Theoretical Limit to Monetarism. Shuji Nishijima 1

Theoretical Limit to Monetarism Shuji Nishijima 1 1. The purpose of the study The purpose of the study here is to challenge present orthodoxy in economics namely Monetarists. By Monetarist, I focus on Milton Friedman, since Friedman is the most influential Monetarist in the World. Friedman is not only the most influential monetarist, but also one of the most distinguished economist in the 20 th century[1]. Since the final quarter of the 20 th century up until now, Monetarism dominated economic thought. In this article I want to try to examine the assumptions, theory, propositions and policies of Monetarism. I first saw Friedman making a speech on monetarism at Cambridge University s Lady Margaret Hall on the occasion of the Econometric Society World Congress in Cambridge. After the speech there were questions. First the late Professor Joan Robinson asked whether monetarism had any theoretical foundation. Professor Friedman answered that monetarism was an empirical matter and not a theoretical matter. The late Professor Kaldor next asked whether Helicopter money has the same effects. Friedman said that it did. As I was one member of the audiences, I was ambivalent, with both doubt and charm. Monetarism without theoretical foundation was not attractive. On the other hand Monetarism seemed to be interesting because of its relevance and simplicity[2]. A year later, I had to go back to Japan and returned to civil service where I did economic research and economic policy making. Except for the time between 1976 and 1979 when I worked for the OECD in Paris, serving on the Economic Policy Committee and the Economic Development Review Committee (member country s annual economic analysis and policy recommendation), I remained in civil service (economics). In 1988 I moved to Niigata University as Professor of Economics. And in 1997 I moved to Musashi Institute of Technology. I have been teaching economic theory and actual economy for 21 years as a professor. I have been studying and teaching economics, they were classical and neo classical economics, and Keynesian economics, but with monetarism in it. I had been studying and teaching Keynesian economics and Monetarism, both with doubt. When I was teaching economics to first year undergraduates of my university, using the Principle of economics by Gregory Mankiw, I was astonished to find that among the ten great economic principles he listed, only three as principles of macro economics, namely : 1) inflation unemployment trade offs in the short and long term 2) productivity and living standards 3) paper money issuing and inflation 1 Professor, Faculty of Environmental and Information Studies, Musashi Institute of Technology 50

Even Principle of effective demand disappeared, that is, Mankiw himself is negating his macroeconomics : menu cost theory which is in any way doubtful. His macroeconomics part is very plain. His Macroeconomics I, II is a little better but still unsatisfactory. Edmund Phelps says that there are seven macroeconomics in the World[3], although I have not examined all of them. What I wanted to do here is to analyze Monetarism critically and point out it s theoretical weakness and ambiguity. 2. General framework Since Milton Friedman presumably contributed in many fields, I want to criticize as many issues as possible. The only agreement was the case for the flexible exchange rate together with Professor James Meade (my professor who proposed managed float and crawling peg). I admire both of them, Friedman on the stability of exchange rate against speculation, Meade on policy assignment. The scope of my study here is to analyze and critique monetarism in the following steps : Definition Logic, Philosophy Theory Theoretical consistency Empirical relevance Efficiency and equity Originality My study is original in the sense that no other economist analyzed Milton Friedman in this comprehensive way nor negated this economics giant. 3. Theory of inflation 3.1 Definition : Continuous rise of general price level. Continuous means not temporary, not once for all such as the effect of consumption tax which is at least in the short term once for all. General price level is, overall appropriately defined as the weighted average of prices, namely, price index. Usually individual prices are called, roughly, relative prices and have nothing to do with general price level. But it is not true, as I will explain later. Measurement : When inflation or deflation is at issue, how to measure the price index becomes very important. Usually Laspayeres Index becomes higher than Paasche Index because of Paasche effects, which means demand for higher priced goods and services will relatively slow down and therefore experience a reduction of weight. In order to avoid these differences some economist recommend Fisher (Irving Fisher) s geometric mean of Laspayres and Paasche. Choice of price index : the choice of price index is extremely important. The choice is not only between Laspayres, Paashe and Fisher, but also between the Consumer Price Index, the Wholesale Price Index and the GDP deflator. This choice of index affects economic policies. Therefore it is very important, whether it excludes oil (gasoline, kerosine etc) and fresh foods, since these prices are thought to be temporary. In the USA, non oil CPI is used as a measure. 51

Do they think that energy price hikes are just temporary? I think they should include oil prices in the CPI, since oil prices are not so changeable nor temporary as fresh foods, which the Bank of Japan excludes from the CPI. I do not agree with the common knowledge which says individual, therefore, relative prices have nothing to do with the general price level. Individual price consists of the general price level. The sharp distinction between relative and absolute price is artificial fiction[4] in order to make analysis easier. 3.2 What determines the general price level (in the case of inflation) There are several hypotheses about the cause of inflation, Monetarism is one of them. Hypothesis 1 : Genuine inflation Total or aggregate demand exceeds total or aggregate supply therefore the general price level rises. At first sight this hypothesis looks true. But how can you estimate aggregate demand and supply? (Here I do not mean Aggregate Demand and Aggregate Supply curve. In the above hypothesis, real demand and real supply in the vertical axis and time is in the horizontal axis). However, if it is possible to estimate aggregate supply by using the aggregate production function and demand as effective demand. How do you measure excess demand? Do as Keynes did[5]. Hypothesis 1 is not good enough. Before we go to full employment, prices in most cases go up. Hypothesis 2 : The cause of inflation is an increase in money supply Monetarist proposition : Inflation is always and everywhere a monetary phenomenon. This is a definitive statement. But it still has ambiguity. It does not say how high an increase in monetary growth causes inflation. If it means that a price increase is an erosion of purchasing power of money, it is a tautology, since every inflation is by definition the erosion of the purchasing power of money. On the other hand, if we take this proposition strictly, all inflation is caused by monetary phenomenon or money supply increase. In the case of hyper inflation and very high inflation, I accept that money supply is a cause. It may be enough to quote Philip Cagan s study on hyper inflation and Japan s case Professor Komiya s analysis on the Japan s inflation over 20% in consumer price index. Friedman misled us by saying all inflation is like hyperinflation. I think that under hyperinflation and very high inflation, money supply is the cause ; however, it cannot be a proof that the Monetarist proposition is true. Friedman jumped in his logics. There still remains a possibility that other hypotheses could explain moderate inflation. If we examine Money Equation A, namely, MV PT M denotes Money supply, V denotes Velocity of Circulation of Money and P is aggregate price level and T denotes total Transactions. This is merely an Identity. According to the Cambridge tradition, I replace T by Y (real national income) and change M to Demand for Money, we get a significant equation. What Friedman did in his Studies in the Quantity Theory of Money, was just importation from Cambridge tradition. We take natural logarithm of this equation : : marshallian left hand side is a demand for money. If, its derivative is zero. Under full employment, a money supply increase will fully lead to inflation [6]. But actually is not constant. 52

In other words, we differenciate with respect to time : Hyposesis 3 : Struggle for income shares Under competitive factor income share, supposing that productivity[7] is limited, actors want more income and other things being equal, price will rise. By factor income I mean money wages, profit and import cost. Unit labor cost is defined as money wage divided by productivity[8]. Cost push inflation is not popular now, however, it is still important. As Machlup[9] stated, no genuine demand pull nor genuine cost push exists. Further than that, I think that Harvard s Harberler s hypothesis such that the trade union s power is a main cause of inflation, is to some extent true. Thatcher and Regan s success in holding inflation is not only demand management policy, but also their strong stance on labor unions. Although Friedman denied, Baldwin proved that competition in international trade contributed to lower inflation. 4. Theory of deflation 4.1 Definition of Deflation Deflation is defined as the continuous decline of the general price level. Continuous means one to two years according to IMF. On this issue, the Annual Survey of the Japanese Economy (we call it Economic White Paper,.)made a big mistake in insisting that a falling price level does not matter as long as real growth is positive and that falling price level is not deflation but a disinflation process in the latter part of 1990s. 4.2 What determines deflation? Earlier we said that when demand exceeds potential output, it will lead to genuine inflation. However, supply over demand will not necessarily lead to deflation it will lead to deflationary gap. Deflation can also be explained by money contraction. When there is an increase in productivity, lower costs will also lower prices and cause deflation. Friedman insists that the unique case of the Great Depression and deflation are monetary causes. On the other hand, Professor Temin found other causes for depression. The deflation we experienced late 1990s and early 21 th century in Japan could be better explained by a shift eastward of Aggregate Supply Curve (due to import pressure from China and deregulation) plus westward shift of Aggregate Demand Curve due to lower combination of Real GDP and price level. 4.3 Economic consequence of deflation Who loses and who gains from deflation? Debtors lose since they have to repay a higher real amount of money. Creditors might gain if debtors do not bankrupt and therefore can repay. Workers will lose under the influence of high unemployment. Renters and interest earners will gain, if there is no indexation term, deflationary expectations deter production, as Keynes stressed[10]. 53

5. Theory of income determination and division and composition of demand How money income will be divided into more detailed components in monetarism? Monetarists have a theory on consumption. Permanent income hypothesis was attractive in Japan since bonus payments(twice a year)were supposed to be transitory income, June and December bonus payments are already incorporated in the consumer expectation, in Japan. Permanent income hypothesis is disproved by Japanese economists. Monetarist s investment (fixed or inventory) function is less known. On the whole, monetarists model gives us much less information than Keynes model. 6. On Natural rate hypothesis 6.1 Phillips curve 6.2 Samuelson Solow s model (6.1) Original Phillips curve (Economica 1958) Liprey s foundation based on labor markers. (6.2) Samuelson Solow s analytical framework of anti inflation policy you can choose any point and this becomes a target by Friedman. 6.3 Friedman Lucas model 6.1 Phillips curve 6.2 Friedman Lucas model E When, has nothing to do with wage level (Phillip curve becomes vertical at point E) 6.4 Drawbacks of natural rate hypothesis Why must be parameter attached to the rate of increase in price expectation be 1? 54

Why (in Lucas s model) does the agent have much more information about relative price and not about aggregate price level? On the contrary, price level is one of the most easily available indexes. Contractory policy has a symmetrical effect. Monetarists who deny the cost push inflation assume. 7. How far neo liberal proposals are consistent? Neo liberal proposal dates back to von Hayek s socialism controversy against Lange. Lange insisted that so long as marginal principle suffices, socialism works. On the contrary, von Hayek said socialism is impossible particularly due to information inefficiency. Friedman s idea is very similar with Hayek except for one : Money issuing should also be liberalized(von Hayek)or controlled(friedman). In this sense von Hayek is more logically consistent than Friedman. However, Friedman s proposals are more concrete. Proposals are faithful to his price theory and microeconomics, although some of them such as proposal for drug decontrol are very controversial. There are two big pitfalls in his argument. First of all, most of his proposals are from partial equilibrium analysis. Secondly, unless negative income tax which Friedman proposes is not being acted, inequality of income and asset distribution will go up and actually deteriorate equity. Then system as a whole becomes inconsistent and inequal. 8. Friedman s counter revolution on Monetary Theory The followings are from Friedman s counter revolution. Proposition 1 ; There is a consistent though not precise relation between the rate of growth of the quantity of money and the rate of growth of nominal income. If the quantity of money grows rapidly, so will nominal income ; and conversely. Quoted from Friedman (1970). Proposition 2 ; This relation is not obvious to the naked eye largely because it takes time for changes in monetary growth to affect income and how long it takes is itself variable. Proposition 3 ; On the average, a change in the rate of monetary growth produces a change in the growth of nominal income about six to nine months later. This is an average that does not hold in every individual case. Proposition 4 ; The changed rate of growth of nominal income, typically shows up first in output and hardly at all in prices. Proposition 5 ; On the average the effect on prices comes about six to nine months after the effect on income and output, so the total delay between a change in monetary growth and a change in the rate of inflation averages something like 12 18 months. Proposition 6 ; Even after allowance for the delay in the effect of monetary growth, the relation is far from perfect. Although Granger causality runs from Money (M1,M2CD) to nominal GDP, Real GDP, GDP deflator, this confirms that Money matters and do not show in exact quarter by quarter time lag. Proposition 7 ; In the short run, which may be as much as five or ten years, monetary changes affect primarily output. Over decades the rate of monetary growth affects primarily prices. What happens to output depends on real factors. Evidence in Japan is not clearly true on a quarter to 55

quarter basis, although long term trend cannot be denied. A group of British economists also found that Friedman s counter revolution is not true. 9. Conclusions 1. Monetarist Proposition (money matters) is true. 2. Monetarist Proposition (Inflation is always and everywhere monetary phenomenon) is false. Among Monetarist Proposition, this is very definitive statement. It is not ambiguous at all. Therefore, it is relatively easy to disprove. There are other type of inflation than money caused inflation. Cost push and struggle for income share hypotheses are important. 3. Monetarist Proposition (Monetarist identity) is either just identity or depends on the crucial assumptions that velocity is constant and stable. But assuming constancy and predictability causes many problems. 4. On these issues Friedman is very ambiguous. He changed his definition many times. I cannot trust him as the leading Monetarist nor the most distinguished economist in the last quarter of the 20th century up until now. 5. The issue of the division of price and real GDP has not been solved yet. Of the time lag between Money Supply and Price and real GDP in Friedman s original Counter Revolution was not accurate. Recent Japanese deflation proved that. 6. Inflation targeting is not a victory for Friedman but a defeat of him since Money Supply targeting failed. 7. Friedman s way of model building produced many economists[11]. However, some of them failed, in particular, in the field of finance. 8. Friedman is responsible for the recent world financial crisis in the sense that he advocated neo liberalism and globalization. 9. Government intervention is sometimes needed. 10. Then massive supply of money is justified together with expectation and reform of the system. 11. I conjecture that in a very controlled economy, like socialism, and very regulated economy such a pre Thatcher Britain, neo liberalism worked, only with few side effects. 12. Neo liberalism in any way will not lead to perfect competition since more frequent M&A s occur. 13. Even Adam Smith s great books[12] are crucially dependent on the ethical doctrine that human nature is fundamentally good. Alternative case was found in Japan in 2007 to 2008 in the foods industry and anti Seismology issues, which could be added to market failure. 10. For further study This article is mainly theoretical, although it includes the result of statistical evidence. There are different views about how Japan went out from the deflation, first, public money injection to buy bad loans was successful for increasing Banking sector s confidence, second, when the bank of Japan faced zero interest rate, it introduced quantity based easing. That means monetarist tradition? Friedman disliked government intervention in market. He also feared inflation. It means monetarism works in a very special case. If Friedman were alive, which way he would have chosen? 56

Note [1] Martin Anderson s review on Lanny Ebenstein s book a biography Milton Friedman said Friedman was the greatest economist. [2] Friedman later developed a theoretical framework of his own, which was very similar to that of Keynes. [3] For example, see Phelps (1991) [4] Lucas (1977) [5] Keynes (1940) [6] Marshall (1923) [7] Kanamori, H & Nishijima, S (1975). (in japanese) [8] Kanamori, H & Nishijima, S (1975) (in japanese) [9] Maclup (1967) [10] Keynes (1923) [11] Friedman (1953) [12] Adam Smith (1909), (1976) [13] Dorfman, R. Samuelson, P. Solow, R (1958) Bibliography Adam, S. (1976). The Theory of Moral Sentiments. Oxford University Press. Adam, S. (1776). The Wealth of Nations. Modern Library Edition. Blanchard&Fisher. (1989). Lectures on Macroeconomics. MIT Press. Blanchard, O. (1997). Macroeconomics. Prentice Hall,Inc. Cagan, P. (1956). The Monetary Dynamics of Hyperinflation, in Studies in the Quantity Theory of Money edited by Friedman,M. Chicago : University of Chicago Press. Debreu, G. (1959). Theory of Value : An axiomatic analysis of economic equilibrium. Yale University Press. Dorfman, R., Samuelson, P., & Solow, R. (1958). Linear Programming and Economic Analysis. McGraw Hill International Edition. Friedman, M. (1956). The Quantity Theory of Money : A Restatement in Studies in the Quantity Theory of Money. University of Chicago Press. Friedman, M. (1970). A Theoretical framwork of Monetary analysis. Journal of Political Economy, 78, pp193 238. Friedman, M. (1957). A Theory Of The Consumption Function. Princeton Univ Pr. Friedman, M. (1962). Capitalism and Freedom. The University of Chicago Press. Friedman, M. (1970). Counter revolution in monetary theory. Institute of Economic Affairs. Friedman, M. (1953). Essays in Positive Economics. University Of Chicago Press. Friedman, M. (1963). Inflation : Causes and Consequences. Proquest Info & Learning ; Facsimile edition. Friedman, M. (1969). The Optimum Quantity of Money and Other Essays. Aldine Transaction. Friedman, M., & Friedman, R. (1980). Free to Choose. Harvest Books. Friedman, M., & Schwartz, A. (1963). A Monetary History of the United States, 1867 1960. Princeton University Press. Kanamori, H., & Nishijima, S. (1975). The Road to Social Contract. The Mainichi Newspapers (in japanese).,. (1975) 57

Keynes, J. M. (1940). How to Pay for the War : A radical plan for the Chancellor of the Exchequer. Macmillan. Keynes, J. M. (1936). The General Theory of Employment, Interest, and Money. Plagrave Macmillan. Keynes, J. M. (1923). Tract on Monetary Reform. Prometheus Books. Keynes, J. N. (1891). The Scope and Method of Political Economy. Kelley & Millman. Komiya, R. (1998). Analysis of Japanese Economy Macro Economy and International Economic Relations. University of Tokyo Press (in japanese).. (1988) Koopmans, T. C. (1957). Three Essays on the State of Economic Science. McGraw Hill Education. Lucas, R. (1983). Studies in Business Cycle Theory. The MIT Press. Lucas, R. (1977). Understanding Business Cycles. Carnegi Rochester Conference Series on Public Policy 5,pp.7 29. Maclup, F. (1967). Essays in Economic Semantics. New York University Press. Mankiw, G. (2006). Macroeconomics. Worth Publishers Inc. Mankiw, G. (2006). Principle of Economics. South Western Pub. Marshall, A. (1923). Money, credit and commerce. Macmillan. Marshall, A. (1890). Principles of Economics. MacMillan. Modigliani, F. (1977). The Monetarist Controversy or, Should We Forsake Stabilization Policies? American Economic Review 67, pp. 1 19. Nishijima, S. (2004). A Rational of the Seemingly Irrational Behaviors. The Journal of Environmental and Information Studies Musashi Institute of Technology No,5. Nishijima, S. (2000). Asymmetry of Inflation and Deflation. Japan Center of Economic Research (in Japanese). Nishijima, S. (1992). Glory of Neo liberalism and its negative legacy. This is 6 (in japanese). Nisijima, S. (2003). Theoretical basis of environmental and information. The Journal of Environmental and Information Studies Musashi Institute of Technology No,4 (in japanese) Phelps, E. S. (1991). Recent Development of Macroeconomics volume.. E.Elgar. Pigou, A. (1920). The Economics of Welfare. Cosimo Classics. Romer, D. (1996). Advanced Macroeconomics. McGraw Hill Irwin. Samuelson, P. A. (1947). Foundation of economic analysis. Harvard University Press. Siklos&Burdekin. (2004). Deflation Current and Historical Perspectives. Cambridge University Press. Stigliz, J. (2003). Globalization and Its Discontents. W. W. Norton & Company. Temin, P. (1976). Did Monetary Forces Cause the Great Depression? W.W. Norton. Ueda, K. (2005). Fighat in The Midst of Zero Intrest Rate. Nikkei Inc (in japanese).. (2005) Acknowlegements I thank the late Professor Uchida Tadao of Tokyo University who was trained in Chicago but Keynesian. He taught to first year natural science student started with DOSSO s Linear Program- 58

ming13 and Economic Analysis to solve comparative advantage theory. His translation of Stigler s price theory was small and wonderful. I also thank the late Professor H, Kumagai, of Osaka University. He taught me the Economic Policy Theory. He was on leave and president of Economic Institute. I thank Mr. H, Kanamori. He has been not only a teacher but also like a father. Professor Meade J, of Cambridge University influenced me a lot. Although Professor A, Kahn, invited me as a member of political economy club <Keynes club>, where Professor J, Robinson, and Professor N, Kaldor had a debate with students very fiercely. Outside political economy club, young and competent economists are there such as C, Bliss, G, Heal, J, Stigliz, W, Nordhaus, As a senior visitor on leave from Harvard, Professor K. J, Arrow, J. Galbraith. Mr, Akabane former Professor of Keio University remined me of the importance of the data. Professor H. Hayashi of Teykyo University, Professor Y, Kobayashi, econometrician who on my request helped me Granger Causality Test. Former Professor of Tokyo University and former Deputy Governor of the Bank of Japan, Kazumasa Iwata, at present President of Social and Economic Research Institute read my earlier draft and made helpful comments. I acknowledge my graduate student, H, Rokugawa, for helping me typing my Word. Miss T, Tezuka, of Library borrowed many books from many regions of Japan for me. Professor C. J, Poel, helped me as a native checker. Last but not least, my wife took many copies and sorted them for me. 59