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.


15 Responses to “Friedman’s Dictum”

  1. 1 Ray Newton August 16, 2013 at 3:34 pm

    “… 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….”

    Well, how enlightening, David,. That would have been understood, a few thousand years ago, by the first man (or group thereof) who broke from the religious tenet that forbade usury, and harnessed it to a profession that brought forth, money lenders, changers, banks, and eventually institutions that formulated a course of study around the theory of ‘Supply and Demand’, probably inspired by the work of Aristotle who appears to have been the first recorded one to coin the word ‘economics’, or the then Greek equivalent.


  2. 2 Luis August 16, 2013 at 4:01 pm

    I think Friedman was one of the greatest. But also Keynes was one of the greatest. The difference is that Friedman was among the classicals, who think that Economy has its own mecanisms to reach the equilibrium, and Keynes didn’t. I don’t Know who of them was right, but Is a very important Point.
    I think Friedman’s macro works fine when Economy is in (temporal) “equilibrium”. But when acumulative Forces are playing, Keynes’ Is much better.


  3. 3 Ray Newton August 17, 2013 at 4:10 am

    Here we have again an example that I found running through the main artery of Economic theory, the basing of those theories on false assumptions, often attributable to lack of clarity, in defining of what is meant by the various terms used in any economic equation.

    For example, in the key- word ‘money’, it appears to be assumed in these discussions that it refers to that which has the blessings of government as a means of exchange, and (dubious) store of value for the transacting of trade among a population, today, commonly referred to as ‘fiat’.

    In the early days of the 1930’s when the model IS-LM was introduced, ‘money’ was still backed by a precious metal – gold; though to be dumped, minds were still entrenched in its doctrine.

    Today, since the 70’s, money for the masses, is pure fiat.

    But did we really come off the gold standard? In Academia’s philosophy we did. I maintain we did not. This all stems from making incorrect assumptions due to conditioning – like Pavlov’s experiments revealed.

    What really happened was that a two tier money system developed – one for micro (mass) trading, and the other for macro. This accounts for certain goods being ‘agreed’ (mandated) to be traded only in US dollars, it being now the accepted reserve currency.
    Fiat was for the masses – micro trade: and Gold for macro trade.

    There is a strong similarity in – ‘In God we Trust’, and in ‘In Gold we Trust, and I am certain this would not have been lost among the macro banking elite.

    To support my assertion, I reference any chart showing the relationship between the gold price and the oil price particularly since the 1970’s when the US dollar was ‘freed’ from the restrictions imposed by the ‘gold standard.’

    At that time, OPEC totally dominated the oil supply market, and to a great extent ( but for how long) still does. And OPEC was dominated by Saudi Arabia. Anyone who has read ‘The Seven Pillars of Wisdom’ and/or, saw the biopic Hollywood production of Lawrence’s life, ‘Lawrence of Arabia’, will be aware of the powerful affinity of the Arab and gold – the only ‘money’ to be trusted.

    It will be clearly seen from the chart that though there is periodic variance from the mean, it eventually returns to that mean to produce an average ratio of around 15 to 16 (let’s say 15.5) barrels of oil to one ounce of gold.

    The Arabs are very shrewd in ‘accounting’. They envisaged that once the dollar was removed from gold backing, inflation would soon follow. Consequently, if their oil was traded solely on the oil price in US dollars it would be difficult to maintain any stability to their accounting , especially, world-wide trade.

    To overcome this, it was agreed that it would be related to number of barrels of oil to one ounce gold. This allowed for any vagaries in the US dollar value over time, and economic turbulence.

    Why Oil and gold? Because oil is the most widely traded commodity, used by all nations, and vital to any economy, being used in the production of most goods (I could say ALL), it can be viewed as a metaphorical ‘ETF’ for all commodities. Gold, due to its long historical role, and that it ticks all the boxes, as a store of value.

    I could go on with further support, but if you have managed to hang in so far, it is more than I can expect from most. However, there is sufficient to make my point, and allow anyone with a ‘free’ mind, to let their imagination seek to understand – All is rarely what it seems, or what we have been led to believe. And to always be sure there is a clear, concise, and accepted understanding of all terms used in a discussion, ones which ecompass a close relationship to the subject that will avoid asserting assumptions as fact.


  4. 4 Ray Newton August 17, 2013 at 4:40 am

    Further to the above, might I recommend that if anyone wishes to understand whether an inlfation bias looms or deflation, that he/she watches closely the oil/gold ratio.

    When it is above 15.5 barrels to one ounce of gold, it means oil is less costly (cheaper) than norm, And when below it is more so (dearer). It should not require me to explain why, or where, at present, the finger is pointing.

    At the beginning of the year I believe it was over 17 barrels to the ounce. It is now slightly over 12,

    However, there is much turbulence in the Middle East with little sign of it easing soon. The outcome will bring great change to the status quo. Therefore, yardsticks which have served a condition well, can, in the future, change.

    Having said that, I am confident, that it will be a long time, if ever, before gold is replaced as the definitive measure of a store of value – if only for the simple reason that old habits die hard, though another more solid reason exists.


  5. 5 Tas von Gleichen August 17, 2013 at 6:00 am

    The Bretton woods system was the best ever. It’s really unfortunate that we have the current fiat monetary system in place.


  6. 6 Ray Newton August 17, 2013 at 8:36 am

    Tas von Gleichen Why was it? What was its real objective? Was it not, perhaps, to establish the ‘new world order’ following the chaos brought about by two world wars (which some see as only as one with a break for half time)? Ordo ab Chao.

    Was it perhaps just one more stage in the unifying of a very divisive world into a more manageable political, and economic, manageable unit? Is this not what we are seeing continuing right now?

    Is not the forming of the EU with its once high concentration of disunity in the key essentials all part of the program? Is this not the empirical testing, this overcoming of the ‘growing together’ pains, for formulating the blue print for the further eventual expanding of the grand design into other key regions – like Asia?

    Does not everything begin to fall into place and make more sense when one sees ‘the light’ or if you prefer – ‘things in this light’?

    As I see it, Bretton Woods was primarily to establish the United States as the main tool (battering ram) for bringing this about. Aided by the powerful money machines of the Federal Reserve, the IMF, the IBRD, World Bank et al, without which none of it would be possible. The fate of the Russian model was just about sealed at this meeting.

    You may disagree, but, if you are still young, watch how it plays out. Once you know what the plan is, it makes the understanding of ‘real’ economics as clear as a crystal spring – by ‘real’ I mean, as it is practised in the real world, not taught for an overly idealistic one.

    Knowing this, you will be able to predict with absolute confidence, that there is no probability, or possibility, of the EU breaking up. It will only grow. And much more will be revealed to you through observation as the mist clears.


  7. 7 JP Koning August 18, 2013 at 9:03 am

    I read this a couple of times. Fascinating post, David.

    It really highlights the diametric opposition between the IBOF-theory of the Great Depression and Friedman’s money-shortage theory.


  8. 8 David Glasner August 28, 2013 at 9:55 am

    Ray, Glad to be of service, however meager.

    Luis, My own view is that Friedman was a superb microeconomist who wound up doing monetary theory as if there was no difference between macro and microeconomics. He had many superb insights, but he was not conversant in much of the relevant macro literature.

    Ray, Sorry, but I reject the idea that there is any significance to the oil/gold ratio and have written at least one post explaining why I don’t think it has any significance.

    Tas, If it was so great, why didn’t it last for 30 years?

    Ray, Be sure to get back to us all when the mist clears.

    JP, Thanks, glad that you found it helpful.


  9. 9 Ray Newton August 30, 2013 at 3:37 am


    I have only just looked back on this topic, so will now address your comments.

    You say “…Ray, Sorry, but I reject the idea that there is any significance to the oil/gold ratio and have written at least one post explaining why I don’t think it has any significance. ….”

    I can well understand from all your commentaries, and responses to others, that you would reject any significance to the oil/gold price ratio, and probably all the points I make – as you follow the lines of the vast majority. By that, I mean vast, of run of the mill economists in failing to recognise anything outside academia’s doctrine.

    God forbid, otherwise we would not have the economic confusion we have, and the consensus of opinion of more economists would be getting it right sufficiently to bring pressure to bear at its source.

    However, I would seriously enjoy reading your explanation of ‘why’ (you reject) to which you refer. Perhaps, therefore, you would be kind enough to link me to where I may find it.

    As it is still summer here, and we have not yet quite entered the ‘season of mists and mellow fruitfulness,’ to which Keats referred, I am not quite sure of the mist to which you refer. If it is the metaphorical one, I assure you that no mist glazes either my eyes or my mind. And, as I haven’t ‘gone away’, I cannot really fulfil the meaning of ‘returning’.


  1. 1 Noted for August 16, 2013 Trackback on August 16, 2013 at 9:30 pm
  2. 2 Links for 08-17-2013 | Symposium Magazine Trackback on August 17, 2013 at 1:35 am
  3. 3 Krugman’s blog 8/17/13 | Marion in Savannah Trackback on August 18, 2013 at 3:45 am
  4. 4 Nostalgia di inflazione (17 agosto 2013) | La Fata Turchina Trackback on August 25, 2013 at 12:38 am
  5. 5 Milton Friedman, Monetarism, and the Great and Little Depressions | Uneasy Money Trackback on March 31, 2015 at 2:48 pm
  6. 6 'Interest Rates aren't a Good Gauge of Monetary Policy' or Things Sumner Says a Lot | Last Men and OverMen Trackback on February 19, 2017 at 8:45 am

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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