Economy & Business

The Failure of the Monetarist Creed

What if monetary policy is not the all-powerful tool many experts take it to be?

In the late 1980s, I attended a speech by my friend, the brilliant George Gilder, in which he said: “When I was a single man, all I thought about was sex, and all I wrote about was sex. Now that I’m a married man, all I think about is money, and all I write about is money.”

Marriage doesn’t quite have the same effect on women, apparently, or on me at any rate, because I have been very slow to spend much time thinking about money, either before or after marriage, but it appears to me now that Republicans ought to.

A debate took place last week between Paul Krugman and Robert Samuelson on whether Reagan’s supply-side economics had anything to do with the economic boom let loose in the 1980s. Krugman argued that the credit belongs solely to Paul Volcker for squeezing inflation out of the economy. Samuelson agreed that monetary policy was the key, but said that Reagan deserved credit for supporting Volcker while he did the necessary painful work. Both agreed, however, that monetary policy is the key to growth.

Nowadays inflation is not the issue. “Secular stagnation” — meaning widespread stagnation that might well be permanent — and deflation are what the central bankers are worried about.

Consider for example what Larry Summers said this week at Davos: The great danger is that Europe is poised to become Japan and will thus experience a decade or more of economic stagnation. In this context, Summers supports the newly announced European quantitative easing, on the theory that doing something about “secular stagnation” is better than doing nothing. But he warned us not to expect much from it. “I come back to the central importance of demand,” he said. “The focus has to be on providing adequate economic energy, adequate demand, so we avoid these liquidity traps and avoid the problem of secular stagnation. What is striking in Europe today is how much it looks like Japan, seven years in after the bubble. I think Europe is on its way to being the new Japan unless there is a substantial departure.”

Gary Cohn, the CEO of Goldman Sachs — which is now, practically speaking, a subsidiary of Washington, D.C., with profits essentially guaranteed by politicians who control your tax dollars (and which repays the favor by funding political campaigns) — put forth another demand-side explanation for the primacy of monetary policy in creating economic growth: “We are in currency wars,” he told the Davos crowd. “The prevailing view is [that] one of the easier ways to stimulate economic growth is to have a low currency to export against and hopefully to create tourism and imports with.”  

One of the curious mysteries in the way experts talk about monetary policy is that they seem to think two things: It is almost all-powerful in creating economic demand, which they say leads to growth; and there is only one potential negative outcome of poor monetary policy — inflation.

What if neither of those assumptions is true?

The monetarist creed, as Gilder has called it, began with the greatest conservative economic thinker of the post-war era: Milton Friedman. MV equals PT, he told us, or the supply of money times its turnover, or “velocity,” (MV) equals price times transactions (PT). This is roughly gross domestic output. If this creed is true, and if velocity is constant (as Friedman argued), then money supply controls economic output. Central bankers rule.

But what if it is not true?

Worse, what if these assumptions have become non-falsifiable statements? What if monetarism for too many has become a creed immune to falsification by the data?

In this week’s Wall Street Journal, David Malpass points out the overlooked but rapidly growing holes in the monetarist creed:

Central banks in the U.S., Japan, and Europe are trapped in a loop. They are fully invested in the theory that zero rates and bond buying are stimulative and add to inflation, yet growth, inflation, and median incomes keep going down. . . . Central-bank liabilities have grown by an extraordinary $7 trillion since the 2008 crisis, yet many parts of the world are in or near recession, including Japan, Latin America, Eastern Europe, and most of the eurozone.

Larry Summers quietly acknowledged the possibility even as he endorsed the new Euro-easing: “I am not sure the central-bank tools are going to be enough to reverse a very difficult situation.” Japan did not get much return from quantitative easing after all, and even in the U.S., Summers argued, most of the benefit was at first, when it helped resolve a looming failure of the financial market.

The tools we have are not working the way we expect. The same thing happened back in the 1970s. Standard Keynesian economics suggested that inflation and unemployment were opposites, in terms of monetary policy: Increasing one would decrease the other, and vice versa. Instead, the decade witnessed “stagflation” or high inflation with rising unemployment and slow growth.

When the tools are not working as your theory suggests, there is probably something wrong with your theory. What if controlling the money supply is not the key to economic growth?

Time for a new economic theory. The place to start, I would suggest, is a careful reading of Gilder’s latest book, Knowledge and Power.

Supply-side economics is not primarily a theory about tax rates. It is fundamentally a theory about wealth creation; its main tenet is that before wealth can be redistributed, it has to be created. For the economy to grow, new wealth has to be created. Supply side trumps demand side. The barriers to economic growth do not always lie in the tax code. But if human creativity is being stifled, if money is flowing back into static non-investments such as art and Manhattan real estate, there must be a reason why.

Surrendering your failed theory is the first step to finding it.

— Maggie Gallagher is a senior fellow at the American Principles Project. She blogs at


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