Critique of Central Banking By Henry C K Liu Part I: Monetary theology This article first appeared in Asia Times on Line on November 6, 2002   Central bankers are like librarians who consider a well-run library to be one in which all the books are safely stacked on the shelves and properly catalogued. To reduce incidents of late returns or loss, they would proposed more strict lending rules, ignoring that the measure of a good library lies in full circulation. Librarians take pride in the size of their collections rather than the velocity of their circulation. Central bankers take the same attitude toward money. Central bankers view their job as preserving the value of money through the restriction of its circulation, rather than maximizing the beneficial effect of money on the economy through its circulation. Many central bankers boast about the size of their foreign reserves the way librarians boast about the size of their collections, while their governments pile up budget deficits. Paul Volcker, the US central banker widely credited with ending inflation in the early 1980s by administering wholesale financial blood letting on the US economy, quipped lightheartedly at a Washington party that "central bankers are brought up pulling legs off of ants". Central banking insulates monetary policy from national economic policy by prioritizing the preservation of the value of money over the monetary needs of a sound national economy. A global finance architecture based on universal central banking allows an often volatile foreign exchange market to operate to facilitate the instant cross-border ebb and flow of capital and debt instruments. The workings of an unregulated global financial market of both capital and debt forced central banking to prevent the application of the State Theory of Money (STM) in individual countries to use sovereign credit to finance domestic development by penalizing, with low exchange rates for their currencies, governments that run budget deficits. STM asserts that the acceptance of government-issued legal tender, commonly known as money, is based on government's authority to levy taxes payable in money. Thus the government can and should issue as much money in the form of credit as the economy needs for sustainable growth without fear of hyperinflation. What monetary economists call the money supply is essentially the sum total of credit aggregates in the economy, structured around government credit as bellwether. Sovereign credit is the anchor of a vibrant domestic credit market so necessary for a dynamic economy. By making STM inoperative through the tyranny of exchange rates, central banking in a globalized financial market robs individual governments of their sovereign credit prerogative and forces sovereign nations to depend on external capital and debt to finance domestic development. The deteriorating exchange value of a nation's currency then would lead to a corresponding drop in foreign direct or indirect investment (capital inflow), and a rise in interest cost for sovereign and private debts, since central banking essentially relies on interest policy to maintain the value of money. Central banking thus relies on domestic economic austerity caused by high interest rates to achieve its institutional mandate of maintaining price stability. Such domestic economic austerity comes in the form of systemic credit crunches that cause high unemployment, bankruptcies, recessions and even total economic collapse, as in the case of Britain in 1992, the Asian financial crisis in 1997 and subsequent crises in Russia, Turkey, Brazil and Argentina. It is the economic equivalent of a blood-letting cure. A national bank does not seek independence from the government. The independence of central banks is a euphemism for a shift from institutional loyalty to national economic well-being toward institutional loyalty to the smooth functioning of a global financial architecture. The international finance architecture at this moment in history is dominated by US dollar hegemony, which can be simply defined by the dollar's unjustified status as a global reserve currency. The operation of the current international finance architecture requires the sacrifice of local economies in a financial food chain that feeds the issuer of US dollars. It is the monetary aspect of the predatory effects of globalization. Historically, the term "central bank" has been interchangeable with the term "national bank". In fact, the enabling act to establish the first national bank, the Bank of the United States, referred to the bank interchangeably as a central and a national bank. However, with the globalization of financial markets in recent decades, a central bank has become fundamentally different from a national bank. The mandate of a national bank is to finance the sustainable development of the national economy, and its function aims to adjust the value of a nation's currency at a level best suited for achieving that purpose within an international regime of exchange control. On the other hand, the mandate of a modern-day central bank is to safeguard the value of a nation's currency in a globalized financial market of no or minimal exchange control, by adjusting the national economy to sustain that narrow objective, through economic recession and negative growth if necessary. Central banking tends to define monetary policy within the narrow limits of price stability. In other words, the best monetary policy in the context of central banking is a non-discretionary money-supply target set by universal rules of price stability, unaffected by the economic needs or political considerations of individual nations. The theology of monetary economics Inflation, the all-consuming target of central banking, is popularly thought of as too much money chasing too few goods, which economists refer to as the Quantity Theory of Money (QTM). QTM is one of the oldest surviving economic doctrines. Simply stated, it asserts that changes in the general level of commodity prices are determined primarily by changes in the quantity of money in circulation. But the theology of monetary economics has a long and complex history, an understanding of which is necessary for forming any informed opinion on the validity and purpose of central banking. Below is a brief summary of the stuff dinner conversation is made of among the gods of monetary theory. Jean Bodin (1530-96), a French social/political philosopher, attributed the price inflation then raging in Western Europe to the abundance of monetary metals imported from the newly opened gold and silver mines in the Spanish colonies in South America. Though he held many aspects of mercantilist views, Bodin asserted that the rise of prices was a function not merely of the debasement of the coinage, but also of the amount of currency in circulation. Bodin's religious tolerance in a period of fanatical religious wars drew upon him the accusation of being a "freethinker", a label as damaging as being called a communist sympathizer in the United States in modern times. In his Les Six Livrers de la republic (1576), Bodin replaced the concept of a past golden age with the concept of progress. He foreshadowed Thomas Hobbes (1588-1679: The Leviathan, 1651) by stating the political necessity of absolute sovereignty, subject only to the laws of God (morality) and nature (reality). Bodin also anticipated Baron Montesquieu (1689-1755: De l'esprit des lois, 1748) by highlighting environment as a determinant of laws, customs, beliefs and the interpretation of events, a view that influenced the US constitution, a view since rejected by current US moral imperialism. John Locke (1632-1704) and David Hume (1711-76) provided considerable refinement, elaboration and extension to the QTM, allowing it to be integrated into the mainstream of orthodox monetarist tradition. Locke developed the right of private property based on the labor theory of value and the mechanics of political checks and balances that were incorporated in the US constitution. Locke, in 1661, asserted the proportionality postulate: that a doubling of the quantity of money (M) will double the level of prices (P) and half the value of the monetary unit. Hume, in 1752, introduced the notion of causation by stating that variation in M (money quantity) will cause proportionate changes in P (price level). Concurrently with Irish banker Richard Cantillon (1680-1734), Hume applied to the QTM two crucial distinctions: 1) between static (long-run stationary equilibrium) and dynamic (short-run movement toward equilibrium); and 2) between the long-run neutrality and the short-run non-neutrality of money. Hume and Cantillon provided the first dynamic process analysis of how the impact of a monetary change spread from one sector of the economy to another, altering relative price and quantity in the process. They pointed out that most monetary injection would involve non-neutral distribution effects. New money would not be distributed among individuals in proportion to their pre-existing share of money holdings. Those who receive more will benefit at the expense of those receiving less than their proportionate share, and they will exert more influence in determining the composition of new output. Initial distribution effects temporarily alter the pattern of expenditure and thus the structure of production and the allocation of resources. Thus it is understandable that conservatives would be sympathetic to the QTM to maintain the wealth distribution status quo, or if the QTM is skirted, to ensure that the maldistribution tilts toward those who are more likely to engage in capital formation, namely the rich. Thus developing economies in need of capital formation would find logic in first enriching the financial elite while advanced economies with production overcapacity would need to increase aggregate demand by restricting income disparity. Hume describes how different degrees of money illusion among income recipients, coupled with time delays in the adjustment process, could cause costs to lag behind prices, thus creating abnormal profits and stimulating optimistic profit expectations that would spur business expansion and employment during the transition period. These non-neutral effects are not denied by the adherents of QTM, who nevertheless assert that they are bound to dissipate in the long run, often with great damage if the optimism was unjustified. The latest evidence of the non-neutral effects of money is observable in expansion of the so-called New Economy from easy money in the past decade and the recent collapse of its bubble. The QTM formed the central core of 19th-century classical monetary analysis, provided the dominant conceptual framework for interpreting contemporary financial events and formed the intellectual foundation of orthodox policy prescription designed to preserve the gold standard. The economic structure in 19th-century Europe led analysts to acknowledge additional non-neutral effects, such as the lag of money wages behind prices, which temporarily reduces real wages; the stimulus to output occasioned by inflation-induced reduction in real debt burdens, which shifts real income from unproductive creditor-rentiers to productive debtor-entrepreneurs; the so-called "forced saving" effect occasioned by price-induced redistribution of income among socio-economic classes having structurally different propensity to save and invest; and the stimulus to investment imparted by a temporary reduction in the rate of interest below the anticipated rate of return on new capital. Yet classical quantity theorists tended persistently to minimize the importance of non-neutral effects as merely transitional. Whereas Hume tended to stress lengthy dynamic disequilibrium periods in which money matters much, classical analysts focused on long-run equilibrium in which money is merely a veil. David Ricardo (1772-1823), the most influential of the classical economists, thought such disequilibrium effects ephemeral and unimportant in long-run equilibrium analysis. Gods, of course, enjoy longer perspectives than most mortals, as do the rich over the poor. As John Maynard Keynes famously said: "In the long run, we will all be dead." As leader of the Bullionists, Ricardo charged that inflation in Britain was solely the result of the Bank of England's irresponsible overissue of money, when in 1797, under the stress of the Napoleonic Wars, Britain left the gold standard for inconvertible paper. At that time, the Bank of England was still operating as a national bank, not a central bank in the modern sense of the term. In other words, it operated to improve the English economy rather than to strengthen the sanctity of international finance. Ricardo, by focusing on long term-equilibrium, discouraged discussions on the possible beneficial output and employment effects of monetary injection on the national level. Like modern-day monetarists, Bullionists laid the source of inflation, a decidedly evil force in international finance, squarely at the door of the national bank. As Milton Friedman declared some two centuries after Richardo: inflation is everywhere a monetary phenomenon. Friedman's concept of "money matters" is the diametrical opposite of Hume's. The historical evolution in 18th-century Europe from a predominantly full-metal money to a mixed metal-paper money forced advances in the understanding of the monetary transmission mechanism. After gold coins had given way to banknotes, Hume's direct mechanism of price adjustment was found lacking in explaining how banknotes are injected into the system. Henry Thornton (1760-1815), in his classic The Paper Credit of Great Britain (1802), provided the first description of the indirect mechanism by observing that new money created by banks enters the financial markets initially via an expansion of bank loans, through increasing the supply of lendable funds, temporarily reducing the loan rate of interest below the rate of return on new capital, thus stimulating additional investment and loan demand. This in turn pushes prices up, including capital good prices, drives up loan demands and eventually interest rates, bringing the system back into equilibrium indirectly. The central issue of the doctrines of the British classical school that dominated the first half of the 19th century was focused around the application of the QTM to government policy, which manifested itself in the maintenance of external equilibrium and the restoration and defense of the gold standard. Consequently, the QTM tended to be directed toward the analysis of international price levels, gold flow, exchange-rate fluctuations and trade deficits. It formed the foundation of mercantilism, which underpinned the economic structure of the British Empire via colonialism, which reached institutional maturity in the same period. Bullionists developed the idea that the stock of money, or its currency component, could be effectively regulated by controlling a narrowly defined monetary base, that the control of "high-power money" (bank reserves) in a fractional reserve banking regime implies virtual control of the money supply. High-power money is the totality of bank reserves that would be multiplied many times through the money-creation power of commercial bank lending, depending on the velocity of circulation. In the 1987 crash when the Dow Jones Industrial Average (DJIA) dropped 22.6 percent in one day (October 19) on volume of 608 million shares, six times the normal volume then (current normal daily volume is about 1.6 billion shares), the US Federal Reserve under its newly installed chairman, Alan Greenspan, created US$12 billion of new bank reserves by buying up government securities. The $12 billion injection of high-power money in one day caused the Fed Funds rate to fall by three-quarters of a point and halted the financial panic. If the government had been running a balanced budget and there were no government securities to be bought, the economy would have seized up. This shows that government deficits and debt are part and parcel of the modern financial architecture. In the three decades after Britain returned to the gold standard in 1821, the policy objective focused on the maintenance of fixed exchange rates and the automatic gold convertibility of the pound. But the Currency School (CS) versus Banking School (BS) controversy broke out over whether the "Currency Principle" of making existing mixed gold-paper currency expand and contract in direct proportion to gold reserves was sufficient to safeguard against note overissuance, or whether additional regulation was necessary. This controversy grew out of the expansion pressure put on the supply of pound sterling by the rapid expansion of the British empire. Members of the CS argued that even a fully, legally convertible currency could be issued in excess with undesirable consequences, such as rising domestic prices relative to foreign prices, balance-of-payment deficits, falling foreign-exchange rates, gold outflow resulting in depletion of gold reserves and ultimately forced suspension of convertibility. The rate of reserves drain often accelerated when the external gold drain coincided with internal domestic-panic conversion of paper into gold in fear of pending depreciation. Thus the CS promoted full convertibility plus strict regulation of the volume of banknotes to prevent the recurrence of gold drains, exchange depreciation and domestic liquidity crises. The apprehension of the CS was fully justified by past actions of the Bank of England, which had been perverse and destabilizing by international finance standards. The destabilizing argument stressed the time lag on the Bank's policy response to gold outflow and to exchange-rate movements. The inevitably too little, too late measures taken by the national bank, instead of protecting gold reserves, merely exacerbated financial panics and liquidity crises that inevitably followed periods of currency-credit excess. The famous Bank Charter Act of 1844, in modern parlance, imposed a 100 percent reserve requirement, with an unabashed bias toward wealth preservation over wealth creation. The CS also asserts that money substitutes cannot impair the effectiveness of monetary regulation. Thus if banknotes could be controlled, there would be no need to control deposits explicitly, on the ground that money substitutes have low velocity and are of declining substitutional value in times of crisis. Keynesians argue that the QTM is invalid because it assumes an automatic tendency to full employment. If resource under-ultilization and excess capacity exist, a monetary expansion may produce a rise in output rather than a rise in prices, as in the case of the 1930s Depression. Money is not a mere veil. Monetary changes may have a permanent effect on output, interest rates, and other real variables, contrary to the neutrality postulate of the QTM. Post-Keynesians also contend that the QTM erroneously assumes the stability of velocity and its counterpart, the demand for money. Velocity is a volatile, unpredictable variable (technically known as exogenous - due to external causes), influenced by meta-rationality and by changes in the volume of money substitutes, not to mention hedges in the form of derivatives. The erratic behavior of velocity makes it impossible to predict the effect of a given monetary change on prices. John Law (1671-1729), a contemporary of Bodin, elaborated in 1705 on the distinction drawn by Bernardo Davanzati (1529-1606) between "value in exchange" and "value in use", which led Law to introduce his famous "water-diamond" paradox: that water, which has great use-value, has no exchange-value, while diamonds, which have great exchange-value, have no use-value. Contrary to Adam Smith, who used the same example but explained it on the basis of water and diamonds having different labor costs of production, Law regarded the relative scarcity of goods in demand as the generator of exchange value. Davanzati showed how "barter is a necessary complement of division of labor amongst men and amongst nations"; and how there is easily a "want of coincidence in barter", which calls for a "medium of exchange"; and this medium must be capable of "subdivision" and be a "store of value". He remarked "that one single egg was more worth to Count Ugolino in his tower [prison] than all the gold of the world", but that on the other hand, "ten thousand grains of corn are only worth one of gold in the market", and that "water, however necessary for life, is worth nothing, because superabundant". That was of course before International Monetary Fund (IMF) conditionality requiring the poor in the indebted Third World to pay for water through privatization of basic utilities to service foreign debt. Davanzati observed that in the siege of Casilino, "a rat was sold for 200 florins, and the price could not be called exaggerated, because next day the man who sold it was starved and the man who bought it was still alive". Of course, modern economists would call that a market failure. Davanzati viewed all the money in a country as worth all the goods, because the one exchanges for the other and nobody wants money for its own sake. Davanzati did not know anything about the velocity of money, and only recognized that every country needs a different quantity of money, as different human frames need different quantities of blood. The mint ought to coin money gratuitously for everybody; and the fear that, if the coins are too good, they should be exported is simply illusory, because they must have been paid for by the exporter. Law's "Real Bills Doctrine" of money applied the "reflux principle" to the money supply. Money, Law argued, was credit and credit was determined by the "needs of trade". Consequently, the amount of money in existence is determined not by the imports of gold or trade balances (as the Mercantilists argued), but rather on the supply of credit in the economy. And money supply (in opposition to the Quantity Theory) is endogenous (growing from within), determined by the "needs of trade". Post-Keynesians have drawn on the Real Bills Doctrine, which asserts that the money supply is an endogenous variable that responds passively to shifts in the demand for it. Thus monetary changes cannot affect prices. Being demand-determined, the stock of money cannot exceed or fall short of the quantity of money demanded. In short, there is no transmission mechanism running from money to prices. Analysts should look instead for the source of economic dislocations in real rather than monetary causes. Inflation creates a corresponding increase in the money supply, not the other way around. Yet QTM theorists exposed the Achilles' heel of the Real Bills Doctrine by demonstrating that as long as the loan rate of interest is below the expected yield on new capital projects, the demand for loans will be insatiable. Thus the "real bills" criterion as an automatic regulator of the money supply is inoperative unless central banks intervene to raise interest rates in concert with expected return on capital. The attack on the QTM from the Banking School (BS) also supported modern Keynesian views, by pointing out that new money may simply be absorbed into idle balances (gold hoards, a liquidity trap) without entering the spending stream, while the supply of money is determined by the need of trade and thus can never exceed demand (in modern parlance: pushing on the credit string). The BS went farther than the "Real Bills" argument that even if the real-bills criterion of restriction of loans to self-liquidating paper were violated, the law of reflux would prevent overissue. Holders of excess papers would simply redeposit them in banks rather than spending them. The BS asserts that prices are determined by income and not by the quantity of money. For national economies, factor incomes earned from overseas investment, rather than money, are the sources of expenditure that act on prices, unless neutralized by imports. This income-expenditure approach was later developed by Keynes and became a characteristic feature of Keynesian macro-economic models. The BS also disputed the quantity-theory view of money as an exogenous or external independent variable by arguing that the stock of money and credit is a passive, endogenous demand-determined variable. The stock of money and credit is the effect, not the cause, of price changes. The channel of causation runs from prices to money, not the opposite direction as contended by the CS. What determines the volume of currency in circulation is the active initiation of the non-bank public (borrowers) with the banks playing only a passive accommodating role. Implicit in the BS view of massive money are three anti-quantity theory propositions: 1) changes in economic activities precede and cause changes in the money supply (the reverse causation argument); 2) the supply of circulating media is not independent of the demand for it and 3) the central bank does not actively control the money supply, but instead accommodates or responds to prior changes in the demand for money. Against the CS emphasis on a narrowly defined money supply, the BS emphasized the overall structure of credit. The BS advocates more free banking against regulated banking, favoring the discretion of bankers over regulation by government or fixed rules, and, most important, the BS regards attempts to regulate prices via monetary control as futile, since the money supply, especially notes, is an endogenous variable independent of exogenous control. BS views fighting inflation via the supply of money and credit as putting the cart before the horse, since it is prices that determine the quantity of money and credit, and not vice versa. Despite the BS's criticism, the QTM emerged victorious from the mid-19th century Currency-Banking Debate to command wide acceptance until the 1930s. The CS policy of fixed exchange rate, gold standard, convertibility and strict control of banknotes became British monetary orthodoxy in the second half of the 19th century within the context of the triumph of British imperialism. But the rigorous mathematical restatement of the QTM by neo-classical economists around the dawn of the 20th century was the crowning factor to QTM's success in intellectual circles. Irving Fisher (1876-1947) in his classic The Purchasing Power of Money (1911) spelled out his famous equation of exchange: MV=PT, where M is the stock of money, V is the velocity of circulation, P is the price level and T is the physical volume of market transaction. This and other equations, such as the Cambridge cash balance equation, which corresponds with the emerging use of mathematics in neo-classical economic analysis, define precisely the conditions under which the proportional postulate is valid. Yet these conditions include constancy of the velocity of money and of real output. Neoclassical economics assumed that velocity was a near constant determined by individuals' cash-holding decisions in conjunction with technological and institutional factors associated with the aggregate payment mechanism. Today, with interest-bearing cash accounts, electronic payment regimes and cashless credit-card transactions, such assumptions are less valid. Money velocity, like wind velocity in a weather pattern, fluctuates widely and suddenly, caused by complex factors feeding back on each other. Fisher and other neo-classical economists, such as Arthur Cecil Pigou (1877-1959) of Cambridge, demonstrated that monetary control could be achieved in a fractional reserve banking regime via control of an exogenously determined stock of high-power money. Underlying their argument that the total stock of money and bank deposits would be a constant multiple of the monetary base is the claim that the stock of money is governed by three proximate determinants: 1) the high-power monetary base, 2) the banks' desired reserve to deposit ratio and 3) the public's desired cash-to-deposit ratio, and with the the monetary base dominating determinants 2) and 3). Again the financial reality today is very different. Banks routinely borrow through the repos window to bypass reserve requirements. Banks, to reduce the capital requirement based on their balance sheets, also sell their loans regularly as securitized financial products in the credit markets. Yet QTM continues to exercise a strong hold on monetary theory. Neo-classical quantity theorists stress the long-run non-neutrality of money, a topic not well developed in classical analysis. They integrate the QTM into their analysis of business cycles, identifying the quantity of money as a major cause of booms and busts and monetary effects on price as a prerequisite to the stabilization of economic activity. It was not until the 1930s that the QTM encountered serious criticism and was discredited, replaced by the Keynesian income-expenditure model. Notwithstanding Keynes' earlier support for QTM in A Tract on Monetary Reform (1923), Keynes' General Theory (1936) launched a frontal attack on QTM by observing that if the economy were operating at less than full employment, with idle resources to draw from, changes in spending would affect output and employment rather than prices. Keynes reversed the QTM assumption by treating prices as rigid and output flexible, a situation any businessman could recognize. Keynes criticized the QTM equations as tautological and that QTM erroneously treated the circulatory velocity of money as a near constant. Keynes pointed out that the velocity variable in Fisher's equation was in reality extremely unstable by showing that any change in M (money stock) might be absorbed by an offsetting change in V (circulation velocity) and therefore would not be transmitted to P (price level). Likewise, any change in income or the volume of market transaction might be accommodated by a change in velocity without requiring any change in the money supply. Keynes revived the BS conclusion that economic disturbances arise from exogenous shocks originating in the real economy rather than from erratic behavior of the money supply, and the futility of using monetary policy to regulate economic activity to cure unemployment and recession. The conclusion was based on Keynes' theory of an absolute preference for liquidity at low interest-rate levels - the case for the liquidity trap. Keynes argued that either a liquidity trap or interest-insensitive investment draught could render a monetary expansion ineffective in a depression. Keynes stressed a new non-monetary adjustment mechanism - the income multiplier. The chief policy implication of the Keynesian income-expenditure analysis was that fiscal policy would have a more powerful impact on income and employment than would monetary policy. Post-Keynesian economists added to Keynes' contra-QTM arguments by pointing out that inflation is predominantly a cost-pushed phenomenon associated with non-monetary institutional forces, such as union wage inelasticity, monopoly pricing, etc. Cheap money, Post-Keynesian advocates assert, from expansionary monetary policy could be used to keep interest rates at low levels, minimizing the burden of both private and public debt, helping to keep unemployment at permanently low levels. These positions depart from the neutrality proposition. The Radcliffe Committee on British monetary reform in 1959 declared that 1) money is an indistinguishable component of a continuous spectrum of financial assets; 2) the velocity of money is devoid of economic content; and 3) attempts to regulate spending via monetary control are futile in a financial system that can produce a limitless array of money substitutes. The Radcliffe Committee declaration is in fact an update of the Banking School. Then came Milton Friedman, who remodeled the QTM into a theory of the demand for money. It was based on the wealth effect, or the theory of real balance effect, which argues that prices would fall in a depression, thereby raising the purchasing power of wealth held in money from. The price-induced rise in the real value of cash balances would then stimulate spending directly until full capacity utilization had been attained. As the wealth effect operates independently of changes in interest rates, closure of the indirect channel could not prevent the restoration of full employment. It follows that a rise in the real balances and hence spending could be accomplished just as easily via a monetary expansion, validating the potency of monetary policy even in a depression. This argument offered an escape from the Keynesian liquidity trap and a way of thwarting the interest inelasticity of the investment-spending draught, thus contradicting the Keynesian doctrine of underemployment equilibrium. Friedman suggested that the Keynesian view of the monetary transmission mechanism was seriously incomplete. In denying that the quantity theory was a theory of income determination, Friedman freed it from the Keynesian criticism that it assumes full employment. In their A Monetary History of the United States, 1867-1960, Friedman and Anna Schwartz showed that a rapid and large reduction in the money supply played the dominant causal role in the Great Depression of the 1930s. Their observation led to criticism of the Keynesian attribution of the Depression to a collapse of demand. Monetarists argue that the quantity of money, rather than the level and channels of interest rates, is the appropriate variable for the monetary authority to regulate. Greenspan in essence applied this theory to prolong economic expansion in the United States after 1997 and produced the biggest bubble since the 1920s. Monetarists regard monetary policy as having a powerful long-run impact on nominal income as contrasted with fiscal policy. They regard income policy as having a perverse long-term impact on economic activity. Despite lip service paid to the notion of the direct effect of monetary changes on commodity expenditure, modern monetarists acknowledge that the transmission mechanism operates primarily through a complex portfolio or balance-sheet adjustment process involving various interest-rate channels and affecting a wide range of assets and expenditures, generating shifts in the composition of asset portfolios, thereby inducing prices and yields of existing financial and non-financial assets relative to prices of current services and new assets, albeit that the portfolio approach is not of monetary origin, having been first developed by Keynes and J R Hicks in the mid-1930s and subsequently elaborated by James Tobin and others. These asset price and yield changes, in turn, generate changes in the demands for service flows and new asset stocks and hence in the prices and output of latter items. The question of the appropriate range of assets and interest rates to be considered in the analysis of the transmission mechanism is a key point in the monetarist-Keynesian controversy over the spending impact of monetary changes. Keynesian models tended to concentrate on a narrower range of assets and interest rates, forcing the transmission process through a narrow channel, thus choking off some of the spending impact of a monetary change. Of course, in Keynes' days, the financial architecture was primarily a two-asset world: cash and bonds, fundamentally different from today's infinite range of financial assets in the brave new world of structured finance. Modern monetarists generally favor flexible exchange rates without exchange control, whereas the Currency School advocated fixed rates with exchange control. Next: The European experience