Where the Monetarists Go Wrong; H. Hazlitt

468 increased 10 per cent, the prices of commodities will increase 10 per cent; that if the quantity of money is doubled, prices will double, and so on. (This of course is on the assump tion that the quantity of goods remains unchanged. If this is in creased also, the rise in prices due to a greater supply of money will be corresponding ly less.) This is called the Quantity Theo ry of Money. It is not new, but very old. It has been traced by some economic historians as far back as the French economist Jean Bodin in 1566, and by others to the Italian Davanzati in 1588. In its modern form it was most elaborately pre sented by the American Irving Fisher in The Purchasinf{' Power of Money (1911) and in later books. The monetarists have added some refinements to this theory, but prin1976 WHERE THE MONETARISTSGO WRONG 469 ci pally they have devoted them selves to giving it detailed statis tical support, and drawing much differen t concl usions than did Fisher himself regarding an appro priate monetary policy.

When Fisher began writing, the gold standard was still dominant in practice. He proposed to keep it, but with a radical modification. He would have varied its gold content according to the variations of an official price index, so that the dollar should represent, instead of a constant quantity of gold, a con stant quantity of purchasing power. Milton Friedman rejects the gold standard altogether. He would sub stitute for it a law prescribing a precise quantitative issuance of irredeemable paper money: "My choice at the moment would be a legislated rule instructing the monetary authority to achieve a specified rate of growth in the stock of money. For this purpose, 1 would define the stock of money as includ ing currency outside commercial banks plus all deposits of commer cial banks. I would specify that the Reserve System shall see to it· that the total stock of money so defined rises month by month, and indeed, . so far as possible, day by day, at an annual rate of X per cent, where X is some number between 3 and 5. The precise definition of money adopted, or the precise rate of growth chosen, makes far less difference than the definite choice of a particular definition and a particular rate of growth."l It is with considerable reluctance that I criticize the monetarists, because, though I consider their proposed monetary policy unfeasi ble' they are after all much more nearly right in their assumptions and prescriptions than the majority of present academic economists. The simplistic form of the quantity theory of money that they hold is not tenable; but they are over whelmingly right in insisting on how much "money matters;' and they are right in insisting that in most circumstances, and over the long run, it is the quantity of money that is most influential in determin ing the purchasing power of the monetary unit. Other things being equal, the more dollars that are issued, the smaller becomes the value of each individual dollar. So at the moment the monetarists are more effective opponents of further inflation than the great bulk of politicians and even putative economists who still fail to recog nize this basic truth.

I must add that I also regret that '1 take issue on this important ques tion with Milton Friedman, with most of whose great contributions to economics, and especially to the 1 Capitalism and Freedom (University of Chicago Press, 1962), p. 54.

470 THE FREEMAN August defense of the free market, I have long been in full and admiring agreemen t. I hope that no reader of this article will get the impression that I fail to appreciate the extent to which Dr. Friedman's lucidity, persuasi veness and penetration have put us all in his debt. Let us begin by examining what is wrong with "the" quantity theory of money-which might rather be called the strict or mechanical quantity theory of money. It rests on greatly oversimplified assump tions. As formulated by Davanzati in 1588, the total existing stock of money must always buy the total existing stock of goods - no more, no less. So if you double the stock of money, and the supply of goods remains the same, you must double the average level of prices. Each monetary unit must then buy only half as much as before. As formu lated by its modern exponents, the assumptions underlying the strict quantity theory of money are not much advanced from this. As "money is only wanted to buy goods and services;' they argue, this pro portional relationship must hold.

But this is not what happens ..The truth in the quantity theory is that changes in the quantity of money are a very import ant factor in deter mining the exchange-value of a given unit of money. This is merely to say that what is true of other goods is true of money also. The market value of money, like the market value of goods in general, is determined by supply and demand. But it is determined at all times by subjective valuations,' and not by purely objective, quantitative, or mechanical relationships. Three Stages of Inflation In a typical inflation we may roughly distinguish three stages. In the first stage prices do not rise nearly as fast as the quantity of money is being increased. For one thing, if there has been some slack in the economy, purchases made wi th the new money may mainly stimulate increased production. (This is the point so em phasized and overemphasized by Keynes. It can happen, however, only' in the early stages of an inflation, and only in special circumstances.) Apart from this possible early stimulative effect of an inflation, most people at first do not realize that an inflation of the currency has taken place. Some prices have risen, but many people, comparing them with the prices to which they have become accustomed, assume that these new prices are too high, and will soon fall back to "normal." They hold off buying, and increase their cash holdings. As a result, prices do not at first rise as much as the quantity of money has been in creased.

If the inflation is slow and has 1976 WHERE THE MONETARISTSGO WRONG 471 occasional stops, prices tend to catch up with the rate of increase in the money supply, and for· a while there may be a result much like what the strict quantity theory of money would predict, in which prices tend to rise roughly in pro portion to the increase in the money stock: But if the inflation (meaning the increase in the quantity of money) continues, and particularly if it accelerates, people begin to fear tha_t it is a deliberate governmental policy, that it will go on indefinitely, and that prices will continue to soar. So they hasten to spend their money while it still has some value-i.e., before prices rise still further. The result is that prices begin to rise far faster than the quantity of money has been increased, and finally far faster than it even can be increased. So we have the paradoxical result that, in a hyperinflation, when the government is grinding out new currency units at an astronomical rate, prices rise so fast that the existing quantity of money is not sufficient for the volume of transac tions, and we have mounting comp laints of a "scarcity" of money.2 In 2 See, e.g., on the French assignats, Andrew Dickson White, Fiat Monev Inflation in France (Irvington-on-Hudson, New York: Foundation for Economic Education, 1959), p. 8:3 and passim. and on the German inflation of 192:3, Costantino Bresciani-Turroni, The Economics of Inflation (London: George Allen & Unwin, 19:31), pp. 80-1.

the final stage of the German infla tion of 1923, for example, the entire stock of paper money, though with a stamped value billions of times higher, had a gold exchange-value of only one-sixtieth of what it had before the inflation started. Of course the paper mark finally became utterly valueless, as had the French assignats in 1796 and the American Continental currency in 1781. It is for this reason that all inflation must finally have a stop. But the point I am stressing here is that the strict quantity theory of money is not true (though it may a ppear to be true under certain circumstances and for limited periods). So far a~ quantity is con cerned, it is the expected future quantity of money, rather than the immediately existing quantity, that determines the exchange value of the monetary unit. Quality Affects Value The value of money, however, is determined not merely by its quan tity-even its expected future quan tity-but also by its quality. Cur rency issued by a shaky govern ment' for example, will not have as much value, other things being equal, as currency issued by a strong "legitimate" government of long standing.

In recent years we have witnessed much more familiar illustrations of 472 THE FREEMAN August the effect of qualitative deteriora tion in the monetary unit. Scores of nations have repeatedly announced "devaluations" of their currency. Prices have begun to rise in those countries the very next day, before there has been any chance to increase the quantity of money any further. Still more striking is what has happened when nations on a gold standard have announced their abandonment of it. The United States went off the gold standard in March of 1933. By 1934, the average of wholesale prices had increased 14 per cent over 1933, and by 1937,31 per cent. The U.S. formally aban doned gold convertibility again in August, 1971. Wholesale prices had actually fallen by 2 per cent from August of the year before; but by August of the year later they in creased by 4.35 per cent. With all gold discipline removed, wholesale prices rose more than 13 per cent between 1972 and 1973, and more than 34 per cent between 1972 and 1974.

One of the most striking ill ustra tions of the importance of the quality of the currency occurred in the Philippines at the late stage of World War II. The forces under General Douglas MacArthur had effected a landing at Leyte in the last week of October, 1944. From then on, they achieved an almost uninterrupted series of successes. A wild "inflation" broke out in the capital city of Manila. In November and December, 1944, prices in Manila rose to dizzy heights. Why? There was no increase in the money stock. But the inhabitants knew that as soon as the American forces were completely successful their Japanese-issued pesos would be worthless. So they hastened to get rid of them for whatever real goods they could get.: 3 Quantity Theory of Money What has helped to keep the strict mathematical quantity theo ry of money alive, in spite of experiences of the kind just cited, is the famous Irving Fisher equation: MV = PT. In this M stands for the quantity of mon~y, V for its "velocity of circulation," P for "the average price level" of goods and services, and T for the "volume of trade;' or the quantity of goods and services against which money is exchanged.

So when the quantity of money remains unchanged, for example, and prices start to soar (or any similar discrepancy occurs) the quantity theorists are not at all disconcerted. They are provided in advance with an easy alibi: the "velocity of circulation" of money :31 have never seen a reference to this striking event in an,v textbook on money. See e.g., The N('/lJ York Times .Jan. :30, 1945.

1976 WHERE THE MONETARISTS GO WRONG 473 must have changed enough to account for the apparent discrepan cy. True, this requires them some times to assume some remarkable things. I pointed out a few pages back that in the final stage of the German inflation of 1919-1923 the entire stock of paper money had a gold value only one-sixtieth that of the far smaller nominal money stock before the inflation began. This would require us to assume that the average "velocity of cir culation" had increased in the meanwhile sixty times. This is not possible. The <!oncept of the "velocity of circulation" of money, as held by the quantity theorists and embodied in the Fisherine equation MV = PT, is quite fallacious. Strictly speaking, money does not "circulate": it is exchanged against goods. When the turnover of money increases, the turnover of goods increases corres pondingly. (We have here an illustration of how the use of mathematical sym boIs may mislead an economist even in an elementary application. If MV = PT, and you double V, then it seems to follow that 2 MV = 2 PT, and that this can be read as mean ing that doubling V can double ~ But if we spell out the equation as M x V =P x T, it can be seen that M x 2V does not necessarily equal 2P x T, but more likely P x 2T. In fact, the equation MV = PT does not mean what Irving Fisher and his disciples thought it meant. They considered MV the "money side" of the equa tion and PT the "goods side:' But as Benjamin M. Anderson, Jr. long ago pointed out in a shrewd analysis,4 "Both sides of the equation are money sides ... The equation asserts merely that what is paid is equal to what is received.") Velocity of Circulation Geographical Variations There are no reliable statistics on the "velocity of circulation" of hand-to-hand currency.5 But we do have figures on the annual rate of turnover of demand bank deposits.

As bank deposits in the United States cover about eight-ninths of the media of payment, these figures are an important index. What is most striking, when we examine these figures, is first of all the wide discrepancy that we find between the rate of turnover of demand deposits in the big cities, 4 The Value of Money (New York: Richard R. Smith. 1917 and 1936). p. 161. 5 Milton Friedman and Anna Jacobson Sch wartz. in their Monetary History of the United . States: 1867-1960 (Princeton University Press. 1963). do offer annual estimates and tables of "velocity of money" based on worksheets of Simon Kuznets made for another study. But they define this velocity as "the ratio of money income to the stock of money." This hardly makes it a transactions velocity. Moreover. they appear to attach very little commodity-price determining importance to it: "Velocity is a relatively stable magnitude that has declined secularly as real income has risen." (p. 34\.

474 THE FREEMAN August especially New York, and the rate that we find in 226 other reporting centers. In December, 1975, the average annual rate of turnover of demand deposits in these 226 small centers was 71.8. In six large cities outside of New York it was 118.7. When we come to New York City itself, the rate was 351.8. This does not mean that people in New York were furiously spending their money at nearly five times the rate of people in the small centers. (We must always remember that each individual can spend his dollar income only once,) The difference is accounted for mainly by two factors. The big corporations have their headquarters or keep their banking accounts in the big cities, and these accounts are much more active than those of individuals. And New York City especially, with its stock exchanges and commodity exchanges, is the great c~nter of speculation in the United States.

Though the velocity of circulation of money (mainly in the form of bank deposits) increases with spec ulation, speculation itself does not indefini tely increase. In order for speculation to increase, willingness to part with commodities must increase just as fast as eagerness to buy them. It is rapidly changing ideas of commodity values-not only differences of opinion between buyer and seller, but changing opin ions on the part of individual speculators - that are necessary to increase the volume of speculation. The value of a commodity, a stock, or a house does not change in any predictable relationship to the num ber of times it changes hands. Nor does the value of a dollar. When 100 shares of a stock are sold, their value is not thereby necessarily depressed, because the shares are also bought. Every sale implies a purchase, and every purchase a sale. When a man buys a commodity, he "sells" money; but the seller of the commodity "buys" money. There is no necessary connection whatever between changes in the "velocity of circulation" of money and changes in the "level" of commodity prices.

"Velocity of money" is merely a resultant of a complex of other factors, and not itself a cause of any important change whatever. 6 Price Levels and Indexing Still another fallacy into which many quantity theorists (and not they alone) are apt to fall is the concept of a price "level:' This is the partly unconscious assumption that when prices rise during an inflation they rise uniformly-so that when the official consumer price index 6 I have treated this subject at greater length in an essay, "Velocity of Circulation," in Money. the Market and the State: Economic Essays in honor of.James Muir Waller. edited by N. A. Beadles and L. A. Drewry (University of Georgia Press, 1968.) 1976 WHERE THE MONETARISTS GO WRONG 475 has risen over a given period by, say, 10 per cent, all prices in that period have risen just about 10 per cent. This assumption is never made explicitly, otherwise it would be much easier to correct. But it is latent jn the discussions of most journalists and politicians. It therefore leads them greatly to underestimate the harm done by inflation. For the greater part of that harm is precisely that different people's prices, wage-rates and income go up so unevenly and at different rates. This not only means great windfalls for some and tra gedies for others, but it distorts and disrupts economic relationships. It unbalances, reduces, and misdirects production. It leads to unemploy ment and to malemployment. And attempts to correct this through such schemes as "indexing" only tend to increase the harm.