Milton Friedman's Macroeconomic Legacy, 6/27
macroeconomics is an incredibly hard thing to get right. It’s very hard to empirically test any of the theories — at best you can make policy, and wait for history to happen, and then observe whether you kinda-sorta got it right. So how are Milton Friedman’s macroeconomic ideas holding up now? The post below explores this question.
I recently wrote a Bloomberg View post about consumption Euler equations, and how these are increasingly being targeted as a broken piece of macroeconomics. I traced the idea back to Milton Friedman and the Permanent Income Hypothesis, and Bloomberg decided (wisely) to go with Friedman for the headline. "Economists Give Up on Milton Friedman's Biggest Idea" is probably going to get orders of magnitude more clicks than "Economists Search for Replacement for Infinitely Lived Perfectly Far-Sighted Model of Consumption Smoothing".
The headline may have been better for clicks, but it is quite misleading. It is particularly misleading to call it Friedman’s “biggest idea.”
I think that the way Smith goes about doing his evaluation of Friedman is quite wrong. But rather than get into why I disagree, let me proceed to do the evaluation my way.
There is a joke among macroeconomists that students cannot look at last year’s exam to prepare for this year’s. The professors always ask the same questions, but they change the answers. So “incredibly hard thing to get right” is an understatement. I do not want to compare Friedman’s views to what Noah Smith or someone else would say now. I want to compare them to what economists believed then, meaning 1967, prior to Friedman’s address to the American Economic Association.
Back then, monetarism had about the same status as astrology. Robert Solow could quip, “Everything reminds Milton of the money supply. Everything reminds me of sex, but at least I keep it out of my papers.”
As of 1967, Friedman was one of a small set of economists who paid attention to the growth rate of the money supply. By 1980, more economists were paying attention to it. But that has not lasted. All macroeconomists pay attention to the Fed, but only a small set pay attention to the growth rate of the money supply. Most of them pay attention to interest rates. Those of you familiar with Scott Sumner know that he scorns the focus on interest rates and instead urges paying attention to forecasts of nominal GDP or nominal income.
Back then, the Phillips Curve was thought to present policy makers with a “menu” of choices for inflation and unemployment. If they chose to aim for a low value for unemployment, the result would be a high value for inflation, and vice-versa.
Back then, “fine tuning” was thought possible. Economists believed that their advice, if followed by policy makers, could eliminate recessions. The advice would focus on fiscal policy, meaning changes in government spending and taxes deliberately undertaken to manage “aggregate demand.”
Milton Friedman’s project was to undermine the theories that supported policy discretion. He had several objections.
First, regarding the idea of using temporary tax cuts to spur the economy, he proposed the Permanent Income Hypothesis. He never said that all consumers optimize their spending patterns using stochastic calculus—the Euler Equation was an element of the technically elegant but utterly stupid consensus that emerged in the decades after Friedman roiled the profession. It was part of Olivier Blanchard’s survey that infamously concluded that “the state of macroeconomics is good” .
Friedman merely claimed that the propensity to consume out of a temporary tax cut would be lower than the propensity to consume out of a permanent tax cut. If so, then temporary tax cuts might not be very stimulative when enacted. Instead, much of the tax cut would be saved, and it might be spent in later years, even after the economy had recovered. If you want evidence that Friedman was roughly correct, all you have to do is notice that economists believe that consumers have savings left over from the COVID relief checks, and that this is now fueling inflation. I cannot think of any economist who disagrees with the view that spending out of temporary tax cuts is likely to be less than spending out of permanent tax cuts.
Second, regarding the use of discretionary policy, Friedman worried about “long and variable lags” between the attempt to steer the economy and the impact of policy. You might initiate a policy to fight a recession this year, but the impact could show up two years later, when the expansionary policy was no longer appropriate. James Tobin, who disagreed with Friedman, nevertheless eloquently described Friedman’s view that a discretionary regime would be “like an amateur shower tuner, alternately being scalded and chilled.” In response to this, economists proceeded to devote considerable attention to the challenge of ensuring that policy was countercyclical instead of reinforcing the cycle. Recall that in the Obama years, Larry Summers tried, not very successfully, to guide policy with the mantra that stimulus should be “timely, targeted, and temporary.”
Many economists came to support Friedman’s view, which is that rules would work better than discretion. Ben Bernanke threw out the rules playbook when the Financial Crisis hit in 2008. Many economists have subsequently praised him. They also praised the response by Congress and the Fed to COVID. By the time we are finished dealing with our current inflation, economists may rediscover the case for rules.
Third, regarding using the Phillips Curve as a “menu,” Friedman was particularly devastating. He asserted that there was a “natural rate of unemployment” to which the economy gravitates. He claimed that trying to maintain unemployment below that rate would lead not to a one-time increase in inflation, but to an accelerating rate of inflation. According to the state of thinking in 1967, stagflation was impossible. Friedman warned that it was possible, and in the 1970s stagflation is what we got.
I think that macroeconomics, as conventionally practiced, is very nearly hopeless. I do not think that it helps much to think in terms of a “representative household” or “representative firm.” You fool yourself if you think of the economy as one giant GDP factory. You fool yourself by thinking that “spending creates jobs, and jobs create spending.” In fact, jobs are created when entrepreneurs discover sustainable patterns of specialization and trade. Hence my book, Specialization and Trade.
Once you get rid of the “representative agent” mindset, it is easier to understand how government deficits create a false sense of wealth. The person lending to the government (by investing in government bonds) is not the same as the person receiving payments from the government. The lender thinks: I have less cash on hand today, but I will get it back next year, so I am approximately where I was before. The recipient thinks: I have more money now! Perceived wealth goes up, because there is no offsetting person who thinks: I am poorer now, because the government has borrowed money and will soon tax me to get it back.
In the “representative agent” model, you are the only person in the economy. The government borrows from you to write you a check. It is obvious to you that this does not make you wealthier. If only we lived in that simple world, government deficits would not appear to be a free lunch, and politicians would have less incentive to run deficits.
I also do not subscribe to any linear models of inflation. Inflation is not proportional to money growth. It is not inversely related to the unemployment rate.
I think of inflation as having two possible regimes. In one regime, it is low and stable. In the other regime, it is high and variable. It takes a lot of effort to destabilize the dollar. Once it is destabilized, it takes a lot of effort to stabilize it again.
The excessive spending on the Vietnam War and President Johnson’s domestic programs made our gold peg unsustainable. Then President Nixon ended the gold peg and administered the adverse supply shock of wage and price controls. Those policies helped set the stage for the inflationary breakout of the 1970s.
The process of unwinding inflation was long and difficult. In the early 1980s, interest rates were very high, disrupting major sectors of the economy.
More recently, Presidents Bush and Obama ran large deficits. To be honest, I thought that was enough to destabilize the dollar. I was wrong then.
Under President Trump, the response to COVID was to run record deficits, creating more paper wealth even as production and distribution were being curtailed by people avoiding workplaces, mostly by choice but sometimes by government edict. President Biden wanted to run even more deficits. Only Senator Manchin stood in the way of the wildest spending proposals. After more than a decade of fiscal profligacy, the vast creation of phony paper wealth finally reached the point where inflation could no longer be contained. We have to pray that getting things back under control will not be as arduous a process as it was in the early 1980s.
What I believe today certainly does not resemble what economists believed in 1967. But I am no disciple of Milton Friedman, either. I do not think that the Fed can follow a money growth rule, because it is too deeply committed to propping up the market for government debt. And even if it were to follow a money growth rule, I think that would do little to mitigate the inflationary impulse of government deficits of the past dozen years.
These 202x years are not the 70s calling. Then, there was a huge increased demand from Boomers, and a shortage of capital.
Today, no big demographic increase, and no big shortage of capital.
Then, "inflation expectations" were not so much talked about - now they're assumed to be ever-present, and mostly rational. Expecting inflation, and planning for inflation, usually causes individuals to take actions which increase inflation.
Energy price increase ARE similar to the 70s.
Increasing energy prices look a lot like inflation, "(almost) all prices rise", even tho the higher energy using products go up relatively more. While not quite necessary, and certainly not sufficient (there wasn't big inflation with oil at $150/bbl in 2008), higher oil prices, in looking like inflation, DO increase inflation expectations.
The main driver of this years big inflation is last year's excess gov't spending. Trump spent the most that could be spent without big inflation; Biden spending more was spending too much.
But I don't see the dollar getting weaker against the Euro nor the Yen, so it's not like there is an obvious alt currency for investors who don't trust US inflation.
However, if Russia & China combine to lead to an alt BRICS (incl. Brazil, India, South Africa) international payments regime, there might be a viable non-USD international alternative.
Excellent essay. Two observations:
1) Milton Friedman's money supply rules required stable money velocity. That broke down as the government deregulated the financial institutions. in the '80s Friedman and his disciples predicted inflation that never occurred because their basic equation no longer held.
2) Bernanke's biggest failure was not realizing that quantitative easing was making the Fed a giant S&L and providing to a way to unwind it.