Monetarism vs. Mercantilism

by: Howard Richman

In a June 22 Seeking Alpha commentary (The Fed, the Yuan and the Failure of Diplomacy), Peter Morici accurately discussed US economic history, pointing out the ineffectiveness of the Federal Reserve in recent years:

Fed policy is much less relevant to US growth and price stability than in the days of Fed chairman Paul Volcker (1979-1987), because China's yuan policy has substantially limited the importance of Fed interest rate decisions by severing the historic link between short interest rates - like the federal funds rate it targets - and long rates on mortgages, corporate bonds, and the securities banks use to finance lending on cars and credit cards.

He is thinking through the problem in the same way that we have been. As usual, he is way ahead of most of the economic profession, which is still living in a dreamworld in which unilateral free trade is a good policy.

But my father, son and I are actually still a bit ahead of Morici here. We are advocates of the economic philosophy called "monetarism." The founder of monetarism, Milton Friedman, was my father's dissertation advisor at the University of Chicago.

Back on December 4, 2008 (Keynesian borrowing won't solve our economic problems), we enunciated the general principles that should guide economic policy. We wrote:

The central idea of monetarism is that governments are too short-term in their thinking unless they are bound by sensible long-term rules. Monetarists have always advocated the first two rules below. We would add the third:

  1. Balanced Monetary Growth. Governments should maintain a steadily growing money supply, sufficient to prevent deflation, but not so fast as to cause inflation.
  2. Balanced Budgets. Governments should maintain relatively balanced budgets so as not crowd-out private investment or leave a huge government debt to future generations.
  3. Balanced Trade. Governments should insure that foreign trade is relatively balanced so as not to lose production jobs or leave a huge national debt to future generations.

Monetarism, even without the balanced trade rule, has been a successful economic philosophy. The Federal Reserve applied the balanced monetary growth rule during the 1980s and 1990s, keeping the US economy relatively free from inflation. Similarly, President Clinton and the Republican Congress applied the balanced budget rule in the mid 1990s, producing a long period of steady economic growth.

The new balanced trade rule is necessary in order to respond to modern mercantilism, the economic policy that maximizes exports and minimizes imports in order to gain market share from trading partners.

Disclosure: Author long Chinese yuan through CYB