June 24, 2003

More on Naivete...

Daniel Davies (typically) has some intelligent points to make in defense of Paul Krugman's assessment of the naivete of Milton Friedman:

Semi-Daily Journal: Comment on Is Uncle Milton Really Naive?: I am inclined to say that Krugman has a point, for the following reasons:

1) It was not Krugman, Skidelsky or anyone else except Milton Friedman who decided to tie Friedman's reputation to monetary base [should, I think, be "aggregate] targeting. He certainly did make other major contributions, but he also went out into the world, like Keynes, and said to governments "here, do it this way", like Keynes, and it didn't work, unlike Keynes. A certain amount of censure is appropriate here...

2) Friedman was a colleague and contemporary of Modigliani, and therefore ought to have been aware of Modigliani's work on near-money and substitutability of money-like assets. It was therefore naive of him to believe that the velocity of circulation of money was a constant, or that something like Goodhart's Law would not apply. Particularly, someone who had read Hayek and Menger had no business in putting forward a theory in which state-sanctioned money had a very special role indeed, along the lines of Silvio Gesell. He ought to have anticipated that monetary aggregates which were controlled would not be of interest.

3) It was also naive, and in my opinion unforgivably so, to assume that the world would be made a better place by taking the money supply "out of politics". The question of whether we are to have easy or hard money is an important one affecting everybody and is thus an entirely proper subject for democratic decision-making. I never understood why Friedman thought that people were incapable of making their own minds up about inflation, and I think it stemmed from an ugly contempt for "little people". It was naive in the extreme to assume that freedom would be better served by a technocracy than democracy, and Friedman quite definitely deserves to be hung for a while on some of the statements he made with regard to Chile.

Zizka's remarks on Keynes and psychological depression above are entirely *on-topic* and underline the final way in which monetary base [aggregate?] targeting was naive. Keynes correctly noted that investment demand (the I half of I+G) was dependent on a variety of complicated social factors which made up the subjective assessments of indivdual businessmen. Friedman implicitly assumed a representative agent... to jump from a correlation between money and spending in normal conditions to the proposition that "money in the bank would be invested" in recessionary conditions. That's the epitome of what Coase called "blackboard economics" and it's naive.

In two related points,

a) the idea that "goosing the economy immediately before elections" can be carried out successfully is both a highly controversial statement of political sociology and premised on a degree of fine control of the economy which would render the rest of Friedman's program pointless.

b) to give Friedman the credit for time-consistency and "credibility" is pushing it a bit and unfairly diminishes Prescott's original contribution.

Posted by dsquared at June 24, 2003 08:24 AM

Posted by DeLong at June 24, 2003 09:32 AM | TrackBack

Comments

"...here, do it this way, like Keynes, and it didn't work, unlike Keynes."

If we give Keynes credit for reducing the downswings of recessions, we have to deduct *from* him the fact that the upswings were lower. And, in fact, the overall economic growth was lower...at least in the United States:

http://www.house.gov/jec/growth/govtsize/fig-2.gif

By my guesstimate, Keynes has cost the U.S. alone several trillion dollars. (Of course, Keynes wasn't the one who ignored the Constitution, so his culpability has to be ratioed accordingly.)

Posted by: Mark Bahner on June 24, 2003 09:50 AM

Daniel Davies - Fine argument!

Posted by: anne on June 24, 2003 09:59 AM

Stephen Roach also has a fine argument questioning the mix and effectiveness of monetary and fiscal policy in solving this global slow growth problem.

http://www.morganstanley.com/GEFdata/digests/20030623-mon.html

Posted by: anne on June 24, 2003 10:12 AM

I'm wondering if its naivete or simply the limitations of being an empiricist? If M1 is the only aggregate I have reliable data for and I don't believe in creating proxies based on my post hoc assumptions and observations, then what else can I do?

If other people actually accept my assumptions
and build a theoretical structure around them, what is my responsibility for that whether they eventually be proved right or wrong? Should Newton be villianized because Einstein had more correct theories?

I would argue that economists have even a greater responsibility to question because we have no basic truths. Even our basic market rules are based on a market that is an assumed social convention. Is there really an immutable law of economics that works everywhere under every social order?

Now that I've finished flying off into space. I'd expand the debate by asking why real m2 is now so widely followed as a leading economic indicator. Maybe the problem isn't that we can't target the money supply growth rate. I think we could if we knew what it was.

Posted by: ts on June 24, 2003 11:57 AM

I think the question of Friedman's naivete needs to be viewed in the context of the time when he first put forward his monetary proposals--the immediate postwar period. At this time, monetary policy was viewed as totally impotent--pushing on a string. Fiscal policy was everything. Friedman was just trying to tell people that money mattered. Today, after the experience of the 1970s, all economists take this fact for granted. But they didn't in 1950.

Posted by: Bruce Bartlett on June 24, 2003 01:42 PM

Amazing. Mention M. Friedman's name, and people get embroiled in raging discussions about the effectiveness of money supply targeting or of the Chicago Boys' policies in Chile. No one ever mentions that Friedman's biggest and most damaging piece of naivete, which has done no end of injuries to the economics profession, actually has a title: The Essay on Positive Economics. But that's the subject of a whole new discussion. But here's my $.02 on the subject.

Friedman was naive in that he didn't realize that when the central bank fails to generate a money supply that suits the needs of the economy, it inevitably creates long-term resistance as businesses figure out ways to circumvent the fixed money supply. Examples (1) when M1 is too small relative to the needs of non-inflationary economic growth, inevitably financial innovation introduces ways of turning previously illiquid assets into means of payments. (2) When even broad money is insufficient to the needs of non-inflationary economic growth, sooner or later other previously non-liquid commodities and even foreign currencies become tradeable in domestic secondary markets and may even be accepted as means of payment. (3) Money supply growth in excess of the needs of non-inflationary growth leads to price inflation in secondary financial markets before it leads to inflation in the prices of goods and services.
If anything causes such a bubble to collapse (e.g., the central bank having second thoughts, but also exogenous shocks such as an oil crisis) defaults on financial liabilities will put strong downward pressure on the money supply.

i.e., not only is velocity not a constant, but the central bank's long-term control over the money supply has been greatly exaggerated, and fortunately most of the men running the Fed today realize this.

Posted by: andres on June 24, 2003 02:00 PM

"...here, do it this way, like Keynes, and it didn't work, unlike Keynes."

Now that's naive! Did stagflation "work"? Because it was the direct result of (neo) Keynesian policies.

For a hearty laugh, read some of Arthur Burns testimonies before congress sometime, excusing himself for the inflations during his watch: "What's money got to do with it, it's those damn unions negotiating inflationary wage demands that's the real problem. Don't look at me."

Btw, Japan, over the last decade, is almost a laboratory experiment on Keynesianism v. Monetarism. Japan spent gazillions on supposedly stimulative public works projects, to the effect of bupkis. Because their monetary policy was restrictive at the same time.

And if anyone thinks the Fed isn't targeting the money supply by manipulating overnight interest rates...well...they're just naive.

Posted by: Patrick R. Sullivan on June 24, 2003 02:54 PM

Speaking of naive, how would d squared rate the guy who wrote the following:

" I should say that what we want is not no planning, or even less planning, indeed I should say that we almost certainly want more. But the planning should take place in a community in which as many people as possible, both leaders and followers wholly share your own moral position. Moderate planning will be safe if those carrying it out are rightly orientated in their own minds and hearts to the moral issue.

" What we need therefore, in my opinion, is not a change in our economic [programs], which would only lead in practice to disillusion with the results of your philosophy; but perhaps even the contrary, namely, an enlargement of them . . . . No, what we need is the restoration of right moral thinking-a return to proper moral values in our social philosophy . . . . Dangerous acts can be done safely in a community which thinks and feels rightly, which would be the way to hell if they were executed by those who think and feel wrongly."

Posted by: Patrick R. Sullivan on June 24, 2003 04:28 PM

Thanks to Brad for massively improving my comment by removing a few pretentious remarks and correcting "monetary base" to "monetary aggregate" throughout.

Patrick:

a) You are comparing "Bastard Keynesianism" which Keynes regularly advised against, with the correct and Friedman approved versions of monetary targeting. In the case of Japan, to put it bluntly, you simply don't know enough about what you're talking about.

b) I don't play guessing games, and since every single one of your quotes which I have checked up on has proved in the past to be dishonestly wrenched out of context, I am going to assume inductively that this one is too.

Posted by: dsquared on June 24, 2003 11:35 PM

Nice post dd. But
"...to give Friedman the credit for time-consistency and "credibility" is pushing it a bit and unfairly diminishes Prescott's original contribution"
unfairly diminishes the contribution of Finn Kydland. :-)

Posted by: CdM on June 25, 2003 05:33 AM

C'mon d squared, you think I'm going to let you get away with that weak-sister response? Others caught the quote right away, as it's a passage from a very famous letter written to Hayek on the publishing of his, The Road to Serfdom. Here's the better known part of that letter:

"In my opinion it is a grand book . . . .
[M]orally and philosophically I find myself in agreement with virtually the whole of it; and not only in agreement with it, but in a deeply moved agreement."

Need another hint?

But getting back to what you call "Bastard Keynesianism", I wouldn't be surprised to hear that Friedman thinks the Fed's brief experiment with targeting was Bastard Monetarism, and that he well knows the identity of the bastard.

But you've got the inconvenient problem that Hayek, who knew Keynes and warned him about what uses his ideas were going to be put, PREDICTED accurately the stagflation of the 1970s. In his, A Tiger by the Tail.

And (I hope this makes you suitably demoralized) I and several people I knew made nice pots of money in the 70s exploiting Keynesianism, bastard or otherwise. We did it by selling money short, i.e. borrowing it at negative real interest rates from banks and investing that money in real estate that appreciated rapidly, then selling the real estate at obscene profits.

In fact, it was the stagflationary period that got me interested in economics for the first time. It became a matter of survival to understand what was going on back then, so I made a trip to the Univ of Washington's bookstore, headed for the econ section, picked up the standard books on the subject of money and boned up.

I still remember sitting in a laundromat while my clothes were in the drier when I first grasped that inflation was an opportunity waiting to be exploited. The book in my hands was, Dollars and Deficits. So, thanks to the naivete of Keynes and the insights of Friedman, I got to put money into my pocket.

Posted by: Patrick R. Sullivan on June 25, 2003 07:19 AM

"And if anyone thinks the Fed isn't targeting the money supply by manipulating overnight interest rates...well...they're just naive."

Its things like this that causes me just to skip over all Patrick's posts. In order to maintain a given interest rate the Fed must change the money supply. The Fed cannot target both simulataneously. Patrick this is basic monetary policy theory.

Posted by: Rob on June 25, 2003 07:27 AM

Robert Musil, on his Man Without Qualities blog, astutely points to this article which validates Prof. DeLong's claims about how everyone now thinks about monetary policy:

http://www.nytimes.com/2003/06/24/business/24ECON.html?pagewanted=print&position=

For instance:

"Officials now say that the risks of not acting appear to outweigh the risks of setting off inflation by flooding the economy with money."

Sounds like pure Friedman to me.

Posted by: Patrick R. Sullivan on June 25, 2003 08:16 AM

Patrick, you're not making a whole lot of sense to me. If you're trying to actually make a point, take a bit more tobacco with it and try again.

Posted by: dsquared on June 25, 2003 08:24 AM

"In order to maintain a given interest rate the Fed must change the money supply. The Fed cannot target both simulataneously. Patrick this is basic monetary policy theory. "

Not only that, but it can't even target the money supply if it wants to, since money growth is controlled by the loan decisions of banks and borrowers. The analogy I always think of is to electricity: the electric company supplies all the amps that go to it's customers, but it can't decide that it will only supply X amps and no more - in order to maintain voltage in the lines, it has to generate as many amps as its customers demand. If the Fed decides to only supply X amount of reserves, any excess demand will cause a shortage of liquidity in the system (one or more banks will be short in their reserve requirements). There is no discretionary control over reserves, and never has been...

Posted by: jimbo on June 25, 2003 08:26 AM

" 'And if anyone thinks the Fed isn't targeting the money supply by manipulating overnight interest rates...well...they're just naive.'

" Its things like this that causes me just to skip over all Patrick's posts. In order to maintain a given interest rate the Fed must change the money supply. The Fed cannot target both simulataneously. Patrick this is basic monetary policy theory. "

Posted by Rob at June 25, 2003 07:27 AM

Yes, Rob it certainly is basic. And Friedmanian too. Perhaps you should more carefully, as well as more often, read one of us. Say:

http://www.abc.net.au/money/vault/extras/extra5.htm

--------quote---------
RA:
Professor Friedman, can I just take you up on this point about the central banks, or at least some central banks? Some of them don't seem to believe that they can target the money supply through the money base to control the inflation rate and instead seem to have primarily targeted interest rates. Do you think that has occurred, at least in some central banks around the world and what are its implications for monetary policy?


Professor Friedman:
That is a question not of basic principle, but of technique. When they so-called 'target the interest rate', what they're doing is controlling the money supply via the interest rate. The interest rate is only an intermediary instrument. There's only one thing that all of the central banks control and that is the base, their own liability, and they can control that in various ways. They can control it directly by open market operations, buying and selling government securities or other assets, for example, buying and selling gold, or they can control it indirectly by altering the rate at which banks lend to one another.
-----------endquote---------

Posted by: Patrick R. Sullivan on June 25, 2003 08:27 AM

I must confess to being utterly unable to see how someone could read the article linked above, pick out the quote "Officials now say that the risks of not acting appear to outweigh the risks of setting off inflation by flooding the economy with money" and see it as vindicating a k% monetary aggregate targeting rule.

Posted by: dsquared on June 25, 2003 08:29 AM

Sullivan, quoting Friedman:

"They can control it directly by open market operations, buying and selling government securities or other assets, for example, buying and selling gold, or they can control it indirectly by altering the rate at which banks lend to one another."

This is the crux of Uncle Milton's problem. He looks at the tools the Fed uses to maintain interest rates (open market operations) and imagines that they have some discretionary control over them. It's like someone taking a tour of an electric plant, seeing the controls for the generators, and saying, "See - they can set the output at any level they want!" But he fails to see the larger system - and how the tools can ONLY be used in a reactive mode. Just like the engineers at the power plant can't suddenly decide to increase the generators output just to "increase the electric supply" without blowing up every device attached to the network...

Posted by: jimbo on June 25, 2003 08:37 AM

DD

Terrific set of posts.
Point to point, agreed.

Posted by: jd on June 25, 2003 09:31 AM

"In the case of Japan, to put it bluntly,..."

...Keynesian policies weren't responsible for the Japanese federal debt of 1.3 times GDP?

...or Keynesian policies were responsible for the Japanese federal debt, but those policies (all evidence to the contrary) "worked?"

No matter which one is the case, I think Patrick would be interested to read your analysis. I know I would. :-)

Posted by: Mark Bahner on June 25, 2003 10:01 AM

"This is the crux of Uncle Milton's problem. He looks at the tools the Fed uses to maintain interest rates (open market operations) and imagines that they have some discretionary control over them."

So you are saying that at its coming meeting the Open Market Committee isn't going to exercise its discretionary control over interest rates by choosing to lower interest rates or not, by an amount it selects?

And that back in 1981 Paul Volcker didn't use his discretionary control over open market operations to send the Fed Funds rate to 19%, up 10 points in a year? That if someone else had had his job and another government had been in place the same thing would have happened?

And that the fact that inflation had gotten so high to begin back then, to set the situation for such rate increases, did not result from previous discretionary actions by the Fed?

Posted by: Jim Glass on June 25, 2003 10:02 AM

I really have been remiss in not congratulating (and I hope incentivizing) Brad DeLong for his fairly clear-cut repudiation of Herr Doktorprofessor Krugman's preposterous dismissal of Milton Friedman's monetarism as "naive."

But, as with many things Krugmaniacal, the focus of the discussion drifts away from Herr Doktorprofessor's actual (mis)statements. In this case, the relevant Krugmania excerpt (from "Missing James Tobin") is:

In the 1960's Mr. Tobin's sophisticated Keynesianism made him the best-known intellectual opponent of Milton Friedman, then the advocate of a rival (and rather naïve) doctrine known as monetarism. For what it's worth, Mr. Friedman's insistence that changes in the money supply explain all of the economy's ups and downs has not stood the test of time; Mr. Tobin's focus on asset prices as the driving force behind economic fluctuations has never looked better. (Mr. Friedman is himself a great economist — but his reputation now rests on other work.)

Herr Doktorprofessor does not explain why Mr. Friedman felt he needed to go on to such “other work” if Mr. Friedman already thought “changes in the money supply explain all of the economy's ups and downs.” Be that as it may, from actually examining this Krugmania fragment it is immediately apparent that Herr Doktorprofessor is not restricting himself to merely commenting on Mr. Friedman's theories on a central bank's efforts to target the money supply. No, what Herr Doktorprofessor attacks here is what he sweepingly calls "the rather naïve … doctrine known as monetarism…, Mr. Friedman's insistence that changes in the money supply explain all of the economy's ups and downs."

It is therefore also immediately apparent that (1) the Krugmania description of "monetarism" is cartoonish, naïve, deliberately wrong and does not reflect Milton Friedman's thinking ("insistent" or otherwise), (2) it is a reference to much more than the mere ability (or not) of central banks to target the money supply, although Mr. Friedman's linked, ambiguous later musings are restricted to that narrow topic, meaning that efforts by commenters here to justify this Krugmania rant by focusing on that single issue are misapplied.

In the domain of Krugmania, Mr. Keynes is to be given the widest possible scope of admiration, because he (quoting from another Krugmania excerpt) “transformed the way we see the world." So Keynes is to be credited with having made possible all future refinements of his theories. But, also in Krugmania, every subsequent refinement of Mr. Friedman's theories are just so much more evidence that the originals were "naive" and therfore, apparently, of little worth. The mere fact that those refinements essentially define the Fed’s policies and much else today just doesn't count.

Fortuneately, in this case, Mr. DeLong gives ample evidence that he is not prepared to play the fool to Paul Krugman's smear of one of the greatest and most influential minds of economics. For that, he deserves congratulations and kudos for upholding the integrity of his chosen professional field.

Too bad about all the other times.

Posted by: Robert Musil on June 25, 2003 10:54 AM

Mark, Patrick, in re Japan: I find the temptation irresistible to just take a leaf out of Patrick's book and cut'n'paste a semi-attached quotation from the Web:

Letters to the Editor
The Wall Street Journal
1155 Avenue of the Americas
New York, NY

Dear Mesdames and Sirs:

Your September 15 editorial condemned the Japanese government's "drive to balance the budget with new taxes" during its current deep recession. You called its policies "Keynesian": "Japan's Keynesian Flop" was the editorial's title.

But there is a big problem. John Maynard Keynes believed not in balancing the budget but in running large deficits during deep recessions. The policies of trying to balance the budget in a deep recession that you call "Keynesian" are the policies that John Maynard Keynes called "Classical"--and scorned.

As mistakes go, this is a howler: it is like praising Michelangelo for his mastery of the Abstract Expressionist aesthetic, admiring the Federal Register's mastery of poetic rhythm and rhyme, or expressing admiration for the fundamental Communist principle of private property.

My advice? Tell your editorial writers to sharpen their pencils and haul themselves down to NYU night school: they badly need to take the history-of-economic-thought and the macroeconomic-analysis courses they slept through in college.

Brad DeLong
Professor of Economics
University of California at Berkeley

Posted by: dsquared on June 25, 2003 11:03 AM

"In order to maintain a given interest rate the Fed must change the money supply. The Fed cannot target both simulataneously."

This is a common misstatement. The Fed cannot *fix* both the interest rate and money supply simultaneously.

It certainly can target -- aim for, intend to bring about -- a given increase or reduction in the money supply by a reduction or increase in interest rates.

In fact, it cannot *not* do this because the interest rate is the price of borrowed funds and that price, like the price of anything else, will correspond to a given amount supplied with a given demand schedule. So changing the interest rate changes supply correspondingly. I mean, it's not like if the Fed decides to fix either the quantity of money or interest rate at a given level, the other one will be unaffected and go wandering off randomly on its own. ;-)

The Fed can't *fix* both the quantity of money and rates simultaneously because lots of things affect the demand for money on a daily basis. So if you fix one, the other will show movement *around* the corresponding level for it. If rates are fixed there will be a corresponding average quantity of money for this level of price, but variations in demand will bounce that quantity around it. And if quantity is fixed there will be a corresponding average price for it, but changes in demand will bounce rates around it.

Now, either option will produce the average quantity of money the Fed wants and thus the monetary effect it desires -- but a bouncing interest rate is troubling to business while a bouncing quanity of money isn't, so the Fed fixes the interest rate lets the quantity bounce around its new higher or lower level.

Some people think that because the Fed fixes rates rather than quantity like this, or because in recent years it has become more difficult to measure money quantities and relationships reliably, money quantity no longer matters. (A former professor of mine who was a Fed economist compared the latter to believing that if your car's speedometer develops a bad wobble the speed of your car no longer matters.)

But the Fed, at least, still believes the quantity of money is at the root of the effects of central bank policy on inflation, deflation and corresponding business activity. And it uses changes in interest rates to drive the quantity of money in the direction it wants it to go at the speed it wants it to go -- which is targeting, if not fixing, it would seem.

To quote Alan Greenspan:

" ... we recognize that inflation is fundamentally a monetary phenomenon, and ultimately determined by the growth of the stock of money, not by nominal or real interest rates.

"In current circumstances, however, determining which financial data should be aggregated to provide **an appropriate empirical proxy for the money stock** ... represents a severe challenge for monetary analysts." (emphasis added)

_Rules versus Discretionary Monetary Policy_
http://www.federalreserve.gov/boarddocs/speeches/1997/19970905.htm

way rates and not quantity matters, or taht

Posted by: Jim Glass on June 25, 2003 11:10 AM

DD

The Wall Street Journal editorial was not a mistake, rather an effort in a line of efforts to fashion economic history after the radical-right manner in which the Journal editors would have it.

It never occurs to me to read the Journal editorial page or to read those radical-righters who distort what you are arguing. The radical-right has never forgiven our grandparents or parents for electing FDR, nor have they forgiven FDR. Phooey.

Posted by: jd on June 25, 2003 11:42 AM

Well yes Jim. But we are talking about Friedman specifically and his view on money aggregate targeting. The Fed relaizes that adding to the money supply will in the long run lead to higher inflation. But thats not the question.

Patrick was talking about how by targeting interest rates the Fed targets money supply (or money supply grwoth), which is wrong. And the point is the Fed is really targeting inflation and output, which changing the Fed funds rate is the tool to acheive those targets. And the bigger point is that Patrick really doesn't know what he is talking about but still comes off as condescending.

There is little evidence that the Fed has seriously looked at money growth rates since Greenspan became chairman.

Posted by: Rob on June 25, 2003 11:58 AM

Rob

Alan Greenspan has changed the prime indicators to focus on several times since 1987. I seem to remember Alan Blinder telling us that money supply growth was not considered a key indicator by 1990.

Posted by: jd on June 25, 2003 12:14 PM

I'm amazed to learn what Milton Friedman's views are after all these years when what I know about monetary theory I learned from reading Milton Friedman:

1) the economy can not be controlled by government

2) interest rates can not be controlled by government

3) the price of a good is determined by the quantity of money

4) defining money is a tricky matter because money is at once, the cash in the pocket, the cash in the checking account, the cash in the savings account, the cash value of short term bonds, the cash value of long term bonds, and any other form of liquidity. The difference between each is the speed with which they can be used.

5) further, money expands and contracts based on the rate that its used, quantified by velocity

6) perception is as critical to the value of money as the existance of money. If the value of money is see to be increasing over time, ie., increasing in the quantities of goods acquired, then this generally leads to a tendency to hold the money longer, reducing velocity which in effect reduces the quantity of money, further driving down prices. And of course the converse is true.

7) perception is as critical as the value of the money and when the expected liquidity of the money is perceived to be too high, as when you can't draw the money out of your saving account, then savings accounts are no longer an acceptable form or money are eliminated from the available money supply - this is turn causes cash in the pocket to be much more valuable and to be held longer

8) There is a "natural growth rate" for the economy which is difficult to determine even after the fact. The primary reason the government can't control the economy is that it can't predict the course of the economy with the required degree of accuracy - in his thesis, his says predictions would have to be 75% accurate just to maintain the status quo, a cyclic business cycle no worse than the cyclic business cycle that is trying to be "smoothed".

9) inflation and deflation are both bad because money and goods are no longer substitutes; in one case, holding cash generates gain, in the other holding goods generates gain

10) Politicians claim responsibility for the good economy and are thus held responsible for the bad, forcing them to "do something" do make the economy better.

In the face of these facts/theories/observations, Milton Friedman advocates policies that insulate the people from the effects of government policies as much as possible:

1) the fed must be the lender of last resort making sure that checking, savings accounts, etc. retain their monetary value

2) the fed must expand the money supply by some means to keep the value of money generally constant, although a slight inflationary tendency is preferred over the long term - he has suggested that one way of doing this is for the fed to simply "print money" and give it to the people via the federal government

3) the government should index and support indexing of all things with monetary value to remove the government's ability to tax by inflation. The index is problematic, but if the government supported monetary promises are protected while others are not, the pressure on the government to not inflate will be high

In short, what I've concluded from reading Milton Friedman and analysing the events of the past four decades of my life (I'm 55), is that the Fed control of the economy is like that of a group of men trying to control the movement of an elephant by pushing a string, or very gently puling it.

What has the biggest effect if when motion of the men and their emotion as they try to direct the elephant.

When the elephant goes in the direction they want, they conclude that they were successful in controlling the economy.

When the string breaks and the elephant goes its own way, they blame Milton Friedman.

btw, when someone makes statements to the effect that Milton Friedman didn't understand the issue of what money is and velocity, etc., please cite your references in "A Monetary History of the United States 1850-1950" or the more readily available but less rigorous "Free to Choose" or another of his works. I must admit to not having ready access to most of his writings that I've read, so my statements and memories might subtly wrong (I'll even conceded the possibility that I've completely misunderstood his position), but I'd like the opportunity to check for myself.

Posted by: michael pettengill on June 25, 2003 12:14 PM

"... the point is the Fed is really targeting inflation and output, which changing the Fed funds rate is the tool to acheive those targets ..."

... through changing the money supply, since, as AG said, inflation is determined "not by nominal or real interest rates". Don't leave out that link in the causation or the chain won't work.

"There is little evidence that the Fed has seriously looked at money growth rates since Greenspan became chairman"

Which doesn't mean he discounts the importance of money growth at all, or that he thinks monetary policy doesn't work by changing money growth rates. I think his own words above are clear enough about that.

One could read his whole speech on "rules versus discretion" to avoid needless oversimplification of a complex issue of the sort that one finds in short usenet and blog comments.

Posted by: Jim Glass on June 25, 2003 12:36 PM

jd--

Actually, you can make a signifiacant argument that money supply hasn't been targeted since 1983 (strident monetarists would argue it has never actually been targeted). The Fed still reported money growth targets until the 1990s, however most evidnce shows they only provided them because they were required to report growth targets to Congress. Evidence shows that aside from the period of 1979-1982 the Fed maintianed an interest rate target.

Posted by: Rob on June 25, 2003 12:39 PM

A footnote: One thing that I didn't learn from Milton Friedman is supply and demand - that I learned in my current econ 101. This does, however, allow me to "talk like an economist", about money supply.

The supply, demand, and supply-demand graphs show the quantity that results when setting the price _all_things_held_contant_. Those who think the Fed can control interest rates - the price of money - fail to remember _all_things_held_constant_. The "consumer"'s interpretation of the Fed's actions, as well as the availability of other goods in the market can cause a change in the supply and demand curves. The velocity can change, indicating a change in demand, and competitive products can be brought to market which increases the supply in one sense, or create substitutes in another sense.

If a given type of money provides the grease for the economy, the focus should be on managing the quantity of that time of money, not its price, because managing the quantity is possible even when the demand curve changes for that type of money and the supply and demand curves for substitutes changes.

If there is no ability to forecast the optimal quantity of a given type of money, then a strategy must be developed for controlling its quantity in the absence of knowledge of the future.

What the Fed is doing now is trying to predict the new demand curve for money so they can set the price to cause an adequate quantity of money to be added to the economy. The economists reading here must surely agree that the expectation of the Fed should do and the expectation of the results of what the Fed does do, will effect both the supply and demand curves. If the Fed rate is perceived to be deflationary, the supply curve will be moved to the left to reflect the lower velocity resulting from people holding onto cash because they expect it to increase in value relative to substitutes. Further, the expectation that deflation will slow the economy will move the demand curve to the left as people defer borrowing due to the uncertainty.

By setting the price, the Fed must predict many things: the new supply curve, the new demand curve, the demand and supply curves for all the substitutes, the total income which affect the behavior of consumers when buying goods and choosing between substitutes, and all of these things are in flux. What is the chance that the Fed will get it right?

Of course, its pretty clear that the government's attempt to manage the economy will have even worse effects because of the ways the government employs non-market mechanisms that skew the supply and demands curves of goods in so many ways that the result can not be predicted, in the best case. Whether the actions of the government actually increase the GNP/GDP/whatever is nearly impossible to predict given the large number of changes in the market that produce that gross result.

Posted by: michael pettengill on June 25, 2003 12:49 PM

jd--
Actually, in the post-Korean war period the Fed has mostly targeted interest rates, save for teh period of 1979-1982 when the Fed explicitly targeted money aggreagtes (strident monetarists would argue that even then the Fed did not truly target aggregates, but instead Volker used that as a cover to ramp up interest rates to bring inflation down). So since 1983 evidence shows that the Fed has targeted interest rates. The Fed was still required however to report to Congress aggregate targets. M1 targets were abandoned in 1987 and M2 targets were abandoned in 1993.

Jim--

There is nothing there that I disagree with. What I am talking about is monetarist style aggregate targeting. That is not to say the Fed doesn't use changes in the money supply, they use it to affect the interest rate and hence the economy. But the point is they don't set a money supply growth rate.

Posted by: Rob on June 25, 2003 01:02 PM

"sn't going to exercise its discretionary control over interest rates by choosing to lower interest rates or not, by an amount it selects?"

Ok, now you're just willfully misunderstanding me...

The Fed can set interest rates at whatever it wants, as long as it wants. This is beyond dispute. What is in dispute is whether, if it wanted to, it could allow interest rates to "float" and instead simply supply a given quantity of money. It cannot, at least not without causing severe dislocations in the economy of the kind experienced in the early 80's. An attempt to expand reserves beyond the point at which banks are demanding them will immediately drop the overnight rate to 0%. After that, more reserves will simply pile up in bank's reserve accounts, with no affect on the larger money supply. A refusal to provide enough reserves through open market operations will result in one or more banks falling short of reserves, prompting them to go to the discount window to ask for reserves which the fed will be forced to provide. Ergo, the price of money is discretionary; the quantity of money is not.

Why is this so hard to understand?

Posted by: jimbo on June 25, 2003 01:07 PM

d squared must have really been shaken by my posts if now thinks I'm an editorial writer for the WSJ. But, I'm beginning to wonder if he really CAN'T identify the source of the letter to Hayek, since he also wrote:

" I never understood why Friedman thought that people were incapable of making their own minds up about inflation"

Well, the answer comes from the same guy who wrote that letter, and it has a certain fame itself:

"Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis
of society than to debauch the currency. The process engages all the hidden forces of
economic law on the side of destruction, and does it in a manner which not one man in a
million is able to diagnose."

Posted by: Patrick R. Sullivan on June 25, 2003 01:19 PM

Jim:

>>In fact, it cannot *not* do this because the interest rate is the price of borrowed funds and that price, like the price of anything else, will correspond to a given amount supplied with a given demand schedule. So changing the interest rate changes supply correspondingly. I mean, it's not like if the Fed decides to fix either the quantity of money or interest rate at a given level, the other one will be unaffected and go wandering off randomly on its own. ;-)

Unfortunately, that's exactly what happened, empirically in the UK. The monetary aggregates did in fact go wandering off in all sorts of directions, motivating Goodhart to coin his Law.

Michael: I think you've imported a lot of concepts into Friedman that weren't there. In MHUSA, he recognised in principle that velocity could change, but then claimed, empirically, that it hadn't in the past and therefore (because of his positive view of economics) it was safe to assume it wouldn't in the future. Particularly, he assumed that people wouldn't change their behaviour to neutralise the effect of monetary control. Basically, his assumption was that your 6) above was the only way in which behavioural changes would affect velocity, and this was very wrong.

Further, as Keynes showed, the supply and demand curves for money don't work in the simple economics 101 way you outlined.

Posted by: dsquared on June 25, 2003 01:23 PM

" Patrick was talking about how by targeting interest rates the Fed targets money supply (or money supply grwoth), which is wrong. And the point is the Fed is really targeting inflation and output, which changing the Fed funds rate is the tool to acheive those targets. And the bigger point is that Patrick really doesn't know what he is talking about but still comes off as condescending."

Rob, this is just seventh grade albegra. When one side of an equation changes so does the other.

As to who doesn't know what he is talking about, well, I wrote: "targeting the money supply by manipulating overnight interest rates"

Milton Friedman wrote:

"they can control [the money supply] indirectly by altering the rate at which banks lend to one another."

So, I've got a Nobel prize winning economist, the Fed Chairman, and the host of this blog (himself no slouch in the credentials dept.) agreeing with me. And you've got d squared and anne with you. I'd take another look at my cards if I were you.

Posted by: Patrick R. Sullivan on June 25, 2003 01:41 PM

Patrick you still have no clue what you are talking about.

For one thing the Fed does not change the money supply by changing the Federal Funds Rate. It changes the money supply mostly through the buying and selling of treasury notes. The Fed does not have direct control over the Fed rate. They influence it by changing the money supply.

Assume the market is in equilibrium. Now assume there is an increase in money demand. Now the Fed can either keep a constant money supply (Friedman's view) causing interest rates to rise. Or the Fed can increase the money supply maintaining the stable interest rate but making an unstable money supply.

So the Fed can have a stable money supply target or a stable interest rate target but not both. This isn't a change in one side of the equation or the other, but a main point about what should a central bank target since the bank can't maintain two targets.

Posted by: Rob on June 25, 2003 02:10 PM

" Patrick, you're not making a whole lot of sense to me. If you're trying to actually make a point, take a bit more tobacco with it and try again."

Funny, Milton Friedman didn't need any tobacco at all when I put the point to him. He just agreed with it, though he might have been having a little laugh at my ignorance of the same point having been made in his son's "Price Theory".

Posted by: Patrick R. Sullivan on June 25, 2003 02:19 PM

Rob -

You wrote:

"Patrick you still have no clue what you are talking about. For one thing the Fed does not change the money supply by changing the Federal Funds Rate."

But Patrick had already quoted Milton Friedman saying:

"When [the Fed] so-called 'target the interest rate', what they're doing is controlling the money supply via the interest rate. The interest rate is only an intermediary instrument. There's only one thing that all of the central banks control and that is the base, their own liability, and they can control that in various ways. They can control it directly by open market operations, buying and selling government securities or other assets, for example, buying and selling gold, or they can control it indirectly by altering the rate at which banks lend to one another."

It seems to follow that your position is that Milton Friedman was not only wrong, and not only naive, but has no clue what he is talking about with respect to the functioning of central banks, interest rates and the money supply.

Is that your position? Can you clarify that for me? And, by the way, do you think Brad DeLong shares your position with respect to either Friedman or Sullivan?

And, also by the way, with respect to "the Fed does not change the money supply by changing the Federal Funds Rate:" When interest rates go down, don't banks lend more, since the price of loans goes down? Do you think that has any direct effect on the money supply? Or is it just negligible?

Just asking.

Posted by: Robert Musil on June 25, 2003 02:32 PM

" This is the crux of Uncle Milton's problem. He looks at the tools the Fed uses to maintain interest rates (open market operations) and imagines that they have some discretionary control over them. It's like someone taking a tour of an electric plant, seeing the controls for the generators, and saying, "See - they can set the output at any level they want!" But he fails to see the larger system - and how the tools can ONLY be used in a reactive mode. Just like the engineers at the power plant can't suddenly decide to increase the generators output just to "increase the electric supply" without blowing up every device attached to the network... "

Posted by jimbo at June 25, 2003 08:37 AM

Uh Jimbo, had you bothered to click on the url I provided:

http://www.abc.net.au/money/vault/extras/extra5.htm

you could have read Friedman saying:

" The central banks cannot control interest rates. That's a mistake. They can control a particular rate, such as the Federal Funds rate, if they want to, but they can't control interest rates. If central banks could control interest rates, you never would have had interest rates at 10-15% in the late 1970s. If they could control interest rates, would Brazil now be having interest rates in the 20-30% range? What central banks can control is a base and one way they can control the base is via manipulating a particular interest rate, such as a Federal Funds rate, the overnight rate at which banks lend to one another. But they use that control to control what happens to the quantity of money."

Posted by: Patrick R. Sullivan on June 25, 2003 02:53 PM

"Mark, Patrick, in re Japan: I find the temptation irresistible to just take a leaf out of Patrick's book and cut'n'paste a semi-attached quotation from the Web:..."

Well, you'd better cut 'n' paste something that better defends *your* case, then! :-)

Brad DeLong's letter is a very fine piece of writing. I salute him (again...he's a fine writer) on informing the lay public about various economic matters.

But in case you haven't actually READ the letter, it seems to be making the case that running big deficits (high spending, while NOT raising taxes) IS a Keynesian policy. ("Priming the pump," is the phrase I've read.)

Japan has a huge federal debt (currently about 1.0 times GDP, I think). And they also have huge government debt in the prefectures (currently about 0.3 times GDP, I think). So combined federal and prefecture debt in Japan is 1.3 times GDP. And as aate as the early 80's, Japan's federal and prefecture debt were a negligible fraction of their GDP (I think...correct me if I'm wrong).

Ergo, Japan's federal and prefecture governments MUST have run large deficits (high spending, while NOT having high taxes). This is, as far as I know, typical Keynesian medicine. (And Brad DeLong's letter seems to confirm this.)

Now, YOU wrote that Milton Friedman's prescriptions didn't work, "unlike Keynes."

So please explain to Patrick and me how Keynes' medicine "worked" in Japan. Or (I frankly don't view you as the type of person to do this) admit that, well, Keynes' medicine doesn't always work.

If we can all agree that Keynes' medicine didn't work in Japan, during their recent malaise, then maybe we could figure out some instances where Keynes' prescriptions DID work! ;-)

Posted by: Mark Bahner on June 25, 2003 02:57 PM

My Econ 2 professor at UCLA(William Allen, a friend of Friedman's) answered this question log aog for me. He was talking about Milton's mistakes(this was 1986) and brought up the example of a Cubs shortstop who had a fielding % of close to 1000. The reason for this was that he got every ball that came to him but had no range at all. One can be naive or wrong(which is worse) when they try to stretch. But, like Ozzie Smith, they can do amazing things. The world has greatly benfitted from Friedman's insights, even if he has been naive of wrong smoetimes.

Posted by: Richard Vagge on June 25, 2003 03:18 PM

Regarding Marks comment: "If we can all agree that Keynes' medicine didn't work in Japan, during their recent malaise, then maybe we could figure out some instances where Keynes' prescriptions DID work!"

An interesting point. Where, exactly are Keynes' ideas supposed to have been tried and worked? The Kennedy tax cut? The US in the 1930's? In the 1950's? Europe today?

There always seems to be some "bastardization" of his pure theory in there that messes things up. To test Keynes' ideas seems to require a purity of essence unknown in the real world.

And, of course, Marxism has never been tried, either. Any takers?

Posted by: Robert Musil on June 25, 2003 03:22 PM

The monetary odyssey of Rob:

"In order to maintain a given interest rate the Fed must change the money supply."

and:

"... the point is the Fed is really targeting inflation and output, which changing the Fed funds rate is the tool to acheive those targets ..."

and:

" That is not to say the Fed doesn't use changes in the money supply, they use it to affect the interest rate and hence the economy. But the point is they don't set a money supply growth rate."

and:

" The Fed does not have direct control over the Fed rate. They influence it by changing the money supply."

Congratulations, Rob: "The Triumph of Monetarism" without the question mark.

God, I love this place.

Posted by: Patrick R. Sullivan on June 25, 2003 03:32 PM

Robert--

The first thing to understand is that the Fed does not set the Federal Runds rate the way a bank sets the rate at which it gives a loan. When the Fed cuts the rate to 1% it does not just decide by fiat that is the rate. The rate is et by the market between banks. Now the Fed influences this market by expanding or contracting the money supply. If the Fed decides to reduce the target, it increases the money supply by buying bonds. This increases the amount of reserves in the banking system. This means the supply of funds to loan increase causing the price of borrowin, or the interest rate to fall. One of the rates the will fall is the Federal Funds rate.

Now the Fed controls the supply curve (actually just a quantity, often represented by a vertical line on a graph). The price is given by the interest rate and we have a downward sloping money demand curve. So the Fed moves this supply around , it can either maintain the price or the quanity in the face of a demand change, but not both.

So interest rate targets tell what happens to the money supply, but it is not a monetarist growth rate target.

This agrees with the Friedman quote, except for the last phrase which doesn't fully agree with what comes before. Meaning it isn't factually accurate on its own, but Friedman's point is that targeting interest rates is a signal of how the Fed will approach money supply changes.

And Robert, explain why banks would loan more when the return they get decreases?

Posted by: Rob on June 25, 2003 03:43 PM

Patrick---

I am sorry if you still do not understand they difference between a given monetary policy and Monetarism as advocated by Friedman.

But again, interest rate targets would never be advocated by Friedman because it could cause money supply to bounce around (you know his argument of why the money supply shrunk during the Great Depression). That the Fed is targeting interest rates shows that it does not use a Monetarisy policy but instead follow a neoKeynesian policy with, better be sitting, a modified Philips curve.

Posted by: Rob on June 25, 2003 04:12 PM

"If central banks could control interest rates, you never would have had interest rates at 10-15% in the late 1970s."

Now this is just bizarre. Volcker comes in, announces he has seen the Friedmanian light, and declares that from henceforth the Fed will target money supply rather than interest rates. Interest rates then go to 10-15%, the economy crashes, eventually the Fed has to relent and goes back to targeting interest rates, and rates go back down to manageble levels. Friedman then uses this episode as evidence forf his conclusion that central banks can't control interest rates?! Naive, hell: the man is obviously a loon...

Maybe I'm just a young whippersnapper without proper respect for his elders, but can someone explain to me again why this guy is held in such high esteem?

Posted by: jimbo on June 25, 2003 04:38 PM

jimbo--

He did restore the importance of monetary policy as a tool to affect the economy after it fell out of favor due to its apparent failure during the Great Depression.

Posted by: Rob on June 25, 2003 05:00 PM

To return the favor, Rob, I'm sorry you still don't understand 7th grade algebra. You say:

" The rate is et by the market between banks. Now the Fed influences this market by expanding or contracting the money supply. ". So, let's call your statement, "a".

Then you say: "This agrees with the Friedman quote....", which was:

"they can control [the money supply] indirectly by altering the rate at which banks lend to one another."

We'll call the Friedman quote, "b".

Then we have my original comment that you initially objected to:

"targeting the money supply by manipulating overnight interest rates".

Which is indistinguishable from the Friedman quote, and we will call mine, "c"

Sister Mary Somethingorother taught me that if: a = b, and b = c, then a = c. Which means you agree with me, Friedman, DeLong, and Greenspan.

Welcome aboard.

Posted by: Patrick R, Sullivan on June 25, 2003 06:27 PM

" Where, exactly are Keynes' ideas supposed to have been tried and worked? The Kennedy tax cut? The US in the 1930's? In the 1950's? Europe today?

" There always seems to be some "bastardization" of his pure theory in there that messes things up. To test Keynes' ideas seems to require a purity of essence unknown in the real world."

This is a good point by Robert Musil. The General Theory came out in 1936, I believe. In 1939 Britain went to war, which lasted til 1945. Keynes died in 1946. So it was nearly impossible chronologically for Keynes to have gone to politicians to say: "here, do it this way".

Posted by: Patrick R. Sullivan on June 25, 2003 06:36 PM

I always agreed with DeLong, Greenspan, Friedman and all other economists. (Well, except like most other economist and unlike Friedman, I do believe interest rates matter for money demand).

Again it gets back to the fact that you cannot simulutaneously target stable interst rates (neo Keynesian for lack of better words) and stable money supply (Monetarist). It cannot be done, the Fed must choose one or the other to keep constant. In other words, the Fed can keep a stable price (interest rates) or quantity (money supply) in the face of changes in demand. It cannot maintain both. One has to change to keep the other stable.

So if you set a interest rate target, money supply has to jump around to meet shocks to money demand. So if you are targeting interest rates you cannot keep a money growth target because money growth depends on demand shocks.

And all this gets back to the point that changes in the money supply causes changes in the Fed Funds rate. The Fed does not set a target and hope the market brings it to the new target. Changes in the target do not magially lead to changes in money supply as your quote posits.

And none of this is some sort of secret that you can not get out of a decent Money and Banking text.

Posted by: Rob on June 25, 2003 07:16 PM

Rob -

I think Patrick has pretty much done it as far as re-explaining how the money supply is affected by interest rate cuts - which I think takes care of your first point. In any event, I can't do any better.

You also wrote:

"And Robert, explain why banks would loan more when the return they get decreases?"

You imply that bank lending should decrease when the Fed cuts short term rates. As a general preliminary point, Rob, do you think the Fed cuts the rates it controls in order to REDUCE bank lending, or with the expectation that bank lending will decease, because banks' returns decrease? Is that how the Fed stimulates the economy with short-term interest rate cuts?

The Federal Funds Rate is the interest rate charged by banks when banks borrow "overnight" from each other. The funds rate fluctuates according to supply and demand and is not under the direct control of the Fed, but is strongly influenced by the Fed's actions.

The Fed adjusts the funds rate via "open market operations". What actually happens is that the Fed sells US treasury securities to banks. As a result, the bank reserves at the Fed drop. Given that banks have to maintain at the Fed a certain level of required reserves based on their demand deposits (checking accounts), they end up borrowing more from each other to cover their short position at the Fed. The resulting pressure on intrabank lending funds drives the funds rate up.

Adjustments in the discount rate usually lag behind changes in the funds rate. Once the spread between the two rates gets too large (meaning fat profits for the big banks which routinely borrow from the Fed at the discount rate and lend to smaller banks at the funds rate) the Fed moves to adjust the discount rate accordingly. It usually happens when the spread reaches about 1%.

Another interest rate of significant interest is the Prime Rate, the interest that a bank charges its "best" customers. There is no single prime rate, but the commercial banks generally offer the same prime rate. The change in discount rates will affect the prime rate.

In sum, the Federal Reserve Open Market Committee targets the "Fed Funds" rate. While this rate itself doesn't directly impact consumers, it is used as the basis for many rates that do affect consumers (borrowers). After an increase or decrease in the Fed Funds rate, you should expect almost all banks to raise or lower their so called "prime rate," which is used as the base rate for many credit card and consumer loans, by a corresponding amount by the end of the same week. Once the price of credit goes up or down, lending should decline or increase as always, all else being equal).

Of course, as Patrick correctly points out, the Fed Funds rate is just one variable in determining aggregate loan demand.

Does that help you understand, Rob?

Posted by: Robert Musil on June 25, 2003 07:41 PM

ROb is utterly correct in the following passage:

>>Friedman because it could cause money supply to bounce around (you know his argument of why the money supply shrunk during the Great Depression). That the Fed is targeting interest rates shows that it does not use a Monetarisy policy but instead follow a neoKeynesian policy with, better be sitting, a modified Philips curve.

Everyone else on this thread seems to believe that anything which involves doing anything to the money supply is "monetarism", which simply isn't true. "Monetarism" refers to a k% monetary aggregate rule, not anything else. Friedman's natural rate concept is highly influential in central bank policy, but that's *not* the same as monetarism, mainly because any sort of Taylor rule policy involves "clever people working for the government" estimating the NAIRU and output gap, which is /verboten/ under Friedman's monetarism.

Posted by: dsquared on June 25, 2003 11:18 PM

" 'Monetarism' refers to a k% monetary aggregate rule, not anything else."

Hmmm. Didn't read the essay that Jim Glass and I have both provided for you? In which our host tells us:

" Thus a look back at the intellectual battle lines between "Keynesians" and "Monetarists" in the 1960s cannot help but be followed by the recognition that perhaps New Keynesian economics is misnamed. We may not all be Keynesians now, but the influence of Monetarism on how we all think about macroeconomics today has been deep, pervasive, and subtle."

and:

" I believe that the most fruitful way to look at the history of Monetarism is to distinguish between four different variants or subspecies of Monetarism...."

and:

" The First Monetarism is Irving Fisher's Monetarism. .... the equation-of-exchange and the transformation of the quantity theory of money into a tool for making quantitative analyses and predictions of the price level, inflation, and interest rates was the creation of Irving Fisher."

and:

" But it is important to note, as George Tavlas (1997) points out, that Old Chicago Monetarism (a) did not believe that the velocity of money was stable, and (b) did not believe that control of the money supply was straightforward and easy."

and:

" Classic Monetarism contained empirical demonstrations that money demand functions could retain remarkable amounts of stability under the most extreme hyperinflationary conditions (chief among them Cagan (1956)), analyses of the limits imposed on stabilization policy by the uncertain strength and lags of policy instruments (see Friedman (1953a)), the stress on the importance of policy rules and of rules that would be robust (see Friedman (1960), the belief that the natural rate of unemployment is inevitably close to the average rate of unemployment (Friedman (1968)), Friedman and Schwartz's (1963) long narrative of the potency of monetary policy, econometric demonstrations of the short-run power of monetary policy (see Brunner and Meltzer (1963), Anderson and Jordan (1970), Goodhart (1970)), and the start of the process that has cut the multiplier down from the value of four or five that it possessed in economists' minds in 1947 to the value of maybe one that it possesses in economists' minds today (see Friedman (1957)).

" These elements and conclusions of the Classic Monetarist research program have endured. They make up much of what the New Keynesian wing of macroeconomics believes very strongly today."

Posted by: Patrick R. Sullivan on June 26, 2003 06:53 AM

(god the amount of typos I make when I type quickly)

Robert--

You still didn't answer the question. While your talk about the interconectvity of interest rates is nice, it is irrelevant to the point. My question was one to see if you understand the causality at work here, your answer does not address that point.

Yes when the Fed cuts rates, bank's willingnes to lend increases, but not due to the rate cut. Banks are willing to lend more because the money supply is increasing, increasing the amount of funds they have to lend. This increases the supply of loanable funds and increases the quantity of lending while decreasing the interest rate. Assuming an interest rate channel, the lower interest rate sparks investment and output increases along a Keynesian path.

Why is this important? Because interest rates could change and be lowered from the demand side as well, and a lower interest rate would mean less loans. Aside from that it is important to understand when trying to make arguments dealing with monetary policy.

I spend a deal of time with this because one of my pet peeve's are people going on about Monetarism without understanding what they are talking about, pretending that Monetarism has won the argument and the Fed's work is proof of that. In truth the Fed follows a monetary policy closer to Keynes than to Friedman.

Posted by: Rob on June 26, 2003 07:05 AM

Partick, did you read the article? It talks about the influence of Monetarism on neoKeynesian economics, something that neither DD or I would disagree with. That does not mean that the Fed follows a Monetarist policy. Monetarism is what DD said it is. It has other findings that have carried on, but Monetarist policy is a money aggregate target. If we were following a monetarist policy, there would not be interest rate announcements, just annoucements on how close the Fed was to meeting its constant money supply growth target.

You are basically saying that since the automobile incorporated many of the designs and knowledge of the horse and buggy, we all drive horse and buggies today.

Posted by: Rob on June 26, 2003 07:21 AM

"Banks are willing to lend more because the money supply is increasing, increasing the amount of funds they have to lend. This increases the supply of loanable funds and increases the quantity of lending while decreasing the interest rate."

This isn't really true. The fed funds rate is a target, a point which the Fed pledges to use open market operations to maintain. But the traders both buy and sell on a day-by-day basis, in response to market conditions, in order to maintain that rate. Money is created in response to loan activity by banks - there is never a shortage of "loanable funds", since a bank that makes a loan can always go out on the fed funds market to obtain funds which the Fed is forced to supply. If banks are not making new loans, the money supply will shrink regardless of whether the Fed increases or decreases rates.

Posted by: jimbo on June 26, 2003 08:18 AM

""Monetarism" refers to a k% monetary aggregate rule, not anything else. "

Kidding, right?

Irving Fisher did not propose a k% monetary aggregate rule. Neither did David Hume.

Perhaps you can explain how Prof. DeLong's "four different variants or subspecies of Monetarism" fit within your "not anything else"?

BTW, Keynes was a monetarist too prior to 1936....
~~
Review: "A Tract on Monetary Reform". This may well be Keynes's best book. It is certainly the best *monetarist* economics book ever written..."

(Emphasis in the orginal.)
http://econ161.berkeley.edu/Econ_Articles/Reviews/monetaryreform.html
~~~

... and it didn't propose a k% monetary aggregate rule either

Posted by: Jim Glass on June 26, 2003 09:35 AM

"Monetarism is what DD said it is"

I.e., "a k% monetary aggregate rule, not anything else" ?

You'll have to explain then how monetarism so long predated any k% monetary aggregate rule.

For help finding the real answer we can turn to our host's definition:

"The belief that monetary instability --inflation and deflation -- is the principal, or at least a principal, cause of other economic evils; the hope that sound monetary principles can be identified and, when identified, would greatly diminish uncertainty and risk; the focus on the job of the public sector being to provide the private economy with a stable measuring-rod and a stable environment -- all these are core ideas of whatever we choose to call *monetarism* [Emphasis in original.]

"Keynes believed these ideas very, very strongly in the mid-1920s. And his Tract on Monetary Reform is a review of economic theory and a look at the economic problems of post-WWI Europe through this set of monetarist spectacles..."
~~

Which would be distinctly odd being that no k% monetary aggregate rule existed at the time, if monetarism "is not anything else".

But "monetarism" is in fact an extensive theory of how the economy functions in which the role and importance of money is very different than in other such theories, such as Keynesianism 1950s style.

The "k% money aggregate rule" is nothing but a single innovative policy proposal, one of a great many, that arose during the history of monetarism, was tested for utility, and in this case discarded.

"You are basically saying that since the automobile incorporated many of the designs and knowledge of the horse and buggy, we all drive horse and buggies today."

And you are basically saying that since the automobile industry in the course of its history once tried out push-buttom transmissions as an innovation, if a vehicle doesn't have a push button transmission it isn't an automobile, for an automobile is "not anything else".

Posted by: Jim Glass on June 26, 2003 10:09 AM

I thought we were talking about Milton Friedman? I certainly was.

If you're working on a definition of "monetarism" as meaning "policy using money", then I'm surprised it's taken you so many words to say so.

Posted by: dsquared on June 26, 2003 10:39 AM

I thought we were talking about Milton Friedman? I certainly was.

If you're working on a definition of "monetarism" as meaning "policy using money", then I'm surprised it's taken you so many words to say so. Or that I've bothered arguing with you.

I suppose that since Karl Marx wrote about the effect of the "reserve army of the unemployed" on wage demands, a natural predecessor of Friedman's NAIRU, he was a monetarist too?

Posted by: dsquared on June 26, 2003 10:44 AM

I thought we were talking about Milton Friedman? I certainly was.

If you're working on a definition of "monetarism" as meaning "policy using money", then I'm surprised it's taken you so many words to say so. Or that I've bothered arguing with you.

I suppose that since Karl Marx wrote about the effect of the "reserve army of the unemployed" on wage demands, a natural predecessor of Friedman's NAIRU, he was a monetarist too?

There's a good essay on the difference between textual analysis and intellectual history on this very webpage, by the way. I commend it to the confused.

Posted by: dsquared on June 26, 2003 10:52 AM

Note how that multipost grew in repetition :)

Posted by: dsquared on June 26, 2003 11:01 AM

Gee, when you wrote...

"'Monetarism' refers to a k% monetary aggregate rule, not anything else."

... it looks like some of us thought that by "monetarism" you meant "monetarism".

You know, as used by Fisher, DeLong, other economists.

I know I did. My mistake. Apologies

Posted by: Jim Glass on June 26, 2003 11:48 AM

Rob -

You wrote:

"The first thing to understand is that the Fed does not set the Federal Runds rate the way a bank sets the rate at which it gives a loan."

My prior post gives quite an (over)detailed description of how the Fed sets the Federal Funds and how its rates interact. From your response, either you didn't read what I wrote or there is some bigger issue here.

My post also made clear that a cut in the Fed funds rate does not necessarilly mean bank returns (or willingness to lend) decrease - as you insisted was the case. That a "supply of funds" increases will not itself cause an increase in lending, any more than an increase in a supply of shirts will cause increased shirt sales absent a reduction in shirt prices. The marginal return to the seller on a shirt sale is another matter.

The "demand side" speaks to the value of borrowed funds to borrowers (that is, the return they can get from investing borrowed funds). If that value increased, then demand for loans would increase even if interest rates did not decrease. But if that's what you're alluding to, it's really messing up causation.

Patrick and Jim Glass (and Friedman) have long ago copiously explained in this thread why the Fed's tools do not "set" market interest rates or willingness to borrow. Patrick and Jim have also pretty copiously and well explained what "monetarism" is - and it follows that Krugman's characterization and dismissal of Friedman's "monetarism" are silly, ignorant, mean-spirited and wrong.

In addition, with all due respect, you seem to be drawn to a particularly bad Krugmanian error: Refinements of Keynes'theories are attributable to Keynes (he "transformed the way we view the world") and applications of "neo-Keynesianism" just show how sophisticated the original insights were, but refinements of Friedman's theories show that the original insights were "naive" and just "horse-and-buggy" stuff.

From that point of view, Newton's theories were "naive" and just "horse-and-buggy" stuff - as one commenter already noted here.

We would all be lucky to be as "naive" and "wrong" as Uncle Miltie was - even on the points where significant refinements have been felt to be needed. Krugman would be especially lucky to be so "naive" and "wrong" - it might make him a significant economist. I think Krugman's bitter comments about Friedman suggest Krugman knows that - and I think DeLong's distancing himself from Krugman here suggests that DeLong suspects the roots of Krugman's bitterness, too.

Posted by: Robert Musil on June 26, 2003 11:49 AM

Rob, you're the last person to be chiding others for not answering the question. You completely ducked mine about how you can simultaneously be in agreement with Friedman's statement, which is indistinguishable from my statement, yet claim to be in disagreement with me!

Astoundingly, you actually now revise your statement to bring it even closer to mine with:

" Yes when the Fed cuts rates, bank's willingnes to lend increases, but not due to the rate cut. Banks are willing to lend more because the money supply is increasing...."

Now re-read my statement:

"targeting the money supply by manipulating overnight interest rates"

Surely you aren't so far gone in d squared style denial that you can't see that our two statements are nearly identical.

Posted by: Patrick R. Sullivan on June 26, 2003 02:22 PM

" Assuming an interest rate channel, the lower interest rate sparks investment and output increases along a Keynesian path."

The message of The General Theory was to deny the efficacy of monetary policy, and promote fiscal policy. As d squared put it:

" as Keynes showed, the supply and demand curves for money don't work in the simple economics 101 way". (d squared happens to be incorrect, Keynes blundered in this, as Friedman demonstrated.)

Unless you mean the pre-1936 monetarist Keynes.

Posted by: Patrick R. Sullivan on June 26, 2003 02:29 PM

Robert--

The first sentence wasn't really for you as such, but more of a jumping off point.

The interest rate can fall for two reasons, either a decrease in demand or an increase in supply. It is the increase in supply due to the increase in teh money supply that causes the rates to fall. Because it is supply side, the quantity of loans increases. It is not due to the fall in the interest rate that quantity increases, if the rate stayed the same (horizontal demand) the quantity would increase more. So the falling interest rate retards the expansion of loans and investment.

Yes Patrick and Jim explained what they think Monetarism is, and they still are wrong about it. Its simple. Monetarism focuses on stable velocity, and hence stable money demand. This calls for k% growth of money supply. All that matters is the quantity of money, anything else is unimportant. This can be seen in Fisher's MV=PY. Constant velocity, means M controls PY. Fisher believes all this happens in P (the classicist in him). Friedman builds on this, allowing M to affect Y. But he holds veolcity stable as well since he believes interest rates are unimportant in money demand. Friedman's money demand is M/P=f(Y). So solving for velocity: V=Y/(f(Y)). And so given this stable velocity and money demand he calls for a focus on the quantity of money in the economy.

As soon as you move away from focusing on the quantity of money in the economy you leave Monetarism and find yourself either in a neoClassical position or a neoKeynesian position depending on your view of price adjustment. (Or you may end up at RBC.)

This isn't some strange vodoo I'm pulling out, but a basic history of thought. As soon as you mention interest rate targets you have left Monetarism. Friedman's big push was to eliminate interst rate targets as procyclical and hence destabilizing.

This has nothing to do with Friedman's place in history or your obession with Krugman. I am just trying to define what Monetarism really is, not what people believe it to be. Friedman significantly changed thought, forcing monetary policy to be taken seriously again. But that does not mean Monetarism won out.

If you don't think Krugman is a significant economist it just proves you have no clue about what has occured in economics over the past 20 years.

Patrick---
One more time:

The Fed changes money supply to meet interest rate targets. It doesn't set interest rate targets to target the money supply. It controls the money supply, why would it need to target rates. And again the Fed cannot maintian both an interst rate target and a money supply target. So your statement is just wrong.

As to the Keynesian path, it is about how a change in I leads to a change in Y, nothing more in that sentence.

Posted by: Rob on June 26, 2003 04:35 PM

Rob, one more time, you are ducking my question. Please explain the curious notion you have of algebra, in which, when a=b, b=c, a DOES NOT = c.

Or, explain your curious use of words in which:

" Yes when the Fed cuts rates, bank's willingnes to lend increases, but not due to the rate cut. Banks are willing to lend more because the money supply is increasing...."

Does not equal:

"targeting the money supply by manipulating overnight interest rates"


Posted by: Patrick R. Sullivan on June 27, 2003 07:14 AM

Rob: "Yes Patrick and Jim explained what they think Monetarism is, and they still are wrong about it."

Meet Prof. DeLong:

"The belief that monetary instability --inflation and deflation -- is the principal, or at least a principal, cause of other economic evils; the hope that sound monetary principles can be identified and, when identified, would greatly diminish uncertainty and risk; the focus on the job of the public sector being to provide the private economy with a stable measuring-rod and a stable environment -- all these are core ideas of whatever we choose to call *monetarism* "

Posted by: Patrick R. Sullivan on June 27, 2003 08:01 AM

Because Patrick a!=b, and b!= c. a causes b, b does not cause a. A chnage in the money supply will change interest rates. A chnage in interest rates does not lead to a change in the money supply. If the Fed was targeting the money supply, interst rates would be constantly changing and the Fed would have new interst rate targest intradaily.

Not that what I say matters since you'll keep using your misreading of Friedman as justification. Go get yourself a copy of Mishkin and read his chapter on Monetary Policy: Goals and Targets.

As to the four things. Yes monetraists believe those four, but except for the first so would neoClasical economists. The four sperates monetarism from keynesians, but not from other things. Its the first that is important there and that leads to a target on money aggregates.

Posted by: Rob on June 27, 2003 10:23 AM

Rob, you are either really bad at algebra, or really a poor reader. You made this statement:

" The rate is et by the market between banks. Now the Fed influences this market by expanding or contracting the money supply. ". (Which I helpfully labeled as "a")

And you said of it: "This agrees with the Friedman quote"

So, I produced the Friedman quote that you said you agreed with, but now claim was CAUSED(several years previous)by your statement:

"they can control [the money supply] indirectly by altering the rate at which banks lend to one another."

And I said that would be, "b".

Then I produced MY statement that you not only disagreed with, but made numerous arrogant and condescending remarks about. I pointed out that my statement is indistinguishable from Friedman's. And it surely is, see again for yourself:

"targeting the money supply by manipulating overnight interest rates".

And I called that, "c".

Now, that your memory is refreshed, please explain how you are simultaneously agreeing and disagreeing with me.

Posted by: Patrick R. Sullivan on June 27, 2003 02:37 PM

"a causes b, b does not cause a"

Barbie was right, "math class is hard"!

Rob, the issue on the table is how you can claim to agree with statement by Prof Friedman, but disagree with a next-to-identical statement made by me. Unless you actually think a statement made this week by you "caused" a statement by Friedman.

Here's the post you've been ducking, care to try honestly to answer it?:

To return the favor, Rob, I'm sorry you still don't understand 7th grade algebra. You say:

" The rate is et by the market between banks. Now the Fed influences this market by expanding or contracting the money supply. ". So, let's call your statement, "a".

Then you say: "This agrees with the Friedman quote....", which was:

"they can control [the money supply] indirectly by altering the rate at which banks lend to one another."

We'll call the Friedman quote, "b".

Then we have my original comment that you initially objected to:

"targeting the money supply by manipulating overnight interest rates".

Which is indistinguishable from the Friedman quote, and we will call mine, "c"

Sister Mary Somethingorother taught me that if: a = b, and b = c, then a = c. Which means you agree with me, Friedman, DeLong, and Greenspan.

Welcome aboard.

Posted by: Patrick R, Sullivan on June 25, 2003 06:27 PM

Posted by: Patrick R. Sullivan on June 27, 2003 03:07 PM

" a causes b, b does not cause a"

Barbie was right, math class is hard!

You're supposed to be explaining how you can agree with Friedman, who is agreeing with me, and at the same time disagree with me (and make nasty cracks into the bargain). Or do you really think your statement "caused" Friedman's?

Want to try again, this time honestly? Here's the post you've been ducking:

To return the favor, Rob, I'm sorry you still don't understand 7th grade algebra. You say:

" The rate is et by the market between banks. Now the Fed influences this market by expanding or contracting the money supply. ". So, let's call your statement, "a".

Then you say: "This agrees with the Friedman quote....", which was:

"they can control [the money supply] indirectly by altering the rate at which banks lend to one another."

We'll call the Friedman quote, "b".

Then we have my original comment that you initially objected to:

"targeting the money supply by manipulating overnight interest rates".

Which is indistinguishable from the Friedman quote, and we will call mine, "c"

Sister Mary Somethingorother taught me that if: a = b, and b = c, then a = c. Which means you agree with me, Friedman, DeLong, and Greenspan.

Welcome aboard.


Posted by: Patrick R, Sullivan on June 25, 2003 06:27 PM

Posted by: Patrick R. Sullivan on June 27, 2003 05:44 PM

Is Uncle Milton naive?

I really don't think so. On the PBS series, "Commanding Heights," he was shown saying that 1) he's an elitist, and 2) doesn't care about fairness.

Those two off-hand remarks filmed while he was chatting with his students, are really key to his thinking. It would lead one to suspect that secretly, covertly, deep down inside the bowels of his mind, he's not really concerned about economic growth as much as he's concerned about the concentration of wealth, which is the key to the power of the elite, which he admitted he supports. After all, many elitists don't really care about making more money (they already have all they can spend, in many cases), but they do care, and care very much, about aggregating more power to themeselves, even if that means beggaring everyone else.

It should be obvious to anyone that you can't sell something to someone with no money, and if you can't sell it, you won't produce it - i.e., there's no economic growth to be seen in an economy whose wealth has become concentrated beyond a certain point. Where that point is reached, is not well understood, but it's clear that in most third world economies, economic growth is stifled, not by a lack of money as much by the fact that it is so maldistributed that there is no liquidity in the market.

This does not seem to be of concern to Uncle Milton, as he seems to continue to advocate policies that favor ever greater concentration of wealth - in other words, ever greater resemblance to economic structure of third world nations.

Another factor that Uncle Milton seems to conveniently ignore (I believe deliberately) and is completely absent in his public discussions of his theories is the social ramifications of the concentration of wealth. Money equals power. And the unbridled concentration of wealth brings with it the unbridled concentration of power - and as we all know, the concentration of power brings with it the concentration of corruption. So what does the elite, with its concentrated wealth, do with its power? It changes the rules to favor itself - and breed more concentration of money and power. In other words, the concentration of wealth feeds on itself, and unchecked, leads ultimately to the disliquidation of the markets.

Surely Uncle Milton, bright as he is, can't be so naive as to not understand that simple reality. Yet the fact that he ignores it so completely in his public theorizing is evidence to me that he was being frank about what he admitted to on "Commanding Heights" - that he's an elitist and doesn't care about fairness.

And if you do not care about either egalitarianism or justice, then Milton's policies are for you. They'll suit your priorites just fine. They probably won't lead to an increase in median income (as they haven't in Chile). They may not even lead to economic growth. But what they will lead to, is the concentration of power, and in the end, that's what seems to really matter to Milton and friends.

Posted by: Scott Bidstrup on July 6, 2003 11:25 AM
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