I read Paul as accusing Milton Friedman of giving an inconsistent answer to a stupid question. It's a stupid question Paul. Of course Milton would give an inconsistent answer. That's the only sort of answer you can give to a stupid question.

At a fundamental level, however, this was an inconsistent position: if markets can go so wrong that they cause Great Depressions, how can you be a free-market true believer on everything except macro?"

"Think of it this way: Friedman was an avid free-market advocate, who insisted that the market, left to itself, could solve almost any problem. Yet he was also a macroeconomic realist, who recognized that the market definitely did not solve the problem of recessions and depressions. So he tried to wall off macroeconomics from everything else, and make it as inoffensive to laissez-faire sensibilities as possible. Yes, he in effect admitted, we do need stabilization policy — but we can minimize the government’s role by relying only on monetary policy, none of that nasty fiscal stuff, and then not even allowing the monetary authority any discretion.

I used to think that was the most important and fundamental question in macroeconomics.

Why is it a stupid question? Here's why:

Let your imagination run free. Think up the worst possible monetary policy you can imagine. What precisely that would be would depend on your particular model of the economy, and on your imagination. But it would probably have something like the following feature:

MP(worst): When you see inflation rise and market activity rise, loosen monetary policy a lot; and when you see inflation fall and market activity fall, tighten monetary policy a lot.

What precisely you will mean by "loosen/tighten monetary policy a lot" will depend on your particular macroeconomic model and how you conceptualise monetary policy. I will leave that up to you. But Paul's answer would probably not be terribly different from mine; we would both think that the other's personal MP(worst) was pretty terrible.

Now ask yourself this more precise question:

"Conditional on my MP(worst) being followed: at the macroeconomic level, is the market economy self-equilibrating?"

And (at least) 99.9% of macroeconomists would answer that question: "Don't be stupid. Of course it isn't!"

What sort of economist would answer "Yes" to that question? Who's in the 0.1%?

Maybe, just maybe, an extreme RBC theorist who happened to be smoking crack and who had a very stunted imagination would answer "Yes" to that question.

"At the macroeconomic level, is the market economy self-equilibrating?" is a stupid question because it doesn't specify the monetary policy being followed.

The only person who would answer "yes" to that unconditional question is someone who can't think up a worst possible monetary policy. Which means that person thinks that all conceivable monetary policies are equally good. Which means he doesn't think that monetary policy matters.

If I had to summarise Milton Friedman's thought in three words they would be: "Monetary policy matters".

I'm old enough to remember when that was a highly controversial statement in macroeconomics. Modern macroeconomic fish don't feel the Friedmanite water they swim in.

And if there is one thing we ought to have learned from the recent recession, as we ought to have learned from the Great Depression of the 1930's, as Friedman tried to teach us, it is that monetary policy does indeed matter, and matters a lot.

The most dangerous idea in macroeconomics is that monetary policy doesn't matter. [link here (pdf) Thanks Lorenzo!. link to that recent paper please, because I left my brain back on the farm.] Or, since that was precisely Friedman's message, to say the same thing a different way: the most dangerous idea in macroeconomics is that Friedman is an unperson.

Update: and make very sure you read Frances' comment immediately below. Because my point here generalises beyond macro/money. Institutions matter. Monetary policy is one of those institutions. So are markets. So is government.

Update2: as an antidote to all this "Friedman is an unperson" stuff, read R.A.'s superb essay in the Economist.

Update3: or this good post by Scott Sumner.