This separates Friedman from the more intense libertarians. If you probe a libertarian thinker far enough, you will find things that he thinks the state should do. But this, in particular, was a fault line between Friedman and other libertarians; he really saw a role for the Federal Reserve as a planner.
It doesn’t seem like it at first glance, but the idea that the whole level of economic activity and things like inflation and output should be determined by the Federal Reserve setting the money supply the right way is a light version of economic planning. This would put Friedman in conflict with some more libertarian economists.
In his analysis of the Great Depression, Friedman believes that the Depression was caused by the Federal Reserve not expanding the money supply enough. He’s honest enough to admit that it goes both ways, and in some cases you should have monetary expansion, which is really kind of a stimulus. Friedman, for all his libertarian activism, is also someone who accepts a big role for government and a big role in controlling the money supply.
Monetarism provides Volcker with his stated justification for the Volcker Shock. Volcker was appointed in August 1979, but the Volcker shock began in October 1979, and it began with Volcker’s announcement following a meeting of the Fed’s Open Market Committee that he would target growth money supply, rather than targeting interest rates.
Before, you could imagine the Federal Reserve making a policy saying, “Interest rates are at 5%, but there’s too much inflation, so we’re going to try to get them up to 7%. It would be a way to tighten monetary policy – focusing on interest rates as an instrument of that policy.
Volcker announced that he would no longer target the interest rate. They would target money supply growth. “This quarter the money supply has increased by 20%, but there is inflation, so we will make sure that it does not increase by more than 10% in the next quarter.” It is another type of monetary tightening, focusing on money supply growth as a policy tool.
This is essentially what a monetarist, like Friedman, would prescribe. In his stated justification, Volcker embraces monetarism; this is a huge victory for the Friedman school of thought. Much more complicated is what Volcker actually thought he was doing. He was never a doctrinaire monetarist. Volcker was, to his credit, skeptical of all sorts of simplistic schools of economic thought. He hated simplistic and refined Keynesianism. Nor was he ever a monetarist. He was a practical central banker, not a theoretician. In fact, he later confirmed in interviews that he was not driven to cause the Volcker shock because he had suddenly converted to the idea of monetarism.
So why did he do it? The answer is indeed interesting. He said monetarism provided him with political cover.
Volcker replaced interest rate management with money supply management. He did this because he knew that if the Fed said it was targeting interest rates, and interest rates reached the highest point they had ever reached in history, the people would blame the Fed. They would say, “All of a sudden I’m trying to borrow money to buy a car, and they’re telling me I’m going to have to pay 25% interest on it.
He knew that by focusing on limiting the money supply, which would inevitably have the effect of raising interest rates, he would put a buffer between the decisions he and the Fed made and the consequences in the market. They would say, “All we’re doing is limiting the growth of the money supply. It is the market that pushes interest rates up. This is an example of how Volcker was a shrewd political player, not just a technocratic central banker.
The latest confirmation of this instrumental or practical monetarism is that in 1982 the recession was getting too deep. This had a number of adverse effects, including triggering Third World debt defaults like in Mexico – which posed huge problems for international banks, precisely Volcker’s large constituency. His noble experiment in killing inflation has actually begun to conflict with the health of the US financial system at a high level.
What did he do? He moved away from monetarism. He stopped targeting the money supply. He calmed down a bit. Consequently, he no longer presents his choices in a monetarist framework.
Comments from the time show that Friedman and his supporters were upset. They rightly saw that Volcker had abandoned monetarism, which they said was a disaster that would bring back inflation. But this is not the case – which confirms both that Volcker was not really a die-hard monetarist and that the monetarists were not quite right about the causes of inflation, because the abandonment of Volcker did not lead to the return of inflation.