And every few days I come across an economist saying something that he would not have said if he were aware of Milton Friedman's thermostat. Today it was Casey Mulligan , but the class "economists who seem to be unaware of Milton Friedman's thermostat because they say something they would not say if they were aware of it" seems to me to cover lots of very different economists.

Google seems to tell me I'm right. I'm the first link, which is really pathetic for such an important idea; the second is Friedman himself (pdf) ; and most of the rest on the first page are other bloggers, mostly Market Monetarists. But this idea has got nothing (in particular) to do with Monetarism. Compare that to what Google comes up with for another of Milton Friedman's important ideas. Scholarly articles, and its own Wikipedia page.

I know I'm right in saying that Milton Friedman's thermostat is an important idea that all economists ought to be aware of. And I'm pretty sure I'm right in asserting that almost all economists are unaware of this important idea. Am I wrong? Are you aware of this idea? Maybe under some other name??

Milton Friedman's thermostat has got nothing to do with Monetarism, or even macroeconomics. Or rather, Milton Friedman's thermostat is an idea that has very broad application, and has nothing in particular to do with Monetarism or even macroeconomics. Or even economics.

If I had to categorise where this idea belongs, I would say it is an idea that belongs to applied econometrics. But, as far as I can see, I would say that applied econometricians are as unaware of this idea as any other economists, even though they have the greatest need to be aware of this idea.

And it's not even original to Milton Friedman. The first economics article I can find laying out the basic idea was by an Old Keynesian, Maurice Peston (gated), who applied it to fiscal policy, not monetary policy. Like most important ideas, it has probably been independently invented several times, by someone who realised they needed to invent it. (I invented it myself, and only after I had invented it did I learn that other people had previously invented it too). But calling it "Milton Friedman's thermostat" is a good name for the idea, because it's a good metaphor, and Friedman is the one who came up with that metaphor.

And it's not even a very complicated idea. You can explain the gist of it using words and simple examples.

But it's a really really important idea. Both theoretically important, and practically important.

So why does such an important idea need to keep on being reinvented? Why are (almost all) economists unaware of this idea?

It's not as though Milton Friedman were some no-name economist that everybody ignored. Every economist is very aware of lots of Milton Friedman's other ideas. Those other ideas are taught to all economics students. Why not this idea?

Here's the idea:

Everybody knows that if you press down on the gas pedal the car goes faster, other things equal, right? And everybody knows that if a car is going uphill the car goes slower, other things equal, right?

But suppose you were someone who didn't know those two things. And you were a passenger in a car watching the driver trying to keep a constant speed on a hilly road. You would see the gas pedal going up and down. You would see the car going downhill and uphill. But if the driver were skilled, and the car powerful enough, you would see the speed stay constant.

So, if you were simply looking at this particular "data generating process", you could easily conclude: "Look! The position of the gas pedal has no effect on the speed!"; and "Look! Whether the car is going uphill or downhill has no effect on the speed!"; and "All you guys who think that gas pedals and hills affect speed are wrong!"

And no, you can not get around this problem by doing a multivariate regression of speed on gas pedal and hill. That's because gas pedal and hill will be perfectly colinear. And no, you do not get around this problem simply by observing an unskilled driver who is unable to keep the speed perfectly constant. That's because what you are really estimating is the driver's forecast errors of the relationship between speed gas and hill, and not the true structural relationship between speed gas and hill. And it really bugs me that people who know a lot more econometrics than I do think that you can get around the problem this way, when you can't. And it bugs me even more that econometricians spend their time doing loads of really fancy stuff that I can't understand when so many of them don't seem to understand Milton Friedman's thermostat. Which they really need to understand.

If the driver is doing his job right, and correctly adjusting the gas pedal to the hills, you should find zero correlation between gas pedal and speed, and zero correlation between hills and speed. Any fluctuations in speed should be uncorrelated with anything the driver can see. They are the driver's forecast errors, because he can't see gusts of headwinds coming. And if you do find a correlation between gas pedal and speed, that correlation could go either way. A driver who over-estimates the power of his engine, or who under-estimates the effects of hills, will create a correlation between gas pedal and speed with the "wrong" sign. He presses the gas pedal down going uphill, but not enough, and the speed drops.



How could the passenger figure out if the gas pedal affected the speed of the car? Here's a couple of ideas:

1. Watch what happens on a really steep uphill bit of road. Watch what happens when the driver puts the pedal to the metal, and holds it there. Does the car slow down? If so, ironically, that confirms the theory that pressing down on the gas pedal causes the car to speed up! Because it means the driver knows he needs to press it down further to prevent the speed dropping, but can't. It's the exception that proves the rule. (Just in case it isn't obvious, that's a metaphor for the zero lower bound on nominal interest rates.)

2. Ask the driver. If the driver says that pressing the gas pedal down makes the car go faster, and if the driver says he wants to go at a constant 100kms/hr, and if you see the car going a roughly constant 100kms/hr, then you figure the driver is probably right. Even more so if you ask him to slow the car to 80kms/hr, and he says "OK", and then the car does slow to a roughly constant 80kms/hr. If the driver were wrong about the relation between gas pedal and speed, he wouldn't be able to do that, and it wouldn't happen, except by sheer fluke. (Just in case it isn't obvious, that's a metaphor for inflation targeting.)

3. Find a total idiot driver, who doesn't understand the relation between gas pedals and speed, and who makes random jabs at the gas pedal that you know for certain are uncorrelated to hills or anything else that might affect the car's speed, and then do a multivariate regression of speed on gas and hills. But you had better be damned sure you know those jabs at the gas pedal really are random, and uncorrelated with hills and stuff. Which means this can only work if you are certain that you know more about what is and is not a hill than the driver does. Or you are certain he's pressing the gas pedal according to the music playing on the radio. Or something that definitely isn't a hill. Are you really really sure your instrument isn't a hill, or correlated with hills? And if so, why doesn't the driver know this, and why does he jab at the gas pedal in time with that instrument? You had better have a very good answer to those questions. And no, Granger-Sims causality does not answer those questions, or even try to.

Why is this idea so important for economists to be aware of? Because economists look at correlations in the data. And a lot of correlations in the data are created by someone looking at some first thing, and adjusting some second thing in response to the first thing, in order to control some third thing. That someone could be a government, or a central bank, or a firm, or a person. And the first, second, and third things could be almost anything. And if you are unaware of what Milton Friedman's thermostat tells you about the correlation between those three things, you will misunderstand the correlations between those three things. And you will make some bad mistakes about lots of things.

Milton Friedman's thermostat is an idea that is both important and right. Why are (almost all) economists unaware of this idea?

Here are some of my old posts, where I either explain the idea, or use it to explain why economists who are unaware of this idea are making mistakes, or use it to explain how to do it properly:

My simplest and clearest.

A bit more technical.

An application to critique econometric methods for identifying monetary shocks.

An application to critique tests of core inflation as an indicator. [Update, a much clearer version.]

An application to properly test core inflation as an indicator. And again, more simply.

I've probably missed some.