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.
Uneasy Money 
“The use of quantity of money as a target has not been a success. I’m not sure I would as of today push it as hard as I once did.” Milton Friedman
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The k-percent rule makes no more sense for money than it does for apples. A free banking system will automatically match the amount of money to the needs of business, just like free markets will match the production of apples to customers’ demand for apples. Pretty amazing that Friedman saw the importance of free markets so clearly when it came to apples, but not at all when it came to money. I blame his teachers, Lloyd Mints and Henry Simons, who had turned him away from the real bills doctrine at an early age.
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David, does Hayek’s critique not also apply to a k% NGDP targeting rule?
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David, I mostly agree, but two quibbles:
1. You seem to imply Friedman supported a K-percent rule for ideological reasons. However later in his life he switched to support for inflation targeting, and that switch seems to have been done for pragmatic reasons.
2. Friedman’s policy was not tried in 1979-92, so that era doesn’t really disprove the effectiveness of a K percent rule. Nonetheless, I agree it is a bad idea.
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Is financial repression more libertarian than central banking?
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Samo Sale, You are certainly right that Friedman eventually gave up on the k-percent rule, but that wasn’t before he suffered the embarrassment of predicting double-digit inflation in the mid-1980s when the money supply was consistently expanding at double-digit rates.
Mike, You are exactly right about the inconsistency in Friedman’s views about free markets for goods and free markets for money, and you are probably right that he was probably unduly influenced by Henry Simons and especially Lloyd Mints, whose book on the History of Banking Theory Friedman had excessive admiration for. But Friedman was also convinced that competition in banking was self-destructive because the value of banknotes is greater than the cost of producing them, which to Friedman, like David Hume, meant that banks were inherently engines of inflation unless subjected to regulation, preferably 100-percent reserves.
Rajiv, It might, but I don’t see how the argument would work. In the case of Friedman’s rule, there is a positive feedback loop. If the money supply is expanding at the limit allowed by the rule, and the public expects the demand for money to increase more rapidly in the future, they will, as a precaution demand money immediately so that they won’t be deprived of liquidity later when the rule forces a tightening, but the precautionary demand tends to increase the rate of growth in the money supply which forces the monetary authority to tighten immediately causing a panic, and an even greater increase in the demand for money, causing the money supply to increase faster, and the monetary authority to tighten again. What is the comparable story under NGDP targeting?
Scott, You are right that Friedman eventually conceded that his rule would not work. I agree that Friedman had a pragmatic side, but I think that the attraction of the k-percent rule to him was very much ideological which is why he preferred it to price level or inflation targeting which was the earlier position of his intellectual forbears Simons and Mints and Irving Fisher.
I disagree that the Friedman rule was not tried. Volcker did try to adopt a Monetarist-lite approach in 1979 when he was appointed, but was forced by Carter to back off in 1980 when the economy went into recession. Reagan supported the adoption of targets for the monetary aggregates, though at a higher rate than Friedman had advocated. The Fed was consistently unable to meet the targets for precisely the reasons that Hayek had identified. Friedman tried to pin the blame on the Fed for the failure to meet its growth targets for monetary aggregates, but that reflected the unworkability of the targets rather than a failure of the Fed to execute the policy.
Max, Not in my view, but that is a very metaphysical question.
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Ironically, (simple) inflation targeting has the same problem as the gold standard — it concerns itself with the value of the currency but not income expectations. Hence the Great Recession having some similarities to the Great Depression, but not being nearly as bad as a x% pa inflation rule just won’t create 25% falls in the price level.
Unless you are Greece and in the Eurozone when you get a 15% collapse, but the Euro is an artificial gold standard, so that just reinforces the similarity.
If you read Friedman’s 1967 AEA Presidential address, it is striking that he stops short in his expectations analysis. He applies the effect of expectations to the Philips Curve as a policy framework, but then does not then apply it to any set rate of expansion in the monetary base. The lapse is no doubt much more obvious in post Market Monetarism hindsight.
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Great blogging.
I keep coming back to it—a focus on inflation is deathly to intelligent monetary policy. Yet the profession can hardly speak a sentence without referencing inflation.
Sure, double-digit inflation is not desirable, and may even retard real growth. But sub-4 percent inflation? In an era of the Internet when checking prices is done easily and continuously?
It still seems to me that NGDP targeting makes a great deal of sense. The question is which policy tools will work? QE? IOER?
Little noticed: Unless I am mistaken, since the Fed went to open-ended, result-dependent QE (QE3- 9/12), the economy has been generating 200k private-sector jobs a month.
See http://research.stlouisfed.org/fred2/data/USPRIV.txt
We had third-quarter GDP with 4 percent growth (a bit dubious, but). Inflation still dead.
Okay, I can’t prove QE resulted in good job growth and the 4 percent real growth. But something is working (I would go to even higher levels of QE).
The other non-PC question: The Fed has monetized trillions in federal debt without inflation. We just lifted a debt-monkey off the back of taxpayers and future generations. And lower inflation than ever. Should not this be explored a little bit more?
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The k-percent rule, “…importantly combined with flexible exchange rates…”
Do you have a post elsewhere on here that unpacks that thought a little? If not could you explain briefly?
Enjoy your blog.
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Lorenzo, I agree, of course, about inflation targeting and its similarities to the gold standard as well as the comparison between the Great Depression and the Great Recession (except that I call it the Little Depression). One of my early blog posts over two years ago (“The Perverse Effects of Inflation or Price-Level Targeting”) tried to make this point. I agree that euro is now almost indistinguishable from the gold standard except that it is much harder to get out of. And your insightful point about the incomplete expectational analysis of Friedman’s Presidential Address seems exactly right to me.
Benjamin, Thanks. Good point about the pick up in growth since QE3. And yes, of course it should.
JMRJ, It may have come up in one of my earlier posts about Friedman, but I can’t really remember. Actually, I don’t think that there is all that much unpacking necessary. The point is simply that because Friedman was so committed to the idea that a monetary policy rule had to be defined in terms of some instrument under the Fed’s, rather than a target, Friedman somehow concluded that it was illegitimate for a central bank to try to influence the exchange rate except by committing itself irrevocably to a pegged exchange rate, which he opposed on economic grounds (see his famous essay “The Case for Flexible Exchange Rates”). But even a commitment to a pegged exchange rate, like the gold standard, allows the central bank some discretion in how it will execute that target, e.g., it can choose to accumulate or reduce its holding of foreign exchange reserves. So Friedman rejected all those alternatives to his k-percent rule, and consistently berated the Fed for paying the slightest attention to the dollar exchange rate. Of course, he had no explanation for the increased volatility of exchange rates whenever central banks targeted monetary aggregates, unable to fathom that fluctuations in the demand for money that were not accommodated by movements in the rate of growth of the monetary aggregates would be reflected in increased exchange-rate volatility.
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David, what if the central bank had a machine target a k spread between a (say) MZM-linked government bond and a vanilla bond, automatically adjusting the monetary base to achieve k? I don’t feel like that would be vulnerable to any of your (or Hayek’s) objections, but it would take discretion away from the CB. Of course, if we went as far as that we might as well target something better like the price level, or nominal income, or nominal wages, but presuming they were out of reach.
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