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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.      

November 19, 2006 in Federal Reserve and Monetary Policy , Interest Rates , This, That, and the Other | Permalink


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Of course, money matters. To say otherwise is an extreme proposition. Of course to say only money matters would also be extreme. I doubt any serious economist would say the latter - but check out those "tributes" to Milton Friedman over at the National Review. It's sort of like the old adage - with friends like these, who needs enemies.

Posted by: pgl | November 19, 2006 at 09:15 AM

Pgl tries to trivialize Friedman's view by arguing that it would be extreme to argue that money matters not at all and extreme to argue that only money matters. What Friedman actually said in 1970 is "Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output... A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth. It will not produce perfect stability; it will not produce heaven on earth; but it can make an important contribution to a stable economic society."

Notice that he did made a specific claim. "Money matters" is the shorthand that many have used to characterize his view. To riff off a second hand quote in order to give another tedious jab at NRO is pretty lame.

Posted by: Rich Berger | November 19, 2006 at 01:42 PM

Rich - it is a fair point that Milton Friedman did argue that monetary restraint could stop inflation, which again few deny. The debate then - as is now - how much lost output would this require. The new classical view of Tom Sargent and Bob Locas (something I noted that Friedman did not endorse 100%) was there was no need for a recession to disinflate. As I noted when the National Review referred to Thatcher's recession in their strange tribute, I don't blame Friedman for this.

But Sargent's unpleasant monetarist arithmetic stands for the propostion that reckless fiscal policy can undo attempts at monetary restraint. The Reagan - Volcker tug of war was an early indication of this. Argentina around the turn of the century was a dramatic representation of how bad fiscal policy can undo tight money.

Posted by: pgl | November 19, 2006 at 04:41 PM

Further, to what extent is current central bank behaviour driven by the effects of tightening on aggregate demand, not on the money supply as such?

Posted by: Alex | November 20, 2006 at 12:04 PM

Debating Moneterism is wading into treacherous waters, but Bernanke argued in his tribute to Friedman back in 03 that you can Reconcile the Sargent/Lucas and Fiedman views by throwing in expectations.

Since the public knows the budget deficit must be financed via increased money supply, inflation rises. It looks like this has a lot to do with Central Bank credibility, the level of the deficit, etc.



Posted by: Matt festa | November 21, 2006 at 09:28 AM

Japan offers the best vindication of the quantity theory. Japan brought interest rates to almost zero, but failed to stimulate its economy. However, money growth was weak.

Then they went to "quantitative easing," increasing money supply more rapidly even though interest rates couldn't fall any more. That brought their economy around.

The Fed is using interest rates as a tool, but they are thinking monetarist thoughts, not Keynesian thoughts. The use of interest rates is about challenges caused by the widespread use of sweep accounts rather than any fundamental problems with the quantity theory.

Posted by: Bill Conerly | November 21, 2006 at 02:56 PM

It seems to me that the Fed's current stance is diametrically opposite from Friedman's: fine-tune the interest rate to keep the economy at trend growth, and no inflation should result.

The implicit assumption is above-trend real growth causes inflation, not excess money. Of course, the corrolary is this: below trend growth is incompatible with inflation, and it therefore should be fought with lower rates, regardless of money growth.

This single idea will be the cause of much dislocation in the economy in the years to come.

Posted by: michael pearson | November 23, 2006 at 06:43 AM

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