Whatever Happened to Milton Friedman's Ideas?
Answer: For one thing, they're thoroughly embedded in current monetary policy issues.
I saw an article, “The End of Friedmanomics,” referenced by Paul Krugman on Twitter, which attempts to make the case that Milton Friedman was not only a terrible economist, but an atrocious human being, and that his ideas have been appropriately tossed in the ash heap of history, the compost pile of odd notions, the purgatory of horrible mistakes, or wherever wrongheaded and discarded economics goes to rest. I didn’t quite know what to think. So, I read the article, then went back and looked for the part addressing something I think I know, to see if the author, Zachary Carter, actually knows what he’s talking about.
Here’s what I found:
“In 1963, he [Friedman] at last delivered on the empirical promises he made to the field in 1953, publishing the work that made him the most famous economic thinker of his era, A Monetary History of the United States, 1867–1960. Co-written with Anna Jacobson Schwartz, the book offered a sweeping, meticulous account of changes in the quantity of money across the American economy over the course of nearly a century, with detailed explanations for the various forms of currency creation and destruction that occurred along the way. Friedman had never published anything nearly so ambitious, and would never do so again.”
“Constructing a 93-year account of fluctuations in the money supply is a curious endeavor to assume for its own sake. But of course Friedman had an intellectual motivation, which he detailed in a famous 1967 speech before the American Economic Association: He hoped to dethrone the ghost of John Maynard Keynes.”
So, that makes it seem that Friedman and Schwartz wrote the Monetary History, and there wasn’t much else going on in Friedman’s academic career, before or after. It helps to read the presentation speech for Friedman’s 1976 Nobel Prize, to get some idea of the depth and breadth of his work, and his influence on the economics profession. Further, in economics, a Nobel Prize and a boatload of citations to your published work essentially certifies you as a big deal in your generation of economists. From Google Scholar (yesterday), these are numbers of citations for Friedman’s most-cited work:
Monetary History of the United States (1963): 10,617
Theory of the Consumption Function (1957): 10,482
The Role of Monetary Policy (1968): 10,347
To put that in perspective, Woodford’s Interest and Prices gets 8,391 Google citations. Tobin, who was Friedman’s contemporary (and adversary) gets 7,778 for his most-cited work, “A General Equilibrium Approach to Monetary Theory.” So, Friedman indeed has received a boatload of citations. In fact, in contrast to what Zachary Carter is telling us, Friedman had two boatload-of-citations pieces well before and well after he and Anna Schwartz published the monetary history. And that’s just a start. Friedman had much more stuff than that, a good part of it influential and well-regarded by academics.
Finally, if you read Friedman’s work, you won’t find him taking issue with the fundamentals of Keynesian economics. He wasn’t out to “dethrone” Keynes, whatever that might entail. If you read “The Role of Monetary Policy,” you’ll see that Friedman is comfortable with the mechanisms and language of Keynesian economics as it existed at the time. There are plenty of references to aggregate demand and thought experiments involving stickiness in prices, wages and expectations. Friedman’s issues are with the details of Keynesian economics, and with developing and pushing new ideas. But he certainly loved a good argument, and had many of those with his contemporaries, including James Tobin.
So, after running my truth test on Zachary Carter’s piece, my bullshit meter was flashing red. I’m going to dismiss the article to Mount Doom, hopefully never to be read again by human beings.
But what of Friedman’s legacy? What lasting impact has he had on the economics profession, and on economic policy? Here, I’m going to confine attention to his contributions to monetary policy, as I’m more confident about my knowledge there, as opposed to writings of the laissez-faire-capitalism Friedman.
So, to start, it’s important to recognize that some of the dominance of Keynesian economics that people think they currently see has more to do with the use of language than the substance of the ideas. For example, New Keynesian economics has less to do with Keynes, or even the so-called “neoclassical synthesis” of Friedman’s time (circa 1968), than it does with Robert Solow, David Cass, Tjalling Koopmans, Robert Lucas, Brock and Mirman, Ed Prescott, and Dixit and Stiglitz. And more recent incarnations of “Keynesian” economics (HANK for example) build on work by Bewley and Aiyagari. I don’t think Keynes would recognize this stuff.
But, just because we don’t have people writing papers about Friedmanite economics or developing New Friedmanite models (or even HANF models) doesn’t mean we’re not somewhat saturated with ideas that you can trace to Friedman. So, to be specific, let’s take a look at “The Role of Monetary Policy,” and see what that has to do with current monetary policy debates in the United States, both inside and outside the Eccles Building.
So, first, “The Role of Monetary Policy” is very ambitious. What Friedman sets out to do is to introduce a new concept - the natural rate of unemployment - to sketch out a theory of the Phillips curve, and then to make some specific, and novel, recommendations for how monetary policy should be conducted. That’s a lot to put on your plate, and Friedman covers it all in 17 pages.
To set the stage, Friedman tells us something about the state of monetary policy in 1968:
“Today, primacy is assigned to the promotion of full employment, with the prevention of inflation a continuing but definitely secondary objective. And there is major disagreement about criteria of policy, varying from emphasis on money market conditions, interest rates, and the quantity of money to the belief that the state of employment itself should be the proximate criterion of policy.”
Sounds familiar, right? Though note in the first sentence of that passage the idea that inflation is in the back of policymakers’ minds. There’s been a move on the FOMC for example, to put more emphasis on “full employment,” or “maximum employment” as a goal, but modern central bankers have inflation very much in their conscious minds, and that has a lot to do with Friedman, as I’m going to argue. As well, in 1968 the period of high inflation in the U.S. was years off, but Friedman was already attuned to the risks to inflation control of then-current ideas about monetary policy.
In the body of “The Role for Monetary Policy” are ideas that have been adopted by monetary policymakers in the United States, and are so familiar that we may have forgotten where they come from. There are also some important ideas discussed by Friedman that the current FOMC should take to heart. Finally, there are Friedman ideas that are currently in use at the Fed that are wrongheaded, and should be ditched.
The importance of crisis intervention. Friedman says:
“The first and most important lesson that history teaches about what monetary policy can do - and it is a lesson of the most profound importance - is that monetary policy can prevent money itself from being a major source of economic disturbance.”
So, Friedman saw everything through the lens of monetary aggregates. Money being a source of “economic disturbance” is about financial crises. That’s clear for example in the Monetary History. Friedman and Schwartz argued that, in the Great Depression, appropriate crisis intervention by the Fed could have stopped retail banking panics, or at least mitigated their effects. Keynes, I think, focused on the powerlessness of monetary policy in a liquidity trap, and put the emphasis on fiscal policy in mitigating major downturns. But Friedman’s ideas certainly seem in tune with current views about central bank crisis intervention. During the financial crisis many people, Ben Bernanke included, liked to talk about Bagehot, but Friedman certainly deserves some credit for pushing the importance of the role of central banks in crises.
Price Stability. Friedman says:
“A second thing monetary policy can do is provide a stable background for the economy… Our economic system will work best when producers and consumers, employers and employees, can proceed with full confidence that the average level of prices will behave in a known way in the future - preferably that it will be highly stable.”
So, that’s become boilerplate for central banks. In 1968, policymakers in the U.S. were cognizant of episodes of high inflation and hyperinflation, in other countries and at other times. But the policy view then seemed to be that inflation in the U.S. would look after itself while the Fed conducted stabilization policy.
Stabilization Policy. Friedman says:
“Finally, monetary policy can contribute to offsetting major disturbances in the economic system arising from other sources. If there is an independent secular exhilaration - as the postwar expansion was described by the proponents of secular stagnation - monetary policy can in principle help to hold it in check by a slower rate of monetary growth than would otherwise be desirable. If, as now, an explosive federal budget threatens unprecedented deficits, monetary policy can hold any inflationary dangers in check by a slower rate of monetary growth than would otherwise be desirable.”
Except for framing policy moves as changes in the money growth rate, Friedman’s sounding a lot like Larry Summers in this passage. So, apparently Friedman was fine with the principle that responding to everyday macroeconomic shocks - not just the unusual shocks that cause financial crises - is something the central bank should be on board with. I don’t think anyone on the FOMC would argue with that.
The central bank should target things it can actually control. Friedman says:
“Monetary growth, it is widely held, will tend to stimulate employment; monetary contraction, to retard employment. Why, then, cannot the monetary authority adopt a target for employment or unemployment…The reason it cannot is…the difference between the immediate and the delayed consequences of such a policy…Thanks to Wicksell, we are all acquainted with the concept of a ‘natural’ rate of interest and the possibility of a discrepancy between the ‘natural’ and the ‘market’ rate.”
What follows is what might be the most famous part of the paper, where Friedman discusses the “natural rate of unemployment.” Here’s an important point:
“To avoid misunderstanding, let me emphasize that by using the term ‘natural’ rate of unemployment, I do not mean to suggest that it is immutable and unchangeable. On the contrary, many of the market characteristics that determine its level are man-made and policy-made…I use the term ‘natural’ for the same reason Wicksell did - to try to separate the real forces from monetary forces.”
So, this is a bit subtle. Friedman proceeds with a narrative about what happens when the central bank tries to control something it can’t. That is, it tries to permanently push the unemployment rate below the natural rate, and in the process causes inflation expectations to rise, which negates the effect of the policy, leading to higher inflation and higher inflation expectations, etc. That’s all very familiar. What seems to have happened in monetary policy circles is that policymakers interpreted Friedman as saying that, if the central bank could somehow “anchor” expectations, then we would be back in a stable Phillips curve world. Basically. policymakers think, through some magic, that people come to believe that inflation will be 2% forever, so the Phillips curve is stable. Then controlling inflation is just a matter of controlling the unemployment rate - it’s the same thing.
So, policymakers seem to have turned Friedman’s natural rate/Phillips curve narrative into a Phillips curve theory of inflation. Friedman was in fact marketing a monetary theory of inflation, and the natural rate/Phillips curve parable was a cautionary tale about what happens when the central bank gets too enamored with an unattainable goal. As well, it’s clear in Friedman’s narrative that his “natural rate of unemployment” is not a minimum - that we might expect to see the unemployment rate fluctuating around the natural rate.
So, the current FOMC seems to have bolloxed this specific Friedman idea in a number of ways:
A current part of the FOMC’s forward guidance specifies that there will be no change in the policy rate until “maximum employment” is achieved. And, I think it’s clear from public statements by Fed officials that essentially this means they have a notion of a natural rate of unemployment that is unattainable.
Non-monetary shocks are apparently viewed by most FOMC members as inducing movement along a stable Phillips curve. Jay Powell made it clear in his last press conference that what will make inflation go up, and overshoot the 2% inflation target, as planned, is a sufficient reduction in unemployment. If you’ve been watching monetary policy around the world in the last 12 years or so, it’s not clear why you would think that.
More than anything, the FOMC’s new policy approach puts more weight than previously on the real part of the dual mandate - an increased emphasis on what the Fed can’t control in the long run.
Monetary policy is limited. Friedman says:
“I have put this point last, and stated it in qualified terms - as referring to major disturbances - because I believe that the potentiality of monetary policy in offsetting other forces making for instability is far more limited than is commonly believed. We simply do not know enough to be able to recognize minor disturbances when they occur or to be able to predict either what their effects will be with any precision or what monetary policy is required to offset their effects. We do not know enough to be able to achieve stated objectives by delicate, or even fairly coarse, changes in the mix of monetary and fiscal policy. In this area particularly the best is likely to be the enemy of the good. Experience suggests that the path of wisdom is to use monetary policy explicitly to offset other disturbances only when they offer a ‘clear and present danger.’”
Our current FOMC is a very confident bunch. They remind me of the guy in Bonfire of the Vanities, cruising down the freeway thinking he’s Master of the Universe. One particular trait they share with Friedman is a belief in the power of monetary policy. But they’re not only very self-assured about the current stance of policy given current conditions - they’re confident that they know what appropriate monetary policy will be for the next two or three years, and that they can finely tune the U.S. economy so that it delivers inflation rising to 2%, then a little above 2%. Seemingly, in their minds there’s no potential catastrophes waiting in the future, and we’ve got the theory and practice of inflation control all worked out.
Target money growth, and we’ll solve a lot of problems. Friedman says:
“My own prescription is still that the monetary authority go all the way… by adopting publicly the policy of achieving a steady rate of growth in a specified monetary total.”
Basically, Friedman thinks that money growth targeting simultaneously accomplishes everything you want the central bank to do - it’s crisis intervention, price stability, and stabilization policy all rolled into one. Simple, easy to understand, and central bankers won’t have to think too hard.
So, Friedman was sticking his neck out here, but had a lot of work to back up the policy recommendation. The Monetary History attempts to make the case that monetary shocks are key to fluctuations in real activity, and theory and evidence tell us that money growth drives inflation, according to Friedman.
And guess what? Friedman achieved something that few economists do. His recommendation actually got implemented widely by central banks, starting in the late 1970s. So that’s an achievement. Did the policy work? Well, yes and no. Paul Volcker’s FOMC was essentially a bunch of monetarists (read the transcripts if you don’t believe me). The idea was to induce a disinflation through a reduction in money growth, all the time ignoring what was going on with market interest rates. This is consistent with Friedman’s notion that nominal interest rates are poor indicators of the “tightness” of monetary policy.
But, due to instability in money demand induced by financial innovation and regulatory changes, money growth targeting proved to be a poor approach to ongoing inflation control, and was rightly abandoned, to be replaced by inflation targeting, beginning in 1989 at the Reserve Bank of New Zealand.
But it wasn’t like Friedman was entirely confident about money growth targeting, as opposed to price level targeting:
“Attempting to control directly the price level is therefore likely to make monetary policy itself a source of economic disturbance because of false stops and starts. Perhaps, as our understanding of monetary phenomena advances, the situation will change. But at the present stage of our understanding, the long way around seems the surer way to our objective.”
So, that’s wrong, as some central banks, the Bank of Canada in particular, have had long periods of successful inflation targeting. But, in 1968 Friedman doesn’t rule out the possibility that he could be wrong. As far as we know (and maybe someone knows more about this than I do) Friedman was perfectly happy with the abandonment of money growth targeting in favor of inflation targeting, given the experience with money growth targeting in the 70s and 80s. Also note that the alternative he had in mind in 1968 was price level targeting - an approach related to what the FOMC may have been shooting at with its new average inflation targeting framework (though the new framework has some issues).
So, here’s where Friedman gets close to an additional useful insight, I think, but doesn’t quite follow through. He says:
“…a higher rate of monetary expansion will correspond to a higher, not lower, level of interest rates than would otherwise have prevailed. Let the higher rate of monetary growth produce rising prices, and let the public come to expect that prices will continue to rise. Borrowers will then be willing to pay and lenders will then demand higher interest rates - as Irving Fisher pointed out decades ago.”
So, there are Fisher effects - in the long run, high inflation goes with high nominal interest rates. Friedman also says:
“As an empirical matter, low interest rates are a sign that monetary policy has been tight - in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy - in the sense that the quantity of money has grown rapidly. The broadest facts of experience run in precisely the opposite direction from that which the financial community and academic economists have all generally taken for granted.”
And that’s still widely taken for granted. The standard view is: low nominal interest rates mean accommodative policy; high nominal interest rates mean tight policy. What Friedman does not appear to have thought through is the connection between monetary policy and inflation in a world with unstable money demand (or an asset purchase policy of the central bank that disconnects outside money growth from inflation) and nominal interest rate targeting by the central bank.
So, plenty of people think that the risk associated with the Fed’s new policy regime is what Friedman had in mind. That is, the FOMC attempts to overshoot its inflation target so as to exploit the short run Phillips curve, and then inflation starts running away with itself. But, I think this is one of the instances (maybe the only one) in which a misconception about policy actually doesn’t lead down a bad road. The misconception is that keeping overnight nominal interest rates lower for longer is an “accommodative” policy. As Friedman says, that’s actually a tight policy, in terms of the effect on inflation, as the Fisher effect sets in - what one of my professional acquaintances called the “curse of Irving Fisher.”
So, don’t worry about inflation for a while. But worry about what your central bankers don’t know.