For decades, the U.S. economy has been plagued by faltering growth, variations in the dollar's exchange rate, and swings in rates of unemployment and inflation. Monetary growth has also been erratic. Are these facts connected? One group of new classical economists, the monetarists, cite inconsistent growth of the money supply as the basic cause of all these problems.[1]

 

            Such external shocks as the Vietnam War, conflict in the Persian Gulf, and OPEC oil price hikes may also partially explain cyclical swings, but most monetarists view attempts at economic fine-tuning as doomed. Indeed, many observers lay the full blame for a deep recession in 1981--1983 and for a milder one during 1990-1992 at the Federal Reserve's doorstep.

 

            Uneven but growing inflation marked the 1970s. Inflation has not reached double-digit rates since 1980 and has lost its rank as "Public Enemy #1" in the minds of most people, but it continues at annual rates of 3 to 4 percent in the 1990s---rates that would have been intolerable in the 1950s and 1960s. Paul Volcker, chair of the FED during the late 1970s and early 1980s, viewed curbing the growth rate of the money supply as the key to halting inflation.

 

            In 1979, the FED announced that it would target M1 and control its rate of growth. Since then, monetary growth and GDP growth continue to be on a roller coaster---up for a few quarters, and then down for the next few. The FED announces targets, but then adjusts them when economic conditions seem to warrant different targets.[2]

 

            Figure 4 indicates that slowing growth of the money supply is a painful process. Economists have reached consensus that FED' "disinflation" strategies, adopted to squelch the "double-digit" inflation of the 1970s, triggered the downturn of 1981-1983.  No consensus exists, however, as to whether the benefits of slower inflation outweighed the losses of employment and output because of the recession. The drop in the rate of monetary growth during 1979--1980 was so abrupt that, although inflation decelerated, the economy went into a deep slump. Severe monetary restrictiveness was then temporarily abandoned to facilitate economic recovery. Between 1986 and 1994, however, the FED held monetary growth under a tight reign.

 

Figure 4  Rate of Change in M1 and GDP (Current Dollars, Quarterly Percentage Change)

In the early 1980s, the FED announced it would target and control the rate of growth of the money supply. Since then, both M2 and GDP have risen for a few quarters, then fallen the next few. Targeting the money supply has proven challenging for the FED, but as this figure shows, changes in M2 and GDP are relatively closely correlated.

The Recession of 1990-1992

            Discerning a pattern in the FED's policies during the early 1990s requires more detective work.  Most economists view low interest rates as critical for balanced investment and economic growth. The FED lowered its discount rate 25 times during 1989-1993.  Federal deficits during the early 1990s were at record levels, so expanding the monetary base should have been easy:  The FED could simply absorb (monetize) substantial chunks of new federal debt by buying Treasury bonds.  Then, readily available bank reserves would swell the money supply---after bankers made loans to investors. But this predicted chain of events failed to unfold.

 

            The FED regularly announces targets for monetary growth in the moderate range (2-6 percent), with precise targets depending on economic conditions.  However, Figure 4 indicates that while unemployment rates hovered between 6 and 8 percent during the Recession of 1990-1992, the money supply (M2) fell below the FED's targeted growth rates.

 

            This slow growth represented a sharp departure from most economic recoveries since World War II, when the real (inflation-adjusted) money supply grew at an average annual rate of 7 percent.[3]  Among possible explanations for sluggish monetary growth:

1.         The FED bought too few Treasury bonds through its open market operations, so the monetary base expanded too slowly.

2.         Despite increased availability of bank reserves, banks, fearing widespread defaults, were reluctant to lend, and pessimistic investors were reluctant to borrow during this recession.

3.         Foreign financial investors responded to lower U.S. interest rates by transferring their funds to countries where interest rates were higher, reducing the funds available for lending by U.S. financial intermediaries.

            More refined information and better detective work is needed before we can identify which factors best account for slow monetary growth in the midst of recession.  One thing, however, is certain.  Irate voters tend to adopt "throw-the-rascals-out" attitudes when the economy is in the doldrums. In 1992, more incumbent senators and members of congress retired or were defeated than in any other election in the preceding four decades, and Bill Clinton replaced George Bush in the White House.

 

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