The Hindu Business Line : The Great Divide: Monetary vs fiscal purism

There are deep-seated differences of approach to economic problems between fiscalists, who see a major role for state, and monetarists, who swear by the role of money. In the context of the passing of Milton Friedman, T.C.A. RAMANUJAM examines the position on either side of the divide.

The recent actions of central banks the world over bring into focus once again, the great debate on the efficacy of monetary versus fiscal policy. The renewed emphasis on the former than on fiscal management stems from a desire to reduce the possibilities of specific government intervention by introducing a high degree of automatic regulation of those aspects of the social environment that determine the operation of the economy.

Protagonists of the monetary school of thought regard such automatism as superior to the wisdom likely to be shown by deliberate human action. Yet, the basis of the monetary school is to be found in the ancient quantity theory of money, a theorem which relates prices and money in the traditional equation MV = PT, that is, the amount of money in circulation multiplied by its velocity of circulation equals the general level of prices multiplied by the volume of trade.

Foundation of modern economics

Milton Friedman was the first and most famous disciple of the Chicago School of Economic Thought to be conferred the Noble Prize in Economics. Keynes and Samuelson alone could rival Friedman among the 20th century economists in their combined impact on secular and academic thought.

If Keynes is considered the most seminal economist of the 20th century, many regard Friedman as leading the anti-Keynesian counter-revolution. Keynes laid the foundations of the modern day macroeconomics, stressing the importance of aggregate demand in determining the level of economic activity.

In the 1920s, Keynes was both a leading orthodox economist and foremost critic of monetary and financial orthodoxy. He was a critic of the gold standard and its illusory automaticity and benevolence, as also of the idea that greater government spending ipso facto meant less private investment. He opposed deliberate deflationary policies and advocated public sector investment.

He was not preoccupied with inflation as the crucial problem. He directed attention to the factors governing the holding and the spending of money, rather than to the quantity of money alone. There has been both a left-right spectrum of interpretations of Keynes's General Theory. Many saw him as a conservative innovator seeking to strengthen the market economy; others saw in him a radical threat to the system.

At a time when the field was monopolised by Keynes and Keynesians, Friedman and his wife Rose came to lecture in a hostile intellectual climate, at odds with the reigning orthodoxy about both public policy and economic theory, about welfare state and socialist views in public policy, and Keynesiansism in economic theory.

Friedman explained the Depression as being induced by the Federal Reserve's actions in tightening the liquidity and not by the spontaneous changes in consumer and investment behaviour that Keynes analysed in order to seek governmental action. Many agreed with Friedman that Keynesian solutions would accelerate inflation.

The Wall Street Journal proclaims that Friedman provided the intellectual foundations for the anti-inflation, tax-cutting and anti-government policies of the US President, Ronald Reagan, and the British Prime Minister, Ms Margaret Thatcher, and an era of more-disciplined central banking. Inflation targeting is now accepted the world over as an important goal for monetary policy and even India's policy framers do not talk of deficit financing, so famously discussed and adopted at the time of the Mahalonobis Plan Frame in the 1950s.

Deficit financing for growth

V.K.R.V. Rao circulated a notable paper on deficit financing for growth, imbibing the spirit of Keynesian economics. Today, Friedman is best known for explaining the role of money supply in inflation fluctuations. The US Fed put the monetarist theory into practice in 1979, adopting money supply targets that drove interest rates to double-digit levels, sent the economy into a deep recession and ultimately brought inflation down drastically. The then Federal Reserve Governor admitted that Friedman's ideas held enormous sway in the field.

Friedman was all for the free market. Yet, his concept of negative income-tax laid the foundation for today's earned income-tax credit. Friedman's prescriptions called for maintaining a steady rate of money supply growth to produce low inflation. The ECB, which sets monetary policy for the nations that share the euro, has kept the monetarist faith throughout, maintaining a target for money growth since 1999, when the euro was launched.

The Bank of England cited strong money growth as the reason for raising interest rates in August. The renewed concern about money growth arises from the anxiety to prevent asset price bubbles, which can threaten stability. The Reserve Bank of India too is fighting inflation and periodically trying to reduce liquidity in the system by adjusting interest rates or cash reserves of banks.

There was a time when champions of the free market such as Friedman and Hayek were seen as cranks. That was at the height of the Keynesian revolution, which advocated an increasing role for the state through fiscal intervention and cheap money policies

In the Keynesian context, monetary policy was subordinated to the fiscal initiative of the state. The monetarist assailed the Keynesian position and asserted that it is wrong to assign too effective a role to fiscal policy. In the simplest terms, the debate can be summed up in the two slogans: "Money does not matter," said the fiscalists. "Inflation is a purely a monetary phenomenon," said the monetarists.

Friedman did not believe in "fine-tuning" the economy, not even through monetary policy. Keynes would go to the extent of advising pump-priming to give a boost to the economy even if that produces a little inflation. There are deep-seated differences of approach to the problems of economy as a whole between "interventionists' and `expansionists' on the one hand against `non-interventionists' and `deflationists' on the other. An echo of these differences can still be found in the differing perceptions between the Finance Ministry and the RBI about the specific policy guidelines to be provided.

Limiting inflation

Friedman was against big governments. He was a laissez faire economist. The monetary school had limited success insofar as central banks accepted the view that inflation should be limited by targeting the rate of growth of money supply.

But the other objectives of the monetary school such as limiting the role of government were not taken up at any serious level. Government spending as a share of GDP did not come down at any stage in the US. Friedman and the monetarists were against protectionist policies. America is known to be the most protectionist of all governments, at least with regard to the agricultural commodities, as one knows from the Doha round of trade talks.

The Economist recalls what the Friedman couple wrote in their Memoirs: "Judged by practice, we have been, despite some success, mostly on the losing side. Judged by ideas, we have been on the winning side".

(The author is a former Chief Commissioner of Income-Tax.)

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