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November 19, 2006
Is Monetarism Dead?
Courtesy of Mark Thoma, I am sent to the Scientific American blog, where JR Minkel ruminates on the contributions of Milton Friedman, asking the question "Is economics a science?". Minkel offers up the question in the spirit of open debate, so fair enough. I did, however, find this passage somewhat puzzling:
Well, Friedman's most famous prediction was a pretty good one: he foresaw the possibility that high unemployment could accompany high inflation, a phenomenon better known as stagflation. That foretelling earned him the Nobel Memorial Prize, although Friedman's monetary theory is currently out of favor.
A similar sentiment is expressed by the eminent historian Niall Ferguson, in an article titled "Friedman is dead, monetarism is dead, but what about inflation?"
It wasn't just that Friedman rehabilitated the quantity theory of money. It was his emphasis on people's expectations that was the key; for that was what translated monetary expansion into higher prices (with positive effects on employment and incomes lasting only as long as it took people to wise up)...
... it will be for monetarism — the principle that inflation could be defeated only by targeting the growth of the money supply and thereby changing expectations — that Friedman will be best remembered.
Why then has this, his most important idea, ceased to be honoured, even in the breach? Friedman outlived Keynes by half a century. But the same cannot be said for their respective theories. Keynesianism survived its inventor for at least three decades. Monetarism, by contrast, predeceased Milton Friedman by nearly two.
The claim that "Friedman's monetary theory is currently out of favor" is, I think, wildly overstated -- at best. Pick up virtually any textbook in monetary or macroeconomics and what you will find is a presentation that it is fully steeped in Professor Friedman's justly famous "The Quantity Theory of Money: A Restatement." In simple terms, the quantity theory says something like this: Inflation results from an excess of money growth over the amount of money that people want (expressed in terms of money's purchasing power over goods and services). If you have taken a course in macroeconomics, or money and banking, that is probably what you learned, and it was bequeathed to you by Milton Friedman.
So why the belief Friedman's views have fallen into disrepute? I think it is a result of two things that, in the end, have little to do with whether Friedman's version of the quantity theory remains the dominant intellectual tradition among macroeconomists.
First, there is the association of Friedman's oft-cited constant money growth rule with the broader quantity-theoretic logic. Part of the rationale for the constant money growth rule had to do with specific assumptions that Friedman invoked regarding money demand -- the assumption, specifically, that changes in money demand not associated with income growth tend to be relatively slow and predictable. Part of it had to do with his judgment that the control needed to successfully "fine tune" the economy far exceeds the capacity of mortal men and women. These elements are not, however, essential to the quantity theory itself. Not accepting Friedman's views on these matters is very much different than rejecting the general quantity theory framework or its core implication that inflation is, in the end, a monetary phenomenon.
Second, there is the fact that monetary aggregates are themselves little used in the practical implementation of monetary policy. An exception, of course, is the European Central Bank, which still claims fealty to the notion that growth in monetary aggregates is a legitimate guide to policy choices. But, as William Keegan reports in the Guardian Unlimited, even that pillar of monetary policy may be "tottering":
The two elements became known as the 'two pillars' of the ECB's approach - an approach which seems to give too much influence to changes in the money supply (the 'second pillar'), which most economists now believe to be unreliable guides to the kind of short-term changes in the economy that concern central banks when they take their decisions about rates.
Sensitive to such criticisms, the ECB held a conference in Frankfurt 10 days ago, and its subject was 'The role of money: money and monetary policy in the 21st century'. Guests included a glittering array of central bankers, including Ben Bernanke, Alan Greenspan's successor as chairman of the US Federal Reserve, many distinguished academic economists, and a few journalists such as myself.
Bernanke and most of the academics gave short shrift to the importance of the 'second pillar', with varying degrees of politeness. Trichet delivered a spirited defence of the ECB's approach, as did Otmar Issing, the embodiment of the second pillar, who recently retired from being the highly influential chief economist of the ECB.
The tone of the conference was so one sided - that is, against the message of the hosts - that a conspiracy theory developed about this being the last stand of the monetarist-inclined ECB, and that they had invited hostile academics to give them an excuse to get off the hook, rather in the way that organisations employ management consultants to advise them to make changes they wish to make anyway.
Central banks these days do tend to conduct monetary policy with reference to interest rates rather than monetary growth. But choosing a target for an overnight bank lending rate -- like the federal funds rate -- is implicitly about choosing a path for money growth. Once an interest path is chosen, money growth follows automatically, and is in that sense invisible (or, mathematically, redundant). That does not, however, mean that the insights of the quantity theory are obsolete. That central bank practice has evolved toward a focus on a price (the short-term interest rate) rather than a quantity (money growth) says more about our confidence in the measurement of money than it does about our confidence in the theory that inflation has its roots in money growth (a theme that is expanded on, at length, in an essay in Federal Reserve Bank of Cleveland's 2001 annual report.)
It is true that recent influential ideas about inflation and central banking have incorporated the existence of "cashless" economies, which would indeed move us outside of the reach of the quantity theory. But those ideas contemplate the control of inflation in a hypothetical world (asking, for example, whether rules that work well in a monetary economy might work equally well in a non-monetary economy). That alone does not invalidate quantity-theoretic reasoning. What is more, justifying some aspects of central bank behavior -- the desire to avoid sharp movements in interest rates, for example -- seems to require the existence of money, and in an entirely conventional way. Which is to say, in more or less the fashion handed down by Milton Friedman.
Up to the very end -- hat tip, again, to Mark Thoma -- Professor Friedman was explaining why money matters. How appropriate. Although many these days would be less enthusisatic than he about emphasizing a particular measure of money, his ideas about money are as vital to the core of monetary policy reasoning as they ever were.
The king is dead. Long live his kingdom.
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