Channeling Milton Friedman

December 30, 2011

Ask not what your monetary policy can do for you, but what you can do for your monetary policy. That’s the jist of a 1968 paper by Milton Friedman, the poster-child for monetarist economics, entitled “The Role of Monetary Policy,” whose key questions remain hotly debated more than four decades on. Friedman’s answer is simple (some might argue too simple), and all too familiar to those who read the speeches of present-day Federal Reserve hawks – focus on the only thing monetary policy can truly control, which in Frideman’s view is price stability.

By setting itself a steady course and keeping to it, the monetary authority could make a major contribution to promoting economic stability. By making that course one of steady but moderate growth in the quantity of money, it would make a major contribution to avoidance of either inflation or deflation of prices. […] That is the most that we can ask from monetary policy at our present stage of knowledge.

Friedman’s writing suggests he was not a big fan of the Fed’s own dual-mandate, introduced in 1978. Any effort to goose employment through a persistent period of low very low interest rates, Friedman argues, would likely lead to overshooting and inflation.

The monetary authority should guide itself by magnitudes that it can control, not by ones that it cannot control.

Sound familiar? Here’s Charles Plosser, president of the Philadelphia Fed, last month:

The level of prices and thus inflation is a monetary phenomenon over the intermediate to longer term, and so the inflation rate can be chosen and controlled through monetary policy. The same cannot be said for the goal of maximum employment or the unemployment rate. These are largely determined by factors that are beyond the direct control of monetary policy.

Of course, it’s not just Fed hawks who channel the fiercely anti-government University of Chicago economist and Nobel Laureate. Charles Evans of the Chicago Fed cites Friedman’s seminal work with Anna Schwartz, “A Monetary History of the United States,” to argue that the U.S. central bank should actually be doing more to boost growth and employment. Friedman and Schwartz said the monetary authorities in the 1930s mistook rising bank reserves for expansive monetary policy, amplifying the Great Depression by keeping policy too tight.

Broad monetary aggregates contracted, even though bank reserves were higher, because 1) banking panics and the weak real economy led the public to hoard cash and 2) banks wanted to increase reserve ratios as insurance against liquidity shortages and runs. As a result, the amount of lending supported by a given level of reserves fell dramatically, and the U.S. economy experienced a period of deflation.

It is unclear what Friedman’s prescription for the United States today would be. Still, this paper on Japan from 1998 shows he was quite open to the idea of quantitative easing to battle deflation – all the more so for a non-interventionist free-marketeer.

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While Fed intervention may seem contrary to Friedman’s free market ideals, in fact what he was recommending was for the Fed to imitate a free banking system in which the money supply expands and contracts in response to demand.

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