In my previous post about Nick Rowe and Milton Friedman, I pointed out to Nick Rowe that Friedman (and Phelps) did not discover the argument that the long-run Phillips Curve, defined so that every rate of inflation is correctly expected, is vertical. The argument I suggested can be traced back at least to Hume. My claim on Hume’s behalf was based on my vague recollection that Hume distinguished between the effect of a high price level and a rising price level, a high price level having no effect on output and employment, while a rising price level increases output and employment.
Scott Sumner offered the following comment, leaving it as an exercise for the reader to figure out what he meant by “didn’t quite get there.”:
As you know Friedman is one of the few areas where we disagree. Here I’ll just address one point, the expectations augmented Phillips Curve. Although I love Hume, he didn’t quite get there, although he did discuss the simple Phillips Curve.
I wrote the following response to Scott referring to the quote that I was thinking of without quoting it verbatim (because I couldn’t remember where to find it):
There is a wonderful quote by Hume about how low prices or high prices are irrelevant to total output, profits and employment, but that unexpected increases in prices are a stimulus to profits, output, and employment. I’ll look for it, and post it.
Nick Rowe then obligingly provided the quotation I was thinking of (but not all of it):
Here, to my mind, is the “money quote” (pun not originally intended) from David Hume’s “Of Money”:
“From the whole of this reasoning we may conclude, that it is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still encreasing; because, by that means, he keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which consists all real power and riches.”
The first sentence is fine. But the second sentence is very clearly a problem.
Was it Friedman who said “we have only advanced one derivative since Hume”?
OK, so let’s see the whole relevant quotation from Hume’s essay “Of Money.”
Accordingly we find, that, in every kingdom, into which money begins to flow in greater abundance than formerly, everything takes a new face: labour and industry gain life; the merchant becomes more enterprising, the manufacturer more diligent and skilful, and even the farmer follows his plough with greater alacrity and attention. This is not easily to be accounted for, if we consider only the influence which a greater abundance of coin has in the kingdom itself, by heightening the price of Commodities, and obliging everyone to pay a greater number of these little yellow or white pieces for everything he purchases. And as to foreign trade, it appears, that great plenty of money is rather disadvantageous, by raising the price of every kind of labour.
To account, then, for this phenomenon, we must consider, that though the high price of commodities be a necessary consequence of the encrease of gold and silver, yet it follows not immediately upon that encrease; but some time is required before the money circulates through the whole state, and makes its effect be felt on all ranks of people. At first, no alteration is perceived; by degrees the price rises, first of one commodity, then of another; till the whole at last reaches a just proportion with the new quantity of specie which is in the kingdom. In my opinion, it is only in this interval or intermediate situation, between the acquisition of money and rise of prices, that the encreasing quantity of gold and silver is favourable to industry. When any quantity of money is imported into a nation, it is not at first dispersed into many hands; but is confined to the coffers of a few persons, who immediately seek to employ it to advantage. Here are a set of manufacturers or merchants, we shall suppose, who have received returns of gold and silver for goods which they sent to CADIZ. They are thereby enabled to employ more workmen than formerly, who never dream of demanding higher wages, but are glad of employment from such good paymasters. If workmen become scarce, the manufacturer gives higher wages, but at first requires an encrease of labour; and this is willingly submitted to by the artisan, who can now eat and drink better, to compensate his additional toil and fatigue.
He carries his money to market, where he, finds everything at the same price as formerly, but returns with greater quantity and of better kinds, for the use of his family. The farmer and gardener, finding, that all their commodities are taken off, apply themselves with alacrity to the raising more; and at the same time can afford to take better and more cloths from their tradesmen, whose price is the same as formerly, and their industry only whetted by so much new gain. It is easy to trace the money in its progress through the whole commonwealth; where we shall find, that it must first quicken the diligence of every individual, before it encrease the price of labour. And that the specie may encrease to a considerable pitch, before it have this latter effect, appears, amongst other instances, from the frequent operations of the FRENCH king on the money; where it was always found, that the augmenting of the numerary value did not produce a proportional rise of the prices, at least for some time. In the last year of LOUIS XIV, money was raised three-sevenths, but prices augmented only one. Corn in FRANCE is now sold at the same price, or for the same number of livres, it was in 1683; though silver was then at 30 livres the mark, and is now at 50. Not to mention the great addition of gold and silver, which may have come into that kingdom since the former period.
From the whole of this reasoning we may conclude, that it is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still encreasing; because, by that means, he keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which consists all real power and riches. A nation, whose money decreases, is actually, at that time, weaker and more miserable than another nation, which possesses no more money, but is on the encreasing hand. This will be easily accounted for, if we consider, that the alterations in the quantity of money, either on one side or the other, are not immediately attended with proportionable alterations in the price of commodities. There is always an interval before matters be adjusted to their new situation; and this interval is as pernicious to industry, when gold and silver are diminishing, as it is advantageous when these metals are encreasing. The workman has not the same employment from the manufacturer and merchant; though he pays the same price for everything in the market. The farmer cannot dispose of his corn and cattle; though he must pay the same rent to his landlord. The poverty, and beggary, and sloth, which must ensue, are easily foreseen.
So Hume understands that once-and-for-all increases in the stock of money and in the price level are neutral, and also that in the transition from one price level to another, there will be a transitory effect on output and employment. However, when he says that the good policy of the magistrate consists only in keeping it, if possible, still increasing; because, by that means, he keeps alive a spirit of industry in the nation, he seems to be suggesting that the long-run Phillips Curve is actually positively sloped, thus confirming Milton Friedman (and Nick Rowe and Scott Sumner) in saying that Hume was off by one derivative.
While I think that is a fair reading of Hume, it is not the only one, because Hume really was thinking in terms of price levels, not rates of inflation. The idea that a good magistrate would keep the stock of money increasing could not have meant that the rate of inflation would indefinitely continue at a particular rate, only that the temporary increase in the price level would be extended a while longer. So I don’t think that Hume would ever have imagined that there could be a steady predicted rate of inflation lasting for an indefinite period of time. If he could have imagined a steady rate of inflation, I think he would have understood the simple argument that, once expected, the steady rate of inflation would not permanently increase output and employment.
At any rate, even if Hume did not explicitly anticipate Friedman’s argument for a vertical long-run Phillips Curve, certainly there many economists before Friedman who did. I will quote just one example from a source (Hayek’s Constitution of Liberty) that predates Friedman by about eight years. There is every reason to think that Friedman was familiar with the source, Hayek having been Friedman’s colleague at the University of Chicago between 1950 and 1962. The following excerpt is from p. 331 of the 1960 edition.
Inflation at first merely produces conditions in which more people make profits and in which profits are generally larger than usual. Almost everything succeeds, there are hardly any failures. The fact that profits again and again prove to be greater than had been expected and that an unusual number of ventures turn out to be successful produces a general atmosphere favorable to risk-taking. Even those who would have been driven out of business without the windfalls caused by the unexpected general rise in prices are able to hold on and to keep their employees in the expectation that they will soon share in the general prosperity. This situation will last, however, only until people begin to expect prices to continue to rise at the same rate. Once they begin to count on prices being so many per cent higher in so many months’ time, they will bid up the prices of the factors of production which determine the costs to a level corresponding to the future prices they expect. If prices then rise no more than had been expected, profits will return to normal, and the proportion of those making a profit also will fall; and since, during the period of exceptionally large profits, many have held on who would otherwise have been forced to change the direction of their efforts, a higher proportion than usual will suffer losses.
The stimulating effect of inflation will thus operate only so long as it has not been foreseen; as soon as it comes to be foreseen, only its continuation at an increased rate will maintain the same degree of prosperity. If in such a situation price rose less than expected, the effect would be the same as that of unforeseen deflation. Even if they rose only as much as was generally expected, this would no longer provide the expectational stimulus but would lay bare the whole backlog of adjustments that had been postponed while the temporary stimulus lasted. In order for inflation to retain its initial stimulating effect, it would have to continue at a rate always faster than expected.
This was certainly not the first time that Hayek made the same argument. See his Studies in Philosophy Politics and Economics, p. 295-96 for a 1958 version of the argument. Is there any part of Friedman’s argument in his 1968 essay (“The Role of Monetary Policy“) not contained in the quote from Hayek? Nor is there anything to indicate that Hayek thought he was making an argument that was not already familiar. The logic is so obvious that it is actually pointless to look for someone who “discovered” it. If Friedman somehow gets credit for making the discovery, it is simply because he was the one who made the argument at just the moment when the rest of the profession happened to be paying attention.
Uneasy Money 
Off the specific topic, but I stopped by Hume’s grave while in Edinburgh a few weeks ago:
http://informationtransfereconomics.blogspot.com/2015/01/scottish-enlightenment-photoblogging.html
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I would say that Hayek definitely did get it, and Hume definitely did not. (And Hayek is ready to take the argument one additional derivative too, if anyone wanted to try to escape that way; even a growing rate of inflation won’t work, if people expect it.)
What Friedman did have, and Hayek did not (at least in that passage) is the concept of the natural rate of unemployment. You could argue that it is implicit in Hayek, and is a direct extension of the concept of the natural rate of interest (which Hayek was familiar with, though made a bit of a mess of), but it’s not explicitly there.
Now Friedman made a dog’s breakfast of defining exactly what he meant by the natural rate of unemployment. But it was clear that he meant it as one of a whole vector of natural rates that were in the LR (when expectations are realised) determined by real forces and independent of money growth. Before Friedman, economists and policymakers could talk about using monetary (and/or fiscal) policy to target a real variable (typically “full employment”, which they also made a dog’s breakfast of defining), which means creating a vertical AD curve, and treating inflation as an annoying side-effect that sometimes appeared even before “full employment” was reached, and had to be due to things like monopoly power etc. After Friedman, the idea of creating a vertical AD curve to target “full employment” (however defined) became nonsense.
Friedman wanted a downward-sloping AD curve (target k% M2 growth). Policymakers eventually went further. They went too far. They made the AD curve horizontal (target inflation). MM’s are trying for a sensible compromise, with a downward-sloping AD curve that doesn’t flop around when V changes (target NGDP).
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Hume: “…and even the farmer follows his plough with greater alacrity and attention.”
That bit of Hume always annoyed me. Specifically the word “even”. As though farmers were too stupid and set in their ways that we should be surprised they would ever respond to price signals. Damn’ city kid, with typical urban prejudices!
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Nick,
Yes, Friedman introduced a concept (the natural rate of unemployment) which he made a dog’s breakfast of defining. I’ll certainly give him that. However, the only reason it mattered was that it was a brilliant bit of rhetoric. By labelling a rather high rate of unemployment “natural”, Friedman largely absolved policy-makers of responsibility. It enabled governments to implement policies which would have been political suicide a few years earlier.
I must say, if your aim is to exalt Friedman’s reputation as a theorist, you’re going to have to work on your own rhetoric. I don’t think he’d greatly appreciate your latest comments.
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Kevin: “Theorist” can mean many things, and I hate the modern meaning where it has become “an economist who uses a lot of fancy math and abstract formal lemmas”.
Friedman made a dog’s breakfast of his Monetary Framework too, which looks like it has two IS curves.
What Friedman had is vision, or intuition, and an ability to apply that vision to understanding the world. Nowadays we don’t call an economist like that a “theorist”, but that’s our problem.
Again, does a permanent increase in monopoly power cause a permanent increase in inflation? Economists used to answer “Yes, it might” to that question. Nowadays we would answer “No, but it might cause an increase in the natural rate of unemployment”. That is a very big change in theoretical perspective, or vision.
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I very much agree with your claim that Friedman 1968 did not introduce the expectations critique of the Phillips curve. In fact the argument was made repeatedly before Phillips graphed his scatter plot, James Forder wrote a working paper on this
Click to access paper399.pdf
in which the expectations argument is made quite clearly by, among many others, Friedman in 1958, Simons in 1936, Samuelson and Solow 1960 and Hicks in 1967. Simons and Hicks pretty clearly state the view that the long run Phillips curve is vertical.
By the way, while there is overwhelming evidence against an expectations unaugmented Phillips curve, there is not overwhelming evidence that the long run Phillips curve is vertical. If there is downward nominal rigidity, then there can be a sloping long run Phillips curve (Akerlof GA, Dickens WT, Perry GL (1996) The Macroeconomics of Low Inflation [including
comments by Gordon and Mankiw]. Brookings Papers on Economic Activity, 1996(1):1-59 [60-76]. Notably, in recent years US inflation and unemployment have fallen on what sure looks like an expectations unaugmented Phillips curve.
There are two separate issues 1) is the slope of the long run Phillips curve as low as that of the short run Phillips curve ? Answer definitely not. 2) is the long run Phillips curve vertical ? This does not follow. Importantly, Friedman argued convincingly that it was impossible to keep unemployment below the NAIRU. It doesn’t follow that it is impossible to keep it slightly higher. If there is a range of unemployment over which inflation decelerates to zero, but not below (because of downward nominal rigidity) then unemployment can stay at any point in that range. For example what if with unemployment less than 5% one has accelerating inflation but unemployement must be greater 8% to cause actual deflation. In that case, one can have zero inflation with unemployment at any level between 5% and 8%. Thus far the Phillips curve has a horizontal part. The downward slope comes from having many local labor markets.
In any case, data from the 1970s do not prove that the long run Phillips curve is vertical. Empirical point estimates never had coefficients on lagged inflation adding up to one (unless this was imposed based on Friedman’s theoretical argument).
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Robert: ” Empirical point estimates never had coefficients on lagged inflation adding up to one (unless this was imposed based on Friedman’s theoretical argument).”
And they never would add up to one, even in a natural rate model with rational expectations, unless inflation had a unit root. And if inflation did have a unit root, it would have infinite long run variance, which it doesn’t.
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Robert Waldmann,
Intuitively, one would expect a long-run Phillips curve to be bowed, like a left-hand bracket, i.e. ( shaped, since very high inflation, sustained over a long period, ought to result in a seriously screwed-up economy; at the other extreme, does anyone seriously suppose that a move from -2% inflation to -20% would create no problem once people had got used to living with severe deflation? But the vertical long-run curve seems to fit the worst instincts of economics teachers. It satisfies the Mencken criteria: clear, simple, and wrong.
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Kevin: no economist would go to the wall for a literally vertical LRPC. Because that would mean that inflation is irrelevant, so we don’t care whether the central bank targets 2% or 200%, or minus 200%.
The vertical LRPC is always and everywhere a benchmark, from which we depart to explore various non-super-neutralites (as Friedman did in his Optimal Quantity of Money”).
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David, the Hume quote is a reminder of just how microeconomically detailed macroeconomic analysis used to be. Even the General Theory was mostly based on disaggregated reasoning. The IS-LM model killed the microeconomic detail, and the microfoundations project, ironically, put a nail in the coffin.
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Jason, Thanks for the link.
Nick, You are right about Hayek, and probably right about Hume, but it took no great leap to get from Hume to Hayek, and I think that there were many others who got there.
I ask this in all innocence. What do you think “the concept of the natural rate of unemployment” would have added to the passage of Hayek’s that I quoted?
“Dog’s breakfast.” Interesting expression. Never heard it before. Is it British or Canadian? Are you referring to Friedman’s statement that the natural rate of unemployment is the rate ground out by the Walrasian system of general equilibrium equations?
Have you worked out this discussion of the vertical AD somewhere before? I’ld like to see it worked out step by step, because I can’t quite see how it all hangs together.
Kevin, Do you really think that the voters reelected Reagan once and Thatcher twice because Friedman convinced them that there is a natural rate of unemployment?
Nick, If a permanent increase in monopoly power reduces real GDP (increases the natural rate of unemployment), wouldn’t you expect to see a corresponding increase in the price level? A second-order effect to be sure, but it’s still there.
Robert, Can you identify Friedman 1958, Simons 1936 and Hicks 1967? I agree that the empirical evidence is against a vertical long-run Phillips Curve, but to be fair, the empirical long-run Phillips Curve and the long-run Phillips Curve corresponding to the natural rate hypothesis are not the same. The empirical long-run Phillips Curve is an estimate from observed data, but the long-run Phillips Curve corresponding to the natural-rate hypothesis is a notional curve that would exist at a moment in time, if alternative rates of inflation were correctly expected. You can believe in the natural rate hypothesis without expecting to derive a vertical long-run Phillips Curve from historical time series data.
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David: My post trying to make sense of 1968 and all that: http://worthwhile.typepad.com/worthwhile_canadian_initi/2015/01/does-monopoly-power-cause-inflation.html
“I ask this in all innocence. What do you think “the concept of the natural rate of unemployment” would have added to the passage of Hayek’s that I quoted?”
That’s what I’m trying to figure out too. It all seems sort of obvious, in hindsight, that the concept is implicit in Hayek. But it can’t have been obvious to economists at the time, otherwise they would never have approached questions like “does monopoly power cause inflation?” the way they did. Sometimes we have 1+1, but we can’t see 2.
I think “Dog’s breakfast” is British. Perhaps best not to Google it before eating.
“Are you referring to Friedman’s statement that the natural rate of unemployment is the rate ground out by the Walrasian system of general equilibrium equations?”
Yes. Like Wicksell trying to define the natural rate of interest as that which would prevail in a barter economy, it makes no sense, because it is only in a monetary exchange economy that the natural rates of interest and unemployment are useful theoretical constructs, and monetary and barter (or Walrasian, pace Patinkin) economies will be very different from monetary economies. Without money, we would all probably be living in the Stone Age, and who knows what the rate of interest would be!
“Have you worked out this discussion of the vertical AD somewhere before? I’ld like to see it worked out step by step, because I can’t quite see how it all hangs together.”
There’s nothing to work out, really. Any AD curve holds some things constant, and one of those things is what the central bank holds constant, or “targets”. If the central bank holds money base constant we get a differently-sloped AD curve than if it holds the exchange rate constant (and different things cause it to shift too). Targeting inflation (or the price level) means a horizontal AD curve at the inflation (or price level) target. Targeting “full employment” output means a vertical AD curve. Targeting a fixed nominal rate of interest creates an upward-sloping AD curve (if inflation is on the vertical axis). The slope and shape of the AD curve is whatever the central bank wants it to be, up to a random error caused by imperfections in their crystal ball.
“If a permanent increase in monopoly power reduces real GDP (increases the natural rate of unemployment), wouldn’t you expect to see a corresponding increase in the price level? A second-order effect to be sure, but it’s still there.”
With a fixed downward-sloping AD curve (with an NGDP target or k% M2 target) yes. But not if there’s a price level path target, or even a strict inflation target, if the central bank sees it coming.
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“Do you really think that the voters reelected Reagan once and Thatcher twice because Friedman convinced them that there is a natural rate of unemployment?”
No, I think the reason Friedman is seen as a hugely influential figure, in a way that Samuelson for example is not, is that Friedman’s rhetoric was adopted by a huge number of conservative journalists and politicians on both sides of the pond. But if there had been no Friedman they would have found good lines elsewhere.
This is the nub of my disagreement with Nick. He thinks Friedman revolutionized the way we think about economics. I think that, in the UK, the change was brought about by the words and deeds of Joe Gormley, Arthur Scargill, Enoch Powell, Peter Jay, James Callaghan, Samuel Brittan, Margaret Thatcher and many more that I’ve forgotten. For the sake of brevity I’ll not compile a list of American names.
Friedman’s contribution was a nifty model and a TV series called Free To Choose which provided these people with a vocabulary, so to speak. Without him they’d have found one somewhere else.
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Kevin: *something* changed the way we think about economics (see my post). If not Friedman 68, because every economist already knew everything that was in it, then what did?
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Nick, that’s obviously a big question. But to shrink it to the size of a blog comment, I’d say what changed was the focus of attention. In a nutshell: until the 1930s, the central topic of monetary economics was the determination of the price level. Then monetary economics became macro and the central topic was the determination of the level of employment. The monetarist counter-revolution revived the old agenda, with the focus now on the rate of change of the price level.
Any good politician knows that very often the way to win is to change the subject. That’s what conservatives did in the 1970s and it worked like a charm. I’m reminded of Joan Robinson’s remark about Marshall, who did something similar:
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Nick, Thanks for the link.
There is a difference between an economic concept that has already been discovered and one that is obvious to all economists. I am saying that the concept of a vertical expectations augmented Phillips Curve was discovered long before Friedman’s 1968 article; that doesn’t mean that the idea was accepted by all economists. I agree that it was Friedman who made the idea popular among economists, but there was nothing original about it except the name “natural rate of unemployment.” But as far as I can tell, it was just a name.
Thanks for explaining what you mean by a vertical AD curve. I have never liked the practice, though sometimes it is unavoidable, of building a policy reaction function into a structural model (or what purports to be a structural model), which is why I had trouble following you initially. The slope and shape of the AD curve should be what it is and the policy of the monetary authority should be based on what the structural model is. Building in a reaction function into the model turns the model into a reduced form. That’s why I hate the money multiplier by the way. So I am being consistent.
Kevin, OK, but still, do you think that the vertical Phillips Curve was an important element in the conversation or the propaganda that helped make Reagan and Thatcher popular? I am not so sure. I think voters liked the reduction in inflation that followed their ascendancy, and, after a nasty recession, prosperity and something like full employment was restored. That, plus a discredited opposition, was enough.
Nick, Friedman just connected the dots in a way that made it easy for textbook writers to incorporate into their simple models.
Kevin, Nice quote from Mrs. Robinson, but the conspiratorial tone of her remark just reminds me why so many perfectly fine and upstanding people found her appalling.
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Lots of good comments, and I agree with Nick. By analogy, lots of people may have discovered America, but Columbus was the guy who convinced Europeans that it was there. Lots of people may have discovered the simple Phillips curve (Irving Fisher certainly did in the 1920s), but Phillips was the one who convinced the profession. And lots of people may have anticipated Friedman’s work, but Friedman was the guy who changed economics in a pretty profound way.
Lots of this reflects the issues of the day. Persistent inflation isn’t really an issue under commodity regimes, so the “one derivative beyond Hume” never got any traction until Bretton Woods lost its link with gold (in 1968, not 1971, BTW.) Keynes became famous because his model seemed to apply to the 1930s. Etc.
Friedman became famous largely because he was already using a fiat money model in his empirical work, just as we entered a fiat money world. The irony is that his fiat money model was wrong for the period covered in the Monetary History, as David has ably pointed out. That annoys David, but I cut Friedman some slack. After all, the Monetary History had the right lessons for the fiat money world that we were just entering. Not the specific lesson of “target M2” (which was also wrong) but the broader lesson that the Fed is responsible for steering the nominal economy.
Friedman also became famous because he was advocating neoliberalism just when statism was hitting a wall. When even the socialist governments started privatizing, deregulating, and cutting the top MTRs, it looked like he was on the right side of history.
And now it’s Piketty’s turn. . . .
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