Monetary Policy

A monetarist explanation of the Great Recession

The Great Recession is now being mentioned in the past tense, which is progress of a kind. During its course critics of capitalism directed their polemics particularly against the US, long seen as the champion of free-market capitalism. But growth has resumed. If it had not been for bad winters in 2010/11 and 2013/14, the American economy would now have enjoyed uninterrupted quarter-by-quarter expansion for a full six years from mid-2009. American capitalism remains very much in being, if more heavily regulated than ever before.

But the left persists in lambasting the financial system as the source of and culprit for the Great Recession. The economics profession has failed to offer a persuasive analysis, rooted in widely-accepted theory, of the causes of the sharp downturn in demand, output and employment that occurred in the 18 months to mid-2009. This has allowed the critics – such as Philip Mirowski in Never Let a Serious Crisis Go to Waste – to pour scorn on neo-classical economics.

Mirowski mentions remarks by Professor Mark Thoma of Oregon University on the shambolic performance of the Nobel economics laureates at their fourth meeting in Landau, Germany, in 2011. In Thoma’s words, “the reasons cited for the financial meltdown were all over the map. It was the banks, the Fed, too much regulation, too little regulation, Fannie and Freddie, moral hazard from too-big-to-fail banks, bad and intentionally misleading accounting, irrational exuberance, faulty models and the ratings agencies.”

The absence of a clear explanatory account of the Great Recession is peculiar in one respect. In their celebrated 1963 book A Monetary History of the United States, 1867–1960 Milton Friedman and Anna Schwartz identified a collapse in the quantity of money as the dominant causal influence on the Great Depression from 1929 to 1933. Even their antagonists concede that the monetary interpretation of the tragic macro-economic outcomes of the early 1930s is cogent, and must be acknowledged and discussed. By contrast, a comparable interpretation of the Great Recession has not been presented.

Part of the trouble may be American monetary economists have been perplexed about which measure of money is relevant to macro-economic outcomes. Some pontificate about the monetary base, as if that by itself could determine spending.  Others – such as Allan Meltzer, who has written the history of the Federal Reserve – believe in narrow money as understood by the M1 aggregate (that is, cash held by the general public and sight deposits). Another influential school advocates so-called “divisia” money measures, which attach weights to different types of money balance.

Unhappily, these approaches have not impressed non-monetary economists. Indeed, a salient feature of the five years to 2014 was that an enormous increase in the monetary base coincided with the lowest increases in nominal gross domestic product since the 1930s. (That was true in the USA, and also in the Eurozone and the UK.) An obvious puzzle is economists’ apparent reluctance to check what Friedman and Schwartz said about different money aggregates. In their Monetary History they were straightforward about their preference. To quote, “We have found in our work that a concept of money which includes both categories of deposit (meaning both sight and time deposits) often displays a more consistent relationship to other economic magnitudes than a concept which excludes time deposits.”

So Friedman and Schwartz a broad measure of the money supply which included bank deposits. The appropriate measure in the US today would be M3, which includes sight and time deposits, and also “money market mutual funds” which have “money-like” properties. Oddly, the Fed decided in 2006 to stop publishing data on M3. Nevertheless, M3 estimates are still being put together by private sector bodies, while the International Monetary Fund prepares numbers on “broad money” for the USA, just as it does for the vast majority of its member states.

The point of the Friedman and Schwartz investigation in the Monetary History was that the growth rate of broad money collapsed, and took the American stock market and economy down with it. Whereas in the prosperous 1920s the quantity of money had been rising by about 5 per cent a year, in the four years to 1933 it dropped by about 10 per cent a year. If that sort of argument still applied today, a sharp change in the rate of money growth would be expected to precede, or at least to accompany, the Great Recession.

This is indeed what the data shows (see graph here). In the UK, the US and the eruozone, the annual rate of change in broad money moved up to double-digit growth from the early years of the new century to 2006 or 2007, and then crashed to virtually nil or even experienced an outright decline. On this basis, a monetary interpretation of the Great Recession fits the central facts of the period. The core message of Friedman and Schwartz’s classic therefore continues to resonate.

A common jibe at this argument is that it is “mono-causal”. It suggests that only one variable – the quantity of money – determines the equilibrium levels of national income and wealth. The implication is that mono-causal explanations are naïve, incomplete and unsatisfactory.

But a theory is not false because it is mono-causal. In any case to highlight money is not to deny the relevance of non-monetary forces as well. Over the long run monetary influences seem to over-power the non-monetary influences in determining nominal national income, but, in the short run, a host of other variables are in play. Moreover, for those who value complexity for its own sake, let it be emphasised that the monetary argument can be multi-faceted and convoluted – this is not a simplistic theory.

A striking feature of both the Great Depression and the Great Recession is worth special attention. In 2007 as in 1929, when the rate of growth of the quantity of money started to slide, the earliest effects were not on the prices of goods and services. Instead the big falls were in the prices of key assets such as corporate equity and real estate. Some of the last century’s greatest economists – including Keynes, John Hicks and Friedman – understood that this was important. It is a major weakness of the current generation of Chicago economists that they have forgotten this key insight.

The Great Depression led to disillusionment with free-market capitalism, even though – according to Friedman and Schwartz – the blame fell on incompetent central banking. The Great Recession has also led to disillusionment with free-market capitalism. The monetary interpretation of events again directs analysts towards the failure of central banks, finance ministries and regulatory bodies to maintain stable monetary growth.

Prof Tim Congdon is the chief executive of International Monetary Research Ltd. This article was first published in EA Magazine.

Shadow Monetary Policy Committee

Tim Congdon CBE is an economist and businessman, who has for over 30 years been a strong advocate of sound money and free markets in the UK’s public policy debates. He was a member of the Treasury Panel of Independent Forecasters (the so-called “wise men”) between 1992 and 1997, which advised the Chancellor of the Exchequer on economic policy. He founded Lombard Street Research, one of the City of London’s leading economic research consultancies, in 1989, and was its Managing Director from 1989 to 2001 and its Chief Economist from 2001 to 2005. He has been a visiting professor at the Cardiff Business School and the City University Business School (now the Cass Business School). He was a Visiting Research Fellow at the London School of Economics between 2005 and 2007. He was awarded the CBE for services to economic debate in 1997. His books include Monetarism: an Essay in Definition (London: Centre for Policy Studies, 1978), Monetary Control in Britain (London: Macmillan, 1982), The Debt Threat (Oxford and New York: Blackwell, 1988) and Reflections on Monetarism (Cheltenham: Edward Elgar, 1992). In 2005 the Institute of Economic Affairs published his monograph on Money and Asset Prices in Boom and Bust, and in 2009 it published a further monograph on Central Banking in a Free Society. A collection of papers on Keynes, the Keynesians and Monetarism (Cheltenham: Edward Elgar) appeared in September 2007. His latest book, Money in a Free Society (New York: Encounter Books, 2011), is more specifically a response to the Great Recession. In June 2009 Tim Congdon set up a new economic consultancy, International Monetary Research Ltd., of which he is now chief executive. Tim Congdon was honorary secretary of the Political Economy Club from 1999 to 2010.