Marginal Revolution: Why I disagree with Milton Friedman on monetary policy

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Why I disagree with Milton Friedman on monetary policy

Nothing that I have observed in recent decades has led me to change my mind about the desirability of a monetary rule which simply increased the quantity of money at a fixed rate month after month, year after year. That rule would get rid of the mistakes and that is probably about all you could expect to get from a monetary system.

Greg counters that the lender of last resort function of the central bank may interfere with a fixed monetary rule. Fair enough (in fact I think the earlier Milton admitted this point, although the later Milton may agree with Larry White's comment on Greg), but my objection is more day-to-day. Hardly anyone is willing to live with the consequences of a strict rule for the monetary base.

In particular, the resulting short-term interest rate volatility would be much higher than, prior to experience, most people had expected. Liquidity is quite scarce. The demand for funds goes up and sometimes, in the absence of Fed smoothing, the supply just isn't there. Price has to adjust. No, interest rate volatility is not the end of the world but few people believe this makes for a better marketplace. That is why hardly anyone in the world of central banking defends monetary base targeting these days, even though the idea was fairly popular twenty-five or thirty years ago.

The Swiss tried to target their monetary base, briefly, in the mid 1980s. No one was willing to live with the resulting interest rates and especially the exchange rates; the latter is an additional problem for small open economies. So they stopped. Times since then have not exactly been the Weimar hyperinflation in Bern and Zurich. The Swiss are better off for having a multitude of targets.

We shouldn't target the monetary base either. If we have enough discipline to stick to a base target, we also have enough discipline to endure a regime of acceptable "muddling through."

Addendum: Correct me if I am wrong, but didn't Milton repudiate the money target idea a few years ago and suggest inflation targeting as an acceptable substitute?

Posted by Tyler Cowen on August 17, 2006 at 07:23 AM | Permalink

Comments

In early July of this year, Alistir Bull of Reuters reported on
a set of speeches given by Friedman with William Poole of the
St. Louis Fed, long a monetarist bastion. Friedman is reported
to have supported inflation targeting for the post-Greenspan era
at the US Fed.

Posted by: Barkley Rosser at Aug 17, 2006 8:40:04 AM

Of course, one might reconcile this with his note to Mankiw
if he views the best way of inflation targeting to be to
control the growth of the money supply, which is quite likely
to be his view...

Posted by: Barkley Rosser at Aug 17, 2006 8:41:12 AM

Friedman's 'repudiation' of Monetarism was based on a misunderstanding by a journalist who'd lunched with him. There was a thread on it over at DeLong's, which I can't access right now--his blog is every bit as erratic as he is.

Posted by: Patrick R. Sullivan at Aug 17, 2006 10:04:19 AM

Friedman's interview was part of FT's "Lunch with FT" column published in the weekend magazine. I do not recollect any misunderstanding. He was quite unequivocal about his repudiatin of monetary targeting. I am sure the journalist has it on a tape.

Posted by: Asif Dowla at Aug 17, 2006 10:19:47 AM

Pity about George Smith and Antony Flew; they've been fairly effectively answered by people like Richard Swinburne, Alvin Plantinga, and others.

Posted by: Rhadamanthus at Aug 17, 2006 10:56:58 AM

Friedman in the FT:

"The use of quantity of money as a target has not been a success," concedes the grand old man of conservative economics. "I'm not sure I would as of today push it as hard as I once did."...
[and on the Euro:]"I've been wrong so far, so I don't have too much confidence in my view. But I think within the next 10 to 15 years the eurozone will split apart. The British government, on balance, should stay out of it." I remark that Friedman the economist seems less sure of himself these days than his polemicist alter ego.
After a long pause, he agrees: "You form a philosophy at a certain stage and for the rest of your life it dominates. On the big issues of policy I don't think there is anything I've changed my mind about."

Simon London, "MILTON FRIEDMAN - The long view," The Financial Times June 7, 2003 Saturday, p. 12.

I didn't see a correction or dispute in the FT's letter column over the following several months.

Posted by: Eric Rauchway at Aug 17, 2006 12:51:14 PM

The Financial Times piece was by Simon London and merely said:

'Hold on to your hats and prepare to be amazed: Milton Friedman has changed his mind. "The use of quantity of money as a target has not been a success," concedes the grand old man of conservative economics. "I'm not sure I would as of today push it as hard as I once did." '

London blew Friedman's remarks way out of proportion, and Paul Krugman picked it up and inflated it further to score points in his feud with Ben Stein.

London, btw, in the article, betrayed abysmal ignorance of Friedman's theory and the history of attempts to implement it.

Here's a cached version of one of the discussions at DeLong blog,

Posted by: Patrick R. Sullivan at Aug 17, 2006 1:06:47 PM

Here's Friedman in Spring 2006:

NPQ | The inflation rate in America as well as globally remains historically low, even as oil prices skyrocket. Why?

Friedman | Inflation is a monetary phenomenon. It is made by or stopped by the central bank. There has been no similar period in history like the last 15 years in which you’ve had little fluctuation in the price level. No matter what else happens, this will maintain as long as the US Federal Reserve maintains strict monetary policy and control of the money supply.

The same thing is true in Europe. The ECB (European Central Bank) has held down the rate of monetary growth. So there have been stable prices. The pressures in Europe, however, will be much stronger than in the US. The main pressure is to print money and be more expansive in order to promote employment.

Posted by: Patrick R. Sullivan at Aug 17, 2006 1:39:47 PM

Did anyone catch Charlie Rose's interview with Milton Friedman last year? It seemed that he was very high on Volker and especially Greenspan. I'm not sure how attached he is to his monetary rules anymore. Maybe he believes that we know economics better than we did in the 30s, 40s, 50s, 60s, and 70s, and we'll screw up a lot less now. Or, maybe he believes a monetary rule will avoid catestrophic mismanagement like that which caused the Great Depression.

http://video.google.com/videoplay?docid=-2963837673813979186&q=milton+friedman

Posted by: Scott W at Aug 17, 2006 1:43:52 PM

When you look at periods of falling or restricted money supply growth
you find that it is always associated with high real interest rates
as in the 1980s, 1990s and 1930s.

So my question is has anyone ever clearly demonstrated that the causal relationship runs from money supply to interest rates rather then the other way around?

Posted by: spencer at Aug 17, 2006 3:14:27 PM

"There has been no similar period in history like the last 15 years in which you’ve had little fluctuation in the price level."

I think Freidman was having a "senior moment", the period from 1952 to 1967 had only 3 years with the inflation rate greater that 3% the highest in 1966 of 3.3%. The average was less than the last 15 years.

Posted by: joan at Aug 17, 2006 4:54:57 PM

Larry White's comments, to which Tyler refers, are at Division of Labour:

http://divisionoflabour.com/archives/002887.php

Posted by: Kurt Schuler at Aug 17, 2006 5:42:56 PM

'So my question is has anyone ever clearly demonstrated that the causal relationship runs from money supply to interest rates rather then the other way around?'

It can be either. Depends on what the Fed is using as a guide. In the brief experiment with targeting monetary aggregates by Volcker that caused interest rates to rise.

After that, and especially during Greenspan's tenure, the Fed used the Fed Funds rate to control money.

Friedman is well aware of this, and still says he doesn't like working through interest rates. I think because that's what led the Fed to its disastrous policies in the 1930s; they thought interest rates were low--and NOMINAL rates were low--so monetary policy was 'loose'. When in reality, REAL interest rates were high, and monetary policy was 'tight'.

Posted by: Patrick R. Sullivan at Aug 17, 2006 6:20:05 PM

The fed targets interest rates but must add or subtract money from the system to meet the targets. They do this buying or selling in the overnight market.

Posted by: joan at Aug 17, 2006 8:07:30 PM

The fed targets interest rates but must add or subtract money from the system to meet the targets. They do this buying or selling in the overnight market.

Posted by: joan at Aug 17, 2006 8:08:12 PM

Re Swiss monetary policy, as a result of the 2nd "oil shock" in the late
70s there was intense inflationary pressure due to money that poured in from the oil-producing countries in the Middle East. The SNB therefore introduced a negative rate of interest as a deterrent. That rate reached 4 Percent. In my opinion (I live near Zürich) Swiss monetary policy focuses on keeping the CHF from becoming too strong against the Euro, as Germany is Switzerland's biggest customer, followed by the USA. The USD is currently weak (CHF at 1,22 against the USD) but there's a positive trade-off from that as imported raw materials are priced in USD.

Low interest rates are also important for the Swiss as rents here (70% live in rented homes) move up and down in tandem with interest rates. Therefore high interest rates would push up rents and cause social instability. The Swiss economy is very well managed, with a lot of fine tuning. I did a study on the economy of the canton Zug (near Zürich) which has the highest average income in Switzerland and found that - unsurprisingly - the reasons were many and in small steps at a time, plus all political parties pushing in the same direction - since 1928.

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