Monetarists vs. supply-siders.

MONETARISTS v. SUPPLY-SIDERS

LAST SEPTEMBER, the Nobel Prizewinning economist Milton Friedman predicted in the Wall Street Journal that as a result of "excessive monetary growth' in the past year, there would soon be "an overheated economy,' which in turn would almost certainly mean "a subsequent acceleration of inflation, probably in middle or late 1984.'

So a crucial test of economic theory may be shaping up as one of the little-noticed events of 1984. The theory, which has had and continues to have important political repercussions, is called monetarism, and its leading proponent is Milton Friedman. Early last month, in a New York Times Op-Ed piece, he was more specific. "We shall be fortunate indeed if prices are not rising in the 7 to 10 per cent range by the fourth quarter of the year and in double digits by 1985,' he wrote.

Here is a brief statement of monetarist theory, extracted from Friedman's New York Times article: "Inflation over any substantial period is predominantly a monetary phenomenon. Prices rise in response to a more rapid increase in the quantity of money than in the output of goods and services. The response is not immediate. Indeed, for at least the past century, it has taken about two years in the United States and Britain for a monetary explosion to be reflected in higher inflation . . .

"The rate of monetary growth over the past two years explains why the declaration of victory in the war against inflation is premature. . . . monetary growth jumped to 9.5 per cent [per year]--higher than in any other two-year period since at least the end of World War II. Higher inflation is sure to follow.'

But some economists of the supplyside, rational-expectationist, and "New Chicago' schools are not so sure that Friedman will be vindicated. The supply-siders in particular believe that the clear-cut relationship between the money stock and the price level delineated by Friedman and Anna Schwartz in their classic study, A Monetary History of the United States, 1867-1960, no longer applies. For most of this 93-year period, the dollar was defined in terms of gold, and this definition preserved a measure of order and predictability in the monetary system. In 1971, however, the dollar was completely severed from gold--that is, from real economic activity--and by 1973 all the world's currencies were defined simply in terms of themselves.

All external discipline was thus removed from the monetary authorities, who were free to increase the number of units of their currencies, and almost everywhere did so--operating on the unstated theory that since money is an expression of wealth, additional wealth can be created by additional money. Dramatic, worldwide inflation followed, as Friedman would have predicted (and in fact did predict). Insofar as the alternative to monetarism was the socialist notion that the proper antidote to inflation is wage and price controls, then a monetarist victory was important, and we should be grateful that Friedman won that battle. In 1979, a monetarist policy--the targeting of monetary aggregates--was officially adopted by the Federal Reserve Board.

By 1980, however, something new was beginning to emerge in the marketplace. There was by then a suggestion, at least, that newly sophisticated worldwide markets, which had not existed even a decade earlier, were beginning to assert a market-originated control over inflation in the major industrial countries. Interest rates rose way above the inflation rate, thereby exerting downward pressure on the expansion of credit. The Fed lost power as a result. In the 1970s the Fed had been able to fool lenders by adding to bank reserves artificially (i.e., by creating new money). In the 1980s it was no longer practical to do this. Interest rates would play catch-up swiftly, thereby sharply reducing economic activity. (In the 1970s there were long periods when interest rates were negative in real terms; that is, lower than the inflation rate.)

There was another important change. By 1980 gold had forced its way back into the monetary system, de facto if not de jure, as an alternative to undefined pieces of paper. A worldwide gold market and gold price was established. The latter, transmitted daily and even hourly on news broadcasts, functioned as a beacon signaling inflationary expectations. Again, this put handcuffs on the Fed. Paul Volcker could not dilute dollars, even if he was so inclined, now that there was a readily available alternative that governments were powerless to manufacture.

AS A RESULT of these changes (and there were others, notably the deregulation of financial institutions, permitting them to pay interest on checking accounts), people became more confident about holding dollars: They knew that it had become much harder for the government to devalue them by multiplying them. Thus people began to hold more dollars in their checking accounts. And so the "money supply' (which really should be called "money demand,' because it mainly consists of such checking accounts added together) began to rise.

Excessively so, said Milton Friedman.

In a harmless, non-inflationary way, said the supply-siders. In the same way, the Swiss money supply rose rapidly in the late 1970s. But this was merely an expression of the rapidly rising demand for Swiss francs, not a precursor of inflation.

In monetary matters, supply-siders think on the demand side. They also believe, practically as an axiom, that the relationship between the supply of and the demand for dollars is expressed by the gold price. If the Federal Reserve supplies more reserves to the banking system than the people demand, then the gold price will rise. Expected inflation is thereby signaled.

But as of late April, the price of gold was actually lower than it had been a year earlier. Thus the markets were not anticipating inflation, even though the money "supply' has indeed risen. "What needs to be emphasized is that there is no secret information in the monetary aggregates,' said Alan Reynolds, a vice president of Polyconomics, Inc., and a supply-sider. "They are published every week. Each time Friedman makes a prediction based on these aggregates, he is saying that he knows something the markets don't know. And that's why the old Chicago school and the new Chicago school are at loggerheads.' (New Chicagoans include such economists as Robert Barro and Robert Lucas.)

"When Friedman predicted inflation last September,' Reynolds continued, "why weren't people investing on that publicly available knowledge? Why weren't they switching from dollar-denominated assets into good? There is an unexploited profit opportunity, if Friedman is right, and that's what the rational-expectations crowd says cannot happen. In Friedman's view everything is "baked in the cake'--an old monetarist expression. The outcome is predetermined by what happened to the monetary aggregates two years ago. That shows a lack of respect for markets.'

In other words, Reynolds is saying: If inflation is going to be 10 per cent in the fourth quarter, the gold price at that point will certainly be double its present level. And if that is predictable on the basis of public data, why isn't the price moving now? "There are futures markets where you can play that gamble,' Reynolds added.

Friedman and others have pointed out that price indices have been moving up of late. Reynolds said that commodity prices decline in a recession, rise in a recovery; and some indices (the Dow Commodity Index, for example) show no change over a year ago. George Gilder believes that we have had actual deflation in the past year, and that a year from now a dollar will be worth the same as it is now--perhaps more.

"The Consumer Price Index is almost necessarily going to show inflation because it always measures the past configuration of goods that people are abandoning,' Gilder said. Incidentally, since the publication of Wealth and Poverty, Gilder has continued his independent investigation of the U.S. economy, and his new book, to be called either Entrepreneur or The Spirit of Enterprise, will be published in September by Simon and Schuster. "We do have inflation in the automobile industry, with robber barons like Lee Iacocca raising prices under the protectionist umbrella,' Gilder said. "But I think we have had deflation in the past year, taking into account the new values that have been generated in the economy as a whole. And that deflation was registered by the gold price and not by anything else. Well, now the numbers indicate that the deflation has been corrected, which will appear in the conventional statistics as a revival of inflation.'

Gilder added that he doesn't think economic theories ever really face a crucial test because the statistics are too slippery. "The producer prices are rising,' he said, "although I don't think they've made up for their earlier drop. Nevertheless, the monetarists are going to say that it's inflation resulting from M1. I can see a blip of 8 per cent "inflation,' and that would do it for the monetarists, wouldn't it? They would feel vindicated.'

Gilder said that "the supply-siders were apparently wrong about the savings rate, which was a crucial thing we predicted.' (It was supposed to go up; maybe it did and maybe it didn't.) "It doesn't shake me--very much. It's too bad. I'd rather be right, but I haven't changed my mind. All these statistics that economists use are so murky that they're worthless.' Nevertheless, a sharp and sustained increase in the gold price in the next few weeks would tend to prove the supplysiders wrong on inflation. (True, they could attribute it to something else-- say, an international crisis.) "Sure Milton Friedman's out on a limb,' Gilder concluded. "But I think he'll be able to get off it. He's gotten off previous ones--ask Alan Reynolds.'

According to public figures like Jack Kemp and Lewis Lehrman, the danger of monetarism is that it provides the Federal Reserve with an unwarranted rationale for crunching down on real economic growth on the grounds that the economy is "overheating,' to use Friedman's September metaphor. And the evidence for such "overheating' is simply a rise in the monetary aggregates that is nothing more than an expression of renewed popular confidence in the dollar. Normally the liberals, the news media, and the Democrats set up a great howl if the Fed holds the money tight. This year the liberals are all commending Volcker's statesmanship. No doubt they sense that another recession is their only remaining hope of beating Reagan in November.

So today we encounter those topsyturvy comments and headlines: The good news is that economic growth is slowing. (Interpretation of the markets: If they slow down enough, then maybe Volcker will relent and be more accommodating with the money.) I asked Representative Jack Kemp what he thought of this upside-down world, in which bad news is called good news. "It really is 1984,' he said.