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Economic Policy

Some economists, perhaps most, would argue that the fundamental difference

between monetarists and Keynesians is not so much their respective views on

the influence of the money supply but their differing views on the equilibrating

powers of the market mechanism. Whereas monetarists have faith in the

equilibrating tendencies of market forces, Keynesians argue that there is

substantial market failure requiring some sort of activist intervention at the

macro level. Would you agree with this view?

I do not agree with this view. There are monetarists of all kinds, some who

stress market failure and some who do not. All economists – monetarists,

Keynesians, or what-not – recognize that there is such a thing as market

failure. I believe that what really distinguishes economists is not whether

they recognize market failure, but how much importance they attach to government

failure, especially when government seeks to remedy what are said

to be market failures. That difference in turn is related to the time perspective

that economists bring to various issues. Speaking for myself, I do not believe

that I have more faith in the equilibrating tendencies of market forces than

most Keynesians, but I have far less faith than most economists, whether

Keynesians or monetarists, in the ability of government to offset market

failure without making matters worse.

You have argued [American Economic Review, 1968a] that most disagreements

appear not to be concerned with the major goals of economic policy but

rather are over the choice of appropriate instruments to achieve the goals. In

the light of your work on the consumption function and monetary economics in

general, what role do you see for fiscal policy in a macroeconomic context?

None. I believe that fiscal policy will contribute most if it doesn’t try to offset

short-term movements in the economy. I’m expressing a minority view here

but it’s my belief that fiscal policy is not an effective instrument for controlling

short-term movements in the economy. One of the things I have tried to

do over the years is to find cases where fiscal policy is going in one direction

and monetary policy is going in the opposite. In every case the actual course

of events follows monetary policy. I have never found a case in which fiscal

policy dominated monetary policy and I suggest to you as a test to find a

counter-example. There are two possible explanations for that. One which I

believe to be true is that the Keynesian view that a government deficit is

stimulating is simply wrong. A deficit is not stimulating because it has to be

financed, and the negative effects of financing it counterbalance the positive

effects, if there are any, on spending. But that may not be the reason because

there is the other reason: it is much harder to adjust fiscal policy in a sensitive

short-term way than it is to adjust monetary policy. So I don’t believe that

there is any role for fiscal policy in the short term. There is an enormous role

for fiscal policy in terms of the long-term allocation of resources among

different uses and that is where the argument needs to be.

Are you saying that even in the case of the 1930s you would not have

advocated expansionary fiscal policy?

It wasn’t fiscal policy, it was monetary policy that dominated. There was

nothing you could do with fiscal policy that was going to offset a decline of a

third in the quantity of money. Let me show you a current example. Take

Japan right now. They are wasting their time and money in trying to have an

expansive fiscal policy without an expansive monetary policy. I’m exaggerating

a little about Japan because in the last year or so, mostly since the

appointment of the new Head of the Bank of Japan, they have been starting to

follow an expansive monetary policy. I believe that Japan is going to show a

considerable degree of improvement and that they will start to come back up.

It’s a very interesting phenomenon because the behaviour of the Japanese

central bank in the past five years duplicates the behaviour of the Federal

Reserve after 1929.

Persistent high unemployment has been a feature of European economies

since the early 1980s. A variety of explanations has been put forward including

hysteresis theories. How do you explain such persistent unemployment?

I believe it is a consequence of the extensive welfare state and rigidities in the

system. I have just read a very interesting working paper of the Federal

Reserve Bank of Chicago co-written by Lars Ljungqvist and Tom Sargent

[1998]. I agree with their conclusion. They start out by saying one obvious

explanation is the welfare state arrangements and the change in the incentives

that people have. But then an obvious answer to that is why didn’t that have

the same effect on unemployment earlier. Their explanation is that the earlier

period was a more nearly stationary period in which it was not necessary to

make rapid and extensive dynamic adjustments to the changes in circumstances.

But in the last ten or twenty years, what with the technological

revolution and the political revolution, it has been necessary to make major

changes and the European system is rigid. It’s OK if everything goes along

smoothly but it’s not very good at adapting to major dynamic change. It

seems to me that that makes a great deal of sense. You might ask the question

why is it that the USA hasn’t had the same experience. I’m not sure that my

answer now will be valid in the future because we have been going in the

same direction although we haven’t gone nearly as far. We have a much more

flexible wage system. It’s much easier to fire people although it is getting

harder and harder to hire people. There are more and more disincentives to

employers to hire people because of affirmative action and all the rules and

regulations involved. But still we are better off than the European economies.

In another highly influential paper published in 1953[b], only nine years

after the establishment of the Bretton Woods fixed exchange rates system, you

presented the case for flexible exchange rates. In the light of experience since

the breakdown of the system in the early 1970s, how do you respond to the

issue of variability or instability, which critics of flexible exchange rates have


The variability has been much larger than I would have expected. I don’t have

any doubt about that, but there are two propositions. Number one, the reason

for the high variability is the highly variable forces that have been playing

upon the international market which derive in my opinion from the fact that

beginning in 1971 the world had a monetary system that had no predecessor,

no precedent whatsoever. For the first time in the history of the world no

current major currency, or minor currency for that matter, in the world was

linked to a commodity, however indirectly. To begin with, everybody was

sailing on an uncharted sea and on that uncharted sea some went one way and

some went another. So you had a much wider variability in the rates of

inflation in different countries than you were accustomed to and that led to a

greater variability in exchange rates. The second proposition is that the variability

in exchange rates was a good thing. If you had tried to maintain fixed

exchange rates under those conditions it would have required major interferences

in the freedom of trade among various countries. So that while the

variability of exchange rates was much greater than I would have anticipated,

I believe it was a necessary reaction, maybe overreaction, to what was going

on and that if you look at the experience over that time it did not have any

serious negative effects. I don’t doubt that any exchange rate adjustment is

going to be overdone. If you need a large change it’s going to be too large and

then it’s going to come back again because of the influence of (a) expectations

and (b) speculation. But I don’t believe you have any examples of

destabilizing speculation. The speculators have on the whole performed a

positive function. The European Exchange Rate Mechanism was fundamentally

unstable and in so far as the speculators broke it in September 1992,

earlier than otherwise, it was a desirable thing. Britain made a great mistake

by linking its currency to the Exchange Rate Mechanism; it should never

have done that and it paid dearly for doing so.

What are your views on the desirability of forming a single currency in


There are two different questions, the desirability and the possibility. I believe

that it is an impossible thing to do and this is something that I have been

saying over and over again everywhere. It seems to me that you must distinguish

between a unified currency and currencies linked by a fixed exchange

rate. You can only have a unified currency if you have only one central bank,

one locus of authority. I cannot believe that you are going to be willing to

close down the Bank of England, that France is going to be willing to close

down the Bank of France and so on. So it seems to me political unification

has to come first. How many times do we have to see the same phenomenon

repeat itself? After the war there was the Bretton Woods system and it broke

down, in the 1970s the ‘Snake’ broke down and so on. How many times do

you have to repeat an experience before you realize that there must be some

real problem in having fixed exchange rates among countries that are independent?

The period of the nineteenth century, which is always pointed to,

can be distinguished from the current period in a very simple way. Government

spending of the major countries in the pre-1913 period was around 10

per cent of the national income. A system that could operate when governments

were spending 10 per cent of the national income cannot operate when

governments are spending 50 per cent of the national income. There is a

sense in which a single currency is desirable, but what does it mean to say

something unachievable is desirable?

It is interesting that you say political unification is needed before economic

union, as many critics in Britain suspect that monetary union is being used as

a way of moving towards political union.

I don’t doubt that. I don’t doubt that the Germans and the French are trying to

do that, but I don’t believe that they will succeed.

Macroeconomics is not a laboratory science; we learn from events. What did

we learn from the so-called ‘monetarist experiments’ in the USA and UK at

the start of the 1980s?

You have got to distinguish between two different things. The so-called

monetarist experiment was in 1979 when Volcker [Fed Chairman] announced

that he was going to take the quantity of money and not the interest rate as his

guide. But he didn’t do it! If you look at the monetary aggregates, they were

more variable during the Volcker period than at any previous time in history.

So he did not follow a monetarist course. On the other hand if you eliminate

the perturbations and you look at the general direction over the period from

1980 to 1995 in every country in the world aggregate, monetary growth has

come way down and with it has come inflation. So I think that the experiment

in all of the countries of the world has been enormously confirmatory of the

proposition that inflation is a monetary phenomenon.