Archive for the 'Friedman' Category

Real and Pseudo Gold Standards: Could Friedman Tell the Difference?

One of the first academic papers by Milton Friedman that I read was “Real and Pseudo Gold Standards.” It’s an interesting paper presented to the Mont Pelerin Society in September 1961 and published in the Journal of Law and Economics in October 1961. That it was published in the Journal of Law and Economics, then edited by Friedman’s colleague at Chicago (and fellow Mont Pelerin member) Ronald Coase, is itself interesting, that estimable journal hardly being an obvious place to publish research on monetary economics. But the point of the paper was not to advance new theoretical insights about monetary theory, though he did provide a short preview of his critique of Fed policy in the 1920-21 Depression and in the Great Depression that he and Anna Schwartz would make in their soon to be published Monetary History of the United States, but to defend Friedman’s pro-fiat money position as a respectable alternative among the libertarians and classical liberals with whom Friedman had allied himself in the Mont Pelerin Society.

Although many members of the Mont Pelerin Society, including Hayek himself, as well as Friedman, Fritz Machlup and Lionel Robbins no longer supported the gold standard, their reasons for doing so were largely pragmatic, believing that whatever its virtues, the gold standard was no longer a realistic or even a desirable option as a national or an international monetary system. But there was another, perhaps more numerous, faction within the Mont Pelerin Society and the wider libertarian/ classical-liberal community, that disdained any monetary system other than the gold standard. The intellectual leader of this group was of course the soul of intransigence, the unyieldingly stubborn Ludwig von Mises, notably supported by the almost equally intransigent French economist Jacques Rueff, whose attachment to gold was so intense that Charles de Gaulle, another in a long line of French politicians enchanted by the yellow metal, had chosen Rueff as his personal economic adviser.

What Friedman did in this essay was not to engage with von Mises on the question of the gold standard; Friedman was realistic enough to understand that one could not reason with von Mises, who anyway regarded Friedman, as he probably did most of the members of the Mont Pelerin Society, as hardly better than a socialist. Instead, his strategy was to say that there is only one kind of real gold standard – presumably the kind favored by von Mises, whose name went unmentioned by Friedman, anything else being a pseudo-gold standard — in reality, nothing but a form of price fixing in which the government sets the price of gold and manages the gold market to prevent the demand for gold from outstripping the supply. While Friedman acknowledged that a real gold standard could be defended on strictly libertarian grounds, he argued that a pseudo-gold standard could not, inasmuch as it requires all sorts of market interventions, especially restrictions on the private ownership of gold that were then in place. What Friedman was saying, in effect, to the middle group in the Mont Pelerin Society was the only alternatives for liberals and libertarians were a gold standard of the Mises type or his preference: a fiat standard with flexible exchange rates.

Here is how he put it:

It is vitally important for the preservation and promotion of a free society that we recognize the difference between a real and pseudo gold standard. War aside, nothing that has occurred in the past half-century has, in my view, done more weaken and undermine the public’s faith in liberal principles than the pseudo gold standard that has intermittently prevailed and the actions that have been taken in its name. I believe that those of us who support it in the belief that it either is or will tend to be a real gold standard are mistakenly fostering trends the outcome of which they will be among the first to deplore.

This is a sweeping charge, so let me document it by a few examples which will incidentally illustrate the difference between a real and a pseudo gold standard before turning to an explicit discussion of the difference.

So what were Friedman’s examples of a pseudo gold standard? He offered five. First, US monetary policy after World War I, in particular the rapid inflation of 1919 and the depression of 1920-21. Second, US monetary policy in the 1920s and the British return to gold. Third, US monetary policy in the 1931-33 period. Fourth the U.S. nationalization of gold in 1934. And fifth, the International Monetary Fund and post-World War II exchange-rate policy.

Just to digress for a moment, I will admit that when I first read this paper as an undergraduate I was deeply impressed by his introductory statement, but found much of the rest of the paper incomprehensible. Still awestruck by Friedman, who, I then believed, was the greatest economist alive, I attributed my inability to follow what he was saying to my own intellectual shortcomings. So I have to admit to taking a bit of satisfaction in now being able to demonstrate that Friedman literally did not know what he was talking about.

US Monetary Policy after World War I

Friedman’s discussion of monetary policy after WWI begins strangely as if he were cutting and pasting from another source without providing any background to the discussion. I suspected that he might have cut and pasted from the Monetary History, but that turned out not to be the case. However, I did find that this paragraph (and probably a lot more] was included in testimony he gave to the Joint Economic Committee.

Nearly half of the monetary expansion in the United States came after the end of the war, thanks to the acquiescence of the Federal Reserve System in the Treasury’s desire to avoid a fall in the price of government securities. This expansion, with its accompanying price inflation, led to an outflow of gold despite the great demand for United States goods from a war-ravaged world and despite the departure of most countries from any fixed parity between their currencies and either gold or the dollar.

Friedman, usually a very careful writer, refers to “half of the monetary expansion” without identifying in any way “the monetary expansion” that he is referring to, leaving it to the reader to conjecture whether he is talking about the monetary expansion that began with the start of World War I in 1914 or the monetary expansion that began with US entry into the war in 1917 or the monetary expansion associated with some other time period. Friedman then goes on to describe the transition from inflation to deflation.

Beginning in late 1919, then more sharply in January 1920 and May 1920, the Federal Reserve System took vigorous deflationary steps that produced first a slackening of the growth of money and then a sharp decline. These brought in their train a collapse in wholesale prices and a severe economic contraction. The near halving of wholesale prices in a twelve month period was by all odds the most rapid price decline ever experienced in the United States before or since. It was not of course confined to the United States but spread to all countries whose money was linked to the dollar either by having a fixed price in terms of gold or by central bank policies directed at maintaining rigid or nearly rigid exchange rates.

That is a fair description of what happened after the Fed took vigorous deflationary steps, notably raising its discount rate to 6%. What Friedman neglects to point out is that there was no international gold standard (real or pseudo) immediately after the war, because only the United States was buying and selling gold at a legally established gold parity. Friedman then goes on to compare the pseudo gold standard under which the US was then operating with what would have happened under a real gold standard.

Under a real gold standard, the large inflow of gold up to the entry of the United States into the war would have produced a price rise to the end of the war similar to that actually experienced.

Now, aside from asserting that under a real gold standard, gold is used as money, and that under a pseudo gold standard, government is engaged in fixing the price of gold, Friedman has not told us how to distinguish between a real and a pseudo gold standard. So it is certainly fair to ask whether in the passage just quoted Friedman meant that the gold standard under which the US was operating when there was a large inflow of gold before entering the war was real or pseudo. His use of the subjunctive verb “would have produced” suggests that he believed that the gold standard was pseudo, not real. But then he immediately says that, under the real gold standard, the “price rise to the end of the war” would have been “similar to that actually experienced.” So take your pick.

Evidently, the difference between a real and a pseudo gold standard became relevant only after the war was over.

But neither the postwar rise nor the subsequent collapse would have occurred. Instead, there would have been an earlier and milder price decline as the belligerent nations returned to a peacetime economy. The postwar increase in the stock of money occurred only because the Reserve System had been given discretionary power to “manage” the stock of money, and the subsequent collapse occurred only because this power to manage the money had been accompanied by gold reserve requirements as one among several masters the System was instructed to serve.

That’s nice, but Friedman has not even suggested, much less demonstrated in any way, how all of this is related to the difference between a real and a pseudo gold standard. Was there any postwar restriction on the buying or selling of gold by private individuals? Friedman doesn’t say. All he can come up with is the idea that the Fed had been given “discretionary power to ‘manage’ the stock of money.” Who gave the Fed this power? And how was this power exercised? He refers to gold reserve requirements, but gold reserve requirements – whether they were a good idea or not is not my concern here — existed before the Fed came into existence.

If the Fed had unusual powers after World War I, those powers were not magically conferred by some unidentified entity, but by the circumstance that the US had accumulated about 40% of the world’s monetary gold reserves during World War I, and was the only country, after the war, that was buying and selling gold freely at a fixed price ($20.67 an ounce). The US was therefore in a position to determine the value of gold either by accumulating more gold or by allowing an efflux of gold from its reserves. Whether the US was emitting or accumulating gold depended on the  interest-rate policy of the Federal Reserve. It is true that the enormous control the US then had over the value of gold was a unique circumstance in world history, but the artificial and tendentious distinction between a real and a pseudo gold standard has absolutely nothing to do with the inflation in 1919 or the deflation in 1920-21.

US Monetary Policy in the 1920s and Britain’s Return to Gold

In the next section Friedman continues his critical review of Fed policy in the 1920s, defending the Fed against the charge (a staple of Austrian Business Cycle Theory and other ill-informed and misguided critics) that it fueled a credit boom during the 1920s. On the contrary, Friedman shows that Fed policy was generally on the restrictive side.

I do not myself believe that the 1929-33 contraction was an inevitable result of the monetary policy of the 1920s or even owed much to it. What was wrong was the policy followed from 1929 to 1933. . . . But internationally, the policy was little short of catastrophic. Much has been made of Britain’s mistake in returning to gold in 1925 at a parity that overvalued the pound. I do not doubt that this was a mistake – but only because the United States was maintaining a pseudo gold standard. Had the United States been maintaining a real gold standard, the stock of money would have risen more in the United States than it did, prices would have been stable or rising instead of declining, the United States would have gained less gold or lost some, and the pressure on the pound would have been enormously eased. As it was by sterilizing gold, the United States forced the whole burden of adapting to gold movements on other countries. When, in addition, France adopted a pseudo gold standard at a parity that undervalued the franc and proceeded also to follow a gold sterilization policy, the combined effect was to make Britain’s position untenable.

This is actually a largely coherent paragraph, more or less correctly diagnosing the adverse consequences of an overly restrictive policy adopted by the Fed for most of the 1920s. What is not coherent is the attempt to attribute policy choices of which Friedman (and I) disapprove to the unrealness of the gold standard. There was nothing unreal about the gold standard as it was operated by the Fed in the 1920s. The Fed stood ready to buy and sell gold at the official price, and Friedman does not even suggest that there was any lapse in that commitment.

So what was the basis for Friedman’s charge that the 1920s gold standard was fake or fraudulent? Friedman says that if there had been a real, not a pseudo, gold standard, “the stock of money would have risen more in the United States than it did, prices would have been stable or rising instead of declining,” and the US “would have gained less gold or lost some.” That this did not happen, Friedman attributes to a “gold sterilization policy” followed by the US. Friedman is confused on two levels. First, he seems to believe that the quantity of money in the US was determined by the Fed. However, under a fixed-exchange-rate regime, the US money supply was determined endogenously via the balance of payments. What the Fed could determine by setting its interest rate was simply whether gold would flow into or out of US reserves. The level of US prices was determined by the internationally determined value of gold. Whether gold was flowing into or out of US reserves, in turn, determined the value of gold was rising or falling, and, correspondingly, whether prices in terms of gold were falling or rising. If the Fed had set interest rates somewhat lower than they did, gold would have flowed out of US reserves, the value of gold would have declined and prices in terms of gold would have risen, thereby easing deflationary pressure on Great Britain occasioned by an overvalued sterling-dollar exchange rate. I have no doubt that the Fed was keeping its interest rate too high for most of the 1920s, but why a mistaken interest-rate policy implies a fraudulent gold standard is not explained. Friedman, like his nemesis von Mises, simply asserted his conclusion or his definition, and expected his listeners and readers to nod in agreement.

US Monetary Policy in the 1931-33 Period

In this section Friedman undertakes his now familiar excoriation of Fed inaction to alleviate the banking crises that began in September 1931 and continued till March 1933. Much, if not all, of Friedman’s condemnation of the Fed is justified, though his failure to understand the international nature of the crisis caused him to assume that the Fed could have prevented a deflation caused by a rising value of gold simply by preventing bank failures. There are a number of logical gaps in that argument, and Friedman failed to address them, simply assuming that US prices were determined by the US money stock even though the US was still operating on the gold standard and the internationally determined value of gold was rising.

But in condemning the Fed’s policy in failing to accommodate an internal drain at the first outbreak of domestic banking crises in September 1931, Friedman observes:

Prior to September 1931, the System had been gaining gold, the monetary gold stock was at an all-time high, and the System’s gold reserve ratio was far above its legal minimum – a reflection of course of its not having operated in accordance with a real gold standard.

Again Friedman is saying that the criterion for identifying whether the gold standard is real or fraudulent is whether policy makers make the correct policy decision, if they make a mistake, it means that the gold standard in operation is no longer a real gold standard; it has become a pseudo gold standard.

The System had ample reserves to meet the gold outflow without difficulty and without resort to deflationary measures. And both its own earlier policy and the classical gold-standard rules as enshrined by Bagehot called for its doing so: the gold outflow was strictly speculative and motivated by fear that the United States would go off gold; the outflow had no basis in any trade imbalance; it would have exhausted itself promptly if all demands had been met.

Thus, Friedman, who just three pages earlier had asserted that the gold standard became a pseudo gold standard when the managers of the Federal Reserve System were given discretionary powers to manage the stock of money, now suggests that a gold standard can also be made a pseudo gold standard if the monetary authority fails to exercise its discretionary powers.

US Nationalization of Gold in 1934

The nationalization of gold by FDR effectively ended the gold standard in the US. Nevertheless, Friedman was so enamored of the distinction between real and pseudo gold standards that he tried to portray US monetary arrangements after the nationalization of gold as a pseudo gold standard even though the gold standard had been effectively nullified. But at least, the distinction between what is real and what is fraudulent about the gold standard is now based on an objective legal and institutional fact: the general right to buy gold from (or sell gold to) the government at a fixed price whenever government offices are open for business. Similarly after World War II, only the US government had any legal obligation to sell gold at the official price, but there was only a very select group of individuals and governments who were entitled to buy gold from the US government. Even to call such an arrangement a pseudo gold standard seems like a big stretch, but there is nothing seriously wrong with calling it a pseudo gold standard. But I have no real problem with Friedman’s denial that there was a true gold standard in operation after the nationalization of gold in 1934.

I would also agree that there really was not a gold standard in operation after the US entered World War I, because the US stopped selling gold after the War started. In fact, a pseudo gold standard is a good way to characterize the status of the gold standard during World War I, because the legal price of gold was not changed in any of the belligerent countries, but it was understood that for a private citizen to try to redeem currency for gold at the official price would be considered a reprehensible act, something almost no one was willing to do. But to assert, as Friedman did, that even when the basic right to buy gold at the official price was routinely exercised, a real gold standard was not necessarily in operation, is simply incoherent, or sophistical. Take your pick.

Milton Friedman’s Dumb Rule

Josh Hendrickson discusses Milton Friedman’s famous k-percent rule on his blog, using Friedman’s rule as a vehicle for an enlightening discussion of the time-inconsistency problem so brilliantly described by Fynn Kydland and Edward Prescott in a classic paper published 36 years ago. Josh recognizes that Friedman’s rule is imperfect. At any given time, the k-percent rule is likely to involve either an excess demand for cash or an excess supply of cash, so that the economy would constantly be adjusting to a policy induced macroeconomic disturbance. Obviously a less restrictive rule would allow the monetary authorities to achieve a better outcome. But Josh has an answer to that objection.

The k-percent rule has often been derided as a sub-optimal policy. Suppose, for example, that there was an increase in money demand. Without a corresponding increase in the money supply, there would be excess money demand that even Friedman believed would cause a reduction in both nominal income and real economic activity. So why would Friedman advocate such a policy?

The reason Friedman advocated the k-percent rule was not because he believed that it was the optimal policy in the modern sense of phrase, but rather that it limited the damage done by activist monetary policy. In Friedman’s view, shaped by his empirical work on monetary history, central banks tended to be a greater source of business cycle fluctuations than they were a source of stability. Thus, the k-percent rule would eliminate recessions caused by bad monetary policy.

That’s a fair statement of why Friedman advocated the k-percent rule. One of Friedman’s favorite epigrams was that one shouldn’t allow the best to be the enemy of the good, meaning that the pursuit of perfection is usually not worth it. Perfection is costly, and usually merely good is good enough. That’s generally good advice. Friedman thought that allowing the money supply to expand at a moderate rate (say 3%) would avoid severe deflationary pressure and avoid significant inflation, allowing the economy to muddle through without serious problems.

But behind that common-sense argument, there were deeper, more ideological, reasons for the k-percent rule. The k-percent rule was also part of Friedman’s attempt to provide a libertarian/conservative alternative to the gold standard, which Friedman believed was both politically impractical and economically undesirable. However, the gold standard for over a century had been viewed by supporters of free-market liberalism as a necessary check on government power and as a bulwark of liberty. Friedman, desiring to offer a modern version of the case for classical liberalism (which has somehow been renamed neo-liberalism), felt that the k-percent rule, importantly combined with a regime of flexible exchange rates, could serve as an ideological substitute for the gold standard.

To provide a rationale for why the k-percent rule was preferable to simply trying to stabilize the price level, Friedman had to draw on a distinction between the aims of monetary policy and the instruments of monetary policy. Friedman argued that a rule specifying that the monetary authority should stabilize the price level was too flexible, granting the monetary authority too much discretion in its decision making.

The price level is not a variable over which the monetary authority has any direct control. It is a target not an instrument. Specifying a price-level target allows the monetary authority discretion in its choice of instruments to achieve the target. Friedman actually made a similar argument about the gold standard in a paper called “Real and Pseudo Gold Standards.” The price of gold is a target, not an instrument. The monetary authority can achieve its target price of gold with more than one policy. Unless you define the rule in terms of the instruments of the central bank, you have not taken away the discretionary power of the monetary authority. In his anti-discretionary zeal, Friedman believed that he had discovered an argument that trumped advocates of the gold standard .

Of course there was a huge problem with this argument, though Friedman was rarely called on it. The money supply, under any definition that Friedman ever entertained, is no more an instrument of the monetary authority than the price level. Most of the money instruments included in any of the various definitions of money Friedman entertained for purposes of his k-percent rule are privately issued. So Friedman’s claim that his rule would eliminate the discretion of the monetary authority in its use of instrument was clearly false. Now, one might claim that when Friedman originally advanced the rule in his Program for Monetary Stability, the rule was formulated the context of a proposal for 100-percent reserves. However, the proposal for 100-percent reserves would inevitably have to identify those deposits subject to the 100-percent requirement and those exempt from the requirement. Once it is possible to convert the covered deposits into higher yielding uncovered deposits, monetary policy would not be effective if it controlled only the growth of deposits subject to a 100-percent reserve requirement.

In his chapter on monetary policy in The Constitution of Liberty, F. A. Hayek effectively punctured Friedman’s argument that a monetary authority could operate effectively without some discretion in its use of instruments to execute a policy aimed at some agreed upon policy goal. It is a category error to equate the discretion of the monetary authority in the choice of its policy instruments with the discretion of the government in applying coercive sanctions against the persons and property of private individuals. It is true that Hayek later modified his views about central banks, but that change in his views was at least in part attributable to a misunderstanding. Hayek erroneoulsy believed that his discovery that competition in the supply of money is possible without driving the value of money down to zero meant that competitive banks would compete to create an alternative monetary standard that would be superior to the existing standard legally established by the monetary authority. His conclusion did not follow from his premise.

In a previous post, I discussed how Hayek also memorably demolished Friedman’s argument that, although the k-percent rule might not be the theoretically best rule, it would at least be a good rule that would avoid the worst consequences of misguided monetary policies producing either deflation or inflation. John Taylor, accepting the Hayek Prize from the Manhattan Institute, totally embarrassed himself by flagarantly misunderstanding what Hayek was talking about. Here are the two relevant passages from Hayek. The first from his pamphlet, Full Employment at any Price?

I wish I could share the confidence of my friend Milton Friedman who thinks that one could deprive the monetary authorities, in order to prevent the abuse of their powers for political purposes, of all discretionary powers by prescribing the amount of money they may and should add to circulation in any one year. It seems to me that he regards this as practicable because he has become used for statistical purposes to draw a sharp distinction between what is to be regarded as money and what is not. This distinction does not exist in the real world. I believe that, to ensure the convertibility of all kinds of near-money into real money, which is necessary if we are to avoid severe liquidity crises or panics, the monetary authorities must be given some discretion. But I agree with Friedman that we will have to try and get back to a more or less automatic system for regulating the quantity of money in ordinary times. The necessity of “suspending” Sir Robert Peel’s Bank Act of 1844 three times within 25 years after it was passed ought to have taught us this once and for all.

Hayek in the Denationalization of Money, Hayek was more direct:

As regards Professor Friedman’s proposal of a legal limit on the rate at which a monopolistic issuer of money was to be allowed to increase the quantity in circulation, I can only say that I would not like to see what would happen if it ever became known that the amount of cash in circulation was approaching the upper limit and that therefore a need for increased liquidity could not be met.

And in a footnote, Hayek added.

To such a situation the classic account of Walter Bagehot . . . would apply: “In a sensitive state of the English money market the near approach to the legal limit of reserve would be a sure incentive to panic; if one-third were fixed by law, the moment the banks were close to one-third, alarm would begin and would run like magic.

So Friedman’s k-percent rule was dumb, really dumb. It was dumb, because it induced expectations that made it unsustainable. As Hayek observed, not only was the theory clear, but it was confirmed by the historical evidence from the nineteenth century. Unfortunately, it had to be reconfirmed one more time in 1982 before the Fed abandoned its own misguided attempt to implement a modified version of the Friedman rule.

Richard Lipsey and the Phillips Curve

Richard Lipsey has had an extraordinarily long and productive career as both an economic theorist and an empirical economist, making numerous important contributions in almost all branches of economics. (See, for example, the citation about Lipsey as a fellow of the Canadian Economics Association.) In addition, his many textbooks have been enormously influential in advocating that economists should strive to make their discipline empirically relevant by actually subjecting their theories to meaningful empirical tests in which refutation is a realistic possibility not just a sign that the researcher was insufficiently creative in theorizing or in performing the data analysis.

One of Lipsey’s most important early contributions was his 1960 paper on the Phillips Curve “The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1862-1957: A Further Analysis” in which he extended W A. Phillips’s original results, and he has continued to write about the Phillips Curve ever since. Lipsey, in line with his empiricist philosophical position, has consistently argued that a well-supported empirical relationship should not be dismissed simply because of a purely theoretical argument about how expectations are formed. In other words, the argument that adjustments in inflation expectations would cause the short-run Phillips curve relation captured by empirical estimates of the relationship between inflation and unemployment may well be valid (as was actually recognized early on by Samuelson and Solow in their famous paper suggesting that the Phillips Curve could be interpreted as a menu of alternative combinations of inflation and unemployment from which policy-makers could choose) in some general qualitative sense. But that does not mean that it had to be accepted as an undisputable axiom of economics that the long-run relationship between unemployment and inflation is necessarily vertical, as Friedman and Phelps and Lucas convinced most of the economics profession in the late 1960s and early 1970s.

A few months ago, Lipsey was kind enough to send me a draft of the paper that he presented at the annual meeting of the History of Economics Society; the paper is called “The Phillips Curve and the Tyranny of an Assumed Unique Macro Equilibrium.” Here is the abstract of the paper.

To make the argument that the behaviour of modern industrial economies since the 1990s is inconsistent with theories in which there is a unique ergodic macro equilibrium, the paper starts by reviewing both the early Keynesian theory in which there was no unique level of income to which the economy was inevitably drawn and the debate about the amount of demand pressure at which it was best of maintain the economy: high aggregate demand and some inflationary pressure or lower aggregate demand and a stable price level. It then covers the rise of the simple Phillips curve and its expectations-augmented version, which introduced into current macro theory a natural rate of unemployment (and its associated equilibrium level of national income). This rate was also a NAIRU, the only rate consistent with stable inflation. It is then argued that the current behaviour of many modern economies in which there is a credible policy to maintain a low and steady inflation rate is inconsistent with the existence of either a unique natural rate or a NAIRU but is consistent with evolutionary theory in which there is perpetual change driven by endogenous technological advance. Instead of a NAIRU evolutionary economies have a non-inflationary band of unemployment (a NAIBU) indicating a range of unemployment and income over with the inflation rate is stable. The paper concludes with the observation that the great pre-Phillips curve debates of the 1950s that assumed that there was a range within which the economy could be run with varying pressures of demand, and varying amounts of unemployment and inflationary pressure, were not as silly as they were made to seem when both Keynesian and New Classical economists accepted the assumption of a perfectly inelastic, long-run Phillips curve located at the unique equilibrium level of unemployment.

Back in January, I wrote a post about the Lucas Critique in which I pointed out that his “proof” that the Phillips Curve is vertical in his celebrated paper on econometric policy evaluation was no proof at all, but simply a very special example in which the only disequilibrium permitted in the model – a misperception of the future price level – would lead an econometrician to estimate a negatively sloped relation between inflation and employment even though under correct expectations of inflation the relationship would be vertical. Allowing for a wider range of behavioral responses, I suggested, might well change the relation between inflation and output even under correctly expected inflation. In his new paper, Lipsey correctly points out that Friedman and Phelps and Lucas, and subsequent New Classical and New Keynesian theoreticians, who have embraced the vertical Phillips Curve doctrine as an article of faith, are also assuming, based on essentially no evidence, that there is a unique macro equilibrium. But, there is very strong evidence to suggest that, in fact, any deviation from an initial equilibrium (or equilibrium time path) is likely to cause changes that, in and of themselves, cause a change in conditions that will propel the system toward a new and different equilibrium time path, rather than return to the time path the system had been moving along before it was disturbed. See my post of almost a year ago about a paper, “Does history matter?: Empirical analysis of evolutionary versus stationary equilibrium views of the economy,” by Carlaw and Lipsey.)

Lipsey concludes his paper with a quotation from his article “The Phillips Curve” published in the volume Famous Figures and Diagrams in Economics edited by Mark Blaug and Peter Lloyd.

Perhaps [then] Keynesians were too hasty in following the New Classical economists in accepting the view that follows from static [and all EWD] models that stable rates of wage and price inflation are poised on the razor’s edge of a unique NAIRU and its accompanying Y*. The alternative does not require a long term Phillips curve trade off, nor does it deny the possibility of accelerating inflations of the kind that have bedevilled many third world countries. It is merely states that industrialised economies with low expected inflation rates may be less precisely responsive than current theory assumes because they are subject to many lags and inertias, and are operating in an ever-changing and uncertain world of endogenous technological change, which has no unique long term static equilibrium. If so, the economy may not be similar to the smoothly functioning mechanical world of Newtonian mechanics but rather to the imperfectly evolving world of evolutionary biology. The Phillips relation then changes from being a precise curve to being a band within which various combinations of inflation and unemployment are possible but outside of which inflation tends to accelerate or decelerate. Perhaps then the great [pre-Phillips curve] debates of the 1940s and early 1950s that assumed that there was a range within which the economy could be run with varying pressures of demand, and varying amounts of unemployment and inflation[ary pressure], were not as silly as they were made to seem when both Keynesian and New Classical economists accepted the assumption of a perfectly inelastic, one-dimensional, long run Phillips curve located at a unique equilibrium Y* and NAIRU.”

Friedman’s Dictum

In his gallant, but in my opinion futile, attempts to defend Milton Friedman against the scandalous charge that Friedman was, gasp, a Keynesian, if not in his policy prescriptions, at least in his theoretical orientation, Scott Sumner has several times referred to the contrast between the implication of the IS-LM model that expansionary monetary policy implies a reduced interest rate, and Friedman’s oft-repeated dictum that high interest rates are a sign of easy money, and low interest rates a sign of tight money. This was a very clever strategic and rhetorical move by Scott, because it did highlight a key difference between Keynesian and Monetarist ideas while distracting attention from the overlap between Friedman and Keynesians on the basic analytics of nominal-income determination.

Alghough I agree with Scott that Friedman’s dictum that high interest rates distinguishes him from Keynes and Keynesian economists, I think that Scott leaves out an important detail: Friedman’s dictum also distinguishes him from just about all pre-Keynesian monetary economists. Keynes did not invent the terms “dear money” and “cheap money.” Those terms were around for over a century before Keynes came on the scene, so Keynes and the Keynesians were merely reflecting the common understanding of all (or nearly all) economists that high interest rates were a sign of “dear” or “tight” money, and low interest rates a sign of “cheap” or “easy” money. For example, in his magisterial A Century of Bank Rate, Hawtrey actually provided numerical bounds on what constituted cheap or dear money in the period he examined, from 1844 to 1938. Cheap money corresponded to a bank rate less than 3.5% and dear money to a bank rate over 4.5%, 3.5 to 4.5% being the intermediate range.

Take the period just leading up to the Great Depression, when Britain returned to the gold standard in 1925. The Bank of England kept its bank rate over 5% almost continuously until well into 1930. Meanwhile the discount rate of the Federal Reserve System from 1925 to late 1928 was between 3.5 and 5%, the increase in the discount rate in 1928 to 5% representing a decisive shift toward tight money that helped drive the world economy into the Great Depression. We all know – and certainly no one better than Scott – that, in the late 1920s, the bank rate was an absolutely reliable indicator of the stance of monetary policy. So what are we to make of Friedman’s dictum?

I think that the key point is that traditional notions of central banking – the idea of “cheap” or “dear” money – were arrived at during the nineteenth century when almost all central banks were operating either in terms of a convertible (gold or silver or bimetallic) standard or with reference to such a standard, so that the effect of monetary policy on prices could be monitored by observing the discount of the currency relative to gold or silver. In other words, there was an international price level in terms of gold (or silver), and the price level of every country could be observed by looking at the relationship of its currency to gold (or silver). As long as convertibility was maintained between a currency and gold (or silver), the price level in terms of that currency was fixed.

If a central bank changed its bank rate, as long as convertibility was maintained (and obviously most changes in bank rate occurred with no change in convertibility), the effect of the change in bank rate was not reflected in the country’s price level (which was determined by convertibility). So what was the point of a change in bank rate under those circumstances? Simply for the central bank to increase or decrease its holding of reserves (usually gold or silver). By increasing bank rate, the central bank would accumulate additional reserves, and, by decreasing bank rate, it would reduce its reserves. A “dear money” policy was the means by which a central bank could add to its reserve and an “easy money” policy was the means by which it could disgorge reserves.

So the idea that a central bank operating under a convertible standard could control its price level was based on a misapprehension — a widely held misapprehension to be sure — but still a mistaken application of the naive quantity theory of money to a convertible monetary standard. Nevertheless, although the irrelevance of bank rate to the domestic price level was not always properly understood in the nineteenth century – economists associated with the Currency School were especially confused on this point — the practical association between interest rates and the stance of monetary policy was well understood, which is why all monetary theorists in the nineteenth and early twentieth centuries agreed that high interest rates were a sign of dear money and low interest rates a sign of cheap money. Keynes and the Keynesians were simply reflecting the conventional wisdom.

Now after World War II, when convertibility was no longer a real constraint on the price level (despite the sham convertibility of the Bretton Woods system), it was a true innovation of Friedman to point out that the old association between dear (cheap) money and high (low) interest rates was no longer a reliable indicator of the stance of monetary policy. However, as a knee-jerk follower of the Currency School – the 3% rule being Friedman’s attempt to adapt the Bank Charter Act of 1844 to a fiat currency, and with equally (and predictably) lousy results – Friedman never understood that under the gold standard, it is the price level which is fixed and the money supply that is endogenously determined, which is why much of the Monetary History, especially the part about the Great Depression (not, as Friedman called it, “Contraction,” erroneously implying that the change in the quantity of money was the cause, rather than the effect, of the deflation that characterized the Great Depression) is fundamentally misguided owing to its comprehensive misunderstanding of the monetary adjustment mechanism under a convertible standard.

PS This is written in haste, so there may be some errors insofar as I relying on my memory without checking my sources. I am sure that readers will correct my lapses of memory

PPS I also apologize for not responding to recent comments, I will try to rectify that transgression over the next few days.

Krugman Predicts the Future History of Economic Thought

It’s always nice to have a Nobel Laureate rely on something you’ve written in making an argument of his own, so I would prefer not to turn around and criticize Paul Krugman for the very blog-post in which he cited my recent posts about Milton Friedman. Now there are obviously certain basic points about Friedman that Krugman and I agree on, e.g., that Friedman relied more heavily on the Keynesian theory of the demand for money than he admitted, and second that Friedman’s description of his theory of the demand for money as the expression of an oral tradition transmitted from an earlier generation of Chicago quantity theorists lacked any foundation. Although some people, including my friend Scott Sumner, seem resistant to acknowledging these points, I don’t think that they are really very controversial statements.

However, Krugman goes beyond this to make a stronger point, which is that Friedman, unlike Keynes, is no longer a factor in policy debates, because the policy position that Friedman advocated is no longer tenable. Here’s how Krugman explains the posthumous untenability of Friedman’s position.

[A]t this point both of Friedman’s key contributions to macroeconomics look hard to defend.

First, on monetary policy . . . Friedman was still very much associated with the notion that the Fed can control the money supply, and controlling the money supply is all you need to stabilize the economy. In the wake of the 2008 crisis, this looks wrong from soup to nuts: the Fed can’t even control broad money, because it can add to bank reserves and they just sit there; and money in turn bears little relationship to GDP. And in retrospect the same was true in the 1930s, so that Friedman’s claim that the Fed could easily have prevented the Great Depression now looks highly dubious.

Krugman is making a tricky point. I agree that Friedman was wrong to focus entirely on the quantity of money in the Great Depression, but that’s because, under the gold standard then in place, the quantity of money was endogenous and prices exogenously determined by the gold standard. The Great Depression occurred because the international restoration of the gold standard in the late 1920s was driving up the value of gold and forcing deflation on all gold standard countries, not just the US, which is why leaving the gold standard or devaluation was a sure-fire way of starting a recovery even without expansionary fiscal policy, as evidenced by the spectacular recovery that started in April 1933 when FDR started devaluing the dollar. So Friedman was wrong about the nature of the monetary mechanisms then operating, but he wasn’t wrong about the ultimately monetary nature of the problem.

Second, on inflation and unemployment: Friedman’s success, with Phelps, in predicting stagflation was what really pushed his influence over the top; his notion of a natural rate of unemployment, of a vertical Phillips curve in the long run, became part of every textbook exposition. But it’s now very clear that at low rates of inflation the Phillips curve isn’t vertical at all, that there’s an underlying downward nominal rigidity to wages and perhaps many prices too that makes the natural rate hypothesis a very bad guide under depression conditions.

I don’t subscribe to the natural-rate hypothesis as a law of nature, but it did make an important contribution to the understanding of the limitations of macroeconomic policy. But even the strictest version of Friedman’s natural-rate hypothesis does not imply that, if the rate of unemployment is above the natural rate, an increase in the rate of inflation through expansionary monetary or fiscal policy would not hasten the transition back to the natural rate of unemployment. For an argument against expansionary monetary or fiscal policy in such circumstances, one has to resort to arguments other than those made by Friedman.

So Friedman’s economic analysis has taken a serious hit. But that’s not the whole story behind his disappearance; after all, all those economists who have been predicting runaway inflation still have a constituency after being wrong year after year.

Friedman’s larger problem, I’d argue, is that he was, when all is said and done, a man trying to straddle two competing world views — and our political environment no longer has room for that kind of straddle.

Think of it this way: Friedman was an avid free-market advocate, who insisted that the market, left to itself, could solve almost any problem. Yet he was also a macroeconomic realist, who recognized that the market definitely did not solve the problem of recessions and depressions. So he tried to wall off macroeconomics from everything else, and make it as inoffensive to laissez-faire sensibilities as possible. Yes, he in effect admitted, we do need stabilization policy — but we can minimize the government’s role by relying only on monetary policy, none of that nasty fiscal stuff, and then not even allowing the monetary authority any discretion.

At a fundamental level, however, this was an inconsistent position: if markets can go so wrong that they cause Great Depressions, how can you be a free-market true believer on everything except macro? And as American conservatism moved ever further right, it had no room for any kind of interventionism, not even the sterilized, clean-room interventionism of Friedman’s monetarism.

Well, inconsistency is in the eye of the beholder, and, anyway, it is surely appropriate to beware of that foolish consistency which is the hobgoblin of little minds. The Great Depression was the result of a complex pattern of events, and acknowledging the inability of free markets to cope with those events is not the same thing as agreeing that free markets caused the Great Depression.

So Friedman has vanished from the policy scene — so much so that I suspect that a few decades from now, historians of economic thought will regard him as little more than an extended footnote.

I suspect that Krugman is correct that the small-minded political right-wing of our time is no longer as willing to accept Milton Friedman as their pre-eminent economic authority figure as were earlier generations of political right-wingers in the last three or four decades of the twentieth century. But to extrapolate from that sociological factoid how future historians of economic thought will evaluate the contributions of Milton Friedman seems to me to be a bit of a stretch.

Hicks on Keynes and the Theory of the Demand for Money

One of my favorite papers is one published by J. R. Hicks in 1935 “A Suggestion for Simplifying the Demand for Theory of Money.” The aim of that paper was to explain how to reconcile the concept of a demand for money into the theory of rational choice. Although Marshall had attempted to do so in his writings, his formulations of the idea were not fully satisfactory, and other Cambridge economists, notably Pigou, Lavington, Robertson, and Keynes, struggled to express the idea in a more satisfactory way than Marshall had done.

In Hicks’s introductory essay to volume II of his Collected Essays on Economic Theory in which his 1935 essay appears, Hicks recounts that Keynes told him after reading his essay that the essay was similar to the theory of liquidity preference, on which Keynes was then working.

To anyone who comes over from the theory of value to the theory of money, there are a number of things which are rather startling. Chief of these is the preoccupation of monetary theorists with a certain equation, which states that the price of goods multiplied by the quantity of goods equals the amount of money which is spent on them. The equation crops up again and again, and it has all sorts of ingenious little arithmetical tricks performed on it. Sometimes it comes out as MV = PT . . .

Now we, of the theory of value, are not unfamiliar with this equation, and there was a time when we used to attach as much importance to it as monetary theorists seem to do still. This was in the middle of the last century, when we used to talk about value being “a ratio between demand and supply.” Even now, we accept the equation, and work it, more or less implicitly, into our systems. But we are rather inclined to take it for granted, since it is rather tautologous, and since we have found that another equation, not alternative to the quantity equation, but complementary with it, is much more significant. This is the equation which states that the relative value of two commodities depends upon their relative marginal utility.

Now to an ingénue, who comes over to monetary theory, it is extremely trying to be deprived of this sheet-anchor. It was marginal utility that really made sense of the theory of value; and to come to a branch of economics which does without marginal utility altogether! No wonder there are such difficulties and such differences! What is wanted is a “marginal revolution!”

That is my suggestion. But I know that it will meet with apparently crushing objections. I shall be told that the suggestion has been tried out before. It was tried by Wicksell, and though it led to interesting results, it did not lead to a marginal utility theory of money. It was tried by Mises, and led to the conclusion that money is a ghost of gold – because, so it appeared, money as such has no marginal utility. The suggestion has a history, and its history is not encouraging.

This would be enough to frighten one off, were it not for two things. Both in the theory of value and in the theory of money there have been developments in the twenty of thirty years since Wicksell and Mises wrote. And these developments have considerably reduced the barriers that blocked their way.

In the theory of value, the work of Pareto, Wicksteed, and their successors, has broadened and deepened our whole conception of marginal utility. We now realize that the marginal utility analysis is nothing else than a general theory of choice, which is applicable whenever the choice is between alternatives that are capable of quantitative expression. Now money is obviously capable of quantitative expression, and therefore the objection that money has no marginal utility must be wrong. People do choose to have money rather than other things, and therefore, in the relevant sense, money must have a marginal utility.

But merely to call their marginal utility X, and then proceed to draw curves, would not be very helpful. Fortunately the developments in monetary theory to which I alluded come to our rescue.

Mr. Keynes’s Treatise, so far as I have been able to discover, contains at least three theories of money. One of them is the Savings and Investment theory, which . . . seems to me only a quantity theory much glorified. One of them is a Wicksellian natural rate theory. But the third is altogether more interesting. It emerges when Mr. Keynes begins to talk about the price-level of investment goods; when he shows that this price-level depends upon the relative preference of the investor – to hold bank-deposits or to hold securities. Here at last we have something which to a value theorist looks sensible and interesting! Here at last we have a choice at the margin! And Mr. Keynes goes on to put substance into our X, by his doctrine that the relative preference depends upon the “bearishness” or “bullishness” of the public, upon their relative desire for liquidity or profit.

My suggestion may, therefore, be reformulated. It seems to me that this third theory of Mr. Keynes really contains the most important of his theoretical contribution; that here, at last, we have something which, on the analogy (the approximate analogy) of value theory, does begin to offer a chance of making the whole thing easily intelligible; that it si form this point, not from velocity of circulation, or Saving and Investment, that we ought to start in constructing the theory of money. But in saying this I am being more Keynesian than Keynes [note to Blue Aurora this was written in 1934 and published in 1935].

The point of this extended quotation, in case it is not obvious to the reader, is that Hicks is here crediting Keynes in his Treatise on Money with a crucial conceptual advance in formulating a theory of the demand for money consistent with the marginalist theory of value. Hicks himself recognized that Keynes in the General Theory worked out a more comprehensive version of the theory than that which he presented in his essay, even though they were not entirely the same. So there was no excuse for Friedman to present a theory of the demand for money which he described “as part of capital or wealth theory, concerned with the composition of the balance sheet or portfolio of assets,” without crediting Keynes for that theory, just because he rejected the idea of absolute liquidity preference.

Here is how Hicks summed up the relationship in his introductory essay referred to above.

Keynes’s Liquidity theory was so near to mine, and was put over in so much more effective a way than I could hope to achieve, that it seemed pointless, at first, to emphasize differences. Sometimes, indeed, he put his in such a way that there was hardly any difference. But, as time went on, what came to be regarded in many quarters, as Keynesian theory was something much more mechanical than he had probably intended. It was certainly more mechanical than I had intended. So in the end I had ot go back to “Simplifying,” and to insist that its message was a Declaration of Independence, not only from the “free market” school from which I was expressly liberating myself, but also from what came to pass as Keynesian economics.

Second Thoughts on Friedman

After blowing off some steam about Milton Friedman in my previous post, thereby antagonizing a sizable segment of my readership, and after realizing that I had been guilty of a couple of memory lapses in citing sources that I was relying on, I thought that I should go back and consult some of the relevant primary sources. So I looked up Friedman’s 1966 article “Interest Rates and the Demand for Money” published in the Journal of Law and Economics in which he denied that he had ever asserted that the demand for money did not depend on the rate of interest and that the empirical magnitude of the elasticity of money demand with respect to the interest rate was not important unless it approached the very high elasticity associated with the Keynesian liquidity trap. I also took a look at Friedman’s reply to Don Patinkin essay “Friedman on the Quantity Theory and Keynesian Economics” in Milton Friedman’s Monetary Framework: A Debate with his Critics.

Perhaps on another occasion, I will offer some comments on Friedman and the interest elasticity of the demand for money, but, for now, I will focus on Friedman’s reply to Patinkin, which is most relevant to my previous post. Patinkin’s essay, entitled, “Friedman on the Quantity Theory and Keynesian Economics,” charged that Friedman had repackaged the Keynesian theory as a quantity theory and tried to sell it with a Chicago oral tradition label stuck on the package. That’s an overstatement of a far more sophisticated argument than my one sentence summary can do justice to, but it captures the polemical gist of Patinkin’s argument, an argument that he had made previously in a paper, “The Chicago Tradition, the Quantity Theory, and Friedman” published in the Journal of Money, Credit and Banking which Harry Johnson relied on in his 1970 Richard T. Ely lecture, “The Keynesian Revolution and the Monetarist Counterrevolution.” Friedman took personal offense at what he regarded as attacks on his scholarly integrity in those papers, and his irritation (to put it mildly) with Patinkin is plainly in evidence in his reply to Patinkin. Much, but not all, of my criticism of Friedman stems from my memory of the two papers by Patinkin and Johnson.

Now to give Friedman his due – and to reiterate what I have already said a number of times, Friedman was a great economist and you can learn a lot by reading his arguments carefully because he was a very skillful applied theorist — he makes a number of effective responses to Patinkin’s accusation that he was merely peddling a disguised version of Keynesianism under the banners of the quantity theory and the Chicago oral tradition. These are basically the same arguments that Scott Sumner used in the post that he wrote defending Friedman against my recycling of the Patinkin/Johnson criticism.

First, like earlier quantity theorists, and unlike Keynes in the General Theory, Friedman assumed that the price level is determined (not, as in the GT, somehow fixed exogenously) by the demand for money and the supply (effectively under the complete discretionary control of the monetary authority) of money.

Second, because differences between the demand for money and the supply of money (in nominal terms) are equilibrated primarily by changes in the price level (not, as in the GT, by changes in the rate of interest), the link between monetary policy and the economy that Friedman focused on was the price level not the rate of interest.

Third, Friedman did not deny that the demand for money was affected by the rate of interest, but he maintained that monetary policy would become ineffective only under conditions of a liquidity trap, which was therefore, in Friedman’s view, the chief theoretical innovation of the General Theory, but one which, on empirical grounds, Friedman flatly rejected.

So if I were to restate Patinkin’s objection in somewhat different terms, I would say that Friedman, in 1956 and in later expositions, described the quantity theory as a theory of the demand for money, which as a historical matter is a travesty, because the quantity theory was around for centuries before the concept of a demand for money was even articulated, but the theory of the demand for money that Friedman described was, in fact, very much influenced by the Keynesian theory of liquidity preference, an influence not mentioned by Friedman in 1956 but acknowledged in later expositions. Friedman explained away this failure by saying that Keynes was merely adding to a theory of the demand for money that had been evolving at Cambridge since Marshall’s day, and that the novel element in the General Theory, absolute liquidity preference, was empirically unsupported. That characterization of Keynes’s theory of liquidity preference strikes me as being ungenerous, but both Friedman and Patinkin neglected to point out that Keynes erroneously thought that his theory of liquidity preference was actually a complete theory of the rate of interest that displaced the real theory of interest.

So, my take on the dispute between Friedman and Patinkin is that Patinkin was right that Friedman did not sufficiently acknowledge the extent to which he was indebted to Keynes for the theory of the demand for money that he erroneously identified with the quantity theory of money. On the other hand, because Friedman explicitly allowed for the price level to be determined within his model, he avoided the Keynesian liquidity-preference relationship between the quantity of money and the rate of interest, allowing the real rate of interest to be determined by real factors not liquidity preference. In some sense, Friedman may have exaggerated the conceptual differences between himself and the Keynesians, but, by making a strategic assumption that the price level responds to changes in the quantity of money, Friedman minimized the effect of changes in the quantity of money on interest rates, except via changes in price level expectations.

But, having granted Friedman partial exoneration of the charge that he was a crypto-Keynesian, I want to explore a bit more carefully Friedman’s remarkable defense against the accusation by Patinkin and Johnson that he invented a non-existent Chicago oral tradition under whose name he could present his quasi-Keynesian theory of the demand for money. Friedman began his response to Patinkin with the following expression of outrage.

Patinkin . . . and Johnson criticize me for linking my work to a “Chicago tradition” rather than recognizing that, as they see it, my work is Keynesian. In the course of their criticism, they give a highly misleading impression of the Chicago tradition. . . .

Whether I conveyed the flavor of that tradition or not, there was such a tradition; it was significantly different from the quantity theory tradition that prevailed at other institutions of learning, notably the London School of Economics; that Chicago tradition had a great deal to do with the differential impact of Keynes’s General Theory on economists at Chicago and elsewhere; and it was responsible for the maintenance of interest in the quantity theory at Chicago. (Friedman’s Monetary Framework p. 158 )

Note the reference to the London School of Economics, as if LSE in the 1930s was in any way notable for its quantity theory tradition. There were to be sure monetary theorists of some distinction working at the LSE in the 1930s, but their relationship to the quantity theory was, at best, remote.

Friedman elaborates on this tidbit a few pages later, recalling that in the late 1940s or early 1950s he once debated Abba Lerner at a seminar at the University of Chicago. Despite agreeing with each other about many issues, Friedman recalled that they were in sharp disagreement about the Keynesian Revolution, Lerner being an avid Keynesian, and Friedman being opposed. The reason for their very different reaction to the Keynesian Revolution, Friedman conjectured, was that Lerner had been trained at the London School of Economics “where the dominant view was that the depression was an inevitable result of the prior boom, that it was deepened by the attempts ot prevent prices and wages from falling and firms from going bankrupt, that the monetary authorities had brought on the depression by inflationary policies before the crash and had prolonged it by ‘easy money’ policies thereafter; that the only sound policy was to let the depression run its course, bring down money costs, and eliminate the weak and unsound firms.” For someone trained in such a view, Friedman suggested, the Keynesian program would seem very attractive. Friedman continued:

It was the London School (really Austrian) view that I referred to in my “Restatement” when I spoke of “the atrophied and rigid caricature [of the quantity theory] that is so frequently described by the proponents of the new income-expenditure approach – and with some justice, to judge by much of the literature on policy that was spawned by the quantity theorists.”

The intellectual climate at Chicago had been wholly different. My teachers regarded the depression as largely the product of misguided government policy – or at least greatly intensified by such policies. They blamed the monetary and fiscal authorities for permitting banks to fail and the quantity of deposits to decline. Far from preaching the need to let deflation and bankruptcy run their course, they issued repeated pronouncements calling for governmental action to stem the deflation. . . .

It was this view the the quantity theory that I referred to in my “Restatement” as “a more subtle and relevant version, one in which the quantity theory was connected and integrated with general price theory and became a flexible and sensitive tool for interpreting movements in aggregate economic activity and for developing relevant policy prescriptions.” (pp. 162-63)

After quoting at length from a talk Jacob Viner gave in 1933 calling for monetary expansion, Friedman winds up with this gem.

What, in the field of interpretation and policy, did Keynes have to offer those of us who learned their economics at a Chicago filled with these views? Can anyone who knows my work read Viner’s comments and not see the direct links between them and Anna Schwartz’s and my Monetary History or between them and the empirical Studies in the Quantity Theory of Money? Indeed, as I have read Viner’s talk for purposes of this paper, I have myself been amazed to discover how precisely it foreshadows the main thesis of our Monetary History for the depression period, and have been embarrassed that we made no reference to it in our account. Can you find any similar link between [Lionel] Robbins’s [of LSE] comments [in his book The Great Depression] and our work? (p. 167)

So what is the evidence that Friedman provides to counter the scandalous accusation by Patinkin and Johnson that Friedman invented a Chicago oral tradition of the quantity theory? (And don’t forget: the quantity theory is a theory of the demand for money) Well, it’s that, at the London School of Economics, there were a bunch of guys who had crazy views about just allowing the Great Depression to run its course, and those guys were quantity theorists, which is why Keynes had to start a revolution to get rid of them all, but at Chicago, they didn’t allow any of those guys to spout their crazy ideas in the first place, so we didn’t need any damn Keynesian revolution.

Good grief! Is there a single word that makes sense? To begin with those detestable guys at LSE were Austrians, as Friedman acknowledges. What he didn’t say, or didn’t know, is that Austrians, either by self-description or by any reasonable definition of the term, are not quantity theorists. So the idea that there was anything special about the Chicago quantity theory as opposed to any other species of the quantity theory is total humbug.

But hold on, it only gets worse. Friedman holds up Jacob Viner as an exemplar of the Chicago quantity theory oral tradition. Jacob Viner was a superb economist, a magnificent scholar, and a legendary teacher for whom I have the utmost admiration, and I am sure that Friedman learned a lot from him at Chicago, But isn’t it strange that Friedman writes: “as I have read Viner’s talk for purposes of this paper, I have myself been amazed to discover how precisely it foreshadows the main thesis of our Monetary History for the depression period, and have been embarrassed that we made no reference to it in our account.” OMG! This is the oral tradition that exerted such a powerful influence on Friedman and his fellow students? Viner explains how to get out of the depression in 1933, and in 1971 Friedman is “amazed to discover” how precisely Viner’s talk foreshadowed the main thesis of his explanation of the Great Depression? That sounds more like a subliminal tradition than an oral tradition.

Responding to Patinkin’s charge that his theory of the demand for money – remember the quantity theory, according to Friedman is a theory of the demand for money — is largely derived from Keynes, Friedman plays a word game.

Is everything in the General Theory Keynesian? Obviously yes, in the trivial sense that the words were set down on paper by John Maynard Keynes. Obviously no, in the more important sense that the term Keynesian has come to refer to a theory of short-term economic change – or a way of analyzing such change – presented in the General Theory and distinctively different from the theory that preceded it. To take a noncontroversial example: in his chapter 20 on “The Employment Function” and elsewhere, Keynes uses the law of diminishing returns to conclude that an increase of employment requires a decline in real-wage rates. Clearly that does not make the “law of diminishing returns” Keynesian or justify describing the “analytical framework” of someone who embodies the law of diminishing returns in his theoretical structure as Keynesian.

In just the same sense, I maintain that Keynes’s discussion of the demand curve for money in the General Theory is for the most part a continuation of earlier quantity theory approaches, improved and refined but not basically modified. As evidence, I shall cite Keynes’s own writings in the Tract on Monetary Reform – long before he became a Keynesian in the present sense. (p. 168)

There are two problems with this line of defense. First, the analogy to the law of diminishing returns would have been appropriate only if Keynes had played a major role in the discovery of the law of diminishing returns just as, on Friedman’s own admission, he played a major role in discovering the theory of liquidity preference. Second, it is, to say the least, debatable to what extent “Keynes’s discussion of the demand curve for money was merely a continuation of earlier quantity theory approaches, improved and refined but not basically modified.” But there is no basis at all for the suggestion that a Chicago oral tradition was the least bit implicated in those earlier quantity theory approaches. So Friedman’s invocation of a Chicago oral tradition was completely fanciful.

This post has gone on too long already. I have more to say about Friedman’s discussion of the relationship between money, price levels, and interest rates. But that will have to wait till next time.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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