Monetarism

💵 Monetarism holds that changes in the money supply are the most significant determinant of the rate of economic growth and inflation. Professor Hanke is a committed monetarist whose views draw directly from Milton Friedman's dictum: "Inflation is always and everywhere a monetary phenomenon."

What Is Monetarism?

Monetarism is the school of economic thought that emphasizes the role of the money supply in determining macroeconomic outcomes. Its central claim is straightforward: over the medium and long run, changes in the quantity of money drive changes in nominal national income — and ultimately in the price level.

This stands in contrast to Keynesian approaches that focus primarily on fiscal policy (government spending and taxation) and interest rate management. Monetarists argue that central banks' attempts to "fine-tune" the economy through discretionary interest rate policy are both ineffective and destabilizing.

Professor Hanke's Monetarist Framework

1. The Quantity Theory of Money

The foundation is the Quantity Theory of Money, expressed as:

MV = PQ

Where:

• M = Money supply
• V = Velocity of money (the rate at which money circulates)
• P = Price level
• Q = Real output

If velocity (V) is stable, then changes in money (M) translate directly into changes in nominal income (PQ). This simple identity has profound policy implications: controlling money growth controls inflation.

2. Broad Money Aggregates

Hanke emphasizes broad money aggregates rather than narrow measures like the monetary base:

Broad money (M2, M3, or Divisia equivalents) determines nominal national income. Focusing only on the monetary base or short-term interest rates misses the majority of monetary dynamics.

Hanke follows the approach of Tim Congdon (Institute of Economic Affairs, London) in focusing on broad money as the key policy variable.

3. Divisia Monetary Aggregates

Hanke advocates for Divisia monetary aggregates, pioneered by Professor William A. Barnett (University of Kansas). Unlike simple-sum aggregates (which treat all deposits equally), Divisia measures weight monetary assets by their "moneyness" — how actively they are used for transactions. This produces more accurate measures of the effective money supply.

4. State-Money / Bank-Money Analysis (SMBMA)

💡 Hanke's 2012 Innovation: In 2012, Hanke developed State-Money/Bank-Money Analysis (SMBMA) — a framework that distinguishes between two fundamentally different types of money in the modern economy.

State Money: Money produced by the central bank (monetary base, reserves)

Bank Money: Money produced by private commercial banks through the lending and deposit-creation process

This framework is based on John Maynard Keynes' 1930 *A Treatise on Money* — a remarkable irony given Hanke's generally anti-Keynesian policy views, demonstrating that important analytical tools can be separated from their policy conclusions.

Key insight from SMBMA: Roughly 80% of broad money is bank money — produced by commercial banks, not by the Federal Reserve. This means:

• Bank regulation is monetary policy (capital-asset ratio requirements shrink bank money)
• Fiscal policy affects money (government borrowing crowds out bank lending)
• Central bank actions affect only a minority of the money supply directly

Policy danger revealed: Imposing higher capital-asset ratios on banks during economic downturns is pro-cyclical — it forces banks to shrink their balance sheets precisely when the economy needs credit expansion. SMBMA reveals this regulatory danger that conventional monetary analysis misses.

Application: The 2008 Financial Crisis

Hanke applied SMBMA to analyze the policy responses to the 2008 financial crisis in the United States, United Kingdom, and European Union:

• The Fed's quantitative easing (QE) expanded state money dramatically
• But bank regulatory tightening simultaneously contracted bank money
• The net effect on broad money was much smaller than headline QE figures suggested
• This explains why QE did not produce the inflation many critics feared — most of the new state money was offset by shrinking bank money

Hanke on the Fed

"The Fed does not adhere to the quantity theory of money. The central bank incorrectly focuses only on controlling interest rates. It's really growth in broad money that determines levels of economic expansion and inflation — just as an altimeter regulates the altitude of an aircraft."

— Professor Steve H. Hanke, 2025

Making Money Work (2025)

Hanke and co-author Matt Sekerke's 2025 book Making Money Work: How to Rewrite the Rules of Our Financial System (Wiley, 2025) presents the most complete statement of Hanke's monetarist framework:

Core arguments:

1. 80% of broad money is produced by commercial banks (not the Fed)
2. Bank regulation is a form of de facto monetary policy
3. Fiscal policy matters for money creation and nominal income
4. Rules-based monetary policy outperforms discretionary central banking
5. The current system gives the Fed false credit (and blame) for monetary outcomes mostly determined by banking regulation

Policy Implications

Rules vs. Discretion

Following Friedman and Hayek, Hanke favors rules-based monetary policy over discretionary central banking:

• A fixed money growth rule (Friedman's k-percent rule) outperforms activist Fed policy
• Currency boards (Hanke's specialty) represent the ultimate rules-based monetary system — the money supply is determined automatically by the balance of payments
• Discretionary central banks introduce unpredictability that disrupts economic calculation

Currency Boards as Monetarist Implementation

Hanke's famous work on currency boards is directly connected to his monetarism: a currency board is the monetarist ideal made institutional. It removes discretion entirely, anchors money growth to an external reserve currency, and eliminates the central bank's ability to inflate.

Intellectual Lineage

Related Topics

• Free Market Economics
• Currency Boards
• Hyperinflation
• Ideas & Research