I guess George Selgin is right – Milton Friedman at the end of his life had come to the conclusion that the Federal Reserve should be abolished. See for yourself here. This is six months before his death in 2006.
See George’s excellent paper “Milton Friedman and the Case against Currency Monopoly”.
Posted by Lars Christensen on November 8, 2011
https://marketmonetarist.com/2011/11/08/selgin-is-right-friedman-wanted-to-abolish-the-fed/
David Glasner has a humorous comment on Scott Sumner’s attempt to “ban” the word “inflation”.
Here is Scott:
“Some days I want to just shoot myself, like when I read the one millionth comment that easy money will hurt consumers by raising prices. Yes, there are some types of inflation that hurt consumers. And yes, there are some types of inflation created by Fed policy. But in a Venn diagram those two types of inflation have no overlap.”
While David partly agrees with Scott he is not really happy giving up the word “inflation”:
“So Scott thinks that if only we could get people to stop talking about inflation, they would start thinking more clearly. Well, maybe yes, maybe no…At any rate, if we are no longer allowed to speak about inflation, that is going to make my life a lot more complicated, because I have been trying to explain to people almost since I started this blog started four months ago why the stock market loves inflation and have repeated myself again and again and again and again.”
The discussion between these two light towers of monetary theory reminded me of something I once read:
“When I began studying economics at the University of Vienna, immediately after the First World War, we were having a rapid increase of prices in Austria and, when asked what the cause was, we said it was inflation: By inflation we meant the increase in that thing which many are now afraid to mention – the quantity of money” (Fritz Machlup 1972)
But hold on for a second Fritz! That’s wrong! Lets have a look at the equation of exchange (in growth rates):
m+v=p+y
If the rate of growth in the quantity of money (m) equals inflation then inflation must be defined as p+y-v. And then if we assume (rightly a wrongly) that v is zero then it follows that inflation is defined as p+y.
What is p+y? Well that is the growth rate of nominal GDP! Hence, using the Machlup’s definition of inflation as the growth of the quantity of money then inflation is in fact nominal GDP growth.
So maybe David and Scott should not disagree on whether to ban the word “inflation” – maybe they just need to re-state inflation as the velocity adjusted growth of the quantity of money also known as NGDP growth.
PS this definition of inflation would also make David’s insistence that the stock market loves inflation a lot more reasonable.
Posted by Lars Christensen on November 8, 2011
https://marketmonetarist.com/2011/11/08/sumner-glasner-machlup-and-the-definition-of-inflation/
How often have you heard it? Monetary policy is impotent because interest rates are very low and if you increase the money base banks will just hoard all the money and will not lend out anything. Market Monetarists of course know that this is nonsense, but we have all also tried to explain this to people that seem unable to listen to the arguments.
Here is an idea how you make people listen. If somebody refuses to accept the power of monetary policy just ask them the following question: “So if an increase in the money base will not be able to increase nominal GDP why should we then have taxes?”
Hence, if there indeed were a liquidity trap there would indeed be a free lunch – you could pay for all expenditure with newly printed money from the central bank without getting inflation. This statement will normally upset people quite a bit and they will scream at you “then we will get hyperinflation!”…when you hear that you know you won the argument and you just reply “Q.E.D.”.
PS I am not suggesting this – exactly because I know there is no liquidity trap.
Posted by Lars Christensen on November 7, 2011
https://marketmonetarist.com/2011/11/07/taxes-and-the-liquidity-trap/
A distinct feature of Market Monetarist thinking is that our starting point for monetary analysis is nominal income and that monetary policy determines nominal income or nominal GDP (NGDP). This is contrary to New Keynesian analysis where monetary policy determines real GDP, which in turn determines inflation via a Phillips curve.
Hence, to Market Monetarists the split between prices and quantities is not a monetary matter. Monetary policy determines NGDP and that is all that monetary policy can do. While we acknowledge that there is a high correlation between real GDP and NGDP in the short-run the causality runs from NGDP to RGDP and not the other way. In the long run inflation is determined as a residual between NGDP, which is a monetary phenomenon, and RGDP, which is determined by supply side factors.
Milton Friedman came to the same conclusion 40 years ago. In a much overlooked (or should I say a forgotten) article from 1971 “A Monetary Theory of Nominal Income” he discusses this topic. The paper is a follow up on “Milton Friedman’s Monetary Framework” in which Friedman discusses his monetary framework with his critics. I have always felt that he failed to explain what he really meant in his “Monetary Framework”. Friedman seems to have realised that himself and his 1971 try to make up this failure.
Here is Friedman:
“In … “A Theoretical Framework for Monetary Analysis,” I outlined a simple model of six equations in seven variables that was consistent with both the quantity theory of money and the Keynesian income-expenditure theory…The difference between the two theories is in the missing equation the quantity theory adds an equation stating that real income is determined outside the system (the assumption of “full employment”); the income-expenditure theory adds an equation stating that the price level is determined outside the system (the assumption of price or wage rigidity)…The present addendum to my earlier paper suggests a third way to supply the missing equation. This third way involves bypassing the breakdown of nominal income between real income and prices and using the quantity theory to derive a theory of nominal income rather than a theory of either prices or real income. While I believe that this third way is implicit in that part of my theoretical and empirical work on money that has been concerned with short-period fluctuations, I have not heretofore stated it explicitly. This third way seems to me superior to the other two ways as a method of closing the theoretical system for the purpose of analyzing short-period changes. At the same time, it shares some of the defects common to the other two ways that I listed in the earlier paper.”
Hence, Friedman here acknowledges that the problem in the “Framework” papers was that he tried to come up with a monetary theory that followed a Keynesian route from RGDP to prices rather than “bypassing the breakdown of nominal income between real income and prices and using the quantity theory to derive a theory of nominal income”.
This is something completely lost in modern macroeconomic thinking, which see monetary policy working through a Phillips curve. This is somewhat odd given the weak empirical foundation for the existence of a Phillips curve.
I will not get into the details of Friedman’s model, but I would note that it could be interesting to see how it would look in a rational expectations version.
Back to Friedman:
“I have not, before this, written down explicitly the particular simplification I have labeled the monetary theory of nominal income-although Meltzer has referred to the theory underlying Anna Schwartz’s and my Monetary History as a “theory of nominal income” (Meltzer 1965, p. 414). But once written down, it rings the bell, and seems to me to correspond to the broadest framework implicit in much of the work that I and others have done in analyzing monetary experience. It seems to me also to be consistent with many of our findings. I do not propose here to attempt a full catalog of the findings, but I should like to suggest a number and, more important, to indicate the chief defect that I find with the framework.”
Here Friedman acknowledges that his empirical work for example on the Great Depression is based on a monetary theory of nominal income rather than on a quasi-Keynesian model (like the one he presents in his “Framework”). Any Market Monetarist would of course agree that a monetary theory of nominal income is needed to explain the Great Depression and the Great Recession for that matter. Friedman continues:
“One finding that we have observed is that the relation between changes in the nominal quantity of money and changes in nominal income is almost always closer and more dependable than the relation between changes in real income and the real quantity of money or between changes in the quantity of money per unit of output and changes in prices. This result has always seemed to me puzzling, since a stable demand function for money with an income elasticity different from unity led me to expect the opposite. Yet the actual finding would be generated by the approach of this paper, with the division between prices and quantities determined by variables not explicitly contained in it.”
This empirical result is highly interesting – the correlation between money and NGDP is stronger than between money and prices and income. In that regard it seems odd that Friedman never endorsed NGDP targeting – after all it would be natural to endorse a monetary policy rule that actually is directed towards something monetary policy can determine. However, there is no doubt that Friedman’s 1971 paper clearly provides the theoretical foundation for NGDP targeting. It is only too bad Friedman never came to that conclusion.
Finally I should say that Market Monetarists like David Beckworth and Josh Hendrickson are working on developing a modern monetary theory of nominal income determination.
PS Scott Sumner in a recent comment also discuss the relationship between NGDP, prices and quantities in Keynesian and (Market) Monetarist models.
PPS It should be noted that Bennett McCallum in a number of papers refers to Friedman’s 1971 paper when he argues in favour of nominal income targeting. See for example “Nominal Income Targeting in an Open-Economy Optimizing Model”
Posted by Lars Christensen on November 6, 2011
https://marketmonetarist.com/2011/11/06/friedman-provided-a-theory-for-ngdp-targeting/
In a recent comment Dan Alpert argues that Milton Friedman would be against NGDP targeting. I have the exact opposite view and I am increasingly convinced that Milton Friedman would be a strong supporter of NGDP targeting.
Ed Dolan as the same view as I have (I have stolen this from Scott Sumner):
“I see NGDP targeting as the natural heir to monetarist policy prescriptions of the 1960s and 70s…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.”
Dolan’s clear argument reminded me of Friedman’s paper from 2003 “The Fed’s Thermostat”.
Here is Friedman:
“To keep prices stable, the Fed must see to it that the quantity of money changes in such a way as to offset movements in velocity and output. Velocity is ordinarily very stable, fluctuating only mildly and rather randomly around a mild long-term trend from year to year. So long as that is the case, changes in prices (inflation or deflation) are dominated by what happens to the quantity of money per unit of output…since the mid ’80s, it (the Fed) has managed to control the money supply in such a way as to offset changes not only in output but also in velocity…The improvement in performance is all the more remarkable because velocity behaved atypically, rising sharply from 1990 to 1997 and then declining sharply — a veritable bubble in velocity. Velocity peaked in 1997 at nearly 20% above its trend value and then fell sharply, returning to its trend value in the second quarter of 2003.…The relatively low and stable inflation for this period …means that the Fed successfully offset both the decline in the demand for money (the rise in V) before 1973 and the subsequent increase in the demand for money. During the rise in velocity from 1988 to 1997, the Fed kept monetary growth down to 3.2% a year; during the subsequent decline in velocity, it boosted monetary growth to 7.5% a year.”
Hence, Friedman clearly acknowledges that when velocity is unstable the central bank should “offset” the changes in velocity. This is exactly the Market Monetarist view – as so clearly stated by Ed Dolan above.
So why did Friedman man not come out and support NGDP targeting? To my knowledge he never spoke out against NGDP targeting. To be frank I think he never thought of the righthand side of the equation of exchange – he was focused on the the instruments rather than on outcome in policy formulation. I am sure had he been asked today he would clearly had supported NGDP targeting.
The only difference I possibly could see between what Friedman would advocate and what Market Monetarists are arguing today is whether to target NGDP growth or a path for the NGDP level.
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PS I am not the first Market Monetarist to write about Friedman’s Thermostat – both Nick Rowe and David Beckworth have blogged about it before.
Posted by Lars Christensen on November 5, 2011
https://marketmonetarist.com/2011/11/05/friedman%e2%80%99s-thermostat-and-why-he-obviously-would-support-a-ngdp-target/
As Greek Prime Minister George Papandreou is fighting to putting together a new government after he yesterday survived a no-confidence vote in the Greek parliament I am once again reminded by the Argentine crisis of 2001-2002.
In my view the similarities with the Argentine crisis are striking – and most of the mistakes made by Argentine policy makers and by the international institutions are being repeated today in regard to the Greek crisis. Most important both in the Argentine case and in the Greek case policy makers refused to acknowledge that monetary policy is at the root of the problems rather than fiscal matters.
My favourite account of the Argentine crisis is the excellent book “And the Money Kept Rolling in (And Out)” by Paul Blustein.
You can’t help thinking of Greece and the efforts of the last year to “save“ the country when you see the title of Chapter 7: “Doubling a Losing Bet”.
I highly recommend Blustein’s book for those who want to understand how international institutions like the IMF works and why they fail and to understand how monetary regimes like Argentina’s currency board become “sacred” – in the same as the gold standard used to be – and this leads to crisis.
But back to Greece – or rather to the parallels to the Argentine crisis.
It has been rumours that former Greek central bank governor Lucas Papademos could take over as new Prime Minister in Greece. I have no clue whether this is going to happen, but the story made me think.
When you are in serious trouble you call in a well-respected former central banker to get some credibility. Argentina did that when Domingo Cavallo – the former successful central bank governor – became economics minister. Cavallo became economics minister on March 20 2001. He then tried to push through a number of austerity measures. He resigns on December 20 after massive protest and violence that kills 20 people. So far there has luckily been less killed in Greece.
So Cavallo lasted only 8 months – even respected central bankers cannot preform fiscal miracles in insolvent nations. But Cavollo’s 8 months as economics minister might be a benchmark for how long a central banker can stay on as economics minister – or Prime Minister.
Another measure of how long Papademos will be able to survive as Prime Minister if he indeed where to succeed Papandreou is to look at how many presidents Argentina had in 2001.
First president to step down was Fernando de la Rúa – on December 20 2001 – the same day Cavallo stepped.
Next one to step down was Adolfo Rodríguez Saá after 7 days in power on December 30 2001.
Eduardo Duhalde came into office January 2 2002 and stays on until May 25 2003. Duhalde a populist famously defaulted on Greece foreign debt – and is more popular with the Argentine public than with foreign creditors.
The question is whether Papademos would be Cavallo, Saá or Duhalde. He can’t really be Cavallo – as we are too long into the process and as Greece has already defaulted on some of the debt, but on the other hand the EU has not pulled the plug on Greece yet. It was really the IMF’s stop for funding of Argentina on December 5 2001 that “killed” Saá. Saá, however, while in government defaulted on foreign private debt on December 7 2001 (Greece effective defaulted on a large share of the private sector debt last week).
The Argentine currency board came to an end on January 6 2002 – around a month after the default on foreign debt and three weeks after Saá resigned…
If this is any guidance for the Greek situation we are surely in the end game…
PS I met Cavallo at a seminar back in 2008 – I was somewhat shocked to hear that he still thinks it was wrong that Argentina gave up the currency board despite more than 20 people died in civil unrest while he was economics minister. The Argentine economy rebound strongly after the currency board was given up and has growly strongly since then.I am certainly not claiming everything is fine in Argentina, but things are certainly better than in 2001.
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Update: Cavallo indeed has a view on Greece in the light of his own expirience. See his comment here. Lets just say I think he is mostly wrong…
Update 2 (November 13): Scott Sumner is out with an excellent comment on the lessons from Argentina.
Posted by Lars Christensen on November 5, 2011
https://marketmonetarist.com/2011/11/05/argentine-lessons-for-greece/
In a pervious post I have noted that Tim Lee a scholar at the libertarian Cato Institute has been endorsing basically Market Monetarist ideas. Now Tim has a comment on Market Monetarism. I am happy to see that Tim has nice things to say about Market Monetarism and my paper on Market Monetarism in his latest article at forbes.com.
Once again – I am happy to see that Tim Lee is continuing the work for nominal income targeting that William Niskanen started at the Cato Institute. NGDP should be the natural position of the good people at the Cato Institute.
Posted by Lars Christensen on November 5, 2011
https://marketmonetarist.com/2011/11/05/the-market-monetarist-voice-at-cato-institute/
Much of the debate about NGDP targeting in the blogosphere is about what the Federal Reserve should do. However, I think it is equally important to discuss and focus on what monetary regimes are preferable for other countries. I hope I will be able to increase the focus among Market Monetarists on monetary policy in other countries than the US.
Given that China is the second largest economy is the world it is somewhat surprising how little interest their is in Chinese monetary policy and especially in what are the key drivers of Chinese monetary policy. A working paper – “McCallum rule and Chinese monetary policy” – by Tuuli Koivu, Aaron Mehrotra and Riikka Nuutilainen from 2008 sheds more light on this important topic and Market Monetarists should be very interested in the results.
Here is the abstract:
“This paper evaluates the usefulness of a McCallum monetary policy rule based on money supply for maintaining price stability in mainland China. We examine whether excess money relative to rule-based values provides information that improves the forecasting of price developments. The results suggest that our monetary variable helps in predicting both consumer and corporate goods price inflation, but the results for consumer prices depend on the forecasting period. Nevertheless, growth of the Chinese monetary base has tracked the McCallum rule quite closely. Moreover, results using a structural vector autoregression suggest that our measure of excess money supply could be used to identify monetary policy shocks in the Chinese economy.”
Hence, according to the authors the People’s Bank of China (PBoC) follow a McCallum rule whereby they use the money base to hit a given target for growth in nominal GDP (NGDP).
This in my view is a highly interesting result and it is somewhat of a surprise that these empirical results have not gotten more attention – especially given China’s impressive economic performance in recent years. Furthermore, it would be extremely interesting to see how the results would look if they where updated to include the Great Recession period. I am sure there is lot of aspiring Market Monetarists out there who are getting ready to update these results…
The PBoC is certainly not conducting monetary policy in a transparent way and the Chinese financial markets remain overly regulated, but at least it seems like the PBoC got their money base control more or less right.
Posted by Lars Christensen on November 4, 2011
https://marketmonetarist.com/2011/11/04/does-china-target-ngdp/
Timothy B. Lee at the Cato Institute has a couple of interesting comments out on US monetary policy – they are at the core very much Market Monetarist.
Here is a few recommendations:
Fighting the Last Monetary War (Happy to see Tim is reading Friedman’s Money Mischief – one of my favourite books)
More on Nominal Sales and Monetary Policy (happy to see a tribute to William Niskanen’s monetary policy views)
Beckworth, Ponnuru and Niskanen on Monetary Policy (Tim, you make us proud…)
Most Market Monetarists talk about NGDP level targeting, but I guess people like Beckworth and Woolsey would prefer targeting “nominal final sales to domestic purchasers” as William Niskanen suggested. I have sympathy for that as well – especially if I think of none-US monetary policy then a target on what I would call final domestic spending would be appropriate. Furthermore, final sales was also Clark Warburton’s prefered measure for Py and given I think Warburton is the most underappreciated monetarist ever it is only natural for me to advocate to use final sales rather NGDP as a measure of Py.
Anyway, nice to see a Cato scholar on board. The Cato Institute has been at the forefront of “policy development” in the US for decades and it’s annual monetary conference continues to be hugely influential on US and global thinking about monetary policy and theory so it is truly great that Tim is spreading the message from William Niskanen.
Posted by Lars Christensen on November 4, 2011
https://marketmonetarist.com/2011/11/04/tim-lee-market-monetarist/
David Beckworth and Ramesh Ponnuru just came out with a new article on the economic policy debate in the US. Beckworth and Ponnuru lash out against both left and right in American politics. Let me just say that I agree with basically everything in the article, but you should read it yourself.
However, what I find most interesting in the article is not the discussion about the US political landscape, but rather the very clear description of both the Great Moderation and the causes for the Great Recession:
“The Fed did a pretty good job of stabilizing the economy. The result of its monetary policies was that the economy, measured in current-dollar or “nominal” terms, grew at about 5 percent a year, with inflation accounting for 2 percent of the increase and real economic growth 3 percent. Keeping nominal spending and nominal income on a predictable path is important for two reasons. First, most debts, such as mortgages, are contracted in nominal terms, so an unexpected slowdown in nominal income growth increases their burden. Also, the difficulty of adjusting nominal prices makes the business cycle more severe. If workers resist nominal wage cuts during a deflation, for example, mass unemployment results…During the great moderation, people began to expect spending and incomes to grow at a stable rate and made borrowing decisions based on it. But maintaining this stability requires the Fed to increase the money supply whenever the demand for money balances—people’s preference for cash over other assets—increases. This happened in 2008 when, as a result of the recession and the financial crisis, fearful Americans began to hold their cash. The Federal Reserve, first worried about increased commodity prices as a harbinger of inflation and then focused on saving the financial system, failed to increase the money supply enough to offset this shift in demand and allowed nominal spending to fall through mid-2009″
I wish a lot more people would understand this – Beckworth and Ponnuru are certainly not to blame if you don’t understand it yet.
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UPDATE: See this interesting comment on Niskanen and Beckworth/Ponnuru by Tim B. Lee.
Posted by Lars Christensen on November 3, 2011
https://marketmonetarist.com/2011/11/03/beckworth-and-ponnuru-tight-budgets-loose-money/