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.
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.
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.
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.