Debating (And Misreading) Milton Friedman’s Legacy For Monetary Policy

Amity Shlaes, author of The Forgotten Man: A New History of the Great Depression and a Bloomberg columnist, complains that Fed chairman Ben Bernanke has besmirched Milton Friedman’s recommendations for monetary policy. True, but not for the reasons that Shlaes offers.

Friedman, of course, is the economist who forged the modern template for monetarism, in part by explaining the collapse of the U.S. economy in the 1930s as a failure of central banking to stabilize macro fluctuations. Shlaes pursues her critique on Bernanke by reminding us that Friedman preferred a stable monetary policy. She also notes that the Fed’s recent actions run afoul of this ideal. “Survey his former padawans, his old apprentices in economics, and they will give you different answers, but most say Friedman disliked policy that was too arbitrary,” she writes. Later in the column, Shlaes asserts: “Other scholars and students do not believe that Friedman would have sanctioned the dollar amounts or the style of ‘QEII,’ the second great quantitative easing by the Fed; or Operation Twist and other recent interventions of the Bernanke Fed.”
That’s one interpretation, but there’s another view of what Friedman would have recommended. Nonetheless, Shlaes keeps readers in the dark and instead cites John Taylor, a prominent economist who’s been skeptical of the Fed’s current policies. “In a new book, First Principles, Taylor takes on temporary stimuli, such as Fed purchases of debt. He has lately taken pains to point out that Friedman, while emphasizing the importance of the monetary tool, also liked monetary rules: Friedman believed money supply should follow a regulation, not a whim.”
It’s true that Friedman preferred a stable, predictable monetary policy that was light on surprises and heavy on promoting a steady pace of economic growth. Given that history, it’s curious that Shlaes offers no mention of the Friedman-inspired nominal-GDP-targeting ideas that have animated so much of the monetary policy debates over the last several years. For example, Shlaes doesn’t mention Bentley University’s Scott Sumner, the widely quoted proponent of what’s become known as market monetarism. Sumner, who’s written extensively for several years on the subject at his blog, The Money Illusion, has made his mark across a broad spectrum of monetary discussions, from The National Review to Paul Krugman’s blog. As a result, market monetarism is no longer an obscure idea in the wilderness. Indeed, The Economist recently recognized Sumner as a dismal scientist

who believes that America’s Federal Reserve should promise to restore “nominal” GDP (as opposed to “real” GDP, which takes account of inflation) to its pre-crisis path. Since inflation is in line with the Fed’s implicit target yet nominal GDP is more than 11% below its pre-crisis path, Mr Sumner’s proposal might require a far more expansive monetary policy than anything the Fed has so far considered. This idea was discussed decades ago, but fell into obscurity in the years before the crisis, when inflation-targeting seemed to work. Alternatives to that conventional wisdom are suddenly a live topic, and blogs have brought experts on them out of the shadows.

Or as Sumner wrote in 2009 about the events that led to the Great Recession: “the real problem was nominal.”
Sumner often cites none other than Milton Friedman as the intellectual source for market monetarism. He doesn’t come to the conclusion lightly; rather, he cites a broad array of Friedman’s writings and speeches over the years. Shlaes rightly notes that no one can be sure what Friedman (who died in 2006) would say these days about monetary policy in the wake of the Great Recession. “What we can do, though, is go back through the record and try to discern what Friedman intended,” she allows. In fact, Sumner has been doing exactly that in recent years and he makes a convincing case that Friedman’s policy recommendations have more or less mirrored the prescriptions from the market monetarist school. For example, here’s Sumner in 2010:

After my recent trip I was appalled to discover the number of leading conservative voices opposing monetary easing. Even worse, many seemed to assume the Fed was already engaged in monetary stimulus. Before considering their views, let’s examine the thoughts of the greatest conservative monetary economist of all time, Milton Friedman. Here he discusses the zero rate problem in Japan:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy….

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

Friedman was absolutely right, near-zero interest rates are an almost foolproof indicator that money has been too tight.

That’s just the tip of the iceberg for Sumner’s research that highlights Friedman’s market-monetarist-friendly commentary over the years (see here and here, for instance). But doesn’t Friedman’s preference for stable and steady monetary policy indict the recommendations of today’s market monetarists? No, because if the market monetarists had their way, the Fed would focus on keeping nominal GDP (NGDP) rising at a steady rate by adjusting monetary policy appropriately for the prevailing macro conditions. Economist Ed Dolan reasons that “I see NGDP targeting as the natural heir to monetarist policy prescriptions of the 1960s and 70s.” Dolan explains:

If we look at the textbook version of monetarism, the point is almost trivial. Textbook monetarism begins from the equation of exchange, MV=PQ, where M is money (M1, back in the day), V is velocity, P is the price level, Q is real GDP, and PQ is NGDP. Next it adds the simplifying assumption that velocity is constant. It follows that targeting a steady rate of money growth is identical to targeting a steady rate of NGDP growth.

The failure of Bernanke Fed’s to keep NGDP growth from dropping sharply during the Great Recession is widely cited by market monetarists as a serious policy blunder and one that conflicts with what Friedman would have recommended. Marcus Nunes summarized this point last week (as he has many times before) in a chart that illustrates how actual NGDP (blue line) crashed in recent years relative to NGDP’s long-term trend (red line).

“It´s amazing that having read most of what Friedman wrote, and having ‘showered’ him with praise in more than one occasion, Bernanke should have ‘forgotten’ Friedman´s spirited defense of ‘nominal stability,’ a concept much more general than just ‘price stability,'” Nunes writes.
In other words, Friedman might very well have argued that the Fed erred in recent years by not doing enough to keep NGDP hugging its trend line. Indeed, Friedman leveled a similar charge at the central bank for its misguided policy decisions in the early 1930s.
The bottom line: if you’re intent on raising substantive doubts about whether Friedman would support the Fed’s monetary stimulus of recent vintage–and whether he’d recommend even more aggressive Fed policies–you’ll need to refute the market monetarists. Schlaes doesn’t even try. She’s either unaware of market monetarism or chooses to ignore it. That’s not to say that nominal GDP targeting is beyond criticism. Greg Ip at The Economist, for instance, published a skeptical essay on the subject last November, which in turn was refuted by economist David Beckworth. Yes, there’s room for debate about whether keeping NGDP stable would do the same for real GDP in times of crisis (i.e., late-2008). But in order to have this debate–and it’s a productive one–we must first recognize that there’s an alternative view about how the Fed could run monetary policy. Shlaes overlooks the alternative and instead tells us that the U.S. should “appoint more Fed governors who are trained by other masters: Taylor, or, say, Friedrich ‘Yoda’ Hayek.” In other words, let’s simply dismiss market monetarism without considering it.
But that’s shortsighted, not to mention unsatisfying. Debating monetary policy these days can’t sweep market monetarism under the rug. You may or may not agree with its premise, but it’s hard not to recognize its influence and empirical support in the debate about a central bank’s role vis-à-vis the business cycle. In any case, there’s too much at stake to ignore market monetarism without a fair hearing. After all, there’s always another recession coming. The only question: How should the central bank deal with the business cycle going forward? The good news is that there’s room for improvement. Quite a bit of Milton Friedman’s research and analysis tells us as much, even if some pundits suggest otherwise.