Money Matters No More?
Although there are deep and abiding differences between Chicago school monetarists and Austrian monetary theorists, there has always been strong agreement among them on one thing: the central importance of the money supply in explaining the purchasing power of money or "price level" in the economy.
This does not appear to be the case any longer. The June 2004 cover article of Monetary Trends a publication of the St. Louis Federal Reserve Bank, long a staunch bastion of monetarism, is entitled "How Money Matters." A more accurate description of its contents is "Why Money Doesn’t Matter Anymore." The author, William T. Gavin, emphasizes that "money still matters"—just not its quantity.
When economists such as Irving Fisher and other pre-Friedmanite quantity theorists used to conceive the medium of exchange as the central function of money, they focused on M1—basically currency and demand deposits—as the relevant empirical measure of the money supply. Later, under the influence of the Keynesian Revolution, Friedman "restated" the quantity theory, shifting its main focus to money’s function as a "store of value" whose corresponding statistical aggregate M2 included interest-bearing financial assets in addition to the transaction balances included in M1.1
Austrians, beginning with Carl Menger in 1871,2 considered the store of value function of money as secondary and derived from its primary function as the general medium of exchange. They therefore objected that some of the items included in the Friedman/Schwartz M2 aggregate did not fulfill this primary function while other assets excluded from M2 were in fact instantaneously interchangeable at par with currency or demand deposits and hence economically indistinguishable from the latter.3
This led to differences in the monetary aggregates emphasized by the two groups, but they remained united in a shared view of the tight link between the quantity of money and the height of prices despite Friedman’s formalization of the "inflation transmission mechanism" in terms of a Keynesian portfolio balance approach.
Now it appears that this last area of agreement between Austrians and monetarism, or at least its policy branch, has gone by the boards.
For Gavin now tells us that money’s role as "the unit of account"—another derivative function of the general medium of exchange, as Menger pointed out—"is at the center stage in monetary policy today." The reason, according to Gavin, is "Our models and our discussions focus not on the quantity of money but on the purchasing power of the dollar." In other words the essential nature of money has changed merely because economists’ models and Fed policy have been altered to "keep [the] federal funds rate fixed for months at a time," in which case "the short-term money supply is perfectly elastic with respect to the interest rate and all changes in money demand are perfectly accommodated."
Gavin goes on to conclude: "[A]n important channel by which the Federal Reserve stabilizes the value of a dollar is through expectations of future inflation, the main channel through which monetary policy affects the real economy. We do not have to pay attention to the quantity of money today because policymakers are paying attention to its price, by focusing on inflation and inflation expectations."
Gavin thus depicts the essential role of money in the economy today as a disembodied accounting unit whose value can be stabilized by a central bank that ignores the law of supply and demand while carefully molding the public’s expectations of inflation through the hocus pocus of manipulating, or even just making "credible" threats to manipulate, a short-term interest rate. This is nonsense on stilts and merely a sophisticated version of George Knapp’s mystical State theory of money—demolished by Ludwig von Mises in 1912—according to which the value of money was not determined by market forces but directly imposed by State fiat regardless of its quantity.4
Hayek once commented to the effect, "God help us, if people ever forget the lessons taught by the naive quantity theory of money." Who would have thought that the St. Louis Fed would one day require such divine guidance?
- 1. Milton Friedman, "The Quantity theory of Money—A Restatement" in idem, ed., Studies in the Quantity Theory of Money (Chicago: University of Chicago Press, 1973), pp. 3-21. For a description of the monetary aggregate preferred by monetarists, see Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960 (Princeton: University Press, 1963), pp. 4-5.
- 2. Carl Menger, Principles of Economics, trans. James Dingwall and Bert F. Hoselitz (New York: New York University Press, 1981), pp. 258-80.
- 3. For an explanation of the empirical definition of the money supply based on the Austrian theoretical emphasis on money the general medium of exchange, see Murray N. Rothbard, "Austrian Definitions of the Supply of Money," in idem, The Logic of Action One: Method, Money, and the Austrian School (Lyme, NH: Edward Elgar Publishing, Inc., 1997) pp. 337-49; and Joseph T. Salerno, The ‘True’ Money Supply: A Measure of the Supply of the Medium of Exchange in the U.S. Economy," Austrian Economics Newsletter 6 (Spring 1987): 1-6.
- 4. For Mises’s critique of the several variants of the State theory of money, see Ludwig von Mises, The Theory of Money and Credit, trans. H. E. Batson, 3rd ed. (Indianapolis, IN: Liberty Classics, 1981), pp. 506-512.