Thomas Palley

January 29, 2007 has been declared Milton Friedman day. To add balance to the day, I am posting the following article on Monetarism. It draws on an earlier article, “Milton Friedman: The Great Conservative Partisan”, which provides a fuller survey of Friedman’s work. Readers may also want to visit www.Maxspeak.com that has an e- colloquium on Friedman.

Someone once told me that the late Charles Kindelberger jokingly mused that to win the Nobel Prize in Economics you have to have one big new idea, and that idea has to be proved wrong. The story is probably apocryphal, but if it’s true Kindelberger got it wrong. Milton Friedman (the 1976 prizewinner) had two big new ideas – monetarism and the natural rate of unemployment – and they’re both wrong.

Monetarism recommends that central banks target money supply growth. It flourished as an idea in the late 1960s and 1970s, and was briefly adopted by central banks as a policy framework in the late 1970s and early 1980s. That experiment produced devastating interest rate volatility, prompting central banks to revert to their traditional practice of targeting interest rates – which is what they do today.

At the theoretical level, monetarism asserts that central banks control the money supply and should aim for steady money supply growth. Friedman even recommended replacing the Fed with a computer that would mechanically manage the money supply regardless of the economy’s state. Furthermore, he suggested the Fed aim for a zero nominal interest rate. If the equilibrium real interest rate is three percent, that policy implies steady deflation of three percent.

These monetarist propositions reflect a flawed understanding of money. Money is a form of credit – an IOU. If central banks try to control the narrow money supply, the private sector just moves to create other forms of credit. That is why the Fed was unsuccessful in targeting the money supply, and why predicating economic policy on the relationship between the money supply and economic activity is a will o’ the wisp.

With regard to Friedman’s recommendation of zero nominal interest rates and deflation, Japan’s recent experience has confirmed the lessons of the Great Depression. In a credit-money economy generalized deflation is catastrophic and should be avoided.

Monetarism’s most famous aphorism is that “inflation is always and everywhere a monetary phenomenon.” This saying reflects Friedman’s polemical powers, capturing for monetarists what all sensible economists already knew. Inflation is about rising prices, and prices are intrinsically a monetary phenomenon since they are denominated in money terms.

Sustained inflation requires that the money supply grow in order to finance transacting at higher prices. For Friedman, this made villainous central banks the exclusive cause of inflation because of his belief that they control the money supply. However, the reality is that the private sector can also inflate the money supply through its own credit creation activities. Additionally, central banks (viz. the Bernanke Fed) may be compelled to temporarily accommodate inflationary private sector pressures to avoid triggering costly recessions. The implication is that inflation can have different causes, something Friedman denied. Sometimes inflation is caused by excessively easy monetary policy or large budget deficits financed by central banks. Other times it is due to private sector forces, including speculative booms and conflicts over income distribution.

Monetarism was supported by Friedman’s joint work with Anna Schwartz in which they argued that the Federal Reserve caused the Great Depression through mistaken monetary tightening. This was Friedman’s first major salvo in his crusade against government, implicitly blaming government for the Depression.

Friedman’s claim has always smacked of the tail wagging the dog since the Fed’s tightening was modest and brief, suggesting an underlying instability of the 1929 economy. The 1929 stock market was characterized by feverish speculation, and the Fed would indeed have done better to provide easy liquidity when investors rushed to exit. However, that also proves the dangerous instability of financial markets and makes the case for an active government regulatory presence, the very opposite of Friedman’s monetarist perspective.

Monetarism encapsulates all the strengths and weaknesses of Friedman’s thinking. It helped correct early (mainly British) Keynesian disregard of monetary factors, the post-Depression era disregard for the price system, and blindness to the possibilities of government policy failure. But it is one thing to say that money matters and another to say that money is all that matters; to say the price system usually works versus it works perfectly all the time; and to say government policy interventions can fail versus they fail all the time and these failures are worse than the market failures they seek to correct. Friedman replaced an “anti-market pro-government” bias with an even more extreme “pro-market anti-government” bias. Almost all of Friedman’s work, including monetarism, is infected by this bias. That tarnishes his contribution, making him a great conservative ideologue rather than a great balanced economist.

Copyright Thomas I. Palley

This entry was posted on Monday, January 29th, 2007 at 7:36 am and is filed under Economics. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.