Further thoughts on Friedman's Presidential address
By Scott Sumner
A few weeks back I did a couple posts (here and here) on Friedman’s highly influential AEA Presidential address, which was delivered 50 years ago. Today, I’ll make a few more observations. This is from the very first page:
In the first flush of enthusiasm about the newly created Federal Reserve System, many observers attributed the relative stability of the 1920s to the System’s capacity for fine tuning-to apply an apt modern term. It came to be widely believed that a new era had arrived in which business cycles had been rendered obsolete by advances in monetary technology. This opinion was shared by economist and layman alike, though, of course, there were some dissonant voices. The Great Contraction destroyed this naive attitude. Opinion swung to the other extreme. Monetary policy was a string. You could pull on it to stop inflation but you could not push on it to halt recession. You could lead a horse to water but you could not make him drink. Such theory by aphorism was soon replaced by Keynes’ rigorous and sophisticated analysis.
Keynes offered simultaneously an explanation for the presumed impotence of monetary policy to stem the depression, a nonmonetary interpretation of the depression, and an alternative to monetary policy for meeting the depression and his offering was avidly accepted.
That final sentence is a really nice summary of what makes the General Theory so distinctive. Friedman was old enough to recall the Great Depression, and notice that he points out that the liquidity trap concept was actually a sort of conventional wisdom in the early 1930s, and was only later formalized in theoretical models by Keynes and others. That’s actually a bit like 2008, where the “folk wisdom” about the Great Recession developed almost immediately, and the models to justify that folk wisdom tended to follow later. (As you may know, I believe the conventional wisdom was mostly wrong.)
Of course there were models such as Krugman’s 1998 expectations trap paper, which anticipated some of the difficulties of 2008-09, but at the time Krugman did not see that model as implying that monetary policy, broadly defined, was ineffective. Put simply, 2008-09 in America made Western economists much more pessimistic than did 1997-2006 in Japan, because Western economists respected Ben Bernanke far more than they respected a bunch of Japanese central bankers about which they knew almost nothing.
Here is Friedman on the pace of the self-correcting mechanism, sounding much more Keynesian that I would have expected:
But how long, you will say, is “temporary”? For interest rates, we have some systematic evidence on how long each of the several effects takes to work itself out. For unemployment, we do not. I call at most venture a personal judgment, based on some examination of the historical evidence, that the initial effects of a higher and unanticipated rate of inflation last for something like two to five years; that this initial effect then begins to be reversed; and that a full adjustment to the new rate of inflation takes about as long for employment as for interest rates, say, a couple of decades. For both interest rates and employment, let me add a qualification. These estimates are for changes in the rate of inflation of the order of magnitude that has been experienced in the United States. For much more sizable changes, such as those experienced in South American countries, the whole adjustment process is greatly speeded up.
Here’s why this surprised me. I recall quite a few natural rate hypothesis skeptics pointing out that it took a long time for the unemployment rate to fall back to pre-recession levels after the Great Recession, People wondered why it would take so long for the public to adjust wages and prices in response to the fall in NGDP. And yet here Friedman suggests a full adjustment might take “decades” whereas it actually took more like 8 years (say from early 2009 to early 2017.) And note that Friedman uses an expansionary shock, a situation where I’d expect the economy to adjust even more rapidly than for a contractionary shock (as wages are probably a bit stickier in the downwards direction.)
The problem here is that Friedman had too little faith in his model. As of 1968, there as no sign of the labor market adjusting to the higher inflation rate of the 1960s, yet by 1970 the adjustment was essentially complete. On the other hand, you can’t really blame Friedman for playing it safe, as recessions are hard to predict and the weight of opinion at that time was all in the other direction. In the kingdom of the blind, the one-eyed economist quickly becomes king.
Here’s the very next paragraph:
To state the general conclusion still differently, the monetary authority controls nominal quantities-directly, the quantity of its own liabilities. In principle, it can use this control to peg a nominal quantity-an exchange rate: the price level, the nominal level of national income, the quantity of money by one or another definition-or to peg the rate of change in a nominal quantity-the rate of inflation or deflation, the rate of growth or decline in nominal national income, the rate of growth of the quantity of money. It cannot use its control over nominal quantities to peg a real quantity-the real rate of interest, the rate of unemployment, the level of real national income, the real quantity of money, the rate of growth of real national income, or the rate of growth of the real quantity of money.
There’s a lot of sophisticated analysis summarized in that brief paragraph, but one conspicuous absence: nominal interest rates. Elsewhere Friedman makes it very clear that he doesn’t think the central bank can peg nominal interest rates. But including that insight in this paragraph would completely throw off the symmetry. He is basically saying that the central bank can control virtually any nominal variable but not a single real variable.
The NeoFisherians can be seen as taking the symmetry to be even more fundamental than Friedman believes to be the case. They’d include nominal interest rates as one of the things the central bank can peg.
At the very end of the article, Friedman advocates a fixed money supply growth rate target, something in the range of 3% to 5% per year. Before doing so, however, he offers a limited endorsement of policy discretion, in unusual circumstances:
Finally, monetary policy can contribute to offsetting major disturbances in the economic system arising from other sources. If there is an independent secular exhilaration-as the postwar expansion was described by the proponents of secular stagnation-monetary policy can in principle help to hold it in check by a slower rate of monetary growth than would otherwise be desirable. If, as now, an explosive federal budget threatens unprecedented deficits, monetary policy can hold any inflationary dangers in check by a slower rate of monetary growth than would otherwise be desirable. This will temporarily mean higher interest rates than would otherwise prevail-to enable the government to borrow; the sums needed to finance the deficit-but by preventing the speeding up of inflation, it may well mean both lower prices and lower nominal interest rates for the long pull. If the end of a substantial war offers the country an opportunity to shift resources from wartime to peacetime production, monetary policy can ease the transition by a higher rate of monetary growth than would otherwise be desirable–though experience is not very encouraging that it can do so without going too far.
In retrospect, Friedman was wrong about budget deficits. The deficits of the 1960s were not very large, and were far less important than either Friedman or his critics assumed at the time.
Now we face the opposite problem—people slightly underrate the importance of budget deficits.