Milton Friedman: Why Money Matters

The publication date, November 17, 2006, on this commentary from Milton Friedman appearing in the Wall Street Journal is correct. Here's part of the accompanying editorial:

Capitalism and Friedman, Editorial, WSJ: There are some public figures whose obituaries can be written years in advance. Milton Friedman was not one of them. ... He died yesterday at the age of 94, but as the op-ed running nearby attests, he was active in writing about, thinking about and explaining how economics affects our world until the end.

In today's feature, he updates and re-examines conclusions he reached about the Great Depression in "A Monetary History of the United States, 1867-1960," a book published with Anna Schwartz 43 years ago. ...

Here's Milton Friedman's commentary. He concludes that "The results strongly support Anna Schwartz's and my 1963 conjecture about the role of monetary policy in the Great Contraction":

Why Money Matters, by Milton Friedman, Commentary, WSJ: The third of three episodes in a major natural experiment in monetary policy that started more than 80 years ago is just now coming to an end. The experiment consists in observing the effect on the economy and the stock market of the monetary policies followed during, and after, three very similar periods of rapid economic growth in response to rapid technological change: to wit, the booms of the 1920s in the U.S., the '80s in Japan, and the '90s in the U.S.

The prosperous '20s in the U.S. were followed by the most severe economic contraction in its history. In our "Monetary History" (1963), Anna Schwartz and I attributed the severity of the contraction to a monetary policy that permitted the quantity of money to decline by one-third from 1929 to 1933. Since 1963, two episodes have occurred that are almost mirror images of the U.S. economy in the '20s: the '80s in Japan, and the '90s in the U.S. All three episodes were marked by a long period of rapid economic growth, sparked by rapid technological change and the emergence of new industries, and accompanied by a stock market boom that terminated in a crash. Monetary policy played a role in these booms, but only a supporting role. Technological change appears to have been the major player.

These three episodes provide the equivalent of a controlled experiment to test our hypothesis about what we termed the Great Contraction. In this experiment, the quantity of money is the counterpart of the experimenter's input. The performance of the economy and the level of the stock market are the counterpart of the experimenter's output... The three boom episodes all occurred in developed private enterprise market economies, involved in international finance and trade, and with similar monetary systems, including a central bank with power to control the quantity of money. This is the counterpart of the controlled conditions of the experimenter's laboratory.

The Money Supply: In addition, history has provided a close counterpart to the kind of variation in input that our hypothetical experimenter might have deliberately chosen. As Fig. 1 shows, monetary policy ... was very similar in the three boom periods, and very different in the three post boom periods, with settings that might be described as low, medium, high.

To measure the quantity of money, I use M2 in the U.S. and the conceptually equivalent M2 plus certificates of deposit in Japan. To express the data for the two countries and the widely separated periods in comparable units, I use as an index of the money stock the ratio of the quantity of money to its average value for the six years prior to the cycle peak... Finally, the data are plotted to align the dates at the cycle peak.

Fig. 1 shows a striking contrast between the period before the cycle peak and the period after the cycle peak. There are some differences before the peak -- money growth is slowest on the average for the earlier U.S. episode, fastest for Japan -- but the differences are small and there is reasonably steady money growth in all three episodes. The contrast with the period after the cycle peak could hardly be greater. Money supply declines sharply after the cycle peak in the first episode, goes from stable to rising mildly in the second, and rises steadily and sharply in the third. Our hypothetical experimenter planned his experiment well.

The GDP: The results of the third episode of this natural experiment are now all in. Fig. 2 shows how GDP in nominal terms (dollars or yen in current prices) behaved during the boom and post boom periods. I use nominal GDP rather than real GDP because M2 is also a nominal magnitude. How changes in nominal GDP are divided between prices and output is an important question but one that is not directly relevant to this experiment...

As in Fig. 1, there is a striking contrast between the boom and the post-boom periods: roughly similar growth during the booms, widely variable growth during the post-boom. Both before and after the cycle peak, nominal GDP growth paralleled monetary growth. During the boom, money and nominal GDP grew most rapidly in Japan, most slowly in the first U.S. episode, and at an intermediate rate in the second U.S. episode...

After the cycle peak, money fell sharply in the first episode and so did nominal GDP; money growth stagnated in the second episode and so did GDP; money grew at a rapid rate in the third episode and, after a brief lag (corresponding to the mild 2001 recession) so did GDP. ...

The Stock Market: The peak of the stock market, as measured by S&P's index, coincided with the cycle peak in the first episode, both occurring in the third quarter of 1929... However, that was not the case in the later episodes. ... Accordingly, Fig. 3 plots the data to align the series at the stock market peak.

The near identity of the three stock market series during the boom is truly remarkable. ... Of more interest for our purpose is what happened after the peak. For a year after, the three stock-price series fell in tandem, responding to the inner dynamics of a collapsing bubble. Then, the differences in monetary policy began to have an effect. Beginning in late 1930, the S&P index started falling away from the others under the influence of a collapsing money stock. For another year and a half, the other two indexes move in tandem. Then the much more expansive policy of the Fed in the '90s than of the Bank of Japan in the '80s takes effect and pulls the S&P 500 away from the Nikkei, which stabilizes in response to the passive monetary policy of the Bank of Japan...

The results of this natural experiment are clear, at least for major ups and downs: What happens to the quantity of money has a determinative effect on what happens to national income and to stock prices. The results strongly support Anna Schwartz's and my 1963 conjecture about the role of monetary policy in the Great Contraction. They also support the view that monetary policy deserves much credit for the mildness of the recession that followed the collapse of the U.S. boom in late 2000.

Comments

[aa]

Why look at nominal GDP? Sure nominal GDP may go down in a deflationary environment, but it's real GDP which measures (well, sort of) how the economy is doing.

[James Kroeger]

Milton Friedman: a man of great reputation who, unfortunately, contributed very little of value to economic theory. He took some intuitively obvious economic facts---the strong connection between economic activity and the money supply---and then proceeded to offer some overly simplistic and ultimately detrimental policy recommendations.

Monetary Policy: He advised that the evil of inflation be fought at all costs through a restricted money supply (high interest rates).

NAIRU: He recommended that society accept chronic unemployment and a permanent underclass in order to keep inflation rates as low as possible for the benefit of asset holders.

Permanent Income Hypothesis: In spite of the fact that academic economists are supposed to be interested in identifying the most important variables out there that affect the economy's performance, Friedman picks out one variable---the consumption decisions of wealthy consumers---and emphasizes its importance above all other variable considerations, in spite of the fact that such decisions have a very, very small impact on the movement of major monetary aggregates. (And the fact that the Fed can fully compensate for any changes in the consumption decisions of this small segment of the overall economy.) Properly understood, the effect of this variable is so small, no serious economist should include it in a macroeconomic consumption function.

Still, I must say that I am fond of butchering a certain famous Friedman line in order to make my point about the essential harmlessness of inflation: "Inflation is always and everywhere harmless when it comes to the purchasing power of consumers." Yes, prices go up, but wages must also be going up, enough to cover the higher costs. This must be true, or we would not be able to logically blame the price increases on inflation. People may not gain in real terms from increases in disposable income that are due to inflation, but neither do they lose in real terms from inflation. From our understanding of market dynamics, we can know with certainty that if the disposable incomes of consumers were ever to fail to keep up with the higher prices being charged, then the higher prices would not hold.

Thanks to the influence of Milton Friedman and his cohort, both the rich and the poor have been deprived of the optimized levels of wealth production and consumption that they otherwise could be enjoying. In other words, we are all poorer as a consequence of their flawed contributions to economic science.

[cuerposinorganos]

Yeah, I'm with aa here -- how can you do this analysis without looking at inflation? If you pump lots more money into an economy aren't prices, and hence nominal output, bound to go up? And if this effect is real, why don't we just have bubbles all the time? First you get a period of incredible growth, and then the thing bursts but the economy barely slows down? But I am hardly an economist, and given that Friedman was no idiot, I assume I must be missing something here. Can anyone succinctly explain?

[bailey]

Nice try Mark, BUT NOBODY at the FED is listening!

[reason]

Hi James Kroeger,
I missed you on the pigouvian post. I thought it was your hobby horse.
http://economistsview.typepad.com/economistsview/2006/11/pigouvian_redis.html

Still, I don't quite agree with you here, I think you are missing the point that Friedman made. His argument was you can pull the inflation trick only once - after that (like a drug) you need ever more inflation, because of inflationary expectations. I think his argument was right for the 1970s. It is just he became a bit irrelevant today when we have other problems (mainly because he tended to ignore developments in the real economy and allowed his analysis to misused and misinterpreted by the right in a classic bait and switch).

[reason]

As regards the topic of the post, I remain suspicious that there is more to this than meets the eye. It surely matters not just how much money is out there, but how it is created. Large amounts of debt, means large amounts of risk. I'm not ready to write off the Austrians just yet. Everything looks simple in two dimensions, but I think you need more dimensions to see the whole picture.

[Don]

If you look at Figure 1, showing the money supply growth prior to and after the three peaks, you might notice that the money supply grew slowest during the 1920's in America, and plummeted after the crash. By growing the money supply slower than the economy, you get money that is more and more valuable relative to output, in other words, you get deflation.

Deflation is harder to lick than inflation in many ways--if prices are steadily going down and money is steadily becoming more valuable, the incentive is to hold on to money and not use it to purchase a good or service whose value is diminishing--hence the "Great Contraction" as Friedman refers to it. Contrast the money supply growth in Japan after her own asset crash in the early 90's, when the Bank of Japan wisely reduced interest rates to less than zero in order to devalue the Yen. No Great Contraction there--just several years of stagnant growth, which might be the best one can hope for in the circumstances.

Interestingly, China, by pegging the value of her fiat currency to the dollar, is doing much the same thing as the U.S. did in the twenties--increasing the money supply at a rate slower than the growth in output. In other words, the juan (spelling?) is steadily becoming more valuable relative to China's output. I wonder if the Chinese will know, when the crash inevitably comes, that they will need to quickly print more juan (devalue) in order to minimize the effects of the crash and grow out of it. Hopefully they have smart people that know and understand Friedman. Elsewise, they are apt to have their own "Great Contraction", which would undoubtedly reverberate throughout the world economy.

[Lafayette]

cuerposinorganos: "First you get a period of incredible growth, and then the thing bursts but the economy barely slows down? But I am hardly an economist, and given that Friedman was no idiot, I assume I must be missing something here. Can anyone succinctly explain?"

If you've not seen the economy slow down, then it is not a bubble bursting. The bubble broke in North American real estate and housing transactions as well as new housing starts contracted. (See here: http://www.census.gov/briefrm/esbr/www/esbr020.html)

According to the theory, demand is reduced thereby reducing production thereby stabilizing prices at a lower equilibrium AND thereby reducing pressure on wages. If the cycle is sustained, then unemployment is triggered.

All of this is NOT automatic and DOES NOT happen over night. Usually it lasts from six months to a year, at its worst, in the US. In Europe, it has lasted for the better part of a decade!

Why the HUGE difference between the two cases? Because Europe is less flexible in terms of employment mobility and companies more regulated in their ability to easily hire and fire. This simply perpetuates the lower equilibrium at higher unemployment rates.

What to do? Keynesian spending on the part of the state to break the stranglehold on demand. Why doesn't this work? Because in the US, the administration tried to reduce taxes and thereby increase disposable income ... but they did it in the higher income brackets of people who simply pocketed the savings. In Europe, everyone signed a pact that kept budget deficits at 3% of GDP, so the state(s) have had no real amounts of money to spend (except on unemployment compensation, used to maintain minimum consumer demand). Besides, there is no Central Government to assure that the spending is undertaken or uniform.

Choose your mess, Europe or the US ... either one leads to immobility as regards present economic policy.

[yartrebo]

Don: People use far too high a discount rate to stop spending just because there is a percent or two deflation.

However, when debt levels are high, deflation means that all sorts of Ponzi schemes and bubbles come to an end. After all, who wants to pay 5% interest on a mortgage for a vacant investment property when it's going down in value by 5% a year? Heck, I wouldn't even want to pay 0% interest on that loser of an investment. The demand created by the bubbles vanishes and many people lose their jobs, causing tax revenues and disposable income to drop precipitously and making the debt problem even worse.

[pgl]

Even Lord Keynes in his 1936 book conceded that monetary policy mattered. The issue during the 1960's in my view was whether anything else did. I think the answer is clearly - yes.

[Don]

Vatrebo:

The problem with debt and deflation is that money, being more valuable, is harder to come by, thus debt service in a deflationary spiral becomes quite problematic, especially for governments, but also for individuals and corporations.

Fortunately the incentive for a government that owes money is to make the money with which it will pay back its loans less valuable (inflation), which is precisely the cure for the deflationary spiral.

Keynesian government deficits during times of demand contraction fit neatly with the correct program as well, because any time a government runs a deficit, it is necessarily increasing the money supply beyond that demanded by its output. In that regard, Keynes was correct, but in my estimation, for the wrong reasons.

[Greg T]

James, I think you are forgetting (or worse still, don't know) that high inflation hurts low income individuals the most because wealthy speculators can gain on higher real prices of real assets such as property, art, etc.

Also, you refer to 'chronic' unemployment. The natural rate does not necessarily have to be chronic, but if it is, there is little the govt can do about it, because at best, there is only a temporary trade-off between inflation and unemployment - this was Freidman (& Phelp's) point.

If you want to reduce unemployment, you really have to look at promoting long-term output growth ie TFP growth and L & K accumulation

[James Kroeger]

...the point that Friedman made. His argument was you can pull the inflation trick only once - after that (like a drug) you need ever more inflation, because of inflationary expectations.
I've always had a problem with this reasoning, Reason.

Inflationary expectations may encourage lenders to demand higher interest rates, but they will only get higher interest rates if the Fed wants them to go higher, since the Fed possesses unlimited control over money supply. Wage earners may 'demand' higher wages, but they will only receive higher wages if their employers can afford to pay them higher wages.

Paying employees higher wages out of increasing revenues is not an action that will---by itself---increase the money supply. A net increase in the spending of saved money (or money created by the Fed) will increase the money supply. But if an absolute limit is placed on the quantity of money that banks can lend for consumption purposes, it will become largely impossible for the money supply to grow, all else equal, no matter what happens to expectations.

The Fed can enforce an absolute limit the growth of the inflation rate---obviating the possibility of hyperinflation---by setting absolute limits on the amount of dollars that banks [and other money creating institutions] are able to lend. In order to sustain investment spending at the same time it is trying to temper consumption spending, the Fed could selectively set absolute limits on the number of dollars banks can lend for consumption or real estate purchases. This would drive up interest rates for some kinds of loans, while leaving commercial lending somewhat unscathed.

Expectations be damned...

[James Kroeger]

James, I think you are forgetting (or worse still, don't know) that high inflation hurts low income individuals the most because wealthy speculators can gain on higher real prices of real assets such as property, art, etc.
On the contrary, the poor and working class are never better off than when the economy is experiencing 'robust' inflation. This is because they would enjoy---not just zero unemployment, but---a chronic labor shortage. They would enjoy optimal market power in their negotiations with employers. Competition for scarce labor would inspire employers to offer ever more attractive compensation packages. It just doesn't get any better than that for a person who has to work for a living.

In such a labor market, national output---in real terms---is at optimal levels. Investment is at optimal levels. (I.e., [real] capital accumulation would be at optimal levels, ensuring an optimum of long-term growth.) The production and consumption of real wealth is at optimal levels. Any supposition that low income individuals might be hurt 'worse' than the rich in such an environment is---if you'll forgive me---pure fantasy. There is no greater favor that society could do for low income individuals than providing and sustaining a chronic labor shortage for them.

Oh yeah, not only would the lower classes ideally benefit from a robust-inflation-economy in real terms, but so also would the rich. Indeed, the rich could never be better off---in real terms---than they would be in a robust inflation economy. None of them would lose any of the purchasing power they had when the economy operated at low inflation levels. In addition, they would finally have the problem of the poor and lower classes solved in a way that costs them nothing in real terms. In addition to those optimized realities, the rich would finally know what it is like to experience the true gratitude of the lower classes. They'd be experiencing the gift that keeps on giving. The result? A true enhancement in the quality of life that the wealthy would be experiencing.

If you focus on the REAL economy, there just isn't any more rational goal to pursue.

[Betsy L. Angert]

Dear Mark . . .

How cosmic. As I thought to honor Milton Friedman, I wondered how might I do this. I wanted to share similarities, ideas that I might support; yet, I feared, could I find these.

I knew there would be much to quarrel with. I ultimately included some of each. I did appreciate and still do his activism. It is far better than apathy. I think this Milton Friedman's commentary validates this position. I thank you for sharing it. I invite you to review and comment on my own assessment of the man and his life . . .
How Might I Honor Free Market Economist, Milton Freidman? ©
Feel free to express your views on the market.

Betsy L. Angert
BeThink.org or Be-Think

[Spencer B. Hall]

No accolades here:

Milton has always been loath to grant central bankers much discretion in formulating and executing monetary policy. .

1) Friedman couldn't define "money". Money is the measure of liquidity, the "yardstick" by which the liquidity of all other assets is measured.
1) the "monetary base/high powered money” [sic] is not a base for the expansion of the money supply.
2) the "multiplier" is derived from "money" divided by member commercial bank legal reserves.
3) aggregate demand is measured by monetary flows (MVt), i.e., income velocity is a contrived figure (WSJ, Sept. 1, 1983)
4) the rates of change used by the Fed are specious (always at an annualized rate having no nexus with economic lags; Friedman pontificates variable lags)

A. Friedman didn't know the A. difference between the supply of money and the supply of loan funds.
B. didn't know the difference between means-of-payment money and liquid assets.
C. didn't know the difference between financial intermediaries and money creating institutions.
D. didn't recognize aggregate monetary demand is measured by the flow of money not nominal GDP.
E. didn't recognize that interest rates are the price of loan-funds, not the price of money
F. didn't recognize that the price of money is represented by the price (CPI) level.
G. didn't realize that inflation is the most important factor determining interest rates, operating as it does through both the demand for and the supply of loan-funds.

Re: Great Depression - it was impossible for the Fed to create money within the Fed system because it’s issuance was so circumscribed until 1933.

That's some legacy.