Milton Friedman’s 1967 Presidential Address (pdf) is something monetary economists regularly say anyone interested in monetary economics should read. Having recently read it, I have come to the conclusion that it is something anyone interested in monetary economics should read.
As is normal with Friedman, it is beautifully clear, one his great attributes. His analysis holds that money is not neutral (monetary changes can have short-run effects on “real” economic variables, such as unemployment) in the short-run but is so in the long run.
What monetary policy cannot do
Friedman sets out two things monetary policy cannot do–peg interest rates and peg unemployment rates for more than very limited periods. Both analyses hinge on the effect of expectations. In the second case, Friedman was arguing against reliance on the Phillips Curve, the notion that a little less unemployment could be traded off for a little more inflation. Extending Knut Wicksell‘s notion of a natural rate of interest, Friedman argued that there was a “natural” rate of unemployment (one that he stressed was significantly people-created by policy and institutional structures). You might fool people in the short run by an unexpected increase in inflation but, once expectations adjusted, then ever high rates of inflation would be required to have any effect. There was a short-run trade-off but not a long-run trade-off; a temporary trade-off but not a permanent one.
Having discussed what monetary policy could not do, Friedman moved onto what it could do and policy recommendations. He was pessimistic about central banks being able to target inflation. In this, he proved to be wrong. His argument is that the knowledge did not exist on how to use monetary levers to reliably control the rate of change in the price level. It turned out that, by managing expectations, central banks could have any level of inflation they wanted. What is sometimes called the Chuck Norris Effect or central banking as Jedi Mind Trick. Inflation targeting has proved very successful–at taming inflation.
Unfortunately, inflation expectations are not the only ones that matter, so do income expectations.
The problem with Friedman’s economic policy recommendations is that, having brilliantly analysed the role of expectations in economic life, he suddenly stops, and ends up reverting to a stabilising-quantities-is-enough analysis of monetary aggregates. But why would not expectations also potentially feed variably into the effects of monetary aggregates? The answer is, that they do. This, for example, is the basis of Goodhart’s Law.
To be fair, Friedman does note that monetary velocity tends to be stable. Which was the same “but that is the empirical pattern” reasoning he criticises later in his address about relying on the Phillips Curve.
(As an aside, I hate this usage of the term “velocity”: it is actually better described as money turnover but Irving Fisher already had a T in his equation of exchange [for transactions] so used V-for-velocity instead. Like most economists, I much prefer to think in terms of k, the proportion of NGDP that people hold as money.)
If you stop your expectations analysis short of monetary aggregates, so that they drive expectations but are not affected by them in their economic consequences, you get (Quantity) Monetarism, which turned out not to work. (And, indeed, it not working was how Goodhart’s Law got to be formulated in the first place.) If you keep going in your analysis of expectations, then you get Market Monetarism. (It is reading market monetarist and similar bloggers–such as Scott Sumner, Lars Christensen and David Glasner–that has enabled me to achieve any understanding of monetary economics.)
If you like, Market Monetarism = Friedman + expectations mattering for money as well.
Paul Krugman once wrote of something Friedman had written that “it is typical Milton, too simple but mostly correct”. (Krugman also wrote a fine appreciation of Friedman’s economic contributions; as for his criticisms of Milton as public intellectual, Krugman should look in the mirror more.) To have that said to be typical of your work in any area of intellectual exploration is high praise. I would say of Milton’s 1967 analysis that he just needed to keep going on the significance of expectations. Because he did not, he ended up being too simple but mostly correct.
Sadly, 45 years after Friedman gave his address, far too many economists still do not manage to be “mostly correct” on the very points Friedman got right in his address. Particularly what a poor indicator of monetary policy interest rates are. So, to remind us all that Friedman was a great economist and that his 1967 Presidential Address can still be read with profit, I will finish with a passage that all monetary economists, macroeconomists, economic and financial commentators should have pinned up over their computer screen, or operating as a screen saver, because far too many of them still don’t get it:
As an empirical matter, low interest rates are a sign that monetary policy has been tight–in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy–in the sense that the quantity of money has grown rapidly. …
Paradoxically, the monetary authority could assure low nominal rates of interest–but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy. Similarly, it could assure high nominal interest rates by engaging in an inflationary policy and accepting a temporary movement in interest rates in the opposite direction.
These considerations not only explain why monetary policy cannot peg interest rates; they also explain why interest rates are such a misleading indicator of whether monetary policy is “tight” or “easy.”