What would Milton Friedman say?

In a recent post I pointed out the uncanny correlation between the very small group of economists that either explicitly or implicitly criticized Fed policy as being too tight during the recent crisis, and the even smaller group that had published articles advocating a forward-looking policy of “targeting the forecast.”  It seems that having this forward-looking perspective made us especially likely to view monetary policy as too contractionary last fall.  When I came up with that list, I was thinking only of those who had made a contribution to the futures targeting literature, not minor figures who merely endorsed the ideas of what others.  I know only one economist who falls into the latter category:

Milton Friedman.

Carl Futia sent me the following note and the quotation from Friedman:

Here is an excerpt (edited to improve readability) from the preface to Hetzel’s 2008 book “The Monetary Policy of the Federal Reserve”. It is part of a March 1991 letter sent by Milton Friedman to Michael Bruno, then governor of the Bank of Israel:

“..Hetzel has suggested…that the Federal Reserve be instructed by the Congress to keep the difference between a nominal and an indexed bond yield below some number. [This] is the first nominal anchor that has been suggested that seems to me to have real advantages over the nominal money supply. Clearly it is far better than a price level anchor which is always backward looking.”

So it looks like we can add Friedman to the list:

Did “targeting the            Viewed Fed policy as too                                           forecast” research           contractionary in late 2008

1.  Thompson                  1.   Thompson

2.  Hall                             2.  Hall

3.  Glasner                       3.  Glasner

4.  Me                              4.  Me

5.  Hetzel                         5.  Hetzel

6.  Woolsey                      6.  Woolsey

7.  Svensson                    7.  Svensson

8.  Jackson                      8.  Jackson

9.  Dowd                         9.  Congdon

10.  Friedman              10.     ???

Even if you completely disagree with my view of the crisis, I don’t see how anyone could deny the close correlation between these two lists.  To repeat, the lists are undoubtedly not complete, but adding a few more names wouldn’t change that fact the correlation is not due to chance.

It turns out that Friedman also spent about three pages discussing Hetzel’s idea in what I believe was his last major book on monetary economics; Money Mischief.   I have often criticized the monetarists’ focus on long and variable lags, arguing that monetary policy should immediately impact asset prices.  If one targets the forecast, then there should be no lag at all.  What does the person who actually coined the term “long and variable lags” have to say about that idea?

“There have been recent proposals for legislation requiring the Fed to aim at zero inflation.  The objective is desirable, but such a requirement cannot be effectively monitored or enforced—again because of the ‘long lag,’ which would visit the sins (or the reverse) of the current monetary authorities on their successors.  That problem does not arise with a requirement based on the difference between the two interest rates.”  (p. 229, emphasis added.)

The phrase “the two interest rates” refers to the yields on conventional and indexed bonds.  Something tells me that the man who fervently condemned the deflationary monetary policies of the 1930s, and who claimed that even the milder post-war recessions were triggered by tight money, would not have looked kindly on a monetary policy that drove TIPS yields much higher than conventional bond yields, i.e. a policy expected to produce deflation.  Especially if the policy was adopted during the worst financial crisis since the 1930s.  What do you think?

Friedman was known as a monetarist, but the central planning aspects of monetarism (fixed money growth rate, 100% reserve money, etc.) seem oddly out of place for a libertarian economist who had a passionate belief in free markets.  Given that one of his most famous arguments was that speculation stabilizes prices, I don’t think he would have been persuaded by those who discount the relevance of market signals such as TIPS spreads.   Toward the end of his life Friedman was clearly moving away from monetarism and toward what in the 1980s was known as the “New Monetary Economics.”  That is, a monetary policy based on efficient markets theory, not central planning.  A policy focused on directly stabilizing the (expected) value of money, rather than stabilizing its quantity and hoping for the best.

Friedman died less than a year before the sub-prime crisis flared up.  I imagine that many people assume that if Friedman were alive he would now share Anna Schwartz’s view that money has been far too easy.  Certainly she claimed her recent views corresponded to the ideas in their Monetary History, although in this post I showed they were actually 180 degrees opposed.   Obviously I cannot claim to know for certain what Friedman would have thought, but I wouldn’t discount the possibility that his late conversion to targeting the forecast might have led him in some rather surprising directions.

PS.  When I visited the cathedral in Ely, England, the guide mentioned that there was a revered Saxon princess buried there, whose remains had been stolen from a nearby town.  I hope my fight over the intellectual legacy of Milton Friedman is not considered equally unseemly.



14 Responses to “What would Milton Friedman say?”

  1. Gravatar of Greg Ransom Greg Ransom
    31. July 2009 at 16:23

    In his last years Friedman was endorsing free banking.

  2. Gravatar of Greg Ransom Greg Ransom
    31. July 2009 at 16:30

    In 2006 interviews Friedman essentially endorsed The Feds management of money and credit — and he saw no problems ahead for the economy. See for example Friedman’s EconTalk interview with Russ Roberts.

  3. Gravatar of Current Current
    31. July 2009 at 16:55

    “When I visited the cathedral in Ely, England, the guide mentioned that there was a revered Saxon princess buried there, whose remains had been stolen from a nearby town. I hope my fight over the intellectual legacy of Milton Friedman is not considered equally unseemly”

    Etheldreda. I lived in Ely a few years ago.

    I recommend it to anyone visiting the south-east of england.

  4. Gravatar of TA TA
    31. July 2009 at 17:07

    I am not a monetary economist. Actually, I am not an economist at all. My economics education consists of three introductory courses in college in the late 1950’s (macro, micro, and money and banking), plus reading this, that and the other, especially since I retired from business. But, here goes….

    I read the Hetzel paper you cite. As I get it, perhaps wrongly, his argument is this:
    1. The Fed can anchor long-term inflation expectations, with the right policies, pursued consistently.
    2. There is a real interest rate that will yield equilibrium at full employment.
    3. Because of (1), the Fed can drive real interest rates to that point by driving nominal interest rates.
    4. The amount of money (creation) required to do this will be consistent with the public’s desire to hold money at the target interest rate (more or less — this is sort of a throw-away line in his paper).
    5. If halted short of the target by the ZLB, throw more money out there; eventually the public will spend it.

    Is that it? Or am I lost in the weeds?

    In any event, now what? I’m not too clear how the spread of nominal and indexed bonds should operate as a guide in all this.

  5. Gravatar of TA TA
    31. July 2009 at 17:11

    One more thing: when the spread between nominal and indexed bonds flips to negative, doesn’t that mean that the Fed has lost control of long term inflation expectations? What happens then?

  6. Gravatar of ssumner ssumner
    31. July 2009 at 17:39

    Greg, Thanks. That supports my argument that late in life he was moving from monetarism to his more natural libertarianism.

    Greg#2, Thanks. That suggests he thought 2% inflation was about right, and that he would have strongly opposed the deflationary policy adopted in 2008, and easily predictable from the TIPS spreads that he endorsed in both his last book and his letter quoted in the post. (BTW, since I favor NGDP targets, not inflation, I think money was a bit too easy in 2004-06.)

    Current, Thanks, it’s been 23 years since I was there. Ely was a pleasant surprise, as I knew nothing about the town. The guide was amusing. I also visited Thetford, where my dad was stationed during the war–he had a lot of great stories. I stopped in Cambridge, Ely, Lincoln, York, Durham. One great cathedral after another.

    TA, You are not lost at all, that summary is about right. I have a post on inflation, and then the Hetzel one should be up by Monday. Yes, they had lost credibility in late 2008 when the real rates rose above the nominal rates.

    They’re back below now, but the gap needs to be wider. In other posts I discuss ideas like a penalty rate on excess reserves and an explicit growth path for NGDP with a promise to catch up to any shortfalls.

  7. Gravatar of TGGP TGGP
    31. July 2009 at 17:51

    Given that Anna Schwartz came to conclusions that seem to go against her theory for this recession, while Hayek & Robbins allegedly did for the Great Depression, I wouldn’t discount the probability that Friedman could have gotten swept up in the panic like Bernanke.

    It’s a bit off topic, but I’ve recently been reading some of Herb Gintis‘ reviews on Amazon. A point that struck me is his contention that (contra the “Animal Spirits” types) there is no basis in economic theory for believing that an economy of rational actors will be stable. I think Post Keynesians believe something similar, though he doesn’t seem to accept that theory either.

  8. Gravatar of jean jean
    1. August 2009 at 01:14

    I think you should have a look at this:

    The views expressed there are quite consistent with those of Anna Schwartz today.

    Of course, this does not answer the question “What Milton Friedman would have thought in the 1980s?”

  9. Gravatar of ssumner ssumner
    1. August 2009 at 04:52

    TGGP, That’s a good point. But Friedman had a much more abstract perspective on macro than most other economists. I think he would have been able to focus on the essentials of what was going on. Remember that in the early 1960s he saw clearly what had happened in the Great Depression, at a time when most other (Keynesian) economists were hopelessly confused about the event there.

    Jean, Very interesting. Of course these views are seemingly at odds with the comments reported by Greg Ransom above. My hunch is that his support for a fixed money base and free banking that you cite reflected his utopian libertarian leanings, whereas Greg’s citation reflects Friedman the pragmatist’s take on current policy.

    So I think either interpretation is possible. Of course neither are anything like what Anna Schwartz was advocating, with her views that the Fed should “manage” markets.

    BTW, I agree with one thing Friedman said. The world’s central bankers made it seem like controlling inflation is difficult. It isn’t. That’s precisely why virtually all countries succeeded after 1982. It was just a matter of trying.

  10. Gravatar of 123 123
    1. August 2009 at 10:43

    The best indication is in his 1998 WSJ article “Rx for Japan: Back to the Future”, where he supports QE. Link is here:

    Current situation differs from Japan’s experience, because now velocity has sharply dropped as a result of a run on the financial system, and the remaining mystery is would Milton Friedman give greater weight to monetary aggregates or to nominal income (abovementioned article mentions both). In one case he would say that Fed is right on track, in another he would say that even more stimulus is needed.

  11. Gravatar of Lawton Lawton
    1. August 2009 at 13:08

    Maybe Friedman would have an easy “out” — monetary aggregates MINUS the excess reserves. (I haven’t checked the numbers to see if that’s sufficient.)

  12. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    1. August 2009 at 16:55

    123 Thanks for that link. I have been arguing that MF would support real QE. Where I disagree with him is that I believe that a stimulus and QE can work together, and work better than either alone. This is put forward in the Chicago Plan of 1933, by MF’s teachers and Irving Fisher.

  13. Gravatar of ssumner ssumner
    2. August 2009 at 11:12

    123, Thanks, that’s a really nice article. it shows that one has to be careful, Friedman didn’t always support a stable monetary base, he was very pragmatic. And there was also this:

    “Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.”

    And this:

    “After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

    Sometimes I’ve felt lonely making exactly this argument in this blog. Especially when people like Anna Schwartz argue just the reverse, that low interest rates indicate easy money. It’s good to know that at least Milton Friedman would agree with me.

    To answer your question, I think Friedman would give greater weight to falling NGDP, but I can’t be sure.

    Lawton, I agree the ERs would be his “out.” But I’d put it slightly differently. I think he’d say this was the same mistake the Fed made in 1936-37, and then once the mistake was made the aggregates rose because FDIC-insured deposits were a safe haven in a financial crisis (like cash was in the 1930s.)

    Don, You are right about the Chicago plan, it did have a fiscal component. I think it could work alone, but I understand why some want to combine them just to make sure.

  14. Gravatar of TheMoneyIllusion » Milton Friedman, Ben Bernanke and me TheMoneyIllusion » Milton Friedman, Ben Bernanke and me
    10. November 2010 at 12:59

    […] July 31, 2009 […]

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