Tim Congdon laments the fact that academic monetary theory has become so technical, abstruse and remote from day-to-day practicality, that busy decision-takers in banking may start ignoring it.

Why did peace break out? Why, more precisely, did the debates among macroeconomists – particularly the debate between Keynesianism and monetarism – abate in the mid-1990s after 20 years of squabbling and confusion?

If economists in central banks had to limit their answer to these questions to two words, there is not much doubt what those two words would be – ‘inflation targets’. Of course a proper description of the now standard system of monetary policy-making needs to be quite a bit longer, but these two words would be the favourite catchphrase.

Under an inflation-targeting regime, policy is not distracted by intermediate targets such as the exchange rate or money supply growth, and instead focuses on keeping the growth of demand consistent with the level of output associated with low and stable inflation. That level is accompanied by approximate balance between supply and demand in the labour market or, in the phrase made famous by Milton Friedman in his 1967 presidential address to the American Economic Association, by unemployment at its “natural rate”.

Mr Friedman’s ideas have been amplified in a theoretical schema which in 1993 Gavyn Davies (then the chief economist at Goldman Sachs in London) labelled “output gapology”. The output gap is the difference between the actual level of output and the level of output when unemployment is at the natural rate, also known as “trend output”.

If actual output is at its trend level (if, in other words, the output gap is zero), inflation ought to be stable. When inflation is on target and the output gap is zero, and when forecasts are that this blissful state of affairs will continue, the central bank should leave interest rates roughly where they are. When inflation is above target and the output gap is positive, interest rates should be increased. On the other hand, when inflation is beneath target and the output gap is negative, interest rates should be reduced.

In short, the combination of inflation targeting and output gapology provides central banks with a straightforward agenda. Experience has shown that variations in interest rates are sufficiently powerful to steer demand. The deliberate use of fiscal policy, as advocated by the UK’s Keynesians in the 1950s and 1960s, is an unnecessary and ineffective complication. Central banks, not finance ministries, have therefore been made responsible for keeping inflation on target, often by being granted independence in interest rate decisions.

Rumbling disagreement

Inflation targets have now been introduced in many countries and the accompanying policy-making framework has been remarkably successful. The apparent triumph of inflation targeting – conducted by independent central banks and supported by in-depth research on output gaps – has made much of the Keynesian-monetarist debate obsolete. However, economists have not stopped disagreeing with each other. The rest of this article will contend that the apparent ending of the Keynesian-monetarist debate does not mean that monetary theorising is approaching a harmonious ‘steady state’.

In the universities, the system of macroeconomic control associated with inflation targets has come to be known as ‘New Keynesianism’. The explanation for this terminology is to be sought in journal articles and academic seminars remote from the original debates over Keynesianism and monetarism, and is in fact very odd. While policy-makers around the world grappled in the 1980s with such down-to-earth matters as monetary base control and the cyclical behaviour of budget deficits, a number of (almost exclusively) American economists extended the monetarist critique of the effectiveness of fiscal policy. Professor Eugene Fama, who like Mr Friedman taught at the University of Chicago, was probably the key figure in the new thinking.

The monetarist assault on fiscal fine-tuning was developed into a wider claim that, if rational agents expected a macroeconomic policy change, they would be able to anticipate its impact and so render it ineffective. So in a world of rational expectations, the case for policy activism of any kind disintegrated. One of the accompanying arguments was that the two sides of a balance sheet cancel out, so that the behaviour of organisations with balance sheets could not affect anything important in the economy. The paradoxical effect of this argument – set out by Mr Fama in a celebrated 1980 article ‘Banking in a Theory of Finance’ – was twofold.

First, the theorists of rational expectations demolished – or at any rate thought they had demolished – traditional monetary economics. Today most money takes the form of bank deposits, but deposits are of course a liability of the banking system and liabilities exactly match assets. It seemed to follow from the Fama argument that – since deposit liabilities and loan assets are equal and offsetting – rises and falls in the level of bank deposits could not alter wealth or spending. By extension, fluctuations in the growth rate of broadly defined money were irrelevant to the business cycle.

Second, in their conduct of policy, central banks could more or less ignore developments in the commercial banking system. Indeed, the logical conclusion was that commercial banks were no more significant for macroeconomic policy than companies in any industry, and should not be accorded any special attention in central bank commentary and data collection.

The exponents of this rather nihilist type of thinking became known as the New Classical School. For many people, New Classical Economics went too far. A counter-argument developed, again among (almost exclusively) American economists, that the wide range of price and wage rigidities found in the real world preserved the macroeconomic potency of monetary policy. They married their emphasis on the labour market with the notion of basing interest rates on the output gap to engender ‘New Keynesian macroeconomic policy’.

Ignoring banks

The adoption of the ‘Keynesian’ label is largely to be sought in these twin emphases on the labour market and interest-rate setting, and in the oppositional stance to aspects of the rational expectations thinking associated with the University of Chicago. Nevertheless, the New Keynesians agreed with the New Classical school’s dismissal of traditional monetary economics. They shared, and continue to share, an important attitude with the devotees of the New Classicism. This was an aversion to any kind of macroeconomic theorising in which the behaviour of commercial banks, and the broadly defined money aggregates dominated by bank deposits, mattered to demand and output.

Further, the New Keynesians agreed with the New Classical economists that interest rate decisions should not be geared to the meeting of money supply targets. Although New Keynesianism relies on Friedman’s analysis of the natural rate of unemployment, it is certainly Keynesian in its hostility to money. Economists in the two schools criticised the Bundesbank for following broad money targets in the 1990s and they now criticise the European Central Bank for pursuing the same approach.

The prominence of the New Keynesian and the New Classical schools in American academic life has undoubtedly been one reason for the downgrading of the money supply in Federal Reserve research work.

For long-run participants in the Keynesian-monetarist debates, and indeed for people interested in these debates for their wider message about politics and society, the rotation of labels may be bewildering. The subject would be hard enough if economists used words with accuracy, brevity and consistency.

At any rate, for people in real-world finance and banking who want to stay on top of ‘the latest thinking’ in the universities, the conclusion is clear. In the opening decade of the 21st century, the two leading schools of academic macroeconomic thought deny that the quantity of money and the banking system should be accorded much attention in the making of monetary policy.

Practicing bankers and central bankers may be staggered by this proposition. But that is the view expressed – quite explicitly – by professor Michael Woodford of Princeton University in a recent paper from the New York-based National Bureau of Economic Research. In his words: “It is certainly possible to design a policy framework that will ensure the desired average inflation rate, over a sufficiently long period of time, without any reference to monetary aggregates.”

Indeed, in 2003 Mr Woodford published a book on interest and prices which was advertised as about the “foundations of a theory of monetary policy” and yet which omitted any discussion of the banking system. The book was highly praised in academic journals, but there were no references to such down-to-earth but vital subjects as the link between corporate liquidity and investment expenditure, banks’ capital adequacy and the effect of capital on bank behaviour, and the significance of clearing mechanisms in retail banking.

Managing expectations

For Mr Woodford and other New Keynesians, monetary policy is reduced to the setting of an interest rate by the central bank, and the analysis of so-called ‘monetary policy’ is limited to the dynamics of the labour market and the evolution of inflation expectations. Indeed, they believe that the crux of inflation control is the management of expectations. Stated most baldly, their view is that, if expectations are that inflation will stay at 2% a year, inflation will stay at 2% a year. Stable and low inflation expectations will deliver stable and low inflation, regardless of the rate of money growth.

An extreme, but justified interpretation of Mr Fama’s New Classical position was that macroeconomic outcomes – including the inflation rate – would not be in the least affected by the rate of growth of commercial bank balance sheets. This was the position adopted by professor Patrick Minford of Liverpool University during the UK’s Lawson boom of the late 1980s, when the then UK chancellor of the exchequer, Nigel Lawson, denied that broad money growth of almost 20% a year would lead to more inflation. (Mr Fama did think that the growth rate of central bank money mattered, but did no-one tell him that more than 99% of payments in the modern world are made by banks and not in cash?)

Even today, Mr Minford seems not to have learned his lesson from the catastrophic boom-bust cycle that developed because of the drastic fluctuations in the growth rates of bank balance sheets that occurred in the UK between the mid-1980s and early 1990s. In a recent paper he has commended the neglect of money (in the sense of deposits) and banking in both New Keynesianism and the New Classical school.

In the real world...

One might ask: ‘What would New Classical theory and the New Keynesians have to say about the American subprime crisis and the UK’s Northern Rock affair? What do their approaches have to contribute?’ The short answer is that neither school could say anything worthwhile to policy-makers. The New Classical position is that – if we think in terms of value added, employment and so on – banking has no more relevance to macroeconomic analysis than the car industry, pharmaceutical research or whatever. So why should it matter to the UK economy in late 2007 and 2008 than an organisation with a capital of little more than 0.1% of gross domestic product may go bust?

As for the New Keynesians, they might waffle about ‘frictions’, ‘implicit contracts’, ‘information asymmetries’ and various other seminar abstractions, but they also would inject nothing useful and relevant to decision-taking. If Mr Woodford recommends that central banks restrict themselves to analysing labour markets and inflation expectations, then central banks should restrict themselves to analysing labour markets and inflation expectations, full stop.

Would it be fair to warn that central bank governors and senior executives might be infuriated by the heads of their research departments if – when confronted by the subprime crisis or the Northern Rock affair – these departments consist entirely of labour market experts and specialists in inflation modelling?

The Keynesian-monetarist debates of the 1970s and 1980s may now be dormant or even extinct. But the economists involved in those debates believed them to be relevant to real-world policy-making. It is possible that the two leading schools of thought in academic monetary theory today think that their analyses are also relevant to the real world. The argument here has been that, on the contrary, academic monetary theory has become so technical and abstruse, and so remote from day-to-day practicality, that busy decision-takers in banking can safely ignore it. This is a shame. Keynes once warned that a remorseless logician, starting from error, could end up in bedlam. He was right.

Professor Tim Congdon is an economist and businessman. This article is based on the introduction to his latest book, Keynes, the Keynesians and Monetarism.

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