Cochrane needs to review Hume, Fisher, and Friedman

John Cochrane has lots of sensible things to say about the euro-crisis, but his analysis is marred by a serious error:

A currency is simply a unit of value, as meters are units of length. If the Greeks had skimped on the olive oil in a liter bottle, that wouldn’t threaten the

metric system.

Bailouts are the real threat to the euro. The European Central Bank has been buying Greek, Italian, Portuguese and Spanish debt. It has been lending money to banks that, in turn, buy the debt. There is strong pressure for the ECB to buy or guarantee more. When the debt finally defaults, either the rest of Europe will have to raise trillions of euros in fresh taxes to replenish the central bank, or the euro will inflate away.

Leaving the euro would also be a disaster for Greece, Italy and the others. Reverting to national currencies in a debt crisis means expropriating savings, commerce-destroying capital controls, spiraling inflation and growth-killing isolation. And getting out won’t help these countries avoid default, because their debt promises euros, not drachmas or lira.

Perils of Devaluation

Defenders think that devaluing would fool workers into a bout of “competitiveness,” as if people wouldn’t realize they were being paid in Monopoly money. If devaluing the currency made countries competitive, Zimbabwe would be the richest country on Earth.

Hume, Fisher, and Friedman would have approved of the measuring stick analogy.  But they also understood that money is non-neutral in the short run.

In Zimbabwe the government destroyed the supply-side of the economy and then printed money to paper over the problem.  Of course their RGDP fell.  I could offer the following examples in reply:

1.  The big Argentine devaluation of 2002 turned a depression into 8% a year RGDP growth.

2.  The big US devaluation of 1933 turned a depression into 8% a year RGDP growth.

Cochrane could argue that there must have been “real” factors at work, but unfortunately in both Argentina and America all the real factors were government policies he (rightly) loathes.  Both countries grew rapidly in response to currency devaluation despite counterproductive statist policies.  And those two examples are at least as relevant (or irrelevant) as Zimbabwe.  Greece has both real and nominal problems, and thus is totally unlike Zimbabwe.

We know that when countries are severely depressed due to a fall in NGDP, a sharp currency devaluation most certainly will boost competitiveness.  That doesn’t mean that Greece doesn’t have all sorts of other problems, but Greek wages would not immediately double if they exchanged two drachmas for each euro.

I’m increasingly frustrated with the tendency of modern Chicago economists to treat Friedman as a hero, and then gloss over the fact that his greatest achievement was showing that recessions and depressions are caused by nominal shocks.

On all the microeconomic issues Cochrane is right, but on the euro he couldn’t be more wrong:

The euro, like the meter, is a great idea. Throwing it away would be a real and needless tragedy.

Fisher said the dollar was like a measuring stick with a length that was always changing.  He opposed fixed exchange rates (i.e. the gold standard) because he wanted the central bank to keep the “length” stable.  Greece can’t do that if it’s tied to Germany.  Friedman understood this problem as well, which is why he predicted the euro would end badly.  He was right.

Cochrane should have called for the ECB to make sure nominal growth doesn’t plunge next year.  If they want to make the euro work (and it seems they do) then the least the ECB can do is provide enough NGDP growth so that the structural problems in countries like Greece are not compounded by disequilibrium in the labor market.  [The original version omitted “not” before compounded.]

And I sure wish Chicago would go back to teaching its students the lessons of Hume, Fisher, and Friedman.

HT:  Tyler Cowen

Update: Ramesh Ponnuru has an excellent critique of a piece in The American Conservative that is critical of NGDP targeting.


I read Tyler Cowen’s review of Keynes/Hayek in the National Review with mixed feelings:

There is one part of the longer story that Wapshott leaves out, and it is a quite recent development. Circa 2009, enter Scott Sumner, professor of economics at Bentley University and author of the blog TheMoneyIllusion. Sumner has almost singlehandedly resurrected the tradition of Milton Friedman and, more broadly, the philosophy of neo-monetarism.

Although Sumner is a brilliant thinker, and extremely well read, he admits he hasn’t given Hayek’s Prices and Production a thorough tussle; he seems to find the ideas too difficult and too obscure, as indeed do most other professional economists. Sumner’s diagnosis is simple: The American economy has collapsed because the Fed did not stabilize the flow of purchasing power in the economy,or what Sumner calls “nominal GDP.” Circa 2008, the Fed let purchasing power decline when it should have supported it with an aggressive commitment to reflate the economy. This may sound too interventionist to many free-market supporters, and the parts of the argument that emphasize “aggregate demand” seem suspiciously Keynesian. Nonetheless, Sumner persuasively couches the entire argument in terms of constraining the Fed with rules, in this case a “nominal-GDP rule” that would stabilize the flow of purchasing power and create a predictable macroeconomic environment for businessmen and consumers.

The bottom line is this: Whether we like it or not, the Fed has to do something, and letting the money supply continue to fall, in down times, is one of the worst options. It will give the economy a sharp negative shock in the short run and sweep interventionists and their cure-all policies into power, while creating a public hungry for quick-fix recipes. That is indeed what has happened in the United States.

Over the last two years, I’ve been amazed, and pleased, to see how many market-oriented economists have come around to Sumner’s point of view. (These days I cannot go anywhere in the world of economics, or blog readers, without hearing his name.) What that means is not a victory for either Hayek or Keynes, but rather a comeback for Milton Friedman, Irving Fisher, and the good old-fashioned “quantity theory of money.” Stabilizing the flow of purchasing power is indeed what the central bank should be trying to do, even if it achieves this end only imperfectly.

For all his brilliance, Hayek didn’t””at the critical time””have a good enough understanding of the dangers of deflation.  He didn’t fully realize the extent of sticky wages and prices and, more deeply, he didn’t see that ongoing deflation would render the “calculation problem” of a market economy more difficult. Hayek stressed that a market calculates value in a way that a central planner cannot””but lying behind this ability to calculate is some basic macroeconomic stability. At the key moments, Hayek did not offer the proper recipe forth at stability.

Why the mixed feelings?  Well it’s nice to be praised, but Tyler ignored all the other market monetarists (neo-monetarists?) who have played a big role in the revival of monetarism.  And then there’s poor Nicholas Wapshott, who must have felt like I hijacked the review of his book.

Tyler’s right that I’m no expert on Hayek; I recommend Lawrence White’s Journal of Money, Credit and Banking piece on Hayek’s views during and after the Great Depression.  White is sympathetic to Hayek, but also points out that late in his life Hayek expressed some regret at initially missing the dangers posed by deflation during the early 1930s.

Am I being disingenuous in claiming “mixed feelings” while reading Tyler Cowen’s book review?  Not at all; I felt a mixture of elation and euphoria.

PS.  I read lots of interwar stuff when I was much younger, but most of it didn’t stick.  I tend to remember things that interest me, and there’s really only two things about macro that I find interesting; how monetary policy drives nominal aggregates, and why nominal shocks have real effects.  I liked Fisher best, and also like Hawtrey, Cassel, Warren and Einzig.  I had mixed feelings about Keynes (Tract > Treatise > General Theory), Hayek, and Benjamin Anderson.  Don’t remember much about Pigou and Robertson.

PPS.  The book review is in the November 28th National Review.  Unfortunately it’s behind a pay wall.

Market monetarism?

In a recent post I complained that ‘quasi-monetarism’ was a horrible label and that we needed to change it.  I have considered ideas like ‘new monetarism’ and ‘post monetarism,’ but none of the alternatives seems satisfactory.  Now frequent commenter Lars Christensen has suggested ‘market monetarism.’  But he’s also done much more, he’s written an entire article on the quasi-, er market monetarist movement in the blogosphere.  It’s well worth reading for those who want an overview of the movement.  Marcus Nunes allowed Lars to do a guest post explaining his idea.

An economic school’s name naturally should represent the key views of the school. The Monetarist part is obvious as there is a very significant overlap with traditional monetarism. The difference between Market Monetarism and traditional monetarism, however, is the rejection of money supply targeting and the assumption about the stability of velocity is at the core of Market Monetarists’ reformulation of monetarism.

Instead of monetary aggregates and stability of velocity, Market Monetarists advocate the use of markets as an indicator of monetary disequilibrium. Furthermore, Market Monetarists advocate using market instruments such as NGDP futures – and in the case of William Woolsey Free Banking – as a tool to stabilise the policy objective (nominal GDP).

I am intrigued by this label, although I want to see what the other quasi-monetarists think before switching over.  As far as I can tell there are some subtle differences between the various quasi-monetarists in the blogosphere:

1.  David Beckworth, Nick Rowe, Bill Woolsey and Josh Hendrickson seem to focus a bit more on Yeager-style monetary disequilibrium models.

2.  Woolsey, David Glasner, Marcus Nunes and I focus on the need for NGDP future contracts (or perhaps wage contract in Glasner’s case.)  Beckworth recently mentioned the idea.

3.  Some of the quasi-monetarists may be a bit closer to old style monetarism than I am, whereas Glasner is probably a bit further way.  I’m not too sure exactly where Kantoos fits in.  I’ve been so busy I haven’t always kept up with the various blogs.

It’s not clear what the essence of quasi-monetarism actually is.  Nick Rowe doesn’t focus on US monetary policy quite as much as the rest of us (he’s in Canada), so I don’t know his precise policy views.  I think it’s fair to say the rest of us are all opposed to the Fed’s decision to allow NGDP to plunge sharply in 2009, and there seems to be general consensus that level targeting is the way to go.  We are all skeptical of interest rate targeting.  As far as using NGDP futures contracts, there seems to be varying degrees of enthusiasm.  It seems to me that the term ‘market’ is an implied critique of old-style monetarists like Anna Schwartz and Allan Meltzer, who have warned of the threat of inflation, even as both past movements in NGDP, and market forecasts of future gains, suggest money is too tight.  Indeed even though I am a big fan of Milton Friedman, I think one weakness of his approach was that he’d sometimes predict high inflation based on past money supply growth, even when market participants saw low inflation ahead.  Late in his life he endorsed Robert Hetzel’s proposal to have the Fed target TIPS spreads.

BTW, I’ve left out non-blogging quasi-monetarists, as it’s unclear where to draw the line.  I should add that even within the blogsphere it’s not obvious where to place various figures.  People like George Selgin share some of the perspectives of the quasi-monetarists.  In this respect quasi-monetarism is no different from the other “isms,” there are almost as many varieties as there are members.  And that’s good; we should never try to enforce ideological uniformity.

I’d like to see what other quasi-monetarists think before making any sort of name change.  But we can’t let Krugman label us any longer!

PS.  Josh Hendrickson has a new article in National Review.

Update:  I keep forgetting to include Niklas Blanchard, who is also a quasi (market?) monetarist.  Perhaps I forget because Karl Smith tends to dominate that blog.  It’s interesting how many of us there are—surely a sizeable fraction of all monetary economics bloggers.

The vacuum on the right

A year ago I did a post called “Two untimely deaths.”  Here’s an excerpt:

Milton Friedman died on November 16, 2006, one year before the sub-prime crisis.  I’d like to suggest that his death was the closest equivalent to the death of Strong in 1928.  In 1998 Friedman pointed out that the ultra low interest rates were a sign that Japanese monetary policy was very contractionary, at a time when most people characterized the policy as highly expansionary.

There is little doubt that Friedman would have recognized the low interest rates of late 2008 were a sign of economic weakness, not easy money.  But what about the big increase in the monetary base?  First of all, the base also rose by a lot in Japan, and in the US during the Great Contraction.  Second, Friedman would have clearly understood the importance of the interest on reserves policy, which was very similar in impact to the Fed’s decision to double reserve requirements in 1936-37.  And in his later years he became more open to non-traditional policy approaches, for instance he endorsed Hetzel’s 1989 proposal to target inflation expectations via the TIPS spreads.  Note that the TIPS markets showed inflation expectations actually turning negative in late 2008.

Why was Friedman so important?  I see him as having played the same role among right-wing economists that Ronald Reagan did among conservatives.  Reagan was really the only conservative that all sides respected; social conservatives, economic conservatives, and foreign policy (or neo-) conservatives.  After he left the scene, the conservative movement cracked-up.

Friedman was respected by libertarians, monetarists, new classicals, etc.  Last year I criticized Anna Schwartzfor adopting the sort of neo-Austrian view that she and Friedman had strongly criticized in their Monetary History.  If Friedman was still alive, and strongly insisting that money was actually far too tight, then I doubt very much that Schwartz would have gone off in another direction.  It would be like Brad DeLongdisagreeing with Paul Krugman on macroeconomic policy.  Once in a blue moon.

Today there is no real leadership among right wing economists.

[BTW, I kind of regret the shot at DeLong—I’m increasingly impressed by his brilliance, despite the fact that we often disagree.]

Now this issue is resurfacing.  Here’s Will Wilkinson:

TIM LEE asks an important question: why are conservatives and libertarians so uniformly hawkish about inflation? Mr Lee (a friend and former colleague) notes that this regularity is far from inevitable. Milton Friedman, a revered figure in right-of-centre circles, famously pinned the severity of the Great Depression on contractionary monetary policy. Scott Sumner, a professor of economics at Bentley University who identifies himself as a “neo-monetarist”, has argued that Friedman would have supported monetary stimulus. And he has argued, on neo-Friedmanite grounds, that tight monetary policy both precipitated and exacerbated our recent recession. I happen to think Mr Sumner is correct, but his expansionary prescription remains anathema on the right. Why?

.   .   .

Milton Friedman was one of the 20th century’s great economists as well as one its most formidable debaters. This made him a powerful check on the influence of anarcho-capitalist Austrians, obviously much to the chagrin of Rothbard. “As in many other spheres,” Rothbard wrote, “[Friedman] has functioned not as an opponent of statism and advocate of the free market, but as a technician advising the State on how to be more efficient in going about its evil work.” Rothbard’s fulminations notwithstanding, Mr Friedman died a beloved figure of the free-market right. Yet it does seem that his influence on the subject of his greatest technical competence, monetary theory, immediately and significantly waned after his death. This suggests to me that Friedman’s monetary views were more tolerated than embraced by the free-market rank and file, and that his departure from the scene gave the longstanding suspicion that central banking is an essentially illegitimate criminal enterprise freer rein.

I’d add a couple points here.  During his period of greatest influence he was known as somewhat of an inflation hawk, as high inflation was the big problem and the old Keynesian model didn’t have good answers.  The right was happy with that monetarist critique of Keynesianism.  And second, the most important section of Friedman and Schwartz’s Monetary History of the United States was the chapter on the Depression, where they were highly critical of the Fed’s deflationary policies.  Even inflation hawks don’t think rapid deflation is a good idea.  But the subtext of their monetary history was even more important.  The Great Depression had discredited capitalism in the eyes of most intellectuals.  By showing that the problem was tight money, not laissez-faire policy, Friedman and Schwartz opened the door to the neoliberalrevolution.  The New Keynesian technocrats who ran the world economy from 1983 to 2007 are much more comfortable with laissez-faire than their old Keynesian predecessors.

And here’s Tim Lee:

This has gotten me thinking about the broader connection between peoples’ views on monetary policy and their broader ideological worldviews. With the lonely exception of Scott Sumner, virtually every libertarian or conservative who has expressed a strong opinion about monetary policy has come down on the side of the inflation hawks. Over the last three years, a wide variety of fiscally conservative Republican politicians have attacked the Federal Reserve for its unduly expansionary monetary policy. I can’t think of a single Republican on the other side.

Yet it’s not obvious why this should be. There’s a coherent ideological argument for abandoning central banking altogether in favor of a gold standard or free banking. In a nutshell, the argument is that no single institution will have the knowledge necessary to “steer” monetary policy, and so we should prefer a monetary system that decentralizes control over the supply of money.

But whether you like it or not, we do have a central bank and it’s important that it function effectively. Logically, it seems like libertarians should be equally worried about both the threat of too much inflation and the threat of too little. After all, one of Milton Friedman’s most famous books argued that the Depression was worsened by the Federal Reserve’s unduly contractionary monetary policy. Yet (again, aside from Sumner) no free-market thinkers or politicians made this argument even in the depths of the 2009 contraction.

So why is right-of-center opinion so lopsided? I can think of two possible explanations. One is that we’re still having the monetary policy debates of the 1970s, when right-of-center thinkers, following Milton Friedman, argued that the era’s persistently high inflation was the fault of unduly expansionary monetary policy. They were right about this, and a whole generation of free-market intellectuals has been on guard against the threat of inflation ever since. And this is obviously reinforced by the reciprocal trend on the left: because most of the inflation doves are on the left, people who are in the habit of disagreeing with left-wingers are discouraged from adopting their arguments on this issue.

Those are good points, but I’ll add a few more:

1. I t makes me uncomfortable to level this charge (as there is nothing I hate more than others questioning my motives) but it’s a bit awkward when you have conservative bastions like the Wall Street Journal bashing the Fed’s tight money policies in 1984, when inflation was 4% (and Reagan was in office) and making the opposite change when inflation is even lower, and Obama is in office.  I actually have a fairly positive view of the motives of most intellectuals on both the left and the right.  I assume they are well-intentioned.  But if a person strongly opposes a set of policies and hopes a new government will soon reverse them, it may at least subconsciously affect that person’s enthusiasm for monetary stimulus that would make the economy look much better, almost assuring the incumbents re-election.

2.  However I don’t believe even subconscious bias is the main issue.  The current policy stance looks much more expansionary than it really is (due to low rates and the hugely bloated monetary base.)  So there are certainly worrisome indicators that even the best macroeconomists could point to, especially given the (overrated) worry about “long and variable lags.”  It’s not all populism.  I was at a conference last year full of conservatives who knew just as much monetary economics as I do and they were almost all were opposed to QE2.  And conservatives weren’t criticizing the Fed in September 2008, when easier money might have helped McCain.

3.  I have very mixed feelings about seeing my name mentioned in both pieces.  Naturally I’m happy that people are paying attention to my ideas.  But I also worry about a world where I’m the name people mention when looking for someone who will carry on the tradition of Milton Friedman.  And this isn’t just false modesty.  No matter how highly I regard my own views, or those of similar bloggers like David Beckworth (who also could have been cited), the hard reality is that we don’t have the sort of credentials that carry a lot of weight among the elites.  (BTW, this doesn’t apply to Nick Rowe, who is probably has a much higher profile in Canada than we quasi-monetarists have in America.)

Cryptic prediction:  Before 12 moons have passed, a star will arise in the East to lead Milton’s scattered tribe into the promised land of respectability.

PS.  Thus far we’ve been called “quasi-monetarists.”  I would have preferred “new monetarists,” but Stephen Williamson’s already grabbed that name.  Will calls us neo-monetarists.  I’m growing increasing fond of ‘post-monetarist’—particularly for the futures targeting idea.  Weren’t post-modernists like Foucault skeptical of central authority?  And is it just me, or does “quasi” have a slightly negative connotation?

A dilemma for conservatives

Milton Friedman helped revive capitalism when he showed that the Great Depression didn’t show capitalism was unstable, but rather that monetary policy had been unstable.  Some critics argue he actually was a closet interventionist, as he thought capitalism required active stabilization policy.  Perhaps, but one could also argue that he was saying “as long as the government runs our monetary regime, they need to do it well.”  Sort of like a libertarian arguing that if governments build our bridges, they should build them so that they don’t collapse.

In any case, conservatives later started to drift away from the Friedman/Schwartz view of the Great Depression, and became increasingly disdainful of “demand shock” explanations of the business cycle.  This created a huge problem in 2008, as conservatives had great difficulty defending the free market, which seemed to have once again failed us.

To be sure, they did find some important policy failures; from the GSEs to deposit insurance to the regulation of the ratings agencies to the moral hazard created by “Too-Big-to-Fail.”  Nevertheless, given all the bad loans that were made without government pressure, by private banks, to middle class borrowers, it was pretty hard to completely absolve the private sector.

I believe that abandoning the Friedman/Schwartz view of the business cycle was a big mistake.  It’s not that this view would have magically absolved the private sector from any role in the sub-prime fiasco, I’m somewhere in the middle on this issue, believing both regulators and private actors made huge mistakes.  Rather the F/S view would have absolved the financial crash from being the primary cause of the Great Recession.  It would be much easier to live with the occasional financial fiasco if it didn’t lead to a Great Recession.  Remember 1987?

If RGDP hadn’t fallen sharply in 2009 then the banking crisis would have been resolved much more easily, with far less public money.  For that to have happened we would have needed to prevent NGDP growth from turning negative.  And that would have required that conservatives accept the F/S view of the Great Depression, instead of drifting toward “real” theories of business cycles.

Why focus on conservatives, weren’t liberals also clueless about monetary stimulus?  If people like Fisher, Plosser, and Hoenig had warned that aggressive monetary stimulus was needed to prevent a severe slump; does anyone really believe the doves at the Fed would have stood in the way?

In 1930-33 the policies advocated by Friedman and Schwartz would have been viewed as being highly progressive.  Later Friedman moved away from steady monetary growth toward policies that would offset velocity shocks—even more progressive.  It’s a pity that so few liberal and conservative economists picked up the torch when Friedman died in 2006.  What is “the torch?”

1.  Demand shocks drive the business cycle.

2.  Monetary policy is the best tool for demand stabilization.

3.  Monetary policy is very powerful at the zero bound.

How many economists believed all three in October 2008?