[A-List] Henry Liu on central banking 1

["Michael Keaney" <michael.keaney@xxxxxx>]

BANKING BUNKUM
Part 1: Monetary theology
By Henry C K Liu
Asia Times: November 6 2002

Central bankers are like librarians who consider a well-run library to be
one in which all the books are safely stacked on the shelves and properly
catalogued. To reduce incidents of late returns or loss, they would proposed
more strict lending rules, ignoring that the measure of a good library lies
in full circulation. Librarians take pride in the size of their collections
rather than the velocity of their circulation.

Central bankers take the same attitude toward money. Central bankers view
their job as preserving the value of money through the restriction of its
circulation, rather than maximizing the beneficial effect of money on the
economy through its circulation. Many central bankers boast about the size
of their foreign reserves the way librarians boast about the size of their
collections, while their governments pile up budget deficits. Paul Volcker,
the US central banker widely credited with ending inflation in the early
1980s by administering wholesale financial blood letting on the US economy,
quipped lightheartedly at a Washington party that "central bankers are
brought up pulling legs off of ants".

Central banking insulates monetary policy from national economic policy by
prioritizing the preservation of the value of money over the monetary needs
of a sound national economy. A global finance architecture based on
universal central banking allows an often volatile foreign exchange market
to operate to facilitate the instant cross-border ebb and flow of capital
and debt instruments. The workings of an unregulated global financial market
of both capital and debt forced central banking to prevent the application
of the State Theory of Money (STM) in individual countries to use sovereign
credit to finance domestic development by penalizing, with low exchange
rates for their currencies, governments that run budget deficits.

STM asserts that the acceptance of government-issued legal tender, commonly
known as money, is based on government's authority to levy taxes payable in
money. Thus the government can and should issue as much money in the form of
credit as the economy needs for sustainable growth without fear of
hyperinflation. What monetary economists call the money supply is
essentially the sum total of credit aggregates in the economy, structured
around government credit as bellwether. Sovereign credit is the anchor of a
vibrant domestic credit market so necessary for a dynamic economy.

By making STM inoperative through the tyranny of exchange rates, central
banking in a globalized financial market robs individual governments of
their sovereign credit prerogative and forces sovereign nations to depend on
external capital and debt to finance domestic development. The deteriorating
exchange value of a nation's currency then would lead to a corresponding
drop in foreign direct or indirect investment (capital inflow), and a rise
in interest cost for sovereign and private debts, since central banking
essentially relies on interest policy to maintain the value of money.
Central banking thus relies on domestic economic austerity caused by high
interest rates to achieve its institutional mandate of maintaining price
stability.

Such domestic economic austerity comes in the form of systemic credit
crunches that cause high unemployment, bankruptcies, recessions and even
total economic collapse, as in the case of Britain in 1992, the Asian
financial crisis in 1997 and subsequent crises in Russia, Turkey, Brazil and
Argentina. It is the economic equivalent of a blood-letting cure.

A national bank does not seek independence from the government. The
independence of central banks is a euphemism for a shift from institutional
loyalty to national economic well-being toward institutional loyalty to the
smooth functioning of a global financial architecture. The international
finance architecture at this moment in history is dominated by US dollar
hegemony, which can be simply defined by the dollar's unjustified status as
a global reserve currency. The operation of the current international
finance architecture requires the sacrifice of local economies in a
financial food chain that feeds the issuer of US dollars. It is the monetary
aspect of the predatory effects of globalization.

Historically, the term "central bank" has been interchangeable with the term
"national bank". In fact, the enabling act to establish the first national
bank, the Bank of the United States, referred to the bank interchangeably as
a central and a national bank. However, with the globalization of financial
markets in recent decades, a central bank has become fundamentally different
from a national bank.

The mandate of a national bank is to finance the sustainable development of
the national economy, and its function aims to adjust the value of a
nation's currency at a level best suited for achieving that purpose within
an international regime of exchange control. On the other hand, the mandate
of a modern-day central bank is to safeguard the value of a nation's
currency in a globalized financial market of no or minimal exchange control,
by adjusting the national economy to sustain that narrow objective, through
economic recession and negative growth if necessary.

Central banking tends to define monetary policy within the narrow limits of
price stability. In other words, the best monetary policy in the context of
central banking is a non-discretionary money-supply target set by universal
rules of price stability, unaffected by the economic needs or political
considerations of individual nations.

The theology of monetary economics

Inflation, the all-consuming target of central banking, is popularly thought
of as too much money chasing too few goods, which economists refer to as the
Quantity Theory of Money (QTM). QTM is one of the oldest surviving economic
doctrines. Simply stated, it asserts that changes in the general level of
commodity prices are determined primarily by changes in the quantity of
money in circulation. But the theology of monetary economics has a long and
complex history, an understanding of which is necessary for forming any
informed opinion on the validity and purpose of central banking. Below is a
brief summary of the stuff dinner conversation is made of among the gods of
monetary theory.

Jean Bodin (1530-96), a French social/political philosopher, attributed the
price inflation then raging in Western Europe to the abundance of monetary
metals imported from the newly opened gold and silver mines in the Spanish
colonies in South America. Though he held many aspects of mercantilist
views, Bodin asserted that the rise of prices was a function not merely of
the debasement of the coinage, but also of the amount of currency in
circulation. Bodin's religious tolerance in a period of fanatical religious
wars drew upon him the accusation of being a "freethinker", a label as
damaging as being called a communist sympathizer in the United States in
modern times. In his Les Six Livrers de la republic (1576), Bodin replaced
the concept of a past golden age with the concept of progress. He
foreshadowed Thomas Hobbes (1588-1679: The Leviathan, 1651) by stating the
political necessity of absolute sovereignty, subject only to the laws of God
(morality) and nature (reality). Bodin also anticipated Baron Montesquieu
(1689-1755: De l'esprit des lois, 1748) by highlighting environment as a
determinant of laws, customs, beliefs and the interpretation of events, a
view that influenced the US constitution, a view since rejected by current
US moral imperialism.

John Locke (1632-1704) and David Hume (1711-76) provided considerable
refinement, elaboration and extension to the QTM, allowing it to be
integrated into the mainstream of orthodox monetarist tradition. Locke
developed the right of private property based on the labor theory of value
and the mechanics of political checks and balances that were incorporated in
the US constitution. Locke, in 1661, asserted the proportionality postulate:
that a doubling of the quantity of money (M) will double the level of prices
(P) and half the value of the monetary unit.

Hume, in 1752, introduced the notion of causation by stating that variation
in M (money quantity) will cause proportionate changes in P (price level).
Concurrently with Irish banker Richard Cantillon (1680-1734), Hume applied
to the QTM two crucial distinctions: 1) between static (long-run stationary
equilibrium) and dynamic (short-run movement toward equilibrium); and 2)
between the long-run neutrality and the short-run non-neutrality of money.
Hume and Cantillon provided the first dynamic process analysis of how the
impact of a monetary change spread from one sector of the economy to
another, altering relative price and quantity in the process. They pointed
out that most monetary injection would involve non-neutral distribution
effects. New money would not be distributed among individuals in proportion
to their pre-existing share of money holdings. Those who receive more will
benefit at the expense of those receiving less than their proportionate
share, and they will exert more influence in determining the composition of
new output. Initial distribution effects temporarily alter the pattern of
expenditure and thus the structure of production and the allocation of
resources. Thus it is understandable that conservatives would be sympathetic
to the QTM to maintain the wealth distribution status quo, or if the QTM is
skirted, to ensure that the maldistribution tilts toward those who are more
likely to engage in capital formation, namely the rich. Thus developing
economies in need of capital formation would find logic in first enriching
the financial elite while advanced economies with production overcapacity
would need to increase aggregate demand by restricting income disparity.

Hume describes how different degrees of money illusion among income
recipients, coupled with time delays in the adjustment process, could cause
costs to lag behind prices, thus creating abnormal profits and stimulating
optimistic profit expectations that would spur business expansion and
employment during the transition period. These non-neutral effects are not
denied by the adherents of QTM, who nevertheless assert that they are bound
to dissipate in the long run, often with great damage if the optimism was
unjustified. The latest evidence of the non-neutral effects of money is
observable in expansion of the so-called New Economy from easy money in the
past decade and the recent collapse of its bubble.

The QTM formed the central core of 19th-century classical monetary analysis,
provided the dominant conceptual framework for interpreting contemporary
financial events and formed the intellectual foundation of orthodox policy
prescription designed to preserve the gold standard. The economic structure
in 19th-century Europe led analysts to acknowledge additional non-neutral
effects, such as the lag of money wages behind prices, which temporarily
reduces real wages; the stimulus to output occasioned by inflation-induced
reduction in real debt burdens, which shifts real income from unproductive
creditor-rentiers to productive debtor-entrepreneurs; the so-called "forced
saving" effect occasioned by price-induced redistribution of income among
socio-economic classes having structurally different propensity to save and
invest; and the stimulus to investment imparted by a temporary reduction in
the rate of interest below the anticipated rate of return on new capital.

Yet classical quantity theorists tended persistently to minimize the
importance of non-neutral effects as merely transitional. Whereas Hume
tended to stress lengthy dynamic disequilibrium periods in which money
matters much, classical analysts focused on long-run equilibrium in which
money is merely a veil. David Ricardo (1772-1823), the most influential of
the classical economists, thought such disequilibrium effects ephemeral and
unimportant in long-run equilibrium analysis. Gods, of course, enjoy longer
perspectives than most mortals, as do the rich over the poor. As John
Maynard Keynes famously said: "In the long run, we will all be dead."

As leader of the Bullionists, Ricardo charged that inflation in Britain was
solely the result of the Bank of England's irresponsible overissue of money,
when in 1797, under the stress of the Napoleonic Wars, Britain left the gold
standard for inconvertible paper. At that time, the Bank of England was
still operating as a national bank, not a central bank in the modern sense
of the term. In other words, it operated to improve the English economy
rather than to strengthen the sanctity of international finance. Ricardo, by
focusing on long term-equilibrium, discouraged discussions on the possible
beneficial output and employment effects of monetary injection on the
national level. Like modern-day monetarists, Bullionists laid the source of
inflation, a decidedly evil force in international finance, squarely at the
door of the national bank. As Milton Friedman declared some two centuries
after Richardo: inflation is everywhere a monetary phenomenon. Friedman's
concept of "money matters" is the diametrical opposite of Hume's.

The historical evolution in 18th-century Europe from a predominantly
full-metal money to a mixed metal-paper money forced advances in the
understanding of the monetary transmission mechanism. After gold coins had
given way to banknotes, Hume's direct mechanism of price adjustment was
found lacking in explaining how banknotes are injected into the system.

Henry Thornton (1760-1815), in his classic The Paper Credit of Great Britain
(1802), provided the first description of the indirect mechanism by
observing that new money created by banks enters the financial markets
initially via an expansion of bank loans, through increasing the supply of
lendable funds, temporarily reducing the loan rate of interest below the
rate of return on new capital, thus stimulating additional investment and
loan demand. This in turn pushes prices up, including capital good prices,
drives up loan demands and eventually interest rates, bringing the system
back into equilibrium indirectly.

The central issue of the doctrines of the British classical school that
dominated the first half of the 19th century was focused around the
application of the QTM to government policy, which manifested itself in the
maintenance of external equilibrium and the restoration and defense of the
gold standard. Consequently, the QTM tended to be directed toward the
analysis of international price levels, gold flow, exchange-rate
fluctuations and trade deficits. It formed the foundation of mercantilism,
which underpinned the economic structure of the British Empire via
colonialism, which reached institutional maturity in the same period.

Bullionists developed the idea that the stock of money, or its currency
component, could be effectively regulated by controlling a narrowly defined
monetary base, that the control of "high-power money" (bank reserves) in a
fractional reserve banking regime implies virtual control of the money
supply. High-power money is the totality of bank reserves that would be
multiplied many times through the money-creation power of commercial bank
lending, depending on the velocity of circulation.

In the 1987 crash when the Dow Jones Industrial Average (DJIA) dropped 22.6
percent in one day (October 19) on volume of 608 million shares, six times
the normal volume then (current normal daily volume is about 1.6 trillion
shares), the US Federal Reserve under its newly installed chairman, Alan
Greenspan, created US$12 billion of new bank reserves by buying up
government securities. The $12 billion injection of high-power money in one
day caused the Fed Funds rate to fall by three-quarters of a point and
halted the financial panic. If the government had been running a balanced
budget and there were no government securities to be bought, the economy
would have seized up. This shows that government deficits and debt are part
and parcel of the modern financial architecture.

In the three decades after Britain returned to the gold standard in 1821,
the policy objective focused on the maintenance of fixed exchange rates and
the automatic gold convertibility of the pound. But the Currency School (CS)
versus Banking School (BS) controversy broke out over whether the "Currency
Principle" of making existing mixed gold-paper currency expand and contract
in direct proportion to gold reserves was sufficient to safeguard against
note overissuance, or whether additional regulation was necessary. This
controversy grew out of the expansion pressure put on the supply of pound
sterling by the rapid expansion of the British empire.

Members of the CS argued that even a fully, legally convertible currency
could be issued in excess with undesirable consequences, such as rising
domestic prices relative to foreign prices, balance-of-payment deficits,
falling foreign-exchange rates, gold outflow resulting in depletion of gold
reserves and ultimately forced suspension of convertibility. The rate of
reserves drain often accelerated when the external gold drain coincided with
internal domestic-panic conversion of paper into gold in fear of pending
depreciation. Thus the CS promoted full convertibility plus strict
regulation of the volume of banknotes to prevent the recurrence of gold
drains, exchange depreciation and domestic liquidity crises.

The apprehension of the CS was fully justified by past actions of the Bank
of England, which had been perverse and destabilizing by international
finance standards. The destabilizing argument stressed the time lag on the
Bank's policy response to gold outflow and to exchange-rate movements. The
inevitably too little, too late measures taken by the national bank, instead
of protecting gold reserves, merely exacerbated financial panics and
liquidity crises that inevitably followed periods of currency-credit excess.
The famous Bank Charter Act of 1844, in modern parlance, imposed a 100
percent reserve requirement, with an unabashed bias toward wealth
preservation over wealth creation. The CS also asserts that money
substitutes cannot impair the effectiveness of monetary regulation. Thus if
banknotes could be controlled, there would be no need to control deposits
explicitly, on the ground that money substitutes have low velocity and are
of declining substitutional value in times of crisis.

Keynesians argue that the QTM is invalid because it assumes an automatic
tendency to full employment. If resource under-ultilization and excess
capacity exist, a monetary expansion may produce a rise in output rather
than a rise in prices, as in the case of the 1930s Depression. Money is not
a mere veil. Monetary changes may have a permanent effect on output,
interest rates, and other real variables, contrary to the neutrality
postulate of the QTM. Post-Keynesians also contend that the QTM erroneously
assumes the stability of velocity and its counterpart, the demand for money.
Velocity is a volatile, unpredictable variable (technically known as
exogenous - due to external causes), influenced by meta-rationality and by
changes in the volume of money substitutes, not to mention hedges in the
form of derivatives. The erratic behavior of velocity makes it impossible to
predict the effect of a given monetary change on prices.

John Law (1671-1729), a contemporary of Bodin, elaborated in 1705 on the
distinction drawn by Bernardo Davanzati (1529-1606) between "value in
exchange" and "value in use", which led Law to introduce his famous
"water-diamond" paradox: that water, which has great use-value, has no
exchange-value, while diamonds, which have great exchange-value, have no
use-value. Contrary to Adam Smith, who used the same example but explained
it on the basis of water and diamonds having different labor costs of
production, Law regarded the relative scarcity of goods in demand as the
generator of exchange value.

Davanzati showed how "barter is a necessary complement of division of labor
amongst men and amongst nations"; and how there is easily a "want of
coincidence in barter", which calls for a "medium of exchange"; and this
medium must be capable of "subdivision" and be a "store of value". He
remarked "that one single egg was more worth to Count Ugolino in his tower
[prison] than all the gold of the world", but that on the other hand, "ten
thousand grains of corn are only worth one of gold in the market", and that
"water, however necessary for life, is worth nothing, because
superabundant". That was of course before International Monetary Fund (IMF)
conditionality requiring the poor in the indebted Third World to pay for
water through privatization of basic utilities to service foreign debt.

Davanzati observed that in the siege of Casilino, "a rat was sold for 200
florins, and the price could not be called exaggerated, because next day the
man who sold it was starved and the man who bought it was still alive". Of
course, modern economists would call that a market failure. Davanzati viewed
all the money in a country as worth all the goods, because the one exchanges
for the other and nobody wants money for its own sake. Davanzati did not
know anything about the velocity of money, and only recognized that every
country needs a different quantity of money, as different human frames need
different quantities of blood. The mint ought to coin money gratuitously for
everybody; and the fear that, if the coins are too good, they should be
exported is simply illusory, because they must have been paid for by the
exporter.

Law's "Real Bills Doctrine" of money applied the "reflux principle" to the
money supply. Money, Law argued, was credit and credit was determined by the
"needs of trade". Consequently, the amount of money in existence is
determined not by the imports of gold or trade balances (as the
Mercantilists argued), but rather on the supply of credit in the economy.
And money supply (in opposition to the Quantity Theory) is endogenous
(growing from within), determined by the "needs of trade".

Post-Keynesians have drawn on the Real Bills Doctrine, which asserts that
the money supply is an endogenous variable that responds passively to shifts
in the demand for it. Thus monetary changes cannot affect prices. Being
demand-determined, the stock of money cannot exceed or fall short of the
quantity of money demanded. In short, there is no transmission mechanism
running from money to prices. Analysts should look instead for the source of
economic dislocations in real rather than monetary causes. Inflation creates
a corresponding increase in the money supply, not the other way around. Yet
QTM theorists exposed the Achilles' heel of the Real Bills Doctrine by
demonstrating that as long as the loan rate of interest is below the
expected yield on new capital projects, the demand for loans will be
insatiable. Thus the "real bills" criterion as an automatic regulator of the
money supply is inoperative unless central banks intervene to raise interest
rates in concert with expected return on capital.

The attack on the QTM from the Banking School (BS) also supported modern
Keynesian views, by pointing out that new money may simply be absorbed into
idle balances (gold hoards, a liquidity trap) without entering the spending
stream, while the supply of money is determined by the need of trade and
thus can never exceed demand (in modern parlance: pushing on the credit
string). The BS went farther than the "Real Bills" argument that even if the
real-bills criterion of restriction of loans to self-liquidating paper were
violated, the law of reflux would prevent overissue. Holders of excess
papers would simply redeposit them in banks rather than spending them. The
BS asserts that prices are determined by income and not by the quantity of
money. For national economies, factor incomes earned from overseas
investment, rather than money, are the sources of expenditure that act on
prices, unless neutralized by imports. This income-expenditure approach was
later developed by Keynes and became a characteristic feature of Keynesian
macro-economic models.

The BS also disputed the quantity-theory view of money as an exogenous or
external independent variable by arguing that the stock of money and credit
is a passive, endogenous demand-determined variable. The stock of money and
credit is the effect, not the cause, of price changes. The channel of
causation runs from prices to money, not the opposite direction as contended
by the CS. What determines the volume of currency in circulation is the
active initiation of the non-bank public (borrowers) with the banks playing
only a passive accommodating role. Implicit in the BS view of massive money
are three anti-quantity theory propositions: 1) changes in economic
activities precede and cause changes in the money supply (the reverse
causation argument); 2) the supply of circulating media is not independent
of the demand for it and 3) the central bank does not actively control the
money supply, but instead accommodates or responds to prior changes in the
demand for money. Against the CS emphasis on a narrowly defined money
supply, the BS emphasized the overall structure of credit.

The BS advocates more free banking against regulated banking, favoring the
discretion of bankers over regulation by government or fixed rules, and,
most important, the BS regards attempts to regulate prices via monetary
control as futile, since the money supply, especially notes, is an
endogenous variable independent of exogenous control. BS views fighting
inflation via the supply of money and credit as putting the cart before the
horse, since it is prices that determine the quantity of money and credit,
and not vice versa.

Despite the BS's criticism, the QTM emerged victorious from the mid-19th
century Currency-Banking Debate to command wide acceptance until the 1930s.
The CS policy of fixed exchange rate, gold standard, convertibility and
strict control of banknotes became British monetary orthodoxy in the second
half of the 19th century within the context of the triumph of British
imperialism. But the rigorous mathematical restatement of the QTM by
neo-classical economists around the dawn of the 20th century was the
crowning factor to QTM's success in intellectual circles.

Irving Fisher (1876-1947) in his classic The Purchasing Power of Money
(1911) spelled out his famous equation of exchange: MV=PT, where M is the
stock of money, V is the velocity of circulation, P is the price level and T
is the physical volume of market transaction. This and other equations, such
as the Cambridge cash balance equation, which corresponds with the emerging
use of mathematics in neo-classical economic analysis, define precisely the
conditions under which the proportional postulate is valid.

Yet these conditions include constancy of the velocity of money and of real
output. Neoclassical economics assumed that velocity was a near constant
determined by individuals' cash-holding decisions in conjunction with
technological and institutional factors associated with the aggregate
payment mechanism. Today, with interest-bearing cash accounts, electronic
payment regimes and cashless credit-card transactions, such assumptions are
less valid. Money velocity, like wind velocity in a weather pattern,
fluctuates widely and suddenly, caused by complex factors feeding back on
each other.

Fisher and other neo-classical economists, such as Arthur Cecil Pigou
(1877-1959) of Cambridge, demonstrated that monetary control could be
achieved in a fractional reserve banking regime via control of an
exogenously determined stock of high-power money. Underlying their argument
that the total stock of money and bank deposits would be a constant multiple
of the monetary base is the claim that the stock of money is governed by
three proximate determinants: 1) the high-power monetary base, 2) the banks'
desired reserve to deposit ratio and 3) the public's desired cash-to-deposit
ratio, and with the the monetary base dominating determinants 2) and 3).
Again the financial reality today is very different. Banks routinely borrow
through the repos window to bypass reserve requirements. Banks, to reduce
the capital requirement based on their balance sheets, also sell their loans
regularly as securitized financial products in the credit markets. Yet QTM
continues to exercise a strong hold on monetary theory.

Neo-classical quantity theorists stress the long-run non-neutrality of
money, a topic not well developed in classical analysis. They integrate the
QTM into their analysis of business cycles, identifying the quantity of
money as a major cause of booms and busts and monetary effects on price as a
prerequisite to the stabilization of economic activity.

It was not until the 1930s that the QTM encountered serious criticism and
was discredited, replaced by the Keynesian income-expenditure model.
Notwithstanding Keynes' earlier support for QTM in A Tract on Monetary
Reform (1923), Keynes' General Theory (1936) launched a frontal attack on
QTM by observing that if the economy were operating at less than full
employment, with idle resources to draw from, changes in spending would
affect output and employment rather than prices.

Keynes reversed the QTM assumption by treating prices as rigid and output
flexible, a situation any businessman could recognize. Keynes criticized the
QTM equations as tautological and that QTM erroneously treated the
circulatory velocity of money as a near constant. Keynes pointed out that
the velocity variable in Fisher's equation was in reality extremely unstable
by showing that any change in M (money stock) might be absorbed by an
offsetting change in V (circulation velocity) and therefore would not be
transmitted to P (price level). Likewise, any change in income or the volume
of market transaction might be accommodated by a change in velocity without
requiring any change in the money supply.

Keynes revived the BS conclusion that economic disturbances arise from
exogenous shocks originating in the real economy rather than from erratic
behavior of the money supply, and the futility of using monetary policy to
regulate economic activity to cure unemployment and recession. The
conclusion was based on Keynes' theory of an absolute preference for
liquidity at low interest-rate levels - the case for the liquidity trap.
Keynes argued that either a liquidity trap or interest-insensitive
investment draught could render a monetary expansion ineffective in a
depression. Keynes stressed a new non-monetary adjustment mechanism - the
income multiplier. The chief policy implication of the Keynesian
income-expenditure analysis was that fiscal policy would have a more
powerful impact on income and employment than would monetary policy.

Post-Keynesian economists added to Keynes' contra-QTM arguments by pointing
out that inflation is predominantly a cost-pushed phenomenon associated with
non-monetary institutional forces, such as union wage inelasticity, monopoly
pricing, etc. Cheap money, Post-Keynesian advocates assert, from
expansionary monetary policy could be used to keep interest rates at low
levels, minimizing the burden of both private and public debt, helping to
keep unemployment at permanently low levels. These positions depart from the
neutrality proposition. The Radcliffe Committee on British monetary reform
in 1959 declared that 1) money is an indistinguishable component of a
continuous spectrum of financial assets; 2) the velocity of money is devoid
of economic content; and 3) attempts to regulate spending via monetary
control are futile in a financial system that can produce a limitless array
of money substitutes. The Radcliffe Committee declaration is in fact an
update of the Banking School.

Then came Milton Friedman, who remodeled the QTM into a theory of the demand
for money. It was based on the wealth effect, or the theory of real balance
effect, which argues that prices would fall in a depression, thereby raising
the purchasing power of wealth held in money from. The price-induced rise in
the real value of cash balances would then stimulate spending directly until
full capacity utilization had been attained. As the wealth effect operates
independently of changes in interest rates, closure of the indirect channel
could not prevent the restoration of full employment. It follows that a rise
in the real balances and hence spending could be accomplished just as easily
via a monetary expansion, validating the potency of monetary policy even in
a depression.

This argument offered an escape from the Keynesian liquidity trap and a way
of thwarting the interest inelasticity of the investment-spending draught,
thus contradicting the Keynesian doctrine of underemployment equilibrium.
Friedman suggested that the Keynesian view of the monetary transmission
mechanism was seriously incomplete. In denying that the quantity theory was
a theory of income determination, Friedman freed it from the Keynesian
criticism that it assumes full employment. In their A Monetary History of
the United States, 1867-1960, Friedman and Anna Schwartz showed that a rapid
and large reduction in the money supply played the dominant causal role in
the Great Depression of the 1930s. Their observation led to criticism of the
Keynesian attribution of the Depression to a collapse of demand.

Monetarists argue that the quantity of money, rather than the level and
channels of interest rates, is the appropriate variable for the monetary
authority to regulate. Greenspan in essence applied this theory to prolong
economic expansion in the United States after 1997 and produced the biggest
bubble since the 1920s.

Monetarists regard monetary policy as having a powerful long-run impact on
nominal income as contrasted with fiscal policy. They regard income policy
as having a perverse long-term impact on economic activity. Despite lip
service paid to the notion of the direct effect of monetary changes on
commodity expenditure, modern monetarists acknowledge that the transmission
mechanism operates primarily through a complex portfolio or balance-sheet
adjustment process involving various interest-rate channels and affecting a
wide range of assets and expenditures, generating shifts in the composition
of asset portfolios, thereby inducing prices and yields of existing
financial and non-financial assets relative to prices of current services
and new assets, albeit that the portfolio approach is not of monetary
origin, having been first developed by Keynes and J R Hicks in the mid-1930s
and subsequently elaborated by James Tobin and others. These asset price and
yield changes, in turn, generate changes in the demands for service flows
and new asset stocks and hence in the prices and output of latter items.

The question of the appropriate range of assets and interest rates to be
considered in the analysis of the transmission mechanism is a key point in
the monetarist-Keynesian controversy over the spending impact of monetary
changes. Keynesian models tended to concentrate on a narrower range of
assets and interest rates, forcing the transmission process through a narrow
channel, thus choking off some of the spending impact of a monetary change.

Of course, in Keynes' days, the financial architecture was primarily a
two-asset world: cash and bonds, fundamentally different from today's
infinite range of financial assets in the brave new world of structured
finance. Modern monetarists generally favor flexible exchange rates without
exchange control, whereas the Currency School advocated fixed rates with
exchange control.