Wednesday, November 3, 2010

A Reply to Those Who Claim We Misreprensented Milton Friedman

[Update: I see that Allan Meltzer has an Op-Ed in the WSJ where he argues Milton Friedman would not support Ben Bernanke's QE2.  He is responding to those people who "believe the great Nobel laureate would favor this inflationary program. I am certain he would not."  Meltzer's big counter argument is that "Friedman's main message for central banks was to maintain a monetary rule that kept the growth of the money supply constant."  The problem with this claim is that it ignores Friedman's call for the Fed to target the expected inflation rate.  As I show below, Friedman explicitly wrote this approach was better than targeting the money supply.  But even if we ignore this point, Meltzer's key argument about monetary stability still does not imply Friedman would be against QEII.  The growth rate of various money supply measures has fallen and are far from stable. If anything, QEII would move these monetary aggregates closer to a stable growth path. I would like to see how certain Allan Meltzer  is after grappling with these two points, both of which are discussed in my post below.]

There are some observers who find the article Will Ruger and I did on Milton Friedman very irritating.  They believe we have misrepresented his views.  A key complaint they have is that our analysis ignores Friedman's long-standing commitment to stable growth in the money supply. Okay, let us look at the recent growth path of the money supply.  Below is a graph showing the year-on-year growth rate of three monetary aggregates: M2, MZM, and M3.  The M3 data comes Capital Economics. (Click on figure to enlarge.)

The growth rates of the monetary aggregates have been anything but stable.  In fact,  M3 and MZM--arguably better measures of money during this crisis than M2--have had a recent run of negative growth. While M2 has had positive growth, it too appears below trend.  All of them have seen plunges in their growth rates.  Would Milton Friedman really look at this graph and conclude there has been monetary stability?

With that said, one should note that in this 2003 WSJ article Milton Friedman appears to have moved beyond aiming to just stabilize the growth of the money supply.  For in this piece he praises the Fed for adjusting M2  in response to a M2 "velocity bubble" in the 1990s. Friedman is endorsing the Fed's actions  at this time to offset money demand shocks. Thus, in this article he is implicitly calling for the Fed to stabilize the MV part of the equation of exchange (i.e. MV=PY).  So how does money velocity look right now? The graph below answers that question. It divides final sales of domestic product (a more accurate measure of AD than NGDP) by the monetary aggregates. (Click on figure to enlarge.)

Here again we see anything but stability. It is hard to believe that Friedman would not have been concerned by the pick up in money demand implied by this figure.  Moreover, he would realize the that these figures together (i.e. %ΔM +%ΔV) indicate that the growth path of nominal income has not been stable either. This too would have concerned him.  

Finally, it is worth repeating here that Friedman was supportive of the Fed adopting a target for expected inflation. He endorsed it in his book Money Mishief.  The idea was originally Robert L. Hetzel's.  In Hetzel's book The Monetary Policy of the Federal Reserve, he cites a letter Friedman wrote in 1991 where he says the following about this proposal (p. xiv):
It is the first nominal anchor that has been suggested that seems to me to have real advantages over the nominal money supply.  Clearly it is far better than a price level anchor which... is always backward looking.
So Friedman endorses this approach by saying it trumps targeting the money supply.  Now given that inflation expectations were headed down for most of the year (see here), it seems likely Friedman would be concerned on this front too. Only with the talk of QE2 in September did these expectations turn around. I suspect he would have been pleased.


  1. Whether the demand for money increases or the supply of money has decreases depends on how broadly 'money' is defined. Wherever one draws the line, there will always be some money-like asset not included, but which the supply and demand for are important for monetary policy.

    It seems that the supply of many money-like assets fell significantly in 2008. The unmet demand for these assets then spilled over into conventional monies. Therefore, whether one interprets events as an increase in money demand or decrease in money supply depends on broadly 'money' is defined.

    Friedman could not advocate monetary expansion under one interpretation and not the other and be consistent, because both interpretations are logically equivalent. However, it seems as though this is the argument your critics are trying to make.

  2. By the way,

    Check out Russell Roberts's EconTalk episode with Friedman in 2006.

    Go to 23:00 and listen to Friedman's 'favourite proposal'. In short, he wanted the supply of high powered money frozen. Friedman says it should be a constant: 'like gravity'. He explains that the ratio of high powered money to total money has been going up over time; the economy would create more money and roughly emulate a monetary growth rule.

    He mentions 'money demand' only once, much earlier in the podcast, and unfortunately stumbles over his words and appears somewhat confused. I believe he was trying to say: holding money demand constant, everything I say follows. But it is unclear exactly what he means.

  3. Lee, regarding your comment on the inherent difficulty in determining the correct measure of money I agree. That is why I used multiple measures of the money supply to show that the documented changes in them are robust to different measures.

    I would love to get feedback from folks like Jerry O'Driscoll and others luminaries at the Monetarist conference who did not like our Friedman piece or that of David Wessel in the WSJ. How do they grapple with the lack of stability shown in the money supply graphs or the Friedman quote at the end of the post?

  4. Seems to me that Friedman might say that while he wouldn't prefer *discretionary* monetary adjustments, he still prefers Greenspan's moves in the 90s to doing nothing, and that such adjustments are best for when we are in a more or less economically stable period of growth. A major recession due to a collapse in the financial sector resulting in a drop in V might not be the situation he had in mind for such adjustments. He might say "V dropped for a *reason*, and we shouldn't target monetary growth to get our graphs looking right because those graphs *should* look off, owing to the crisis."

  5. What needs to be understood, here, is that money exists with a supply/demand curve like any other resource.

    What is necessary is for the supply of money to match its demand, in order for pricing to not be distorted, allowing the economy to communicate optimally.

    When money velocity declines, this alters the supply/demand curve (against supply) as much as if money quantity declined.

    Pricing is distorted by a shift in either direction, deflationary or inflationary. Both cause "malinvestment", blurring where real prices should be.