MONETARY POLICY FAILINGS RESULT FROM USING DATA BASED ON OUTMODED ACCOUNTING MEASURES
Research, policy and public information about monetary policy should be based on competently produced aggregate data. But according to former Federal Reserve Board member Professor William Barnett, writing in the latest issue of the Economic Journal, most central banks are using data produced in accordance with naive and simplistic accounting procedures that have been obsolete within the economics profession for over 70 years. The Bank of England may be an honourable exception with its published Divisia aggregates, but to date these have received little public attention.

Barnett documents the fact that public opinion on monetary policy has been unduly influenced by excessive emphasis on the most visible official sources of information. It has become widely accepted that money demand is mysteriously unstable, that monetary aggregates have little meaning, and that only interest rates are worth watching as indicators of monetary policy.

This misperception of reality arises from the fact that most central banks fail to use index number theory to produce their monetary aggregates. Professional publications by experts in index number theory cast a very different light on monetary policy, money demand and monetary aggregation. Indeed, in all other areas of government data production, the principles of index number theory have been accepted for over 70 years.

The simple sum accounting approach to aggregation implies that components over which aggregation takes place are perfect substitutes: ‘you can add apples to apples, but not apples to oranges.’ But the components of monetary aggregates (currency, demand deposits, certificates of deposit, savings accounts, etc.) are far from perfect substitutes. Decades of research in index number theory have produced the correct methods for weighted aggregation over imperfect substitutes, based upon the Divisia index number formula.

Perhaps the greatest damage to public perceptions of monetary aggregates resulted from an unfortunate prediction error by Milton Friedman in Newsweek magazine in September 1983. Friedman concluded that ‘The monetary explosion from July 1982 to July 1983 leaves no satisfactory way out of our present situation. The result is bound to be renewed stagflation - recession accompanied by rising inflation and high interest rates. The only real uncertainty is when the recession will begin.’

Friedman’s conclusions proved false though the huge growth rate spike he observed in the simple sum monetary aggregates did indeed occur. The failure of his very public prediction was a major source of loss of faith in monetary aggregates. It accounts for much of the subsequent movement towards emphasis on interest rates.

But surprisingly overlooked was another article that appeared on the exact same day in which Barnett was quoted as finding that properly weighted Divisia monetary aggregates showed no such growth rate spike. Hence, he concluded, no reason existed to anticipate a surge in inflation and a subsequent recession. If ever there was a controlled experiment providing direct comparison between the merits of two data sources, this was it.

Similarly, much damage to public perception of monetary policy and monetary aggregation was done by the ‘monetarist experiment’ of 1979-82 in the United States. Barnett was on the staff of the Federal Reserve Board in Washington during much of that period. The official simple sum monetary aggregates reflected a gradual decrease in money supply in accordance with intended policy, but not a deflationary shock which would have explained the recession that followed. But in the American Statistician, Barnett reported that the Divisia monetary aggregates displayed a severe deflationary shock to the economy, exactly as would have been required to produce the recession that followed.

Barnett shows that every incident that casts doubt on the usefulness of monetary aggregates in monetary policy can be traced to the use of official simple sum monetary aggregates. But, he notes, acknowledgement of the truth by the world’s central banks has progressed very slowly. Although Barnett first drew attention to this issue while on the staff of the Federal Reserve Board over two decades ago, the Federal Reserve System has failed to report the facts until very recently in a Special Report in the latest issue of the St. Louis Federal Reserve Bank’s Review. The Bank of England acted sooner, and has been publishing competent Divisia monetary aggregates for over a year, but with little recognition by the press.

Note: ‘Which Road Leads to Stable Money Demand?’ by William A. Barnett is published in the July 1997 issue of the Economic Journal. Barnett is Professor of Economics at Washington University in St. Louis, editor of the CUP monograph series, ‘International Symposia in Economic Theory and Econometrics’ and editor of the CUP journal, ‘Macroeconomic Dynamics’.

For Further Information: contact William Barnett on 00-1-314-935-4236 (home: 00-1-314-432-0532; fax: 00-1-314-935-4156; email: barnett@wuecon.wustl.edu; website: http://econwpa.wustl.edu/~barnett/); or Melanie Dean of the RES/ESRC Economists in the Media Initiative on 0171-878-2913 (email: mdean@cepr.org).