What’s Wrong with Monetarism?

UPDATE: (05/06): In an email Richard Lipsey has chided me for seeming to endorse the notion that 1970s stagflation refuted Keynesian economics. Lipsey rightly points out that by introducing inflation expectations into the Phillips Curve or the Aggregate Supply Curve, a standard Keynesian model is perfectly capable of explaining stagflation, so that it is simply wrong to suggest that 1970s stagflation constituted an empirical refutation of Keynesian theory. So my statement in the penultimate paragraph that the k-percent rule

was empirically demolished in the 1980s in a failure even more embarrassing than the stagflation failure of Keynesian economics.

should be amended to read “the supposed stagflation failure of Keynesian economics.”

Brad DeLong recently did a post (“The Disappearance of Monetarism”) referencing an old (apparently unpublished) paper of his following up his 2000 article (“The Triumph of Monetarism”) in the Journal of Economic Perspectives. Paul Krugman added his own gloss on DeLong on Friedman in a post called “Why Monetarism Failed.” In the JEP paper, DeLong argued that the New Keynesian policy consensus of the 1990s was built on the foundation of what DeLong called “classic monetarism,” the analytical core of the doctrine developed by Friedman in the 1950s and 1960s, a core that survived the demise of what he called “political monetarism,” the set of factual assumptions and policy preferences required to justify Friedman’s k-percent rule as the holy grail of monetary policy.

In his follow-up paper, DeLong balanced his enthusiasm for Friedman with a bow toward Keynes, noting the influence of Keynes on both classic and political monetarism, arguing that, unlike earlier adherents of the quantity theory, Friedman believed that a passive monetary policy was not the appropriate policy stance during the Great Depression; Friedman famously held the Fed responsible for the depth and duration of what he called the Great Contraction, because it had allowed the US money supply to drop by a third between 1929 and 1933. This was in sharp contrast to hard-core laissez-faire opponents of Fed policy, who regarded even the mild and largely ineffectual steps taken by the Fed – increasing the monetary base by 15% – as illegitimate interventionism to obstruct the salutary liquidation of bad investments, thereby postponing the necessary reallocation of real resources to more valuable uses. So, according to DeLong, Friedman, no less than Keynes, was battling against the hard-core laissez-faire opponents of any positive action to speed recovery from the Depression. While Keynes believed that in a deep depression only fiscal policy would be effective, Friedman believed that, even in a deep depression, monetary policy would be effective. But both agreed that there was no structural reason why stimulus would necessarily counterproductive; both rejected the idea that only if the increased output generated during the recovery was of a particular composition would recovery be sustainable.

Indeed, that’s why Friedman has always been regarded with suspicion by laissez-faire dogmatists who correctly judged him to be soft in his criticism of Keynesian doctrines, never having disputed the possibility that “artificially” increasing demand – either by government spending or by money creation — in a deep depression could lead to sustainable economic growth. From the point of view of laissez-faire dogmatists that concession to Keynesianism constituted a total sellout of fundamental free-market principles.

Friedman parried such attacks on the purity of his free-market dogmatism with a counterattack against his free-market dogmatist opponents, arguing that the gold standard to which they were attached so fervently was itself inconsistent with free-market principles, because, in virtually all historical instances of the gold standard, the monetary authorities charged with overseeing or administering the gold standard retained discretionary authority allowing them to set interest rates and exercise control over the quantity of money. Because monetary authorities retained substantial discretionary latitude under the gold standard, Friedman argued that a gold standard was institutionally inadequate and incapable of constraining the behavior of the monetary authorities responsible for its operation.

The point of a gold standard, in Friedman’s view, was that it makes it costly to increase the quantity of money. That might once have been true, but advances in banking technology eventually made it easy for banks to increase the quantity of money without any increase in the quantity of gold, making inflation possible even under a gold standard. True, eventually the inflation would have to be reversed to maintain the gold standard, but that simply made alternative periods of boom and bust inevitable. Thus, the gold standard, i.e., a mere obligation to convert banknotes or deposits into gold, was an inadequate constraint on the quantity of money, and an inadequate systemic assurance of stability.

In other words, if the point of a gold standard is to prevent the quantity of money from growing excessively, then, why not just eliminate the middleman, and simply establish a monetary rule constraining the growth in the quantity of money. That was why Friedman believed that his k-percent rule – please pardon the expression – trumped the gold standard, accomplishing directly what the gold standard could not accomplish, even indirectly: a gradual steady increase in the quantity of money that would prevent monetary-induced booms and busts.

Moreover, the k-percent rule made the monetary authority responsible for one thing, and one thing alone, imposing a rule on the monetary authority prescribing the time path of a targeted instrument – the quantity of money – over which the monetary authority has direct control: the quantity of money. The belief that the monetary authority in a modern banking system has direct control over the quantity of money was, of course, an obvious mistake. That the mistake could have persisted as long as it did was the result of the analytical distraction of the money multiplier: one of the leading fallacies of twentieth-century monetary thought, a fallacy that introductory textbooks unfortunately continue even now to foist upon unsuspecting students.

The money multiplier is not a structural supply-side variable, it is a reduced-form variable incorporating both supply-side and demand-side parameters, but Friedman and other Monetarists insisted on treating it as if it were a structural — and a deep structural variable at that – supply variable, so that it no less vulnerable to the Lucas Critique than, say, the Phillips Curve. Nevertheless, for at least a decade and a half after his refutation of the structural Phillips Curve, demonstrating its dangers as a guide to policy making, Friedman continued treating the money multiplier as if it were a deep structural variable, leading to the Monetarist forecasting debacle of the 1980s when Friedman and his acolytes were confidently predicting – over and over again — the return of double-digit inflation because the quantity of money was increasing for most of the 1980s at double-digit rates.

So once the k-percent rule collapsed under an avalanche of contradictory evidence, the Monetarist alternative to the gold standard that Friedman had persuasively, though fallaciously, argued was, on strictly libertarian grounds, preferable to the gold standard, the gold standard once again became the default position of laissez-faire dogmatists. There was to be sure some consideration given to free banking as an alternative to the gold standard. In his old age, after winning the Nobel Prize, F. A. Hayek introduced a proposal for direct currency competition — the elimination of legal tender laws and the like – which he later developed into a proposal for the denationalization of money. Hayek’s proposals suggested that convertibility into a real commodity was not necessary for a non-legal tender currency to have value – a proposition which I have argued is fallacious. So Hayek can be regarded as the grandfather of crypto currencies like the bitcoin. On the other hand, advocates of free banking, with a few exceptions like Earl Thompson and me, have generally gravitated back to the gold standard.

So while I agree with DeLong and Krugman (and for that matter with his many laissez-faire dogmatist critics) that Friedman had Keynesian inclinations which, depending on his audience, he sometimes emphasized, and sometimes suppressed, the most important reason that he was unable to retain his hold on right-wing monetary-economics thinking is that his key monetary-policy proposal – the k-percent rule – was empirically demolished in a failure even more embarrassing than the stagflation failure of Keynesian economics. With the k-percent rule no longer available as an alternative, what’s a right-wing ideologue to do?

Anyone for nominal gross domestic product level targeting (or NGDPLT for short)?