“The first and most important lesson that history teaches about what monetary policy can do….and it is a lesson of the most profound importance…is that monetary policy can prevent money itself from being a major source of economic disturbance.” Milton Friedman

“If you read Mr. Friedman’s 1967 speech, ‘The Role of Monetary Policy’, I think it is obvious that our central bank, The Federal Reserve System, has long ignored Mr. Friedman’s monetary advice and warnings, and as a result, I and many others believe its imprudent policies were a major source of the 2008 global financial crisis.” Mike Perry, former Chairman and CEO, IndyMac Bank

Key Excerpts from Nobel Laureate and Monetary Policy Expert Milton Friedman’s Presidential address delivered at the Eightieth Annual Meeting of the American Economic Association, Washington D.C., December 29, 1967, and republished in March 1968 in The American Economic Review entitled “The Role of Monetary Policy”:

“There is wide agreement about the major goals of economic policy: high employment, stable prices, and rapid growth. There is less agreement that these goals are mutually compatible or, among those who regard them as incompatible, about the terms at which they can and should be substituted for one another. There is least agreement about the role various instruments of policy can and should play in achieving the several goals.”

 “My topic for tonight is the tonight is the role of one such instrument….monetary policy.”

“The wide acceptance of these views (Keynesian views re. The Great Contraction/Depression) in the economics profession meant that for some two decades monetary policy was believed by all but a few reactionary souls to have been rendered obsolete by new economic knowledge. Money did not matter.”

“These views produced a widespread adoption of cheap money policies after the war (WWII). And they received a rude shock when these policies failed in country after country, when central bank after central bank was forced to give up the pretense that it could indefinitely keep ‘the’ rate of interest at a low level.”

“Inflation, stimulated by cheap money policies, not the widely heralded postwar depression, turned out to be the order of the day. The result was the beginning of a revival of belief in the potency of monetary policy.”

“The revival of the belief in the potency of monetary policy was fostered also by a re-evaluation of the role money played from 1929 to 1933. Keynes and most other economists of the time believed that the Great Contraction (Depression) in the United States occurred despite aggressive expansionary policies by the monetary authorities…..Recent studies have demonstrated that the facts are precisely the reverse: the U.S. monetary authorities followed highly deflationary policies. The quantity of money in the United States fell by one-third in the course of the contraction….The Great Depression is tragic testimony to the power of monetary policy…..not, as Keynes and so many of his contemporaries believed, evidence of its impotence.”

“In the United States the revival of belief in the potency of monetary policy was strengthened also by increasing disillusionment with fiscal policy, not so much with its potential to affect aggregate demand as with the practical and political feasibility of using it.”

“’Fine-tuning’ (of monetary policy to affect the economy) is a marvelously evocative phrase in this electronic age, but it has little resemblance to what is possible in practice….not, I might add, an unmixed evil.”

“It’s hard to realize how radical has been the change in professional opinion on the role of money. Hardly an economist today accepts views that were common coin some two decades ago.”

“Today, primacy (of monetary policy) is assigned to the promotion of full employment, with the prevention of inflation a continuing but definitely secondary objective.”

“I stress nonetheless the similarity between the views that prevailed in the late ‘twenties and those that prevail today because I fear that, now as then, the pendulum may well have swung too far, that now, as then, we are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve, and as a result, in danger of preventing it from making the contribution it is capable of making.”

“Unaccustomed as I am to denigrating the importance of money, I therefore shall, as my first task, stress what monetary policy cannot do.”

“From the infinite world of negation, I have selected two limitations of monetary policy to discuss: 1) It cannot peg interest rates for more than very limited periods; 2) It cannot peg the rate of unemployment for more than very limited periods.”

“History has already persuaded many of you about the first limitation….The limitation derives from a much misunderstood feature of the relationship between money and interest rates….Paradoxically, the monetary authority could assure low nominal interest rates of interest…but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy. Similarly, it could assure high nominal interest rates by engaging in an inflationary policy and accepting a temporary movement in interest rates in the opposite direction.”

“These considerations not only explain why monetary policy cannot peg interest rates; they also explain why interest rates are such a misleading indicator of whether monetary policy is ‘tight’ or ‘easy’. For that, it is far better to look at the rate of change of the quantity of money.”

“The second limitation I wish to discuss goes more against the grain of current thinking. Monetary growth, it is widely held, will tend to stimulate employment; monetary contraction, to retard employment. Why then, cannot the monetary authority adopt a target for employment or unemployment…?”

“The reason it cannot is precisely the same as for interest rates….the difference between the immediate and the delayed consequences of such a policy.”

“The monetary authority can make the market rate less than the natural rate only by inflation. It can make the market rate higher than the natural rate only by deflation.”

“This analysis has its close counterpart in the employment market. At any moment of time, there is some level of employment which has the property that is consistent with equilibrium in the structure of real wage rates. At that level of unemployment, real wage rates are tending on the average to rise at a ‘normal’ secular rate, i.e., at a rate that can be indefinitely maintained as long as capital formation, technological improvements, etc., remain on their long-run trends. A lower level of unemployment is an indication that there is an excess demand for labor that will produce upward pressure on real wage rates. A higher level of unemployment is an indication that there is an excess supply of labor that will produce downward pressure on real wage rates.”

“You will recognize the close similarity between this statement and the celebrated Phillips Curve….But, unfortunately, it contains a basic defect…..the failure to distinguish between nominal wages and real wages….”

“Suppose, by contrast, that everyone anticipates that prices will rise at a rate of more than 75 percent a year…..as, for example, Brazilians did, a few years ago. Then wages must rise at the rate simply to keep real wages unchanged. An excess supply of labor will be reflected in a less rapid rise in nominal wages than in anticipated prices not in an absolute decline in wages.”

“To avoid misunderstanding, let me emphasize that by using the term ‘natural’ rate of unemployment, I do not mean to suggest that it is immutable and unchangeable. On the contrary, many of the market characteristics that determine its level are man-made and policy-made.”

“Let us assume that the monetary authority tries to peg the ‘market’ rate of unemployment at a level below the ‘natural’ rate….As in the interest rate case, the ‘market’ rate can be kept below the ‘natural’ rate only by inflation. And, as in the interest rate case too, only by accelerating inflation.”

“What if the monetary authority chose the ‘natural’ rate….either of interest or unemployment….as its target? One problem is that it cannot know what the ‘natural’ rate is. Unfortunately, we have as yet devised no method to estimate accurately and readily the natural rate of either interest or unemployment. And the ‘natural’ rate will itself change from time to time. But the basic problem is that even if the monetary authority knew the ‘natural’ rate, and attempted to peg the market rate at that level, it would not be led to a determinate policy. The ‘market’ rate will vary from the natural rate for all sorts of reasons other than monetary policy.”

“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 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, or the rate of growth of the real quantity of money.”

“Monetary policy cannot peg these real magnitudes at predetermined levels. But monetary policy can and does have important effects on these real magnitudes. The one is in no way inconsistent with the other.”

“My own studies of monetary history have made me extremely sympathetic to the oft-quoted, much reviled, and as widely misunderstood, comment by John Stuart Mill. ‘There cannot….,” he wrote, ‘be intrinsically a more insignificant thing, in the economy of society, than money; except in the character of a contrivance for sparing time and labour. It is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts distinct and independent influence of its own when it gets out of order’. True, money is only a machine, but it is and extraordinarily efficient machine.”

“But money has one feature that these other machines do not share. Because it is so pervasive, when it gets out of order, it throws a monkey wrench into the operation of all the other machines. The Great Contraction (Depression) is the most dramatic example but not the only one. Every other major contraction in this country has either been produced by monetary disorder or greatly exacerbated by monetary disorder. Every major inflation has been produced by monetary expansion….mostly to meet the overriding demands of war which have forced the creation of money to supplement explicit taxation.”

“The first and most important lesson that history teaches about what monetary policy can do….and it is a lesson of the most profound importance…is that monetary policy can prevent money itself from being a major source of economic disturbance.”

“This sounds like a negative proposition: avoid major mistakes. In part it is. The Great Contraction (Depression) might not have occurred at all, and if it had, it would have been far less severe, if the monetary authority had avoided mistakes, or if the monetary arrangements had been those of an earlier time when there was no central authority with the power to make the kinds of mistakes that the Federal Reserve System made.”

“Even if the proposition that monetary policy can prevent money itself from being a major source of economic disturbance were a wholly negative proposition, it would be none the less important for that.”

“There is therefore a positive and important task for the monetary authority…..to suggest improvements in the machine that will reduce the chances that it will get out of order, and to use its own powers so as to keep the machine in good working order. A second thing monetary policy can do is provide a stable background for the economy….keep the machine well oiled, to continue Mill’s analogy.”

“Our economic system will work best, when producers and consumers, employers and employees, can proceed with full confidence that the average level of prices will behave in a known way in the future….preferably that it will be highly stable. Under any conceivable institutional arrangements, and certainly under those that now prevail in the United States, there is only a limited amount of flexibility in prices and wages.”

“In an earlier era, the gold standard was relied on to provide confidence in the future monetary stability. In its heyday it served that function reasonably well. It clearly no longer does, since there is scarcely a country in the world that is prepared to let the gold standard reign unchecked….there are persuasive reasons why countries should not do so. The monetary authority could operate as a surrogate for the gold standard, if it pegged exchange rates…..But again, though many central bankers will talk this way, few are in fact willing to follow this course…and again there are persuasive reasons why they should not do so. Such a policy would submit each country to the vagaries not of an impersonal and automatic gold standard but of the policies….deliberate or accidental….of other monetary authorities. In today’s world, if monetary policy is to provide a stable background for the economy it must do so deliberately by employing its powers to that end.”

“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 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.”

“I have put this point last, and state it in qualified terms….as referring to major disturbances….because I believe that the potentiality of monetary policy in offsetting other forces making for instability is far more limited than commonly believed. We simply do not know enough to be able to recognize minor disturbances when they occur or to be able to predict either what their effects will be with any precision or what monetary policy is required to offset their effects. We do not know enough to be able to achieve stated objectives by delicate, or even fairly coarse, changes in mix of monetary and fiscal policy….Experience suggests that the path of wisdom is to use monetary policy explicitly to offset other disturbances only when they offer a ‘clear and present danger’.”

“How should monetary policy be conducted? The first requirement is that the monetary authority should guide itself by magnitudes that it can control, not by ones that it cannot control. If, as the authority has often done, it takes interest rates or the current unemployment percentage as the immediate criterion of policy, it will be like a space vehicle that has taken a fix on the wrong star. No matter how sensitive and sophisticated its guiding apparatus, the space vehicle will go astray. And so will the monetary authority.”

“Of the various alternative magnitudes that it can control, the most appealing guides for policy are exchange rates, the price level as defined by some index, and the quantity of a monetary total….currency plus adjusted demand deposits, or this total plus commercial bank time deposits, or a still broader total.”

“For the United States in particular, exchange rates are an undesirable guide. It might be worth requiring the build of the economy to adjust to the tiny percentage consisting of foreign trade if that would guarantee freedom from monetary irresponsibility….as it might under a real gold standard. But it is hardly worth doing to simply adapt to the average of whatever policies monetary authorities in the rest of the world adopt. Far better to let the market, through floating exchange rates, adjust to world conditions the 5 per cent or so of our resources devoted to international trade while reserving monetary policy to promote the effective use of the 95 per cent.”

“Of the three guides listed, the price level is clearly the most important in its own right. Other things the same, it would be much the best of the alternatives….as so many distinguished economists have urged in the past. But other things are not the same. The link between the policy actions of the monetary authority and the price level, while unquestionably present, is more indirect than the link between the policy actions of the authority and any of several monetary totals. Morever, monetary actions take a longer time to affect the price level than to affect monetary totals and both the time lag and the magnitude of effect vary with circumstances. As a result, we cannot predict at all accurately just what effect a particular monetary action will have on the price level and, equally important, just when it will have that effect. Attempting to control directly the price level is therefore likely to make monetary policy itself a source of economic disturbance because of false stops and starts.”

“Perhaps, as our understanding of monetary phenomena advances, the situation will change. But at the present stage of our understanding, the long way around seems the surer way to our objective. Accordingly, I believe that a monetary total is the best currently available immediate guide or criterion for monetary policy…”

“A second requirement for monetary policy is that the monetary authority avoid sharp swings in policy. In the past, the monetary authorities have on occasion moved in the wrong direction….as in the episode of the Great Contraction (Depression) that I have stressed. More frequently, they have moved in the right direction, albeit often too late, but have erred by moving too far. Too late and too much has been the general practice.”

“The reason for the propensity to overreact seems clear: the failure of monetary authorities to allow for the delay between their actions and the subsequent effects on the economy. They tend to determine their actions by today’s conditions…..but their actions will affect the economy only six or nine or twelve months later. Hence they feel impelled to step on the brake, or the accelerator, as the case may be, too hard.”

“My own prescription is still that the monetary authority go all the way in avoiding such swings by adopting publicly the policy of achieving a steady rate of growth in a specified monetary total…I myself have argued for a rate that would on average achieve rough stability in the level of prices of final products, which I have estimated would call for something like a 3 to 5 per cent per year rate of growth in currency plus all commercial bank deposits or a slightly lower rate of growth in currency plus demand deposits only. But it would be better to have a fixed rate that would on average produce moderate inflation or moderate deflation, provided it was steady, than to suffer the wide and erratic perturbations we have experienced.”

“It is a matter of record that periods of relative stability in the rate of monetary growth have also been periods of relative stability in economic activity, both in the United States and other countries. Periods of wide swings in the rate of monetary growth have also been periods of wide swings in economic activity.”

“By setting itself a steady course and keeping to it, the monetary authority could make a major contribution to promoting economic stability. By making that course one of steady but moderate growth in the quantity of money, it would make a major contribution to avoidance of either inflation or deflation of prices.”

“…steady monetary growth would provide a monetary climate favorable to the effective operation of those basic forces of enterprise, ingenuity, invention, hard work, and thrift that are the true springs of economic growth.”

Click here to download Mr. Friedman’s 1967 speech ‘The Role of Monetary Policy’

Posted on November 4, 2013, in Postings. Bookmark the permalink. Leave a comment.

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