Central bankers have abandoned Milton Friedman

December 17, 2012

It is a cruel irony of fate that 2012, the year that celebrates the centennial of Milton Friedman’s birth, is the year that marks the end of his preeminence as an influence over economic policy. Since the emergence in the early 1970s of stagflation – a corrosive combination of lack of growth matched by inflation in double figures – Friedman’s dictums on the causes and cures of rising prices have been the mood music behind management of many leading economies. Since the Great Recession took hold, however, the priorities of government economists have evolved, and once more growth and employment are emerging as the prime goals of public policy.

In the 33 years since Paul Volcker was made Federal Reserve chairman by President Jimmy Carter in 1979, Friedman’s idea that inflation is the economy’s greatest danger has ruled the roost. So long as inflation is kept at around 2 percent, unemployment has been allowed to find its own level. But times have changed. At the first meeting of the Federal Reserve since Barack Obama’s re-election, Federal Reserve Chairman Ben Bernanke has made the creation of jobs a principal aim alongside keeping inflation in check.

In practice, this means interest rates will not be raised so long as unemployment remains above 6.5 percent and inflation is forecast to remain below 2.5 percent. With this tap on the tiller, Bernanke has quietly dispatched the Age of Friedman, replacing it with a policy that harks back to the Keynesian days when “full employment” was the sole target. (Technical note: In economics, “full employment” does not mean when everyone is employed; to allow for the churn as workers move among employers and other adjustments to the labor force, “full employment” is usually deemed to be when 94 percent to 97 percent of those seeking jobs are employed.)

This significant but surreptitious shift in economic policy did not make headlines in the popular press or on the nightly TV newscasts. Rupert Murdoch’s Wall Street Journal, however, which is fighting a rearguard action on behalf of “classical,” or Hayekian, economics, spotted the importance of the change. “It’s striking to see a central bank in the post-Paul Volcker era say overtly that it wants more inflation,” it wrote, before warning that “sooner or later the bill for open-ended monetary stimulus will arrive.”

Economics in the modern age, since John Maynard Keynes transformed the discipline with his “General Theory of Employment, Interest and Money” in 1936, has been a tussle among those, like Keynes, who believed unemployment to be society’s greatest scourge, and those, like Friedrich Hayek, who saw inflation as a nation’s undoing. The division can be traced to the two men’s personal experiences, with the patrician Keynes indignant that the British should suffer mass unemployment through the 1920s and 1930s and Hayek traumatized by the social decay that overtook his native Austria during the years of rampant inflation after World War One.

Keynes won that pivotal argument almost 80 years ago and ushered in the Age of Keynes ‑ 30 years of improving prosperity, unrivaled in the history of the Western world, in which “full employment” became the preeminent national goal. The reckless application of Keynesian measures – cheap money, tax cuts and large-scale public spending to stimulate the economy on borrowed money – and the failure to pay back debt when the economy was booming led to persistent high inflation. By continuing to funnel vast amounts of money into the economy at the top of the business cycle, inflation was guaranteed.

A solution to the malaise was proffered by Friedman, a Hayek devotee who, with Anna Schwartz, analyzed the causes of the Great Depression. They concluded the disaster was caused by the Federal Reserve’s attempt to choke off the effervescent commodity bubbles of the late Twenties by abruptly raising the interest rate, thereby starving the system of cash. Friedman’s belief that inflation “is always and everywhere a monetary phenomenon” led him to suggest that hyper-inflation in the Seventies could be cured by the Fed rationing the supply of money, then providing a small but predictable amount of inflation. Volcker, Carter’s Fed chairman, agreed with Friedman and under President Ronald Reagan put “monetarism” into practice. Since then, successive administrations have adopted broad monetary measures and imposed a set of rules to maintain inflation at no more than 2 percent.

Since the Great Recession, however, in the face of stubbornly high unemployment and stagnant growth – what might be called “stagployment” – government priorities have slowly altered. Ten years ago, Bernanke, Friedman’s most loyal disciple, toasted his monetarist mentor on his 90th birthday, declaring, “Regarding the Great Depression, you’re right. We [the Federal Reserve] did it. We’re very sorry. But, thanks to you, we won’t do it again.” To prevent the Great Recession turning into a second Great Depression, Bernanke has been flooding the economy with cheap money by buying back bonds in the process known as quantitative easing.

Ahile a protracted slump has been averted, Bernanke has not been thanked for his pains. Some conservatives, fearful of inflation, have harshly criticized him. During the Republican primaries, every presidential contender demanded Bernanke’s head on a plate. Had Mitt Romney won the presidency, Bernanke’s reign, set to end next year, would have been abruptly shortened and a “sound money” chairman would have been appointed. One of the most significant yet barely noticed outcomes of the election is that Bernanke can now operate without threat of dismissal.

Bernanke is not alone in promoting the importance of employment and demoting the fear of inflation. This week, Mark Carney, who in July will become governor of Britain’s central bank, the Bank of England, let it be known that he, too, was considering abandoning the 2 percent inflation target put in place by Margaret Thatcher, who was a devotee of Friedman and Hayek. Carney, who as governor of the Bank of Canada presided over his country’s swift return to growth and its healthy job creation after the Great Recession, suggested in a speech this week that to restore an economy to full health central banks should target growth as well as inflation.

There is more than economics at play here. Those who advocate targeting inflation rather than unemployment are often shills for businesses that benefit from a large permanent pool of jobless. Unemployment and the threat of being fired keep wages and salaries low and undermine labor unions’ bargaining power. But the benefit for employers comes at a high price for the rest of us. Unemployment among the young who cannot find a way onto the job ladder and those too old to find another job before retirement casts a pall over America. Cheap labor comes at the price of endless family tragedies.

Americans cannot hope to recover the prosperity they enjoyed before 2008 unless and until everyone is back to work. So long as there is a large reservoir of jobless, public spending on welfare must remain high. Once full employment is restored, a slight across-the-board rise in personal taxation can before long reduce the deficit and pay down the national debt. That is what happened in the Clinton years.

Just as interest rates will now be pegged to job creation as well as inflation, there is an argument for linking the rise in general taxation and the reduction in public spending to growth and unemployment. Such an approach may bring to an end the perennial, debilitating “fiscal cliff” and debt ceiling brinkmanship. Without such a rational device, the president and House Speaker John Boehner are resigned to replay the scene in Nicholas Ray’s Rebel Without a Cause where two teenagers play chicken, leaping out at the last minute as their cars career off a cliff. In that sorry story, only one survived.

Nicholas Wapshott’s Keynes Hayek: The Clash That Defined Modern Economics is published by W.W. Norton. Read extracts here.

PHOTO: U.S. Chairman of the Federal Reserve Ben Bernanke speaks during a news conference in Washington December 12, 2012. In an unprecedented step, the Federal Reserve said on Wednesday it would hold interest rates near zero until it hit the specific target of a 6.5 percent U.S. jobless rate, and it pledged to keep pumping more money into the economy. REUTERS/Kevin Lamarque


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The main actors in the employment market: Municipalities, States, and the Feds, should all become countercyclical employers as well. When unemployment increases they should hire slightly more and when unemployment decreases they should hire fewer people. Currently, the system is still exaggerating economic cycles.

Posted by M.C.McBride | Report as abusive

Because the Federal Reserve has added another criteria or target does not mean that the primary concern of moderating inflation is no longer a primary issue. During this time of global recession when the dollar as the world’s reserve currency is still supreme, inflation is of little concern, so secondary concerns appropriately come into play.

Friedman and Krugman still reign supreme.

Posted by ptiffany | Report as abusive

“Friedman’s belief that inflation “is always and everywhere a monetary phenomenon” [and] could be cured by the Fed rationing the supply of money” ignored the velocity of that money supply. As distinct from money, I think of currency as the amount of money that circulates per unit of time. The renewed attention to economic growth and employment expands the focus from money alone, so that attention is again paid to currency. Hallelujah.

Defining the amount of money as the measure of its mass, and the rate at which money circulates as the measure of its velocity, the amount of money times its rate of circulation would be the monetary equivalent of momentum. I would like to know whether a frame of reference can be found in which that monetary momentum is conserved. To test that, we could use a few economic Einsteins.

Posted by MoBioph | Report as abusive

Thank you.

Posted by matthewslyman | Report as abusive

It will not make any difference. Unless a President believes in American capitalism, the economy cannot recover, try as it will. The current administration promotes policies of division and “spreading the wealth” (including vast spending mandates on Obamacare) that will keep the economy from recovery. We are in for a rough few years.

For those who point to the Clinton years (as the author does), government spending was 19% of GDP during those years. Today it is around 24%. Growing government does not provide employment; it just causes more bloated bureaucracy.

Posted by stevedebi | Report as abusive

A very major change in the picture is the constant re-definition of the term “unemployment” to cast a rosy glow on the complexions of our current politicians. Over time, the term has become divorced from actual work among the population.

If the same definitions which applied in the early 1930’s were applied today, unemployment would be closer to 20% than to 10%. This means the impact on the society is becoming severe enough to endanger social stability. So, using our gerrymandered definitions of “unemployment”, silly sounding policies are promoted. But they are not silly if you use definitions intended to correspond with social, rather than political, reality.

We live in Orwell’s world of “newspeak”. It is not intended to make sense. It is intended to manipulate.

Posted by usagadfly | Report as abusive

“Americans cannot hope to recover the prosperity they enjoyed before 2008 unless and until everyone is back to work. So long as there is a large reservoir of jobless, public spending on welfare must remain high.”

True. Americans also cannot hope to return to work until their skills align with the market’s demand. Automation has caused so many individuals to be obsolete in the current economy. Until we can be re-trained, or the people that can’t adapt die off, this will probably be the case. I think it’s an inevitable transition period for the world.

Posted by Matt-Chicago | Report as abusive

The way that Milton Freidman was treated as some kind of scientist who’d made an E=mc2 discovery was one reason thinking people started being skeptical about economics as an objective science, as opposed to an intellectual front for politicians and business interests. We have a flood of money out there, and a huge federal deficit — but little inflation. I’m not saying times are good. They are terrible. But there are many factors governing inflation, not just the money supply — especially in a global economy. MF’s dictum was a sop for simple minds who wanted a slogan they could grasp. Too bad the real world is so complex.

Posted by From_California | Report as abusive

This post is wrong in asserting that Margaret Thatcher introduced inflation targeting in the UK. It was her successor, John Major, who first put in place an inflation target in late 1992 following Black Wednesday. The initial range was 1-4%, not 2%. Between 1979 and 1990, the Thatcher government targeted first monetary aggregates and then the pound’s exchange rate, initially by shadowing the Deutschemark under Nigel Lawson and eventually by formally joining the ERM in October 1990. As Chancellor, Nigel Lawson gave consideration to a nominal GDP objective, as apparently envisaged by Carney, but rejected the option mainly for technical reasons such as the lag in the calculation of GDP figures.
More broadly, setting Keynes and Friedman as mutual exclusives is absurd. Both advanced economic knowledge and developed insights and policy tools useful in different economic circumstances.

Posted by vb2b | Report as abusive

What is very different now is that the US and much of the developed world are in a long, protracted economic downturn. We are currently in a severe recession and have been since 2007. The only reason we have positive gdp is that the government is deficit spending at a rate orders of magnitude greater than our “growth”. Our economy is in what is best described as uncharted waters. No doubt there are very difficult times ahead. Precisely what will happen and when are questions that no economic theory or gaggle of economic experts can answer.

Posted by gordo53 | Report as abusive

The central banks pretend to deal with economic reality when they are actually uninformed as to what the result of their tinkering and central planning will do. If you doubt this think of how they contributed massively to the effort that got us into the current situation. They claim to be competent but they are only playing theoretical and egotistical games with people’s lives. Remove the dual mandate – the central banks have proven their stupidity in the real economy and need to stick to stabilizing the currency.

Posted by keebo | Report as abusive