Money Melee: What Milton Friedman said-and why he's right
Forty-four years ago, at the end of the brief book A Program for Monetary Stability, the legendary Chicago economist Milton Friedman offered a rather tentative proposal. He said it might be best if the Federal Reserve gave up trying to fine-tune both the real economy and inflation, and instead simply increased the quantity of money at a fixed rate. That was long before we had unregulated interest rates and money-market funds, so Friedman recommended measuring money relatively simply-as "currency plus all commercial bank deposits."
He opined, humbly and tentatively, that "a rate of increase of 3 to 5 percent per year might be expected to correspond with a roughly stable price level for this particular concept of money."
"Hold on to your hats and prepare to be amazed," Financial Times columnist Simon London wrote recently: "Milton Friedman has changed his mind." The celebrated Nobel laureate had told Mr. London the following: "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." Professor Friedman's brief remark caused quite a stir-particularly in England, where all policies of the Thatcher era are routinely lumped together in scorn by the Left as "monetarism." William Keegan, writing in The Observer, called Friedman's comment "the economic quote of the month-and probably the decade."
Poppycock. The idea of instructing central banks to keep some broad measure of money growing at a 3 to 5 percent rate began as little more than a conditional suggestion. It was never a particularly important part of Milton Friedman's contribution to monetary economics, much less his numerous contributions to economics in general. The topic takes up merely a tenth of his 1962 classic Capitalism and Freedom, and that chapter ends by saying, "I should like to emphasize that I do not regard my particular proposal as a be-all and end-all of monetary management, as a rule which is somehow to be written in tablets of stone and enshrined for all future time." That was scarcely a dogmatic proclamation that must now preclude thoughtful reconsideration after four decades of experience.
The Financial Times interview was adeptly misquoted by Australian economist Peter Brian, who wrote: "Milton Friedman, one of the high priests of monetarism, now lacks conviction about its relevance." Balderdash. For Friedman to concede that a fixed rule for the quantity of money is ineffective is not at all the same as saying monetary policy itself is ineffective. And to concede that a quantity rule for monetary policy may be unworkable is certainly not the same as saying that such policy ought to be conducted by the unconstrained caprice of a dozen Fed governors (as many of Friedman's critics would prefer).
"Monetarism" is not even a Friedman coinage; the word was first used by Karl Brunner (a favorite teacher of mine) and Allan Meltzer. In Money and the Economy, Meltzer and Brunner list many possible rules for money: "A rule may call for activist but predictable responses A rule may rely on forecasts, or past data, or the rule can be independent of past, expected or predicted future values." It is a tribute to Friedman that much recent research deals with the relative merits of various kinds of institutional rules-from explicit targets for commodity prices, price indexes, or nominal GDP to the more complex rules devised by John Taylor and Bennett McCallum. The option Friedman rejected out of hand-unlimited faith in unlimited central-bank discretion-is completely off the table. Simply trusting a central bank is, after all, little different from believing in central planning.
Of course, even today, monetary policy is still not quite an exact science; but nobody now doubts that Federal Reserve blunders can cause or aggravate recession and inflation. In contrast, the fiscal (non-monetarist) varieties of Keynesian demand-side economics are in total disarray, unsure whether budget deficits stimulate or crowd out or neither of the above. U.S. fiscalists once boldly predicted that switching from budget deficits to surpluses in the late 1990s would erase the trade deficit, increase the national savings rate, and reduce interest rates. Not one of those predictions came true. More recently, even as interest rates fell to 40- year lows, the same diehard theorists have tried peddling their old tales about deficits causing high interest rates.
It is important to understand that Milton Friedman's most influential works on money were published between 1956 and 1970, during the heyday of Keynesian macroeconomics. Very little from the economics of that era still survives. Soviet-style command economies were then widely expected to outperform free enterprise. Poor countries were instructed to keep tax rates high to generate forced savings. Monetary policy was said to be ineffective against recession or inflation, but the Fed was nonetheless advised to keep interest rates low to stimulate debt. It was thought feasible and desirable to trade higher inflation for lower unemployment. When such advice led to "stagflation," inflation was conveniently attributed to a mysterious "wage-price spiral" that could supposedly be restrained only by wage and price controls.
In the previously mentioned Observer piece, William Keegan reminisced about inviting John Kenneth Galbraith, in 1980, to write that "Britain has, in effect, volunteered to be the Friedmanite guinea pig." Keegan had asked Friedman to comment on the same subject, and Friedman responded by sending a copy of his testimony to the House of Commons-in which he distanced himself from the Thatcher government's Hooveresque goal of cutting budget deficits during a recession. In any event, British deficits actually remained almost equally large from 1979 through 1986, and did not turn into surpluses until after 1987, when the top tax rate was slashed from 60 to 40 percent.
What about the common belief, implicit in Keegan's repetition of Galbraith's 1980 warning, that the Thatcher regime followed harsh monetarist rules? Britain's money supply increased 12.5 percent in 1979, 18.5 percent in 1980, and 25 percent in 1981. Over the entire Thatcher period, 1979 to 1990, the broadly defined money supply grew by 16.8 percent a year, according to IMF figures. In what sense could that be called monetarist? Yet British inflation did fall from 18 percent in 1980 to an average of 4.7 percent in the period between 1983 and 1988, before heading back up again. Although the quantity of money surely matters, it is proving more difficult to determine what to count as money (should we include my checkable short-term bond fund?) or to figure out in advance just how much is too much or too little.
The alleged "monetarist" experiment during President Reagan's first term is equally invisible. Broadly defined money (M2) grew 9.7 percent in 1981 and 8.8 percent in 1982; it averaged 9.3 percent annually from 1981 to 1986. Whatever the impact of the quantity rule for central banking, it appears to have had little to do with what Reagan and Thatcher were accomplishing with or without the aid of their central banks.
There is only one time when "the use of quantity of money as a target" may have had a serious impact on U.S. policy. In December 1968, Milton Friedman wrote to Richard Nixon urging him to close the gold window and let the dollar float. That would likely have happened anyway, since politicians seemed hell-bent on abandoning the commitment to exchange foreign dollars for gold. It is just speculation on my part, but I suspect that undue confidence in the untested new quantity rule might have made it appear safer than it turned out to be to abandon the seemingly old-fashioned discipline of guaranteeing the greenback's value in gold.
Meanwhile, something more sinister was brewing. By 1971, when John Kenneth Galbraith published Economics, Peace and Laughter, the idea that price controls could substitute for monetary restraint had become ominously respectable. Galbraith had earlier advocated "a permanent system of restraint," promising that this would insulate against any inflationary impact of an easy money policy. "With wage and price controls," he promised, "interest rates can be reduced." That is exactly what happened- Nixon adopted wage-price controls and Fed Chairman Arthur Burns cut the Fed funds rate. By blending wage-price controls and easy money with the permissive closing of the gold window and devalued dollar, President Nixon thus led us into the worst inflationary recession the major industrial countries had ever seen.