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Monetarism Defiant

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Monetarism Defiant

Legendary economist Anna Schwartz says the feds have misjudged the financial crisis. Spring 2009
Economy, finance, and budgets
Schwartz at her Fifth Avenue office.
Photograph by William Meyers
Schwartz at her Fifth Avenue office

Anna Schwartz must be the oldest active revolutionary on earth. Born in 1915 in New York, she can still be found nearly every day at her office in the National Bureau of Economic Research on Fifth Avenue, where she has been tirelessly gathering data since 1941. And as her experience proves, data can transform the world. During the 1960s, with Milton Friedman, she wrote A Monetary History of the United States, a book that forever changed our knowledge of economics and the way that governments operate. Schwartz put ten years of detective work into the project, which helped found the monetarist theory of economics. “Not only by gathering new data but by coming up with new ways to measure information, we were able to demonstrate the link between the quantity of money generated by the banks, inflation, and the business cycle,” she explains.

Before the monetarist revolution, most economists believed that the quantity of money circulating in the economy had no influence on prices or on growth. History showed otherwise, Friedman and Schwartz argued. Every time the Federal Reserve (and the central banks before it) created an excess of money, either by keeping interest rates too low or by injecting liquidity into banks, prices inflated. At first, the easy money might seem to boost consumers’ purchasing power. But the increase would be only apparent, since sellers tended to raise the prices of their goods to absorb the extra funds. Investors would then start speculating on short-term bets—whether tulips in the seventeenth century or subprime mortgages more recently—seeking to beat the expected inflation. Eventually, such “manias,” as Schwartz calls them, would begin replacing long-term investment, thus destroying entrepreneurship and harming economic growth.

By contrast, by removing excess liquidity, the central bank can cause the sudden collapse of speculative excess, and it can also hurt healthy recovery or growth by constricting the money supply. There is now a near-consensus among economists that lack of liquidity caused the Great Depression. During the severe downturn of 1930, the Fed did nothing as a first group of banks failed. Other depositors became alarmed that they would lose their money if their banks failed, too, leading to further bank runs, propelling a frightening downward economic spiral.

To encourage steady growth while avoiding the pitfalls of inflation, speculation, and recession, the monetarists recommend establishing predictability in the value of currency—steadily expanding or contracting the money supply to answer the needs of the economy. “At first, central bankers and governments did not accept our theory,” recalls Schwartz. Margaret Thatcher was the first to understand that the monetarists were right, following their rules when she came to power in 1979, taming inflation and reinvigorating the British economy. The U.S. followed during the early 1980s, led by Paul Volcker, a Friedmanite then at the head of the Federal Reserve, who, with Ronald Reagan’s strong support, ended raging inflation, though not without a lot of short-term pain. “It was a strenuous experience,” Schwartz remembers. As Volcker tightened the money supply, making credit harder to come by, unemployment spiked to about 10 percent; many firms failed. But starting in 1983, the inflation beast defeated, a new era of vigorous growth got under way, based on innovation and long-term investment.

This lesson of the recent past seems all but forgotten, Schwartz says. Instead of staying the monetarist course, Volcker’s successor as Fed chairman, Alan Greenspan, too often preferred to manage the economy—a fatal conceit, a monetarist would say. Greenspan wanted to avoid recessions at all costs. By keeping interest rates at historic lows, however, his easy money fueled manias: first the Internet bubble and then the now-burst mortgage bubble. “A too-easy monetary policy induces people to acquire whatever is the object of desire in a mania period,” Schwartz notes.

Greenspan’s successor, Ben Bernanke, has followed the same path in confronting the current economic crisis, Schwartz charges. Instead of the steady course that the monetarists recommend, the Fed and the Treasury “try to break news on a daily basis and they look for immediate gratification,” she says. “Bernanke is looking for sensations, with new developments every day.”

Yet isn’t Bernanke a disciple of Friedman and Schwartz? He publicly refers to them as mentors, and, thanks to their scientific breakthrough, he has famously declared that “the Great Depression will not happen again.” Bernanke is right about the past, Schwartz says, “but he is fighting the wrong war today; the present crisis has nothing to do with a lack of liquidity.” President Obama’s stimulus is similarly irrelevant, she believes, since the crisis also has nothing to do with a lack of demand or investment. The credit crunch, which is the recession’s actual cause, comes only from a lack of trust, argues Schwartz. Lenders aren’t lending because they don’t know who is solvent, and they can’t know who is solvent because portfolios remain full of mortgage-backed securities and other toxic assets.

To rekindle the credit market, the banks must get rid of those toxic assets. That’s why Schwartz supported, in principle, the Bush administration’s first proposal for responding to the crisis—to buy bad assets from banks—though not, she emphasizes, while pricing those assets so generously as to prop up failed institutions. The administration abandoned its plan when it appeared too complicated to price the assets. Bernanke and then–Treasury secretary Henry Paulson subsequently shifted to recapitalizing the banks directly. “Doing so is shifting from trying to save the banking system to trying to save bankers, which is not the same thing,” Schwartz says. “Ultimately, though, firms that made wrong decisions should fail. The market works better when wrong decisions are punished and good decisions make you rich.” She’s more sympathetic to Treasury secretary Timothy Geithner’s plan, unveiled in March, to give private investors money to help them buy the toxic assets, but wonders if the Obama administration will continue to support the plan if the assets’ prices turn out to be so low, once investors start bidding for them, that they threaten the banks.

What about “systemic risk”—much heard about these days to justify the government’s massive intervention in the economy in recent months? Schwartz considers this an excuse for bankers to save their skins after making so many bad decisions. “The worst thing for a government to do, though, is to act without principles, to make ad hoc decisions, to do something one day and another thing tomorrow,” she says. The market will respond positively only after the government begins to follow a steady, predictable course. To prove her point, Schwartz points out that nothing the government has done to date has really thawed credit.

Schwartz indicts Bernanke for fighting the wrong war. Could one turn the same accusation against her? Should we worry about inflation when some believe deflation to be the real enemy? “The risk of deflation is very much exaggerated,” she answers. Inflation seems to her “unavoidable”: the Federal Reserve is creating money with little restraint, while Treasury expenditures remain far in excess of revenue. The inflation spigot is thus wide open. To beat the coming inflation, a “new Paul Volcker will be needed at the head of the Federal Reserve.”

Who listens to her these days? “I’m not a media person,” she tells me. She rarely grants interviews, which distract her from her current research: a survey of government intervention in setting foreign exchange rates between 1962 and 1985. Never before have these data been combined to show what works and what doesn’t. In her nineties, she remains a trendsetter.

Research for this article was supported by the Brunie Fund for New York Journalism.

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