November 6, 2003
Rethinking Milton Friedman
WENTY-FIVE years ago, I took my first economics class. Like many other college students, I wanted to understand why the economy of our teenage years was such a scary mess, with inflation and rising taxes eroding our parents' paychecks, interest rates soaring and unemployment an ever present threat.
By my freshman year, inflation had morphed into "stagflation," combining rising price levels with relatively high unemployment. For most economists, stagflation was a puzzle. There was supposed to be a trade-off - the so-called Phillips curve - between inflation and unemployment. If you had one, you weren't supposed to have the other.
The "Great Inflation" of the 1970's challenged and permanently altered economic theory. It vindicated the once-controversial analysis of Milton Friedman, then at the University of Chicago.
" Friedman's monetary framework has been so influential that in its broad outlines at least, it has nearly become identical with modern monetary theory," said the Federal Reserve governor Ben S. Bernanke, at a recent conference at the Federal Reserve Bank of Dallas. (The full text of his speech is available at www.dallasfed.org/news /research/2003/03ftc_bernanke.pdf.)
Mr. Bernanke is not a former Friedman student. He did his graduate work at M.I.T. Someone reading Milton Friedman's monetary economics today is likely to miss its significance, Mr. Bernanke noted, much as an apocryphal student called Shakespeare's plays "just a string of quotations."
"His thinking has so permeated modern macroeconomics that the worst pitfall in reading him today is to fail to appreciate the originality and even revolutionary character of his ideas, in relation to the dominant views at the time that he formulated them," he said.
Against the conventional wisdom, Mr. Friedman argued that "inflation is always and everywhere a monetary phenomenon." Inflation had nothing to do with aggressive unions, greedy businesses or even oil cartels - the bad guys who took the blame in the confusing 1970's. Prices shot up everywhere because the federal government made the supply of money grow faster than the real economy created value. Based on the historical record, he argued, the effects of monetary policy were fairly predictable.
In a 1970 lecture, "The Counterrevolution in Monetary Theory," Mr. Friedman outlined 11 propositions about how monetary policy affects the economy. All were wildly controversial, almost disreputable, at the time. Most are accepted today.
The first six propositions described the effects of tightening or loosening the money supply.
Changing the money supply, Mr. Friedman argued, raises or lowers nominal national income - production multiplied by the price level - after six to nine months. That change appears initially in output, so an increase in the money supply spurs production. After another six to nine months, however, prices adjust. Real, as opposed to nominal, income does not change.
With Mr. Friedman's original caveat that these empirical relationships are not perfect, Mr. Bernanke said, most policy makers and economists today would consider that 1970 description "spot on." A large body of empirical research has confirmed the same general pattern in many different countries.
More revolutionary still was Mr. Friedman's proposition that monetary policy can affect real output only in the short run. The Phillips curve works only for a few months. Long-term economic growth depends on real factors like innovation, investment and entrepreneurship.
This proposition "is universally accepted today by monetary economists," Mr. Bernanke said. "When Friedman wrote, however, the conventional view held that monetary policy could be used to affect real outcomes - for example, to lower the rate of unemployment - for an indefinite period."
That belief led to terrible economic policy. Trying to maintain full employment, the Federal Reserve of the 1970's pumped out money faster than the real economy grew. A result, Mr. Bernanke said, was the "Great Inflation of the 1970's - after the Great Depression, the second most serious monetary policy mistake of the 20th century."
Today, most macroeconomists also accept Mr. Friedman's most famous proposition - that inflation is always a monetary phenomenon. Contrary to what I learned in macroeconomics class, "cost push" inflation was a myth. Pay and price increases did not drive inflation; they reflected it. Americans wanted higher nominal wages and prices to keep up as the real value of each dollar declined.
To combat cost-push inflation, the Nixon administration imposed wage and price controls in 1971. Various controls, notably on energy prices, lingered throughout the 1970's. But inflation did not go away, because all these policies treated the symptom, not the cause.
A few of Mr. Friedman's propositions remain subject to debate and research. He contended, for instance, that government deficits cause inflation only if they are financed by creating money. Economists do not yet agree on the exact relation between unsustainable government spending and inflation.
Mr. Friedman tracked monetary policy by tracking the growth of the money supply. While theoretically sound, that practice has become increasingly difficult. Financial innovations keep changing the definition and growth rate of money.
Beyond these descriptive propositions, Mr. Friedman's greatest monetarist legacy is a prescriptive one.
"The most fundamental policy recommendation put forth by Milton Friedman," Mr. Bernanke said, "is the injunction to policy makers to provide a stable monetary background for the economy," avoiding both inflation and deflation.
"Monetary stability actively promotes efficiency and growth," Mr. Bernanke said. It also makes the economy more resilient, because when people are not afraid of general inflation, they adapt more easily to shocks like rapid jumps in energy prices.
Over the last two decades, central bankers here and abroad have worked to keep inflation low and stable, and they have largely succeeded. Back in the 1970's, Milton Friedman didn't think that was politically possible. About that one thing, perhaps, he was wrong.