A (Strict) Monetarist Analysis on Ron Paul’s Policy

by Guinandra Jatikusumo

Former candidate for U.S. President Ron Paul is popular among right-wing conservatives especially for his stance on the existence of the Federal Reserve of the United States, also known as the Fed. He pledged that if he were to be inaugurated as President, he would eliminate the Fed and abolish the monetary system that the U.S. has adopted since 1913. He proposed a return to the gold standard, a monetary concept not a single country has relied on since 1999, to maintain an absolute supply of dollars. His speeches reverberated around university hallways, his sentences were and are still quoted on Youtube videos starring the Democrats, his book entitled ‘End the Fed’ was displayed on the New York Times’ bestselling bookshelf. Yet, just like any other books on economic and political issues, not everybody agrees with every single point he presents. Economists adhering to Keynesianism, and disciples of Milton Friedman have outlined their core differences with the Republican nominee.

I do not intend to write (and rewrite) real and hypothetical cases against Ron Paul’s idea, because there have been a plethora of books, online op-ed pieces, and magazine articles that coherently challenge Paul’s contention already. Writings whose authors are vehement supporters of the Fed are everywhere. Their arguments range from the notion that having a lender of last resort to ensure liquidity is important to the belief that the price and supply of gold fluctuate.

Recently, I have been trying to think in Paul’s shoes and been attempting at finding loopholes within his propositions apart from those already stated. I found that even concepts within (strict) monetarism whose proponents demand for a very limited involvement of the Fed oppose Paul’s proposition. (I put the word ‘strict’ inside a bracket since Wikipedia claims that the concept has been reinvigorated ever since Keynesians, not Libertarians like Ron Paul, challenged it). Quoting from a book written by Professor Case, Fair and Oster, (strict) monetarists:

“…put an emphasis on the velocity of money, which is defined as the number of times a (currency) changes hands, on average, during the course of a year.”

Calculating this velocity is simply an algebraic problem. Intuitively, the velocity is equal to the aggregate value all domestic goods is worth (GDP) divided by the supply of money available in the market: V= GDP/M. Since GDP is composed of the average price (P) per unit and real aggregate output (Y), we can then form the identity that MxV=PxY. (Let us assume that Paul still believes in the importance of mathematizing economics in a fundamental level). Now, according to Wikipedia, in 1956, Milton Friedman restated a claim that the velocity of money, in the short and long run is constant. Due to proportionality, this suggests that whenever variables in the right side of the equation (P or/and V) change, the variable M should change. Friedman’s restated theory thus implies that the Federal Reserve should (and only should) increase or decrease the money supply whenever there is a significant change in price level (P) or amount of real aggregate output (Y). If price level is stationary and sustainable, this means that (strict) monetarists only allow the involvement of the Fed as long as there is a real increase in productivity.

Let us assume that Obama decided not to re-run, Ron Paul received more funding and made Mitt Romney lost his emotions during the Republican primary debates. His ascension to presidency would then allow him to induce Congress to make Professor Bernanke return to Princeton. Without the Fed, Paul would not be able to alter the money supply in strict monetarist term (not Keynesian), which I think is troublesome. As stated previously, since the velocity of money is constant, any increase in price level and/or real aggregate output mandate Fed’s injection of dollars into the market. However, Paul’s return to the gold standard turns money demand ‘M’ to a constant. Furthermore, Paul claims that the abolishment of the Fed will stabilize price level in a way that excessive inflation would not exist at all. Under this claim, we can then turn ‘price level’ (P) into a constant, leaving one variable only, which is the real aggregate output (Y). Hence, during Ron Paul’s presidency, Friedman’s equation would become something that would put a huge burden on the sole variable, because constant(1)*constant(2)=constant(3)*Y.

This means that, with everything constant, Y should be maintained–growth would or must not occur in the economy. Since this is unimaginable, another hypothetical condition is proposed: what if an increase in Y (real output) is inevitable due to U.S.’ rapid development of technology, increase in human capital, or lenient laws on free trade benefiting the country? Since the Fed no longer supplies money and price level is stable because interest rate is controlled by the free market or because there is no (excessive) inflation, the velocity of money is forced to be increased. Of course, under Friedman’s theory, the velocity is constant, but even if it is not, there must be external factors that force people to transfer the dollars they possess to other people in exchange for goods and services. But if the velocity of money remains the same (or worse, decreases), economic growth would be suppressed, banks will become insolvent, and liquidity traps would be ubiquitous.

Note that such a conclusion is reached based on multiple assumptions and exclusions of essential components affecting the economy. Researches show that the velocity of money is not stagnant (the trend shows that it is decreasing, which exacerbates Paul’s condition). That is one of the reasons why I call the monetarist view ‘strict.’ I also have not discussed the economic (especially fiscal) policies Ron Paul would have proposed in conjunction with removing the Fed if he had been appointed as President. With his other economic policies, ending the Fed might work. Or, as what most economists believe, it might backfire.