It's the same with economic theories. In fact, it's even worse. While most people realise they have little or no idea about relativity, everyone thinks they understand economics and finance. Welcome to vulgar keynesianism and vulgar monetarism. I'm going to pay attention to the latter now.
Vulgar monetarism bears only a vague resemblance to the great intellectual works of Milton Friedman and others who reached his level of knowledge. It can be summarised in just five points:
1. Inflation means economic growth, while deflation brings about recessions or even depressions.
2. Inflation is not exactly good, but is at least preferable to deflation.
3. It's not possible to fine-tune the economy using tax rates as they are too crude a tool; interest rates are better.
4. When inflation goes too high, it can easily be tamed by hiking interest rates.
5. When the danger of deflation arises, it usually helps to pump money into the economy by using all available channels, including currency interventions and buying bonds.
Ninety per cent of central bankers would undoubtedly agree with these five points, as would most scholars and politicians. Yet vulgar monetarism as summarised above is quintessentially wrong and can lead to disastrous policy errors.
VULGAR MONETARISM IN ACTION—pay attention to the European credit bubble that peaked in 2008-2009 and caused the financial crisis:
Ad 1. Inflation can indeed be associated with economic growth: a strong economy can suffer from inflationary pressures caused by credit growth and an increase in the money supply. Inflation is the consequence, not the cause of economic growth. Likewise, price deflation can be caused by a credit bust which happens during a banking crisis. Vulgar monetarism therefore mistakes the consequence for the cause.
Conclusion: Inflation does not create economic growth—it's the other way round (and then only under certain special circumstances when the money supply grows faster than productivity).
Ad 2. Price inflation is the consequence of rapid growth in the money supply (monetary inflation) with no corresponding growth in production.
From the point of view of households, inflation is just another form of taxation as it erodes the value of savings and bonds. High inflation is more harmful than low inflation.
What about deflation? If the price of food, clothing, shoes, furniture, cars and consumer electronics keeps falling due to growth in productivity, this can cause deflationary pressures. If it’s accompanied by falling energy prices and lower telecommunication charges, it may very well lead to general price deflation.
Is this harmful, though? Of course not. The purchasing power of households rises, and so does consumption. Everyone is happy except for the vulgar monetarists. Their dogma is that there is only one kind of deflation and that it is always bad.
Conclusion: Inflation is bad, but deflation may be good or bad, depending on what kind of deflation it is.
Ad 3. It's certainly true that tax rates are an inadequate tool for smoothing out the ups and downs in the economic cycle. Fiddling with tax rates almost always does more harm than good.
Interest rate policies pursued by politically independent central banks should, in theory, be better. In fact, experience has been at best mixed. There were discussions once about the so-called Great Moderation of the business cycle, which was supposedly a major feat achieved by skillful monetary policy makers. The discussions ended abruptly in September 2008, and Allan Greenspan is no longer called “Maestro”.
Conclusion: It isn’t possible to fine-tune the economy. Full stop.
Ad 4. This point is true: high inflation can be quickly and effectively cooled down by hiking interest rates. It should be added, however, that high inflation is always the consequence of policy failure. Monetary policy can only cure the symptoms, which are caused by monetary policy. Great.
Conclusion: High inflation is always caused by bad policies.
Ad 5. Interest rates are to vulgar monetarists what the accelerator is to someone driving a car. When the pedal is flat on the floor—interest rates at zero percent—and inflation is still low, extra help is needed. Central bankers trained in vulgar monetarism at universities go nuts when they see price deflation. This is why they come up with innovative ways to inflate prices artificially, even when the deflation is of the benign kind.
Vulgar monetarists also believe that pumping money into the economy will boost both prices and production. However, the positive impact of injections of money on production is rather dubious, while the negative impact of price inflation on real household income is pretty much certain and straightforward. The supposed accelerator may, in fact, work as a brake instead.
Conclusion: If zero interest rates don't help, then it's pointless to pump in money: the problem is structural and can't be solved by any kind of monetary policy tool.
So what’s the final conclusion? Monetarism, when properly understood, is a useful tool for explaining the relationships between money supply, inflation and economic growth. However, it provides no magic wand that will enable policymakers to steer the economy clear of recessions. The vulgar and misunderstood version of monetarism can itself become a source of numerous extremely unhealthy policies.