Thursday, November 08, 2007

Debates on macroeconomics hinge on rationality assumptions

Paul Krugman’s velvet-gloved attack on Milton Friedman in the New York Times has aroused a reaction. A particularly strong counterattack has come from Edward Nelson and Anna Schwartz.

The debate is interesting because some fundamental, issues of economics and political ideology arise. Both original papers are well-worth reading and fairly short. The following notes are selective interpretations.

Krugman

The counterattack by NS is hardly surprising – Krugman describes Friedman as ‘a great economist and a great man’ but in the same breath he describes him as ‘less than honest’. He sees Friedman as the counter-revolutionary who almost had to emerge to oppose the revolutionary theories of Keynes on the inability of capitalism to self-adjust back to full-employment. Rather than introspecting about the psychology of individual behaviour as Keynes had done, Friedman took the notion of ‘rational economic man’ more seriously and developed a theory of inter-temporal consumption behaviour and of inflation that was rooted in the precepts of rational behaviour. Krugman recognises that all modern thinking about consumption bears the mark of Friedman’s monumentally important work on the permanent income hypothesis - the idea that people's spending is only loosely tied to their current income so that the marginal propensity to consume is low as is the standard Keynesian fiscal multiplier.

But it is Friedman’s monetarism that Krugman finds less satisfactory as a body of theory. Keynes argument was that monetary policy was ineffective during the Great Depression because of a 'liquidity trap’ – a situation where interest rates were so low people assumed they could only rise and hence were reluctant to invest. The only way out for Keynes was fiscal policy involving increased government spending. This view of course has ideological implications that Friedman did not approve of but Friedman also argued it was flawed on the basis of logic and evidence. He argued that Keynes had misdiagnosed the Great Depression and that ‘money did matter’. He saw the failure of the Federal Reserve to prevent a contraction of the money supply as evidence for the supreme potency of monetary policy rather than a sign of its ineffectiveness. To Krugman this is arguable because the Federal Reserve did increase the monetary base (currency held by the public plus bank reserves, an aggregate which the Fed does control) even though the money stock did fall markedly. It fell because banks were failing everywhere and individuals sought to hold onto their cash whilst banks were reluctant to lend.

Krugman claims Friedman was dishonest by turning the proposition around to say the Fed caused the Depression. Krugman also sees evidence of stagnation in the Japanese economy in the 1980s and 1990s, when interest rates were for a time zero, as further evidence of the liquidity trap proposition and of the ineffectiveness of monetary policy.

Nelson-Schwartz

The counterattack by NS is based on a claimed refutation of Krugman’s assessment of Friedman's views on monetary policy.

The success of monetary policy since the 1980s is not taken as a refutation of Friedman's economics to NS since they take the core of Friedman’s views to be the rejection of the case for wage-price controls, a rejection they claim is supported by modern central banking. They claim opposition to price controls was not common ground with Keynesians and they cite statements by Keynesians (such as James Tobin and Paul Samuelson) to buttress their arguments. Moreover, the view that monetary policy can successfully target inflation and that monetary policy is the decisive instrument for addressing inflation, a position many central bankers would agree on, they take as an endorsement of Friedman’s position.

NS take particular exception to Krugman’s views on the liquidity trap. They claim open market purchases of bonds could have offset the money supply collapse during the Depression and that monetary expansion helped the Japanese economy recover after 2001.

To NC what was decisive about Friedman's views was his rejection of Keynesian cost-push and simple Phillips curve views of inflation based on money illusion. Friedman believed inflation depended on monetary policy via aggregate demand. Cost-push pressures could only operate with an accommodating monetary policy. The Phillips curve Friedman believed in involved expected real wages (depending on expected prices) as a function of unemployment. In the long-run this trade-`off would vanish as unemployment gravitated to its natural level. Inflation in the 1970s was then due to excessive monetary ease.

While monetarism is often taken to reflect an overwhelming concern with monetary aggregates, to NS it should instead reflect the view that inflation can and should be addressed via monetary policy. Other contributions by Friedman included his emphasis on the distinction between real and nominal rates of interest, the costs of inflation in terms of bringing about relative price distortions, the problems of long and variable lags in the effects of monetary policy, refutation of the importance of so-called output gaps because of measurement issues, his pioneering work on the benefits of flexible exchange rates and his rejection of the case for qualitative controls on credit availability.

To me this is a novel interpretation of monetarism. My belief was always that monetarists saw the money stock as a well-defined aggregate which should grow smoothly through time at a low rate both to limit inflation and because varying its growth had complex lag effects on the macroeconomy.

My main question to monetarists such as NS however is why the relation between monetary aggregates and economic activity broke down so markedly after about 1980. NS claim that the payment of interest on money has made the identification of monetary aggregates difficulties so that the main contributions of monetarism are in providing insights that do not depend on such measurements. This comes close to rejecting what I always believed was central to monetarism.

I also think NS come close to saying that belief in the efficacy and importance of monetary policy makes one a monetarist. This seems to me much too strong.

The NS response is bitter in a way that I doubt Friedman would have appreciated. NS claim that Krugman sought to denigrate Friedman but I did not see that in the Krugman article at all. I think Friedman did bring back into focus the need for central banks to target inflation. Moreover I think most economists would now agree that wage and price controls can, in some circumstances, be useful if they can deflate inflationary expectations. In addition monetary targeting has been abandoned everywhere - this does seem to me a key part of Friedman’s early thinking.

Final remarks

Friedman made many contributions to monetary macroeconomics and to economics generally - the commentary here is on his contributions to macroeconomics but he also made very important contributions to our understanding of risk.

On the macroeconomic issues it is interesting to me that both sides of the monetarist versus Keynesian debate see evidence on the possibility of liquidity traps during the Great Depression and in Post-war Japan as crucial to their cases.

I am also interested in Friedman’s emphasis on the neoclassical foundations of macroeconomics and his emphasis on the role of rational economic man. Modern theorists such as Akerloff (see ‘The Missing Motivation’....here) re reinterpreting Keynes as a sophisticated psychologist whose insights provided a much more realistic view of the way people act based on what might now be called behavioural economics. Basic ideas in economic theory - how rational are people? - are still driving important macroeconomic policy debates.

7 comments:

Uncle Milton said...

arry,

NS are both wrong and right when they say that belief in the efficacy of monetary policy makes one a monetarist; wrong in the sense that all economists nowadays believe that monetary policy can control inflation, but right in that this was always the case. Post war Keynesians, based on what happened in the Depression, said that monetary policy was ineffective as instrument for inflation control. They wanted to rely on incomes policy or fiscal policy instead. This was very clear in both academic debates (such as between Friedman and James Tobin) and in policy pronouncments, such as by the Radcliffe Committee in Britain in the late 1950s.

Of course as you point out NS are re-writing history when they say that control of monetary aggregates was a side issue for monetarists. It was the very essence of monetarism in both theory and practice, most recently in Britain in the 1980s, when Margaret Thatcher vigorously endorsed (on Friedman's advice) the link between the money supply and inflation as being as scientific as Newton's law of gravity (or words to that effect).

Overall, NS come across as disciples whose mission it is to defend the works of the the great monetarist Prophet.

This is understandable in Schwarz's case as she was Friedman's co-author of their great work A Monetary History of the United States but more curious in Nelson's case, though he was a true believing monetarist even as a young economic graduate from Macquarie University. Someone there taught him the Monetarist Truth and he swallowed it whole. He has certainly landed in the right place at the Federal Reserve bank of St Louis, historically and still the headquarters of Friedmanesque 1960s monetarism.

Anonymous said...

OF course Friedman was right about monetary policy and Krugman as usual is a disnhonst bastard.

Government spending can never get a nation out of a depression. the 30's US and Japan 90's proved that.

hc said...

Milton,

As a graduate of Macquarie I think I know who sponsored the monetarist zeal.

Its a very human mistake for people to get defensive about ideas.

I recall studying the work of the Radcliffe committee as an undergraduate in the late 1960s -early 1970s. My memory is that it was treated as an extreme view though, yes, undergraduate curricula in those day were focused on public spending and tax multipliers.

Partly this was because Australia then had fixed exchange rates not because of concern about liquidity traps.

Anonymous said...

Harry

There no such thing as a liquidity trap, it's keynesian garbage.

And although Japan had Zirp, interst rates weren't zero while the asset and labor markets weren't allowed to clear.

conrad said...

Thanks for that article. I found it very interesting.

It seems to me that the idea of rational economic man must be the worst possible basis on which to do the type of research you do into drug usage in some instances -- its funny that things like addicitive behavior and risk taking work in reverse in terms of age and possible negative consequences.

hc said...

Conrad, The rationality assumption is often the simplest assumption. It is difficult to model the wrinkles of actual behaviour. Writers like Akerlof (I give the link) argue that Keynes was an insightful psychologist with insight into the way people actually do save and spend. I've made the same comment on Adam Smith who in Theory of Moral Sentiments took a much broader view of human behaviour than simple rationality.

A lot of economists take the Becker-Murphy model of rational addiction seriously. Increasingly though they don't.

I definitely think it is close to being a worthless model for assessing policy. I weasted a year of my life working through it before I came to this conclusion.

Jan said...

I am definitely with Friedman on this one. He makes two main claims in this respect (see his 1967 Presidential address for example).

1) Monetary policy cannot permanently peg unemployment below some natural (understand equilibrium) level.
2) (high) inflation is always monetary phenomenon.

I believe both claims are more true than ever and conventional wisdom among central bankers.

The first one says that the long-run Phillips curve is not downward sloping which is uncontroversial. He never claimed that monetary policy cannot reduce unemployment temporarily! From this perspective, to me the standard New Keynesian model (which assumes a long-run vertical Phillips curve) is a lot more in line with Friedman than it is with Keynes.

The second one says that if you observe high inflation it is due to excessive money provision, which again can hardly be disputed. But this does not necessarily claim the reverse, i.e. that high money growth is always associated with high inflation. And while the quantity theory implies a tight relationship between money and inflation (and hence both of these), Friedman clearly stressed the former causality as he was interested in the causes of the high inflation observed at the time.