Ed Nelson on Milton Friedman

One of my favorite David Beckworth podcasts is his interview of Ed Nelson, who has recently published a book on Milton Friedman (which I plan to read soon.) Here Nelson discusses how Friedman responded to Sargent and Wallace’s Unpleasant Monetarist Arithmetic paper:

And, it’s a good news for monetarists because you can separate monetary and fiscal policy, even with fiscal policy running large deficits. And so Friedman argued that as a practical manner, other than the early 80s, it was the case that US history was characterized by R being lower than little g, growth rate of government spending.  So when you have that, you had a situation in which you can run deficits, you can accumulate debt and you’ll still have debt to GDP, public debt to GDP, often tending to decline. So he regarded that like the practical case. That was his answer to Sargent and Wallace. And in fact, if you look at the Gilder and Fisher textbooks from the 80s, the r less than g edition, and this is something that, has had life breathed into it by Olivier Blanchard’s paper, it’s something that’s been a textbook point for a long time. And Friedman made the point in 1987. And of course it’s basically implicit or explicit in Sargent and Wallace, but anyway, it wasn’t what Sargent and Wallace pushed, but it was what Friedman pushed when he read Sargent and Wallace that, “You will be able to separate monetary and fiscal policy because R is less than G.”

Today, R (interest rates) are even further below g (economic growth.)

A lot of nonsense has been written to the effect that “there is no such thing as a money multiplier”. Nelson sets the record straight:

And the reason he thought an M2 target was feasible is that he thought that the monetary base could be used to manage M2. He believed that there was a ceteris paribus money multiplier relationship between the monetary base and M2. The monetary multiplier is, again, something that gets a lot of trash talking among modern day economists and people who say, “all textbooks are all wrong about the money supply process.”

I think that that is really doing a disservice to the idea of ceteris paribus. Because if you just look at a world without interest on reserves or without a lot of the complications, there is a logic why a change in reserves would lead to a change in deposits. You can add all sorts of bells and whistles to the money supply function, but that’s the basic message that I think is valid.  And so, he was arguing, you should be able to control M2, by offsetting with open-market operations factors affecting the money multiplier. So, you can argue that that was a sense of fine-tuning prescription, the fine tuning would be getting an M2 target, but he believed there was a fairly reliable relationship between the monetary base and M2 and after the 1990s, certainly that was quite accurate.

Friedman used M2 as an intermediate target in roughly the same way as I use NGDP futures prices as an intermediate target. The correct criticism of the money multiplier is that it is not particularly useful, even without IOR, because targeting M2 is not a good idea.

Another common misconception is that monetarists (wrongly) assumed that the actual velocity of circulation was constant. Not so:

Beckworth: And I think he would argue, and correct me if I’m wrong here, he would argue that if the Fed had done this, if the Fed had successfully targeted, say, M2 this whole period, this whole time, then velocity would have been more stable. Is that fair? And therefore this breakdown in the money demand relationship with income would be less of an issue.

Nelson: That’s right. He believed, for example, in the 1930s, particularly that the big fall in velocity, and it was a big fall in the velocity, even though the money and nominal spending had a big relationship. It was a big fall in velocity, but he thought that was due to big uncertainty engendered by the monetary and economic collapse. So he thought that velocity fluctuations often were triggered by monetary instability. And that certainly is something that will be widely shared when it comes to hyperinflation which is well-known in term, inflation engenders big increases in velocity.

PS. In the National Review, David Beckworth pushes back against the view that big deficits will lead to high inflation

PPS. Matt Yglesias has a very clear explanation of why NGDP is a better target than inflation.

PPPS. George Selgin has a very informative post on banknotes during the 19th century. Here’s the image he should have used for government money porn:



17 Responses to “Ed Nelson on Milton Friedman”

  1. Gravatar of John Hall John Hall
    31. March 2021 at 12:19

    It would make for an interesting Econlog blog post to walk through the basics of “Unpleasant Monetarist Arithmetic” and how Milton Friedman responded.

  2. Gravatar of Gene Frenkle Gene Frenkle
    31. March 2021 at 18:33

    With respect to inflation I think the toilet paper scare of 2020 shows that inflation isn’t a concern as long as supply chains are functioning properly. So lumber prices are very high even though potential lumber is plentiful…but the supply chains aren’t functioning properly. I remember from an old 60 Minutes interview that Greenspan would check the lumber prices every day.

  3. Gravatar of postkey postkey
    31. March 2021 at 23:49

    “all textbooks are all wrong about the money supply process.”

    Of course they are?

    “Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.”

    Keep ‘believing’?

  4. Gravatar of postkey postkey
    31. March 2021 at 23:56

    “Another common misconception is that monetarists (wrongly) assumed that the actual velocity of circulation was constant. Not so:”

    It depends upon which ‘velocity’ is being considered?

    “This paper has suggested a simple model that can account for the key anomalies of the traditional monetary approach. It disaggregates the quantity of credit into a ‘real’ and a financial circulation. In time periods, when the ratio of credit in the financial circulation to credit in the real circulation rises, the simple quantity theory must be expected to disappoint, as it is a special case of the more general quantity theorem of disaggregated credit. In such time periods, a financial boom is likely, as asset prices are driven up by speculative borrowing on the back of collateralised assets. This explains why the traditional monetary quantity theory was not popular in the 1920s and 1930s, and again in the late 1980s and early 1990s. Then the traditionally defined velocity of money declines and excess credit creation can ‘spill over’ as foreign investment. However, during time periods such as the 1950s, when in many countries credit was mainly channeled into the real economy, asset prices remained stable and the traditional quantity theory could be expected to hold. The fact that the model can account for the major anomalies observed in many countries over many time periods demonstrates generality and robustness.
    The empirical results for the Japanese case have been unambiguously supportive. The Japanese asset bubble of the 1980s was due to excess credit creation by banks for speculative purposes, largely in the real estate market. The apparent velocity decline is shown to be due to a rise in credit money employed for financial transactions, while the correctly defined velocity of the real circulation is found to be very stable“

  5. Gravatar of Joshua Greenberg on Antebellum Paper Money – Alt-M Joshua Greenberg on Antebellum Paper Money - Alt-M
    1. April 2021 at 04:24

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    […] if the deuce isn’t X-rated enough for you, how about this five-spot (H/T Scott Sumner, who it seems is something of a connoisseur of such […]

  7. Gravatar of marcus nunes marcus nunes
    1. April 2021 at 10:02

    A useful role for the money multiplier, not from targeting M2 but from “freezing reserves”.

  8. Gravatar of ssumner ssumner
    1. April 2021 at 10:49

    Gene, So supply chains did not function properly from 1966-90?

  9. Gravatar of Gene Frenkle Gene Frenkle
    1. April 2021 at 11:05

    I would say through 2008 supply chains were suboptimal if one includes oil and American natural gas as fundamental to supply chains. In 2021 macroeconomists’ models should work better now that most of micro issues have been solved. So demand for toilet paper increases due to more Americans working from home and the toilet paper industry reacts to the demand by producing more toilet paper for home use.

  10. Gravatar of marcus nunes marcus nunes
    1. April 2021 at 11:45

    Correcting the link:
    A useful role for the money multiplier, not from targeting M2 but from “freezing reserves”.

  11. Gravatar of Mark Z Mark Z
    2. April 2021 at 08:54

    What do supply chains have to do with inflation? Inflation isn’t caused by shortages. It’s not as if you keep printing more and more money, producers produce more stuff until prices return to what they were before.

  12. Gravatar of ssumner ssumner
    2. April 2021 at 10:36

    Marcus, Note that the reserve multiplier is totally different from the money multiplier.

    Mark, That’s my reaction too. I think Gene is confusing relative and absolute prices.

  13. Gravatar of Gene Frenkle Gene Frenkle
    2. April 2021 at 10:57

    I thought the rise of China is what has kept inflation low?? China = supply chains. And Yglesias posited that high oil prices were responsible for inflation in the 1970s. Oil is fundamental to supply chains.

  14. Gravatar of Gene Frenkle Gene Frenkle
    2. April 2021 at 11:18

    I will add in the 1950s and 1960s third world countries believed they could skip economic development steps by getting the macroeconomics right. So geniuses like Obama senior and Kamala’s father came to America to study economics so they could help their respective countries—but macroeconomics isn’t magic and so they didn’t magically skip economic development steps.

    Macroeconomic models only work in America because McDonalds and Walmart are properly managed. So America is like Chik Fil A and China is like McDonalds and Argentina is like Burger King. Argentina has good food and good wine…but you might have to wait an hour in the drive thru. 😉

  15. Gravatar of ssumner ssumner
    3. April 2021 at 08:15

    Gene, China affects relative prices, it has zero impact on overall inflation. Low inflation is caused by slow NGDP growth, i.e. tight money.

  16. Gravatar of Gene Frenkle Gene Frenkle
    3. April 2021 at 09:01

    Greenspan looked at lumber prices every day…if our economy didn’t function properly then macroeconomists can’t really do their job. Venezuela has Harvard trained economists…and yet they have inflation. When Amazon and Walmart and McDonalds and frackers are all focused on reducing costs and actually very good at it…it makes the Fed’s job much easier. So I agree the Fed could screw everything up even with Fortune 500 CEOs performing optimally…the Fed hasn’t screwed everything up.

  17. Gravatar of Gene Frenkle Gene Frenkle
    3. April 2021 at 12:27

    From February 2008 NYTimes,

    SHANGHAI — China’s latest export is inflation. After falling for years, prices of Chinese goods sold in the United States have risen for the last eight months.

    Soaring energy and raw material costs, a falling dollar and new business rules here are forcing Chinese factories to increase the prices of their exports, according to analysts and Western companies doing business here.

    The rise was a modest 2.4 percent over the last year. But even that small amount, combined with higher energy and food costs that also reflect China’s growing demands on global resources, contributed to a rise in inflation in the United States. Inflation in the United States was 4.1 percent in 2007, up from 2.5 percent in 2006.

    Because of new cost pressures here, American consumers could see prices increase by as much as 10 percent this year on specific products — including toys, clothing, footwear and other consumer goods — just as the United States faces a possible recession.

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