Saturday, April 7, 2018

Misconceptions about Milton Friedman's 1968 Presidential Address

For macroeconomists, Milton Friedman's (1968) Presidential Address to the American Economic Association about "The Role of Monetary Policy" marks a central event (American Economic Review, March 1968, pp. 1-17).  Friedman argued that monetary policy had limits. Actions by a central bank like the Federal Reserve could have short-run effects on an economy--either for better or for worse. But in the long-run, he argued, monetary policy affected only the price level. Variables like unemployment or the real interest rate were determined by market forces, and tended to move toward what Friedman called the "natural rate"--which is potentially confusing term for saying that they are determined by forces of supply and demand. 

Here, I'll give a quick overview of the thrust of Friedman's address, a plug for the recent issue of the Journal of Economic Perspectives, which has a lot more, and point out a useful follow-up article that clears up some misconceptions about Friedman's 1968 speech.

The Winter 2018 issue of the Journal of Economic Perspectives, where I work as Managing Editor, we published a three-paper symposium on "Friedman's Natural Rate Hypothesis After 50 Years." The papers are:

I won't try to summarize the papers here, along with the many themes they offer on how Friedman's speech influenced the macroeconomics that followed or what aspects of Friedman's analysis have held up better than others. But to giver a sense of what's a stake, here's an overview of Friedman's themes from the paper by Mankiw and Reis:

"Using these themes of the classical long run and the centrality of expectations, Friedman takes on policy questions with a simple bifurcation: what monetary policy cannot do and what monetary policy can do. It is a division that remains useful today (even though, as we discuss later, modern macroeconomists might include different items on each list). 
"Friedman begins with what monetary policy cannot do. He emphasizes that, except in the short run, the central bank cannot peg either interest rates or the unemployment rate. The argument regarding the unemployment rate is that the trade-off described by the Phillips curve is transitory and unemployment must eventually return to its natural rate, and so any attempt by the central bank to achieve otherwise will put inflation into an unstable spiral. The argument regarding interest rates is similar: because we can never know with much precision what the natural rate of interest is, any attempt to peg interest rates will also likely lead to inflation getting out of control. From a modern perspective, it is noteworthy that Friedman does not consider the possibility of feedback rules from unemployment and inflation as ways of setting interest rate policy, which today we call “Taylor rules” (Taylor 1993).

"When Friedman turns to what monetary policy can do, he says that the “first and most important lesson” is that “monetary policy can prevent money itself from being a major source of economic disturbance” (p. 12). Here we see the profound influence of his work with Anna Schwartz, especially their Monetary History of the United States. From their perspective, history is replete with examples of erroneous central bank actions and their consequences. The severity of the Great Depression is a case in point.

"It is significant that, while Friedman is often portrayed as an advocate for passive monetary policy, he is not dogmatic on this point. He notes that “monetary policy can contribute to offsetting major disturbances in the economic system arising from other sources” (p. 14). Fiscal policy, in particular, is mentioned as one of these other disturbances. Yet he cautions that this activist role should not be taken too far, in light of our limited ability to recognize shocks and gauge their magnitude in a timely fashion. The final section of Friedman’s presidential address concerns the conduct of monetary policy. He argues that the primary focus should be on something the central bank can control in the long run—that is, a nominal variable ... "

Edward Nelson offers a useful follow-up to these JEP papers in  “Seven Fallacies Concerning Milton Friedman’s `The Role of Monetary Policy,'" Finance and Economics Discussion Series 2018-013, Board of Governors of the Federal Reserve System, Nelson summarizes at the start:
"[T]here has been widespread and lasting acceptance of the paper’s position that monetary policy can achieve a long-run target for inflation but not a target for the level of output (or for other real variables). For example, in the United States, the Federal Open Market Committee’s (2017) “Statement on Longer-Run Goals and Policy Strategy” included the observations that the “inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation,” and that, in contrast, the “maximum level of employment is largely determined by nonmonetary factors,” so “it would not be appropriate to specify a fixed goal for employment.”
Nelson then lays out seven fallacies. The details are in his paper: here, I just list the fallacies with a few words of his explanations.
Fallacy 1: “The Role of Monetary Policy” was Friedman’s first public statement of the natural rate hypothesis
"Certainly, Friedman (1968) was his most extended articulation of the ideas (i) that an expansionary monetary policy that tended to raise the inflation rate would not permanently lower the unemployment rate, and (ii) that full employment and price stability were compatible objectives over long periods. But Friedman had outlined the same ideas in his writings and in other public outlets on several earlier occasions in the 1950s and 1960s."
Fallacy 2: The Friedman-Phelps Phillips curve was already presented in Samuelson and Solow’s (1960) analysis
"A key article on the Phillips curve that is often juxtaposed with Friedman (1968) is Samuelson  and Solow (1960). This paper is often (and correctly, in the present author’s view) characterized as advocating the position that there is a permanent tradeoff between the unemployment rate and  inflation in the United States."
Fallacy 3: Friedman’s specification of the Phillips curve was based on perfect competition and no nominal rigidities
"Modigliani (1977, p. 4) said of Friedman (1968) that “[i]ts basic message was that, despite appearances, wages were in reality perfectly flexible.” However, Friedman (1977, p. 13) took exception to this interpretation of his 1968 paper. Friedman pointed out that the definition of the natural rate of unemployment that he gave in 1968 had recognized the existence of imperfectly competitive elements in the setting of wages, including those arising from regulation of labor markets. Further support for Friedman’s contention that he had not assumed a perfectly competitive labor market is given by the material in his 1968 paper that noted the slow adjustment of nominal wages to demand and supply pressures. ... Consequently, that (1968 Friedman] framework is
consistent with prices being endogenous—both responding to, and serving as an impetus for, output movements—and the overall price level not being fully flexible in the short run."
Fallacy 4: Friedman’s (1968) account of monetary policy in the Great Depression contradicted the Monetary History’s version
"But the fact of a sharp decline in the monetary base during the prelude to, and early stages of, the 1929-1933 Great Contraction is not in dispute, and it is this decline to which Friedman (1968) was presumably referring." 
Fallacy 5: Friedman (1968) stated that a monetary expansion will keep the unemployment rate and the real interest rate below their natural rates for two decades
"[T]these statements are inferences from the following passage in Friedman (1968, p. 11): “But how long, you will say, is ‘temporary’? … I can 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.” The passage of Friedman (1968) just quoted does not, in fact, imply that a policy involving a shift to a new inflation rate involves twenty years of one-sided unemployment and real-interestrate gaps. Such prolonged gaps instead fall under the heading of Friedman’s “initial effects” of  the monetary policy change—effects that he explicitly associated with a two-to-five-year period, with the gaps receding beyond this period. Friedman described “full adjustment” as comprising decades, but such complete adjustment includes the lingering dynamics beyond the main  dynamics associated with the initial two-to-five year period. It is the two-to-five year period that would be associated with the bulk of the nonneutrality of the monetary policy change."
Fallacy 6: The zero lower bound on nominal interest rates invalidates the natural rate hypothesis
"A zero-bound situation undoubtedly makes the analysis of monetary policy more difficult. In addition, the central bank in a zero-bound situation has fewer tools that it can deploy to stimulate aggregate demand than it has in other circumstances. But, important as these complications are, neither of them implies that the long-run Phillips curve is not vertical."
Fallacy 7: Friedman’s (1968) treatment of an interest-rate peg was refuted by the rational expectations revolution. 
"The propositions that the liquidity effect fades over time and that real interest rates cannot be targeted in the long run by the central bank remain widely accepted today. These valid propositions underpinned Friedman’s critique of pegging of nominal interest rates."
Since the JEP published this symposium, I've run into some younger economists who have never read Friedman's talk and lack even a general familiarity with his argument. For academic economists of whatever vintage, it's an easily readable speech worth becoming acquainted with--or revisiting.