Central Banks Are Yet To Escape The Shadow Of Milton Friedman

Context: The narrowing of the gap between the monetary policy and the fiscal policy in time of crisis like the current pandemic has twisted the language of current idea of macroeconomic policy.

Background:

• Since March 2020, the Bank of England (BoE) bought £450 billion of UK government debt.
  • While this was virtually all of the new debt issued by the government since start of covid, the BOE’s purchase looked like a thinly veiled attempt to use Quantitative Easing (QE) to finance government deficit.

Analysing the changing role of monetary and fiscal policy:

• Before 1980s: Central banks were owned by governments and regarded as operational arms of national treasuries. Thus, there was no existence of independent monetary policy.
  • But in the 1980s, excessive government borrowings became the main cause of inflation.
• In the 1990s: There was a shift of macroeconomic control from the governments to central banks.
  • Thus, if the government and the private sector would spend more, the central banks would raise the policy rates to curb the spending.
  • While until 2008-09, this regime was praised for keeping the prices stable, it ignored other reasons that kept the prices low, such as competition from low-cost Chinese manufacturers.
• In 2008-9: The Great Recession led to the reversal of roles – monetary policy now became expansionary, while the fiscal policy became contractionary.
  • With interest-rate kept too low, central banks resorted to ‘unconventional monetary measures’—in effect, printing money—to generate recovery.
  • At the same time, governments cut back their spending to fight recession on the grounds that it was inflationary. But, this led to the weakest recoveries in history.
• In the wake of pandemic: Both monetary and fiscal policies became expansionary, and the gap between the functions of both has thus vanished.

Implications of coherence between the functions of monetary and fiscal policy

• Loss of central banks’ independence: Monetary policies are thus considered as impotent to stabilise economies. This destroys the foundations of current theory of macroeconomic policy.
  • According to Milton Freidman’s quantity theory of money, market economies are naturally stable at full employment, provided policymakers keep price levels stable. Thus, quantity of money determines the state of economy.
  • So, independent central banks should be given control of money issuance, and governments should balance their budgets, thereby reducing macroeconomic policy to managing the price level.
• Increased predictability of money spent: Contrary to the quantity money theory of Freidman, Keynes called for “speculative demand of money”. This has a different implication –
  • When the trade is slack, trader accumulates money because the prospects of profits are reduced, and when the trade is active, they hasten to sell their resources.
  • This means that the state of the economy determines the quantity of money in circulation and not vice versa.
  • Thus, a central bank’s ability to control the level of prices and of economic activity through purely monetary operations is very limited.
  • For money to affect the economy in a predictable way, it must be spent in a predictable way. And that can happen only if the spender is the government.

Conclusion:

• The effectiveness of monetary policy thus depends on the central bank being the agent of the Treasury (read government).