is smaller and less serious. All the same the Bank of England never refers to money growth in its inflation reports and shows every sign of being just as complacent as its American counterpart. Given the enormous budget deficits now being incurred in both the USA and the UK, policymakers will face an uphill struggle over the next few years in dampening money growth to a non-inflationary rate.

Currently the level of demand is below the 2019 calendar year levels and inflation is dampened whilst this remains true. However, already there are shortages in supply chains and in labour markets. The supply chain shortages may themselves result in restrictions in the actual level of production which could result in the bidding up of prices to reduce general levels of demand.

The housing market has already seen a significant boom due to the stamp duty changes and increasing demand for property outside London and this may continue even after stamp duty is reintroduces at its pre Covid-19 levels.

Labour shortages are more concerning. EU workers have returned home, and many may not come back to the UK having given up their UK accommodation, received generous furlough payments in their home countries and reluctance to return to the UK and chose to work elsewhere in the EU. We are already seeing labour shortages in the hospitality industry, and we have yet to see the expected shakeout of furlough subsidised labour which may be more choosey in its post Covid-19 career decisions.

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