Posts Tagged 'monetary policy'

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.

Two Reviews: One Old, One New

Recently I have been working on a review of a recently published (2011) volume, The Empire of Credit: The Financial Revolution in Britain, Ireland, and America, 1688-1815 for The Journal of the History of Economic Thought. I found the volume interesting in a number of ways, but especially because it seemed to lend support to some of my ideas on why the state has historically played such a large role in the supply of money. When I first started to study economics, I was taught that money is a natural monopoly, the value of money being inevitably forced down by free competition to the value of the paper on which it was written. I believe that Milton Friedman used to make this argument (though, if I am not mistaken, he eventually stopped), and I think the argument can be found in writing in his Program for Monetary Stability, but my memory may be playing a trick on me.

Eventually I learned, first from Ben Klein and later from Earl Thompson, that the naïve natural-monopoly argument is a fallacy, because it presumes that all moneys are indistinguishable. However, Earl Thompson had a very different argument, explaining that the government monopoly over money is an efficient form of emergency taxation when a country is under military threat, so that raising funds through taxation would be too cumbersome and time-consuming to rely on when that state is faced with an existential threat. Taking this idea, I wrote a paper “An Evolutionary Theory of the State Monopoly over Money,” eventually published (1998) in a volume Money and the Nation State. The second chapter of my book Free Banking and Monetary Reform was largely based on this paper. Earl Thompson worked out the analytics of the defense argument for a government monopoly over money in a number of places. (Here’s one.)

And here are the first two paragraphs from my review (which I have posted on SSRN):

The diverse studies collected in The Empire of Credit , ranging over both monetary and financial history and the history of monetary theory, share a common theme: the interaction between the fiscal requirements of national defense and the rapid evolution of monetary and financial institutions from the late seventeenth century to the early nineteenth century, the period in which Great Britain unexpectedly displaced France as the chief European military power, while gaining a far-flung intercontinental empire, only modestly diminished by the loss of thirteen American colonies in 1783. What enabled that interaction to produce such startling results were the economies achieved by substituting bank-supplied money (banknotes and increasingly bank deposits) for gold and silver. The world leader in the creation of these new instruments, Britain reaped the benefits of efficiencies in market transactions while simultaneously creating a revenue source (through the establishment of the Bank of England) that could be tapped by the Crown and Parliament to fund the British military, thereby enabling conquests against rivals (especially France) that lagged behind Britain in the development of flexible monetary institutions.

Though flexible, British monetary arrangements were based on a commitment to a fixed value of sterling in terms of gold, a commitment which avoided both the disastrous consequences of John Law’s brilliant, but ill-fated, monetary schemes in France, and the resulting reaction against banking that may account for the subsequent slow development of French banking and finance. However, at a crucial moment, the British were willing and able to cut the pound lose from its link to gold, providing themselves with the wherewithal to prevail in the struggle against Napoleon, thereby ensuring British supremacy for another century. (Read more.) [Update 2:37 PM EST: the paper is now available to be downloaded.]

In writing this review, I recalled a review that I wrote in 2000 for of a volume of essays (Essays in History: Financial, Economic, and Personal) by the eminent economic historian Charles Kindleberger, author of the classic Manias, Panics and Crashes. Although I greatly admired Kindleberger for his scholarship and wit, I disagreed with a lot of his specific arguments and policy recommendations, and I tried to give expression to both my admiration of Kindleberger and my disagreement with him in my review (also just posted on SSRN). Here are the first two paragraphs of that essay.

Charles P. Kindleberger, perhaps the leading financial historian of our time, has also been a prolific, entertaining, and insightful commentator and essayist on economics and economists. If one were to use Isaiah Berlin’s celebrated dichotomy between hedgehogs that know one big thing and foxes that know many little things, Kindleberger would certainly appear at or near the top of the list of economist foxes. Although Kindleberger himself never invokes Berlin’s distinction between hedgehogs and foxes, many of Kindleberger’s observations on the differences between economic theory and economic history, the difficulty of training good economic historians, and his critical assessment of grand theories of economic history such as Kondratieff long cycles, are in perfect harmony with Berlin.

So it is hard to imagine a collection of essays by Kindleberger that did not contain much that those interested in economics, finance, history, and policy — all considered from a humane and cosmopolitan perspective — would find worth reading. For those with a pronounced analytical bent (who are perhaps more inclined to prefer the output of a hedgehog than of a fox), this collection may seem a somewhat thin gruel. And some of the historical material in the first section will appear rather dry to all but the most dedicated numismatists. Nevertheless, there are enough flashes of insight, wit (my favorite is his aside that during talks on financial crises he elicits a nervous laugh by saying that nothing disturbs a person’s judgment so much as to see a friend get rich), and wisdom as well as personal reminiscences from a long and varied career (including an especially moving memoir of his relationship with his student and colleague Carlos F. Diaz-Alejandro) to repay readers of this volume. Unfortunately the volume is marred somewhat by an inordinate number of editorial lapses and mistaken attributions or misidentifications such as attributing a cutting remark about Paganini’s virtuosity to Samuel Johnson (who died when the maestro was all of two years old). (Read more) [Update 2:37 PM EST: the paper is now available to be downloaded.]

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.

Enter your email address to follow this blog and receive notifications of new posts by email.

Join 244 other followers


Get every new post delivered to your Inbox.

Join 244 other followers