"[Milton Friedman] is quite talented at outraging his intellectual opponents, who have accordingly devoted much energy and knowledge to advertising his work. His only flaw as a debater, in my opinion, is that often his victories are temporary; the defeated adversary will slink off muttering "I'll think of a reply to his argument in a few days.""
(George J. Stigler, Memoirs of Unregulated Economist, 1988: p.154)
"[O]ne must distinguish between the [Monetarist] model as such and a specific implication of that model, namely that the long-run Phillips curve is vertical, or, in substance, that, in the long-run, money is neutral. That conclusion, by now, does not meet serious objection from nonmonetarists, at least as a first approximation."
(Franco Modigliani, "The Monetarist Controversy: or should we forsake stabilization policies?", 1977, American Economic Review).
Was Monetarism a fad? Was it quackery? Or was it a powerful intellectual revolution which, although no longer with us in its original form, nonetheless has left an indelible imprint on macroeconomics and economic policy which is still perceptible today? Whatever the conclusion, there is no doubt that the "Monetarist controversy" that raged in economics in the late 1960s and 1970s has been one of the most passionately fought battles in modern economic history.
Monetarism was prematurely hailed as a Neoclassical "counter-revolution" to the dominant Keynesian "revolution" -- although, one can argue that it did little more than open the door through which the true counter-revolutionaries, the New Classicals, slipped in. Surprisingly, some of its protagonists (e.g. Friedman, 1974, 1976) have played down the intellectual stakes of the Monetarist controversy - considering it to be empirical issues as opposed to theoretical issues, that divided Monetarists from Keynesians. Nonetheless, the biggest guns of Keynesian macroeconomics - such as James Tobin, Franco Modigliani, Robert Solow, Paul Samuelson, Nicholas Kaldor, Don Patinkin, Frank Hahn and many more - were brought out to combat a single man with some very powerful ideas, Milton Friedman. Indeed, it would be hard to find a single economist at the time who did not have an opinion on this debate - and, more often than not, that opinion was passionately held. It was not as graceful as a heavyweight bout, but it was just about as bloody.
The first great casualty was the Phillips Curve. This met a long-overdue demise - not so much because it failed to explain the "facts", but rather that it did not fit with the Keynesian theory which was commissioned to explain the facts.
The second great casualty was Monetarism itself. Despite their willingness to engage them in debate, many Keynesian commentators pooh-poohed the Monetarist challenge as largely an "ideological" rather than scientific assault (e.g. N. Kaldor, 1970, 1980, 1982; H.G. Johnson, 1971; F.H. Hahn, 1971, 1980, 1984; J. Tobin, 1980). Indeed, in his famous Ely Lecture at the American Economic Association, Harry G. Johnson (1971) predicted Monetarism would "peter out", largely because:
"[M]onetarism is seriously inadequate as an approach to monetary theory, judged by the prevailing standards of academic economics, and in the course of repairing its intellectual fences and achieving full scientific respectability it will have to compromise irretrievably with its Keynesian opposition." (H.G. Johnson, 1971).
As Johnson predicted, Monterism did "peter out", but it was replaced with something the Neo-Keynesians did fear and respect tremendously: the New Classicals. As James Tobin notes, "the ideas of the second counter-revolution [New Classicism] are too distinctive and too powerful to be lost in the shuffle. They are bound to shape whatever orthodoxy emerges" (Tobin, 1980).
As such, the third great and perhaps most lamentable casualty was the Neo-Keynesian system itself. Robert Solow has put it gently, regarding the Monetarist and later New Classical challenges to the Neo-Keynesian orthodoxy as "a kick in the pants...to prevent it from getting self-indulgent, and applying very lax standards to itself" (Solow, 1978). Indeed, James Tobin envisaged a future grand synthesis between Neo-Keynesian ideas and New Classical methods which would leave Monetarism behind in the rubble: "[a]s this scientific synthesis proceeds, monetarism will lose the polar simplicity essential to its ideological appeal, which will in any case be eroded by the disillusionment with the results of policies identified with monetarism." (J. Tobin, 1980).
However, the New Classicals were far less willing to reciprocate Tobin's sentiments: in their view, Keynesian macromodels were "incapable of providing reliable guidance in the formulation of monetary, fiscal or other types of policy. This conclusion is based in part on the spectacular recent failures of these models and in part on their lack of a sound theoretical or econometric basis." (Lucas and Sargent, 1978).
Far from burying Monetarism completely, throughout the 1970s and 1980s, the New Classicals took several of its features, formalized them and radicalized them. More than the Monetarists, the New Classicals believed in the stability of the market system, arguing that it adjusted automatically to market-clearing equilibrium. The great stabilizer was rational expectations, which ensured instant adjustment - something far faster than Friedman had ever dreamed of. As a result, long-run money neutrality was extended into the short-run so that only unexpected money supply changes could lead to output fluctuations. Disinflations, which Friedman and the Monetarists advocated but nonethless recognized as temporarily very costly for output and unemployment, was in New Classical eyes virtually costless. Indeed, for the New Classicals, most unemployment was not "temporary" nor even "involuntary" in any meaningful sense; those that insisted it might be, would have to rely on supply-side imperfections of some sort or another, rather than failures in effective demand.
Monetarism "petered out" as a force perhaps, but many of its ideas were channeled through modern macroeconomics with a far more radical tinge than even Friedman had dared propose. It was Neo-Keynesianism, whose theoretical soul lay in Keynes's theory of effective demand, that was almost conclusively buried by the new orthodoxy. In retrospect, then, the Monetarist "counter-revolution" was less of a revolution than it was a watershed between the old orthodoxy and the new. It was from the soil tilled by Friedman that the actual counter-revolution by the New Classicals sprang.
However tempting it is to relegate Monetarism to the role of midwife to New Classicism, it is still very useful to note the independent contributions that Monetarism made. The Monetarist controversy forced Neo-Keynesians to make substantial improvements in their theoretical system and, in this respect, Monetarism was quite constructive. Firstly, it emphasized the LM side of the IS-LM system which Keynesians had been ignoring unduly; secondly, their transmission mechanism expanded the asset menu of the LM system and forced the Keynesians to recognize that the portfolio decision must be integrated with the consumption-savings decision; thirdly, it emphasized inflationary expectations as a component of money demand; fourthly, it forced Keynesian to incorporate inflation expectations into their simple Phillips Curve, and thus improve the working of the Neo-Keynesian wage-price mechanism. Had anybody but Friedman suggested these changes, then the confrontations of the debates of the 1960s and 1970s might not have happened as they would not seem to have a "counter-revolutionary" character.
The great "counter-revolutionary" contribution was the introduction of the natural rate hypothesis by Friedman and Phelps - particularly when it led to the interpretation of the Phillips Curve as an "aggregate supply" theory. Other "anti-Keynesian" contributions by the Monetarists, such as the use of simplistic reduced-form "St. Louis" equations as opposed to complex structural equations to analyze macroeconomic policy, the money-income causality, the gravitation of the Phillips Curve, the advocacy of a disinflation policy and money supply targeting, were just plain troublesome, mere nuisances, rather than deeply dangerous for the Keynesian system. Indeed, one could go further and claim that rational expectations, in and of itself, would be inconsequential without a natural rate hypothesis. It was the Monetarist's natural rate hypothesis, above everything else, that served as the wooden stake in the heart of the Neo-Keynesian system; and it is from this that the New Classical research program was born and by this that it has held together.
We leave the last word to Frank H. Hahn, a Neoclassical (Walrasian) general equilibrium theorist with modest Keynesian propensities, who rendered his personal verdict on Monetarism and New Classical macroeconomics in no uncertain terms:
"I urge you to recognize the monetarism or what passes for modern macroeconomics is also "altogether too sensational". It represents the triumph of artifact over plain and direct thinking. It is sensational in its conclusion that the market always yields the best of all possible worlds. It is sensational in its contention that there are no social phenomena relevant to economic life which are not captured by prices. It is sensational in the sheer bravado of reducing the beautiful structure of general equilibrium theory to one or two log-linear equations and in its neglect of every subtlety. It is sensational in its ignorance of both the scope and limit of economic theory. Above all it is sensational in its confidence in conclusions which are neither proven nor plausible. For all these reasons, I am not a monetarist."
(Frank H. Hahn, 1984: p.326)