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.

Beckworth Smackdown Watch

Peter Boettke and friends take issue with the claim that Milton Friedman would support QEII. There is an interesting discussion there between the Austrians who take the excess money demand problem seriously and those Austrians who don't. Among other things, I learned from the comments that at a recent gathering of Monetarist luminaries the participants really disliked David Wessel's piece on Milton Friedman and by implication my piece too.  In my defense I never have claimed to be a monetarist, only a quasi-monetarist.

Why a NGDP Level Target Trumps a Price Level Target

Two recent articles speak to the advantages of a nominal GDP level target over a price level target.  The first article is from The Economist which actually discusses a price level target but in so doing actually builds the case for a NGDP level target. The Economist article first describes the benefits of a price level target:

Assume that inflation of 2%, on average, is ideal. This implies that if the price level is 100 this year, it will be 102 next year and 104 (or more precisely, 104.04) in the second year. If inflation is only 1% in one year, a conventional inflation-targeting central bank would aim only to return inflation to a rate of 2% the next. This would leave the price level at 103, lower than its original implied path. In contrast, a central bank that targets the price level wants to make up any lost ground on prices. It would seek to raise inflation to 3% in the second year to get to a target of 104.

In theory price-level targeting is superior to inflation-targeting because it provides more certainty about the long-term purchasing power of money. Central banks always target inflation flexibly. The Bank of Canada and the Bank of England, for example, target a rate of 2% but permit a range of 1% to 3%. That means someone making a 30-year investment must plan for cumulative inflation of as much as 143% or as little as 35%. A credible price-level target eliminates that uncertainty.

 So a price level target trumps an inflation target, but it has one glaring problem: it doesn't handle aggregate supply shocks very well. Here is The Economist:

There are questions, too, about how central bankers would deal with a one-time rise in the price level because of a new value-added tax, say, or higher oil prices. The boost to inflation would be temporary, but to the price level, permanent. In theory a central bank would have to wrestle all other prices lower no matter what the cost. It could make an exception, but too many exceptions would dent the bank’s credibility. Conversely, a positive shock such as lower oil prices or higher productivity that pushes prices lower would require the central bank to raise future inflation, driving down real interest rates and maybe risking an asset bubble.

Implicit to this discussion is that a price level target does great if the business cycle is dominated by aggregate demand (AD) shocks. But if aggregate supply(AS) shocks matter at all then a price level target can actually be destabilizing. Would we really want the Fed to tighten because a negative AS shock pushed up prices? This would require the Fed to further constrict an already weakened economy.  On the other hand, if there were a productivity boom that implied a higher neutral interest rate and lower inflation rate, would we really want the Fed pushing interest rates below the neutral rate and raising AD above trend growth just to keep the price level stable?

What then is left? Ramesh Ponnuru provides an answer in a National Review article titled "Hard Money" (sorry, no link):

Economists Scott Sumner of Bentley University and David Beckworth of Texas State University are among those who have suggested that the Fed should move gradually toward a new, more rule-bound and predictable monetary policy. The first step would be to signal to the markets that the Fed is willing to do whatever it takes to reach 2 percent average inflation. Over time the Fed would move to stabilize and then slow the growth of nominal GDP, which is the size of the economy as measured in a given year’s dollars. If the nominal GDP target was for 3 percent growth and the economy grew by 2 percent, there would be 1 percent inflation.

That policy would bind the Fed to a rule, thus reducing the uncertainty that recent policy has generated, including the risk that we will get galloping inflation at some point in the future. But it is superior to simply targeting the inflation rate, Beckworth argues, because it incorporates two worthwhile types of flexibility. It allows the price level to move in response to supply shocks: An oil embargo would cause prices to rise, a technological advance would have the opposite effect. And it allows the money supply to move up and down in response to the demand for cash: In periods such as late 2008, when people were holding on to their money, the Fed would have loosened more than it did. But since the rule would have required tighter money during the boom years, the financial crisis might not have been as severe in the first place.

So the answer is a NGDP level target.  There is some disagreement on exactly how fast NGDP should be growing and thus targeted.  However, supporters of a NGDP level target agree that the beauty of a NGDP level target is that it forces Fed to focus on stabilizing AD while ignoring potentially misleading signals coming from changes in the price level. In short, such a rule would force the Fed to focus on a cause of the business cycles, not a symptom of it. 

What Would Milton Friedman Do? Part III

Terrence Corcoran weighs in on the discussion of what Milton Friedman would recommend if he were alive today:

A cottage industry is building around the question: What would Milton Friedman do? With the U.S. Federal Reserve on the brink of announcing a new round of quantitative easing to pump a fresh supply of money into the U.S. economy, people are looking around for economic guidance. Prof. Friedman, the Nobel-winning free-market economist who died in 2006, earned his Nobel on the basis of his monetary-policy work. He was a “monetarist” who promoted the idea that steady and stable increases in the money supply were needed to keep growth high and inflation low.

The consensus, more or less, appears to be that Prof. Friedman would endorse what Fed chairman Ben Bernanke is expected to announce tomorrow: another massive increase in bond purchases. If the Fed buys up to half a trillion dollars’ worth of bonds, pushing interest rates even lower, the theory is that such quantitative easing will drive Americans into doing something constructive with their money, activity that would push up money-supply measures.

Here is the piece that Will Ruger and I did on the topic and here is the article by David Wessel.

How Would QE II Help?

Mark Thoma is doubtful QEII will pack much economic punch:

It seems to me that everyone fighting today over whether QEII will work are worried about whether the Fed can affect real rates, but are forgetting about the second step in the process. Once real rates rates fall, firms and households then have to be induced to borrow more, then consume or invest (I'm including the response to expected inflation in this). Even if we manage to change real rates, and I have never quarreled with the Fed's ability to do this (though the extent depends upon their ability to affect expectations), why do people think it will bring about a strong consumption and investment response in the current environment?...

Here is why I think QE will pack an economic punch, if done correctly. The expectation of permanently higher prices will cause cash-flushed firms, households, and other entities to start spending more today. Right now there is an excess money demand problem that could be stemmed by meaningfully changing the inflation outlook.  Those folks and entities hoarding money would on the margin face an greater incentive to start spending given an significant increase in inflation expectations. (Yes, many households with weakened balance sheets are deleveraging and saving more.  However, the rise in saving by these troubled households--by paying off debt, cutting back on spending, or buying other assets--should lead to more money  for other non-troubled households unless the money is being hoarded somewhere else.  Maybe the non-troubled households choose to sit on their money, maybe the creditors to whom the troubled households send their  money are sitting on the money, or maybe it's the creditors' creditors that are sitting on the money. The details are not important, what is important is that somewhere in the economy there is an excess demand for money right now that is not being met by the Fed.) 

Now assume the Fed does indeed address this excess money demand problem with QEII.  Given sticky wages and prices, this pickup in spending (i.e. drop in money demand) will translate into real economic gains.  This will encourage banks to start lending more as they see better credit risk going forward while the improved economic outlook encourages firms and households to start borrowing more too.  On top of that, the higher expected inflation will drop the real interest rate and encourage more interest-sensitive spending. Next, we could consider how the pick up in asset prices might have a wealth effect on consumption.  The pickup in asset prices could also improve troubled households balance sheets and thereby enhancing their access to credit.  Finally, further depreciation of the dollar may spur exports. Bottom line is that there are multiple channels through which QE could work.

Bernanke's "Radicalism" is Already Working

Paul Krugman replies to my post on QE in the Great Depression. He then notes that Gautti Eggertson corresponded with him on this discussion:

Gauti Eggertsson writes in to follow up on my piece on quantitative easing in the Great Depression. He points me to a 2008 paper (pdf) in which he shows that the coming of FDR, combined with America’s exit from the gold standard, was seen by markets as a huge regime change; it was, said FDR’s own budget director, “the end of Western civilization.”

This regime change immediately shifted expectations of future inflation, well before there was any actual surge in monetary base. That, rather than the quantitative easing per se, is how monetary policy — or more accurately, expectations of future monetary policy — gained some traction in the 30s liquidity trap. Again, an important lesson — but how relevant is it to current circumstances? Bernanke, unfortunately, cannot convince people that he’s bringing the end of Western civilization.

Two remarks.  First, this is the point I was trying to make in my initial post: change inflation expectations and  follow up with actual changes, as needed to support those expectations, in the monetary base.  

Second, I don't understand Krugman's dismissal of this insight as relevant for today.  There are many folks out there who do think Bernanke is bringing an end to an important feature of Western Civilization today: the value and importance of the dollar. In fact, Krugman himself admitted just last week he was shocked to see such beliefs. It gets worse, there are some who believe Bernanke's QE2 could usher in civil unstrife and maybe even a civil war. As noted by Ryan Avent, Karl Smith, and others, this Bernanke radicalism is already being reflected in the markets.  Below is expected inflation rate from coming from the bond market. Note that after a nine-month fall it does a sudden turn around once the Fed starts talking up QE2 (Click on figure to enlarge):

What more does Krugman need to convince him that Fed is already shaping inflation expectations and can continue to do so if it plays its cards right? Again, have some faith in the efficacy of monetary policy.

Can We Get Some More Certainty, Please?

 This NY Time article highlights one of the key problems with the way the Fed currently functions (my bold below):

Everyone on Wall Street is waiting on the Fed. Whatever the outcome of Tuesday’s midterm elections, the Federal Reserve is widely expected to take new steps this week to spur the nation’s snail-paced recovery.. The question is how aggressively the Fed will act... Analysts expect the central bank to buy securities on the open market in an effort to the unlock the flow of credit to the economy. Estimates of the size of the program range from $500 billion to $2 trillion...

But while investors have been staking out their positions for weeks the announcement — and the potential ramifications — remain fraught with uncertainty. Given that the Fed’s news is expected to land as Wall Street is digesting Tuesday’s election results, analysts are bracing for a volatile day, particularly if the Fed underwhelms investors.

This shouldn't be.  A modern central bank should have an explicit nominal target to help create certainty.  Yet, here we are in the 21st century guessing what the most influential central bank in the world  plans to do at  its next meeting. In fact, we have been guessing all year as we watched in bewilderment as inflation expectations dropped from  January through September.  "Why wasn't the Fed responding?", we wondered.  Then, suddenly, we learn in late September the Fed had had enough.  Inflation would not be allowed to fall any further and this would happen with a second round of quantitative easing.   Inflation expectations responded accordingly by jumping back up.  I am glad for the change of heart, but enough of this monetary policy roller coaster ride!  And this is not just any monetary policy roller coaster ride, but a Space Mountain monetary policy roller coaster ride where you can't see what is coming next.  There are many issues with a gold standard, but at least one knew what to expect going forward. If we are going to make our fiat monetary system work we need to have the same forward-looking certainty. These past few years such certainty has been  missing.   It is not hard to imagine how much  better our economy would  have been had the Fed adopted an explicit nominal target a few years back.  It is well past time for the Fed to move beyond its wishy-washy, guess-if-you-can policy goals and commit to an explicit nominal target.