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Sunday, August 11, 2013

Has Monetarism Been Abandoned?

Some posts from the past in response to this debate:

Has Monetarism Been Abandoned?: David Altig on Monetarism:

Is Monetarism Dead?, by David Altig: Courtesy of Mark Thoma, I am sent to the Scientific American blog, where JR Minkel ruminates on the contributions of Milton Friedman, asking the question "Is economics a science?" Minkel offers up the question in the spirit of open debate, so fair enough. I did, however, find this passage somewhat puzzling:

Well, Friedman's most famous prediction was a pretty good one: he foresaw the possibility that high unemployment could accompany high inflation, a phenomenon better known as stagflation. That foretelling earned him the Nobel Memorial Prize, although Friedman's monetary theory is currently out of favor.

A similar sentiment is expressed by the eminent historian Niall Ferguson, in an article titled "Friedman is dead, monetarism is dead, but what about inflation?":

[I]t will be for monetarism — the principle that inflation could be defeated only by targeting the growth of the money supply and thereby changing expectations — that Friedman will be best remembered.

Why then has this, his most important idea, ceased to be honoured, even in the breach? Friedman outlived Keynes by half a century. But the same cannot be said for their respective theories. Keynesianism survived its inventor for at least three decades. Monetarism, by contrast, predeceased Milton Friedman by nearly two.

The claim that "Friedman's monetary theory is currently out of favor" is, I think, wildly overstated -- at best.

Pick up virtually any textbook in monetary or macroeconomics and what you will find is a presentation that it is fully steeped in Professor Friedman's justly famous "The Quantity Theory of Money: A Restatement." ...

So why the belief Friedman's views have fallen into disrepute? I think it is a result of two things that, in the end, have little to do with whether Friedman's version of the quantity theory remains the dominant intellectual tradition among macroeconomists.

First, there is the association of Friedman's oft-cited constant money growth rule with the broader quantity-theoretic logic. Part of the rationale for the constant money growth rule had to do with specific assumptions that Friedman invoked regarding money demand -- the assumption, specifically, that changes in money demand not associated with income growth tend to be relatively slow and predictable. Part of it had to do with his judgment that the control needed to successfully "fine tune" the economy far exceeds the capacity of mortal men and women. These elements are not, however, essential to the quantity theory itself. Not accepting Friedman's views on these matters is very much different than rejecting the general quantity theory framework or its core implication that inflation is, in the end, a monetary phenomenon.

Second, there is the fact that monetary aggregates are themselves little used in the practical implementation of monetary policy. An exception, of course, is the European Central Bank, which still claims fealty to the notion that growth in monetary aggregates is a legitimate guide to policy choices. But, as William Keegan reports in the Guardian Unlimited, even that pillar of monetary policy may be "tottering"...

Central banks these days do tend to conduct monetary policy with reference to interest rates rather than monetary growth. But choosing a target for an overnight bank lending rate -- like the federal funds rate -- is implicitly about choosing a path for money growth. Once an interest path is chosen, money growth follows automatically, and is in that sense invisible (or, mathematically, redundant). That does not, however, mean that the insights of the quantity theory are obsolete. That central bank practice has evolved toward a focus on a price (the short-term interest rate) rather than a quantity (money growth) says more about our confidence in the measurement of money than it does about our confidence in the theory that inflation has its roots in money growth (a theme that is expanded on, at length, in an essay in Federal Reserve Bank of Cleveland's 2001 annual report.)

It is true that recent influential ideas about inflation and central banking have incorporated the existence of "cashless" economies, which would indeed move us outside of the reach of the quantity theory. But those ideas contemplate the control of inflation in a hypothetical world (asking, for example, whether rules that work well in a monetary economy might work equally well in a non-monetary economy). That alone does not invalidate quantity-theoretic reasoning. What is more, justifying some aspects of central bank behavior -- the desire to avoid sharp movements in interest rates, for example -- seems to require the existence of money, and in an entirely conventional way. Which is to say, in more or less the fashion handed down by Milton Friedman.

Up to the very end -- hat tip, again, to Mark Thoma -- Professor Friedman was explaining why money matters. How appropriate. Although many these days would be less enthusiastic than he about emphasizing a particular measure of money, his ideas about money are as vital to the core of monetary policy reasoning as they ever were.

The king is dead. Long live his kingdom.

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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.

Friedman1_1

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.

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Monetarism as an Oral Tradition?: This ... is about Milton Friedman's claim that "his 1950 monetarism was an outgrowth of a forgotten subtle 'oral tradition' at Chicago." Samuelson says Friedman is wrong about this.

An Interview with Paul A. Samuelson, Interviewed by William A. Barnett, University of Kansas, December 23, 2003, Macroeconomic Dynamics: ...Barnett: What is your take on Friedman’s controversial view that his 1950 monetarism was an outgrowth of a forgotten subtle “oral tradition” at Chicago?

Samuelson: Briefly, I was there, knew all the players well, and kept class notes. And beyond Fisher–Marshall MV =PQ, there was little else in Cook County macro. ...

Before comparing views with me on Friedman’s disputed topic (and after having done so), Don Patinkin denied that in his Chicago period of the 1940’s any trace of such a specified oral tradition could be found in his class notes (on Mints, Knight, Viner), or could be found in his distinct memory. My Chicago years predated Friedman’s autumn 1932 arrival and postdated his departure for Columbia and the government’s survey of incomes and expenditures. I took all the macroeconomic courses on offer by Chicago teachers: Mints, Simons, Director, and Douglas. Also in that period, I attended lectures and discussions on the Great Depression, involving Knight, Viner, Yntema, Mints, and Gideonse. Nothing beyond the sophisticated account by Dennis Robertson, in his famous Cambridge Handbook on Money, of the Fisher–Marshall–Pigou MV =PQ paradigm can be found in my class notes and memories.

More importantly, as a star upper-class undergraduate, I talked a lot with the hotshot graduate students—Stigler, Wallis, Bronfenbenner, Hart—and rubbed elbows with Friedman and Homer Jones. Since no whisper reached my ears, and no cogent publications have ever been cited, I believe that this nominated myth should not be elevated to the rank of plausible history of ideas. ...

    Posted by on Sunday, August 11, 2013 at 04:26 PM Permalink  Comments (16)


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