Milton Friedman on what is monetarism

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The leads and lags on monetary policy are long and variable

Many Keynesians, Friedman notes, advocate “leaning against the wind.” By this they mean, in some sense, that the monetary (and fiscal) authorities should try to balance out the private sector’s excesses rather than passively hope that it adjusts on its own.

There are large uncertainties about the size and timing of responses to changes in monetary policy. There is a close and regular relationship between the quantity of money and nominal income and prices over the years. However, the same relation is much looser from month to month, quarter to quarter and even year to year.

Monetary policy changes take time to affect the economy and this time delay is itself highly variable. The lags on monetary policy are three in all:

  1. The lag between the need for action and the recognition of this need (the recognition lag)

  2. The lag between recognition and the taking of action (the legislation lag)

  3. the lag between action and its effects (the implementation lag)

These delays mean that is it difficult to ascertain whether the effects of monetary policy changes in the recent past have finished taking effect. Secondly, it is difficult to ascertain when proposed changes in monetary policy will take effect. Thirdly, feedbacks must be assessed. The magnitude of the monetary adjustment necessary to deal with the problem at hand is thus never obvious. It is common for a central bank to act incrementally. The central bank makes small adjustments to monetary conditions over time as more information is available on the state of the economy and forecasts are updated.

The existence of lags may mean that by the time policy has its full effect, the problem with which it was meant to deal may have disappeared.

Milton Friedman (1959) tested the Fed’s success at leaning “against the wind” by checking whether the rate of money growth has truly been lower during expansions and higher during contractions. He admits that this method of grading he Fed’s performance is open to criticism, but he decided to go ahead and see what turns up.  Friedman found that Fed has – for the periods surveyed – been unsuccessful.

By this criterion, for eight peacetime reference cycles from March 1919 to April 1958. Actual policy was in the ‘right’ direction in 155 months, in the ‘wrong’ direction in 226 months; so actual policy was ‘better’ than the [constant 4% rate of money growth] rule in 41% of the months.

Nor is the objection that the inter-war period biased his study is good since Friedman found that:

For the period after World War II alone, the results were only slightly more favourable to actual policy according to this criterion: policy was in the ‘right’ direction in 71 months, in the ‘wrong’ direct in 79 months, so actual policy was better than the rule in 47% of the months.

One of the best ways to parry a metaphor is with another metaphor. Keynesians have a host of metaphors in their rhetorical arsenal; one frequently voiced is that a wise government should “lean against the wind” when choosing policy. Friedman counters:

We seldom know which way the economic wind is blowing until several months after the event, yet to be effective, we need to know which way the wind is going to be blowing when the measures we take now will be effective, itself a variable date that may be a half year or a year or two from now. Leaning today against next year’s wind is hardly an easy task in the present state of meteorology.

Friedman’s remarks, as even his strong critics admit, are mighty and strike at the heart of any activist stabilisation policy. By meeting Keynesians on their own theoretical turf and scrutinising their practice, Friedman manages to produce objections that both Keynesians and non-Keynesians must take seriously. A key part of any response to Friedman rests on the ability of forecasters to do their jobs with tolerable accuracy.

Keynesian policies do not necessarily follow even if the Keynesian theory of the business cycle were conclusively proved. It must also be demonstrated that the government has the ability and willingness of the government to act as the theory prescribes. Friedman’s critique does not depend on the quantity theory of money.

New Keynesian macroeconomics as the triumph of monetarism

In The triumph of monetarism, Brad De Long wrote in the Journal of Economic Perspectives—Volume 14, Number 1—Winter 2000—Pages 83–94 that today’s new Keynesian" macroeconomists would include in any list of their  key ideas and premises the five following propositions that:

  1. The key to understanding real fluctuations in employment and output is to understand the process by which business cycle-frequency shocks to nominal income and spending are divided into changes in real spending and changes in the price level.
  2. Under normal circumstances, monetary policy is a more potent and useful tool for stabilization than is fiscal policy.
  3. Business cycle fluctuations in production are best analysed from a starting point that sees them as fluctuations around the sustainable long-run trend (rather than as declines below some sustainable potential output level).
  4. The right way to analyse macroeconomic policy is to consider the implications for the economy of a policy rule, not to analyse each one- or two-year episode in isolation as requiring a unique and idiosyncratic policy response.
  5. Any sound approach to stabilization policy must recognize the limits of stabilization policy—the long lags and low multipliers associated with fiscal policy; the long and variable lags and uncertain magnitude of the effects of monetary policy.

De Long then went on to argue that the above research programme is the macroeconomic research programme of Milton Friedman in the mid-20th century.

The market process is based on voluntary exchange

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From The Economist’s 1963 review of Capitalism and Freedom

Curiously, a family tax credit or earned income tax credit is the most successful anti-poverty tool in the late 20th century. Furthermore, those on the Left are relatively convinced that the sole cause of poverty is a lack of money, and the solution is to give the poor more money.

Friedman, Hayek in the Constitution of Liberty, and George Stigler in his great paper on the minimum wage in 1946 all supported a guaranteed minimum income.

via A Tract for the Times | The Economist.

The institutional foundation of the Great Fact

So that the record of history is absolutely crystal clear. That there is no alternative way, so far discovered, of improving the lot of the ordinary people that can hold a candle to the productive activities that are unleashed by a free enterprise system.  - Milton Friedman

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Milton Friedman summarised Keynes as follows

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The failures of progressive politics

Limiting ourselves to democratically elected governments, and there are many of these even in the under-developed countries, progressive ideas seem to fail, and fail again at the ballot box right around the globe as you concede the strong right-wing bias of many governments across the globe.

There was one left-wing federal government in Australia in the last 60 years. That was for three years between 1972 and 1975, and it lost in a landslide.  the Whitlam government got in buy a few seats  in 1972by beating tired and smelly government that had held office for 23 years

This inability of progressive politics get anywhere is important because every set of ideas needs effective critics to keep it on its toes and stop it from slouching into error and special interest capture.

The Right needs a vibrant Left to keep the Right fit, trim and down to its fighting weight so as to be able to thrash the Left once again at the next election. That is the function of left-wing governments:  mind the shop  while the right-wing parties are fed and rested  and rejuvenated.

Prior to the 1990s, all it took to see progressive ideas off the political and economic stage in a country was a visit or two by Milton Friedman, if some are to be believed. I do not believe that political transformations are as easy as this.

However, some still want to maintain the rage over, for example, Friedman’s April 1975 trip to Australia for 18 days leading to a paradigm shift to neo-liberalism and Hayden’s supposedly monetarist budget shortly after if Alex Millmow is to be believed. Apparently, the spirited, witty Joan Robinson’s visit the same month and her own Monday conference program did not do the trick as an anti-biotic and vaccine.

Progressives will have no role in future political transformations because if you scratch a progressive you will find a left wing populist.

A left-wing populist is too busy telling you who to fear and who to blame to put up policies that are actually robust enough to work and to have worked in the past in a society where people are not perfect in their motivations, they do not have perfect knowledge in a changing world, and there is no offsetting behaviour and unintended consequences when these policies are put in practice.

Does fiscal policy cause inflation?

Milton Friedman on the onset of the Great Depression from the standpoint of 1930s macroeconomics

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The proof is in the pudding

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At least 20% of New Zealand workers are subject to occupational regulation

There are at least 98 regulated occupations in New Zealand covering about 20% of the workforce. In 2011, this amounts to 440,371 workers. The skills that are regulated range across all skill sets and many occupations:

  • 49% of regulation is in the form of a licence;
  • 18% of regulated work is in the form of licensing of tasks;
  • 31% of regulated workers require a certificate; and
  • 4% of regulated workers require registration.

There are 32 different governing Acts that regulated occupations in New Zealand with 55% of the workers subject to occupational regulation are employed in just five occupations:

  • 98,000 teachers;
  • 48,500 nurses;
  • 42,730 bar managers;
  • 32,733 chartered accountants; and
  • 22,749 electricians.

The Health Practitioners Competency Assurance Act 2003 regulates 22 occupations and a total of 89,807 workers. The next best is the 10 occupations regulated by the Health and Safety in Employment Act 2002 which regulates an unknown number of occupations. The Civil Aviation Act 1990 regulates eight occupations and 19,095 workers, the Building Act 2004 regulates seven occupations and 21,101 workers and the Maritime Transport Act 1994 regulates six occupations and 20,500 workers. 12 of the regulated occupations are regulated under laws passed since 2007.

The purpose of occupational regulation is to protect buyers from quacks and lemons – to overcome asymmetric information about the quality of the provider of the service.

Adverse selection occurs when  the seller knows more than the buyer about the true quality of the product or service on offer. This can make it difficult for the two people to do business together. Buyers cannot tell the good from the bad products on offer so many they do not buy to all and withdraw from the market.

Goods and services divide into inspection, experience and credence goods.

  • Inspection goods are goods or services was quality can be determined before purchase price inspecting them;
  • Experience goods are goods whose quality is determined after  purchase in the course of consuming them; and
  • Credence goods are goods  whose quality may never be known for sure  as to whether the good or service actually worked – was that car repair or medical procedure really necessary?

The problem of adverse selection over experience and credence goods present many potentially profitable but as yet unconsummated wealth-creating transactions because of the uncertainty about quality and reliability.

Buyers are reluctant to buy if they are unsure of quality, but if such assurances can be given in a credible manner, a significant increase in demand is possible.

Any entrepreneur who finds ways of providing credible assurances of the quality of this service or work stands to profit handsomely. Brand names and warranties are examples of market generated institutions that overcome these information gaps through screening and signalling.

Screening is the less informed party’s effort, usually the buyer, to learn the information that the more informed party has. Successful screens have the characteristic that it is unprofitable for bad types of sellers to mimic the behaviour of good types.

Signalling is an informed party’s effort, usually the seller, to communicate information to the less informed party.

The main issue with quacks in the labour market is whether there are a large cost of less than average quality service, and is there a sub-market who will buy less than average quality products in the presence of competing sellers competing on the basis of quality assurance. This demand for assurance creates opportunities for entrepreneurs to profit by providing assurance.

David Friedman wrote a paper about contract enforcement in cyberspace where the buyer and seller is in different countries so conventional mechanisms such as the courts are futile in cases where the quality of the good is not as promised or there is a failure to deliver at all:

Public enforcement of contracts between parties in different countries is more costly and uncertain than public enforcement within a single jurisdiction.

Furthermore, in a world where geographical lines are invisible, parties to publicly enforced contracts will frequently not know what law those contracts are likely to fall under. Hence public enforcement, while still possible for future online contracts, will be less workable than for the realspace contracts of the past.

A second and perhaps more serious problem may arise in the future as a result of technological developments that already exist and are now going into common use. These technologies, of which the most fundamental is public key encryption, make possible an online world where many people do business anonymously, with reputations attached to their cyberspace, not their realspace, identities

Online auction and sales sites address adverse selection with authentication and escrow services, insurance, and on-line reputations through the rating of sellers by buyers.

E-commerce is flourishing despite been supposedly plagued by adverse selection and weak contract enforcement against overseas venders.

In the labour market, screening and signalling take the form of probationary periods,  promotion ladders, promotion tournaments, incentive pay and the back loading of pay in the form of pension investing and other prizes and bonds for good performance over a long period.

In the case of the labour force, there are good arguments that a major reason for investments in education is as a to signal quality, reliability, diligence as well as investment in a credential that is of no value the case of misconduct or incompetence. Lower quality workers will find it very difficult if not impossible to fake quality and reliability in this way – through investing in higher education.

In the case of teacher registration, for example, does a teacher registration system screen out any more low quality candidates for recruitment than do proper reference checks and a police check for a criminal record.

Mostly disciplinary investigations and deregistrations under the auspices of occupational regulation is for gross misconduct  and criminal convictions rather than just shading of quality.

Much of personnel  and organisational economics is about the screening and sorting of applicants, recruits and workers by quality and the assurance of performance.

Alert entrepreneurs have every incentive to find more profitable ways to manage the quality of their workforce and sort their recruitment pools.

Baron and Kreps (1999) developed the recruitment taxonomy made up of stars, guardians and foot-soldiers.

Stars hold jobs with limited downside risk but high performance is very good for the firm – the costs of hiring errors for stars such as an R&D worker are small: mostly their salary. Foot-soldiers are employees with narrow ranges of good and bad possible outcomes.

Guardians have jobs where bad performance can be a calamity but good job performance is only slightly better than an average performance.

Airline pilots and safety, compliance, finance and controller jobs are all examples of guardian jobs where risk is all downside. Bad performance of these jobs can  bring the company down. Dual control is common in guardian jobs.

The employer’s focus when recruiting and supervising guardians is low job performance and not associating rewards and promotions with risky behaviours. Employers will closely screen applicants for guardian jobs, impose long apprenticeships and may limit recruiting to port-of-entry jobs.

The private sector has ample experience in handling risk in recruitment for guardian jobs. Firms and entrepreneurs are subject to a hard budget constraints that apply immediately if they hire quacks and duds.

Blackboard economics says that governments may be able to improve on market performance but as Coase warned that actually implement regulatory changes in real life is another matter:

The policy under consideration is one which is implemented on the blackboard.

All the information needed is assumed to be available and the teacher plays all the parts. He fixes prices, imposes taxes, and distributes subsidies (on the blackboard) to promote the general welfare.

But there is no counterpart to the teacher within the real economic system

Occupational regulation  comes with the real risk of the regulation turning into an anti-competitive barrier to entry as Milton Friedman (1962) warned:

The most obvious social cost is that any one of these measures, whether it be registration, certification, or licensure, almost inevitably becomes a tool in the hands of a special producer group to obtain a monopoly position at the expense of the rest of the public.

There is no way to avoid this result. One can devise one or another set of procedural controls designed to avert this outcome, but none is likely to overcome the problem that arises out of the greater concentration of producer than of consumer interest.

The people who are most concerned with any such arrangement, who will press most for its enforcement and be most concerned with its administration, will be the people in the particular occupation or trade involved.

They will inevitably press for the extension of registration to certification and of certification to licensure. Once licensure is attained, the people who might develop an interest in undermining the regulations are kept from exerting their influence. They don’t get a license, must therefore go into other occupations, and will lose interest.

The result is invariably control over entry by members of the occupation itself and hence the establishment of a monopoly position.

Friedman’s PhD was published in 1945 as Income from Independent Professional Practice. With co-author Simon Kuznets, he argued that licensing procedures limited entry into the medical profession allowing doctors to charge higher fees than if competition were more open.

Data Source: Martin Jenkins 2012, Review of Occupational Regulation, released by the Ministry of Business, Innovation and Employment under the Official Information Act.

The Keynesian vision of macroeconomic policy

A market economy is subject to fluctuations which need to be corrected, can be corrected, and therefore should be corrected

Franco Modiglani

Milton Friedman’s vision is far more circumspect because of the limits on the information people have and their ability to update that information. His critique has nothing to do with his views on macroeconomics:

The central problem is not designing a highly sensitive [monetary] instrument that offsets instability introduced by other factors [in the economy], but preventing monetary arrangements becoming a primary source of instability…

Keynesians have a host of metaphors in their rhetorical arsenal; one frequently voiced is that a wise government should “lean against the wind” when choosing policy. Friedman jumped on this:

We seldom know which way the economic wind is blowing until several months after the event, yet to be effective, we need to know which way the wind is going to be blowing when the measures we take now will be effective, itself a variable date that may be a half year or a year or two from now. Leaning today against next year’s wind is hardly an easy task in the present state of meteorology

Friedman’s remarks, as even his strong critics admit, strike at the heart of any activist stabilisation policy. By meeting Keynesians on their own theoretical turf and scrutinising their practice, Friedman manages to produce objections that both Keynesians and non-Keynesians must take seriously.

A key part of any response to Friedman rests on the ability of forecasters to do their jobs with tolerable accuracy. After reading the annual reports of the Fed, Milton Friedman noticed the following pattern:

In the years of prosperity, monetary policy is a potent weapon, the skilful handling of which deserves the credit for the favourable course of events; in years of adversity, other forces are the important sources of economic change, monetary policy had little leeway, and only the skilful handling of the exceedingly limited powers available prevented conditions from being even worse

Central banks pay due to the implications of the leads and lags  on monetary policy only as an ex-post facto rationalisation for disappointment.

If there is such a thing as a liquidity trap, bring it on!

In the Keynesian pipedream, in a liquidity trap, there is perfect substitutability of money and bonds at a zero short-term nominal interest rate. This renders monetary policy ineffective.

Keynesians claim that the demand for money may be so persistently high that the rate of interest could not fall low enough to stimulate investment sufficiently to raise the economy out of the depression. Allan Meltzer explains:

A liquidity trap means that increases in money by the central bank (monetary base) cannot affect output, prices, interest rates or other variables. Changes in the money stock are entirely matched by changes in the demand to hold money.

With a liquidity trap, the public simply hoards the money the central bank creates rather than attempting to run down additions to their cash balances with increased consumer expenditure. This limitless accumulation of money by the public is not a real world phenomenon. The public will not forever accumulate money.

Auerbach and Obstfeld noted in "The Case for Open-Market Purchases in a Liquidity Trap" that to the extent that long-term interest rates are positive short-term interest rates are expected to be positive in the future, trading money for interest-bearing public debt through open market operations reduces future debt-service requirements.

  • A massive monetary expansion during a liquidity trap should improve social welfare by reducing the taxes required in the future to service the now much smaller national debt!!!!
  • A quantitative easing during a liquidity trap is, in effect, as good as or even better than a lump sum tax.

Central banks perhaps should contrive liquidity traps because they can then buy back the public debt because of the unlimited demand for money.

The logic of the liquidity trap is people will without limit give up bonds for non-interest bearing cash. If monetary policy is impotent near the zero bound, the central bank should buy trillions of dollars of federal bonds and payoff the public debt. This is a logical implication of liquidity traps for an optimal fiscal policy!!!! Is my reasoning wrong?

In addition to D.H. Robertson, Jacob Viner, Milton Friedman, Philip Cagan, Don Patinkin, Auerbach and Obstfeld, Robert H. Lucas, Greg Mankiw, and Bernanke and Blinder as sceptics about a liquidity trap, Keynes wrote in 1936:

Whilst the limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test.

Meltzer, who wrote A History of the Federal Reserve, Vol. 1: 1913-1951 points to several periods when interest rates were at or close to zero:

“In 1954, interest rates were 0.5 percent or below, and we had no problem recovering,” he says. “In 1948 to 1949, we had zero interest rates. Also in 1937 to 1938. We had no problem recovering.”

The Pigou effect states that when there is deflation of prices, employment (and output) will be increased due to an increase in wealth (and thus consumption). The deflation increases the value of cash balances and therefore the wealth of consumers. They spend some of this additional wealth.

After reading the annual reports of the Fed in the 1920s and 1930s, Milton Friedman noticed the following pattern:

In the years of prosperity, monetary policy is a potent weapon, the skilful handling of which deserves the credit for the favourable course of events; in years of adversity, other forces are the important sources of economic change, monetary policy had little leeway, and only the skilful handling of the exceedingly limited powers available prevented conditions from being even worse

When is it the right time to cut taxes?

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