Stable money is one of the most important prerequisites of free
markets. In Capitalism and Freedom, Milton Friedman addressed the
questions of the monetary arrangements most consistent with economic
freedom within individual countries and between countries. In Chapter
III Friedman took on the issue of how monetary policy should be made in
a free society. Acknowledging a legitimate role for government in the
management of money, Friedman posed the challenge as being that of
coming up with "... a stable monetary framework for a free
society" and more specifically "to establish institutional
arrangements that will enable government to exercise responsibility for
money, yet at the same time limit the power thereby given to government
and prevent the power from being used in ways that will tend to weaken
rather than strengthen a free society" (39). He assessed the
relative merits of commodity standards and independent central banks,
and concluded by arguing that a rule prescribing that the Federal
Reserve System (Fed) keep some measure of the money stock growing at
some constant rate is preferable to either.
In Chapter IV, Friedman took on the question of international
monetary arrangements. At the time, the Bretton Woods system of fixed
exchange rates was still in place. Friedman argued that "... the
most serious short-run threat to economic freedom in the United States today ... is that we shall be led to adopt far-reaching economic
controls to 'solve' balance of payments problems" (57).
In the international arena, Friedman saw the main challenge as being not
to solve a balance of payments problem, but to solve the balance of
payments problem. Reprising the arguments of Friedman (1953), he argued
for freely floating exchange rates. This paper reviews Friedman's
proposals, and assesses their impact on domestic and international
monetary arrangements in the four decades since Capitalism and Freedom
was published.
The Control of Money
Friedman's discussion began with a review of commodity money
standards. At the time he was writing, the world had not completed the
transition from the gold standard to a fully fiat standard: the major
currencies all retained a partial link to gold through the fixed
exchange rate arrangements of the Bretton Woods system. It is well known
that most early forms of money were commodity moneys. Precious metals in
particular have a long history of use as money, due in no small part to
their desirable characteristics as media of exchange (portability
divisibility, etc.). In Capitalism and Freedom, Friedman acknowledged
the important advantages possessed by pure commodity money standards.
Indeed, pure commodity standards where changes in the money stock are
governed by changes in the technology for producing the monetary
commodity and changes in the demand for money can, in principle,
function without any government involvement. Friedman noted that
automatic commodity standards, if feasible, would provide an excellent
solution to the liberal's dilemma by providing a stable monetary
environment free of the risk of instability due to government
mismanagement of the money stock. However, automatic commodity standards
are neither feasible nor desirable. The primary drawback of commodity
standards is the real resources that are needed to maintain them. The
monetary commodity is a real resource that has value in other uses, and
real resources are needed to add to the stock of the monetary commodity
over time. These real resource costs make commodity standards
undesirable since fiat money standards can facilitate the same volume of
monetary exchange without incurring these resource costs. Commodity
standards are also infeasible because they inevitably evolve to
incorporate fiduciary elements so as to economize on the real resources
needed to operate them. The introduction of fiduciary elements
inevitably opens the door to the involvement of government, be it simply
to prevent counterfeiting or enforce contracts, or to issue fiduciary
money itself.
Friedman then proceeded to a discussion of the management of money
by a discretionary monetary authority. His analysis focused on the
performance of the Federal Reserve System since its creation in 1914.
Friedman argued that the behavior of the stock of money, prices and
output in the United States had been decidedly more unstable since the
creation of the Fed than before, and that this instability was
attributable first and foremost to errors of omission and commission by
the Fed. To support these claims, Friedman drew heavily on the evidence
that he and Anna Schwartz had gathered in the then-unpublished Monetary
History. He paid particular attention to the role of the Fed in making
the Great Depression a more severe downturn in economic activity than it
otherwise would have been. Given the importance of the Depression in
shaping (or, as he put it, "deforming") the public's
ideas about the stability of capitalism and the appropriate role of
government in the economy, this line of argument was quite
controversial. He famously concluded:
"The Great Depression in the United States, far from being a
sign of the inherent instability of the private enterprise system, is a
testament to how much harm can be done by mistakes on the part of a few
men when they wield vast power over the monetary system of a
country" (50).
Friedman dismissed the argument that the mistakes of the Fed during
this period might be attributable to an imperfect understanding of the
workings of monetary policy as being beside the point. Independent
central banks, such as the Fed, are undesirable on political and
technical grounds: on political grounds because they put too much power
in the hands of a few individuals without "... any effective check
by the body politic" (50); and on technical grounds because of the
inevitability of mistakes in any system where responsibility is
dispersed. (1)
So if commodity standards and independent central banks are not the
answer, what is? The challenge, as Friedman saw it, was to legislate "... rules for the conduct of monetary policy that will have the
effect of enabling the public to exercise control over monetary policy
through its political authorities" while at the same time
preventing "... monetary policy from being subject to the
day-to-day whim of political authorities" (51). Friedman dismissed
a price-level rule as being "... the wrong kind of rule because it
is in terms of objectives that the monetary authorities do not have the
clear and direct power to achieve by their own actions" (53). What
was needed, rather, was a rule stated in terms of the stock of money.
Friedman referenced Program for Monetary Stability (Friedman, 1960a) for
details, summarizing by stating:
"I would specify that the Reserve System shall see to it that
the total stock of money ... rises month by month, and indeed, so far as
possible, day by day, at an annual rate of X percent, where X is some
number between 3 an 5. The precise definition of money adopted, or the
precise rate of growth chosen, makes far less difference than the
definite choice of a particular definition and a particular rate of
growth" (54).
Friedman did not see this as "... a be-all and end-all of
monetary management," but rather something that could be used to
develop better rules as our knowledge advanced.
With domestic monetary policy determined by such a rule, how should
international monetary relations be conducted? Friedman turned to this
issue in chapter IV of Capitalism and Freedom, and began his discussion
by noting how the controls on foreign exchange necessitated by
international monetary arrangements then in place (i.e., the Bretton
Woods system of fixed exchange rates) posed a serious threat to economic
liberty. Again Friedman noted that a fully automatic commodity standard
could, in principle, provide a stable architecture for international
monetary arrangements, but noted that the same factors that made it
undesirable and infeasible at the national level also applied at the
international level. Furthermore, even if it were desirable and feasible
for the US to move to a commodity standard on its own, it would not
facilitate adjustment in the international arena unless other countries
adopted the same standard. "The discussion then proceeded to a
further analysis of the role that gold then played in the U.S. monetary
system, with Friedman noting that there was no substantive difference
between the nationalization of the gold stock that took place in the
United States in 1933 and 1934, and Fidel Castro's nationalization
of Cuba's land and factories. After explaining the susceptibility
of fixed exchange rate systems to crises by drawing an analogy to bank
runs, Friedman then laid out the various ways in which countries can
achieve balance in their payments to the rest of the world, namely
changes in reserves, changes in domestic price levels, changes in
exchange rates or controls on trade. He concludes that "... a
system of freely floating exchange rates determined in the market for
private transactions ... is the proper free market counterpart to the
monetary rule advocated in the preceding chapter. If we do not adopt it,
we shall inevitably fail to expand the area of free trade and shall
sooner or later be induced to impose widespread direct controls over
trade" (67). (2) Friedman then laid out the steps he thought would
be necessary for the United States to promote a free market on dollars
and gold. As if to anticipate later developments. Friedman noted that
there should be no reason for the United States to object to other
countries pegging their currencies to the dollar, as long as the United
States did not make any commitment to buy or sell the currencies of such
countries at a fixed price.
Milton and Rose Friedman revisited the issue of the conduct of
monetary policy in a free society in their 1980 book http://waynelippman.blogspot.com/ and TV series Free
to Choose (Friedman and Friedman, 1980). Chapter 3 of Free to Choose,
titled "The Anatomy of Crisis," restated Friedman's view
that the Great Depression was primarily a failure of government (and
specifically a failure of the Fed) rather than a failure of capitalism.
Chapter 9 of Free to Choose was titled "The Cure for
Inflation," which had by then become a much greater problem than it
was when Capitalism and Freedom was published. Both the Great Depression
of the 1930s and the Great Inflation of the 1970s were due to a failure
of government, and could have been avoided by conducting monetary policy
according to a rule. (3) In Free to Choose the Friedmans took the
proposal for a constant money growth rate rule one step further and
argued that a money growth rule, specified in terms of the monetary
base, should be enshrined in the U.S. Constitution. With the Bretton
Woods system largely dismantled by the time Free to Choose appeared, the
Friedmans did not spend any time discussing international monetary
arrangements in that volume.
So what did the reviewers think? Capitalism and Freedom was not
widely reviewed when it was first published, but reviews by John Hicks,
Abba Lerner and Paul Baran were published in Economica, the American
Economic Review and the Journal of Political Economy, respectively. In a
generally favorable review, Nicks spent some time addressing the
monetary prescriptions in Capitalism and Freedom, noting that "A
really thoroughgoing Economic Liberal must surely maintain that the only
sound money is hard money (or commodity money); that the less the state
has to do with money the better" (Hicks, 1963, 319). How then to
make the national money systems that have emerged since the demise of
the gold standard more automatic? Hicks found Friedman's
prescription of an X-percent rule "very unappetizing" and
questioned the basis for the specific rates of growth suggested by
Friedman. Hicks also wondered about how binding such rules would be if
ever established. Hicks was also unsympathetic to Friedman's
prescriptions for international monetary, arrangements, flexible
exchange rates, noting that it appeared to be a "... very
nationalistic form of economic liberalism," which would deprive the
world of the benefits of international money (such as existed under the
Gold Standard). The reviews by Baran and Lemer were less favorable, and
did not pay as much attention to the monetary proposals in Capitalism
and Freedom.
Assessment
Assessing Friedman's influence on public policy, Allan Meltzer (2004) cites the decision to float the dollar in 1971 and 1973 (4) as
one of Friedman's major successes (the others being ending the
military draft and the repeal of interest rates ceilings). Meltzer cites
Friedman's proposal for a constant money growth rule as his most
famous proposal, but notes that it was never adopted. Nevertheless it
helped shape the debate about monetary policy in subsequent decades.
What follows are some observations about the arguments made in
Capitalism and Freedom to support the specific proposals made there
about monetary policy and how the debate subsequently evolved.
Impact on the Economics Profession
Before considering the ideas in the abstract, it is worth asking to
what extent the key proposals regarding money in Capitalism and Freedom
were accepted by members of the economics profession. As show in Table
1, a 1976 survey by Kearl et al. asked a sample of economists whether
they agreed or disagreed with a number of basic economic propositions,
including "The Fed should increase the money supply at a fixed
rate." In 1976 and in a follow up survey in 1990 (Alston et al.,
1990) Kearl et al. found a relatively strong consensus among economists
disagreeing with this proposition. A key difference between the
authors' 1976 and 1990 surveys is that in the 1990 survey they
found less agreement on the ability (as opposed to the desirability) of
the Fed to control the growth of money. (5) Nevertheless, the same
surveys found a growing consensus among economists on a key Friedman
proposition, that inflation is a monetary phenomenon. In 1976, 43
percent of the economists surveyed disagreed with this proposition, as
opposed to 29 percent in 1990, and 17 percent in 2000 (according to
Fuller and Geide-Stevenson, 2003).
While only 14 percent of the economists surveyed by Kearl et al. in
1976 were in general agreement with the prescription of a constant
growth rate rule for the money stock, 61 percent of the respondents in
the same survey agreed with the proposition that, "Flexible
exchange rates offer an effective international monetary
arrangement." The later surveys of Alston et al. and Fuller and
Geide-Stevenson found comparably large percentages of economists
agreeing with this proposition. Interestingly, Alston et al. also
document significant vintage effects in the extent of agreement with the
key Friedman propositions. They find that the older one's highest
degree, the greater the tendency to disagree with the proposition that
inflation is a monetary phenomenon and the proposition that the Fed
should follow a constant money growth rule. (6)
Given the existence of such vintage effects, it is interesting to
see how the views of graduate students on these propositions have
evolved. In their 1985 survey of graduate students at seven major
economics departments, Colander and Klamer (1987) assessed the degree of
agreement with the propositions, "The FRB should maintain a
constant money growth," and "Inflation is primarily a monetary
phenomenon." (7) Only 9 percent agreed with the money growth
proposition without reservations; 34 percent agreed with some
reservations. As to the proposition that inflation is a monetary
phenomenon, almost equal proportions of graduate students agreed, agreed
with reservations, and disagreed. Perhaps not surprisingly, agreement
with both propositions was strongest at the University of Chicago.
Colander (2005) reports findings from a follow-up survey conducted among
students at the same schools between 2001 and 2003. In the later survey,
Colander found fewer students agreeing with the constant money growth
prescription for monetary policy, with the number of students in
agreement at Chicago declining from 41 percent to 18 percent. There was
more agreement among students on the proposition that inflation is a
monetary phenomenon, except at Chicago. In the earlier survey 84 percent
of students agreed with the proposition without reservations; that
number fell to 44 percent in the later survey, with 25 percent of
Chicago students agreeing with reservations and 21 percent in outright
disagreement. (At all the other schools, the percentages disagreeing
with the inflation proposition declined between the two surveys.)
What about economists in other countries? Surveys of
economists' opinions similar to those just reviewed for the United
States have been carried out in a number of other countries. Block and
Walker (1988) surveyed economists in Canada; Ricketts and Shoesmith
(1990) surveyed economists in the UK; Pommerehne, Schneider, Gilbert and
Frey (1984) surveyed economists in a number of continental European
countries. In their surveys of European economists in 1981, Pommerehne
et al. found a relatively high degree of disagreement (close to
two-thirds of respondents) with the X-percent rule proposal in Austria
and Germany, with somewhat less disagreement in Switzerland. However,
almost two-thirds of the French economists in their survey either agreed
or agreed with provisions with the X-percent proposal, a higher fraction
than in any of the U.S. surveys. Block and Walker found more than half
of Canadian economists disagreeing with the proposal, while Ricketts and
Shoesmith found relatively little support among UK economists for the
X-percent rule.
Table 2 summarizes support for the proposition that "Flexible
exchange rates offer an effective international monetary
arrangement" from the same surveys of economists. Support for the
flexible exchange rate proposal is a lot stronger in these surveys than
for the X-percent rule, and also quite widespread. The exception seems
to be France, where only 11.1 percent of economists were in general
agreement, as opposed to close to two-thirds of economists elsewhere.
Commodity Standards
Friedman published a lengthy discussion of commodity standards
topic in his paper "Commodity Reserve Currency," which was
published in the Journal of Political Economy in 1951 and reprinted in
Essays in Positive Economics in 1953. Much of what Friedman had to say
about the resource costs of commodity standards is now conventional
wisdom. Indeed, in a comparison of the competing merits of commodity and
fiat money standards, it is generally accepted that flat standards win
every time because of their lower real resource costs. In recent years
the central banks of most industrial countries have been selling off
their gold stocks, thereby eliminating the last vestiges of any
commodity backing of currencies.
However, in a 1986 paper, Friedman revisited the issue and noted
that fiat standards have real resource costs as well, especially when
they are associated with long run price uncertainty. In the mid-1980s it
was still far from clear that inflation had been tamed, although
inflation had fallen dramatically in the United States. Friedman (1986)
noted that under commodity standards, the price level had a physical
anchor which generated long-run price stability. He noted "The
price level in Britain in 1930 was roughly the same as in 1740; in the
United States in 1932, it was roughly the same as in 1832"
(Friedman, 1986, 643). Friedman (1986) gave a number of examples of the
real resource costs that long-run price level uncertainty under fiat
standards generated: real resources are consumed in financial planning,
as well as in the development of financial markets to allow businesses
and households to insulate themselves against high and variable
inflation. The same price level uncertainty also leads private
individuals to hold precious metals to hedge against uncertainty under
fiat standards, and Friedman speculated that the real resource costs of
these precious metal holdings "... may have been as great as or
greater than it would have been under an effective gold standard"
(Friedman, 1986, 644). Friedman concluded that measurement of the real
resource costs of irredeemable paper money and comparison of these costs
with the better-understood resource costs of commodity money was an open
question for economic research. However, this is not an issue that
economists seem to have embraced: A recent citation search for
Friedman's 1986 article turned up only 3 citations in the SSCI.
Part of the reason for the lack of research on the resource costs
of fiat money, no doubt, is the success central banks have had in the
intervening period in bringing inflation under control. Figure 1 shows
the number of countries experiencing quarterly inflation rates in excess
of 50 percent (a commonly used definition of hyperinflation). Note the
steady increase in the number of high inflation countries following the
collapse of the Bretton Woods system. At the time, Friedman wrote his
1986 article, it was far from obvious that central banks would be as
successful as they subsequently turned out to be in lowering inflation.
Many industrial countries made significant progress in lowering
inflation in the 1980s, with the developing countries catching up in the
1990s. By the turn of the new century, only one or two countries were
experiencing inflation rates in excess of 50 percent a quarter.
[FIGURE 1 OMITTED]
Central Bank Independence
Friedman's discussion of independent central banks runs
contrary to much of the contemporary conventional wisdom on central
banking. Developing ideas expressed in Friedman (1960a, 1960b), as well
as in Capitalism and Freedom and elsewhere (Friedman, 1985) went on to
advocate ending independence of the Federal Reserve by making it a
bureau of the Department of the Treasury. However, subsequent
developments have tended to convince most economists of the need for
greater rather than lesser central bank independence. In an influential
paper, Alesina and Summers (1993) pointed out a remarkable correlation
between central bank independence and inflation outcomes: specifically,
independent central banks seem to deliver better inflation performance
over time, and this better performance comes at no cost in terms of real
growth. This finding and its confirmation by many subsequent studies
motivated the global trend towards granting central banks greater
independence in the 1990s (starting with the Reserve Bank of New Zealand in 1990, the Bank of France in 1994, the Bank of England in 1997, the
European Central Bank in 1998, and most recently, the Central Bank of
Iraq). (8)
Friedman's two major concerns about independent central banks
(the political and technical) have been addressed in recent years by a
variety of means. It is generally accepted that when central banks are
granted independence, mechanisms should be put in place to ensure that
they are held accountable. In many cases the granting of independence to
a central bank has been accompanied by the adoption of some form of
inflation targeting as a monetary policy strategy. This serves to focus
central bank deliberations on the one thing it can consistently deliver
over time, and provide a ready metric by which its performance can be
judged. In the case of the Bank of England, for example, which was
granted operational independence by the Labour government in May 1997,
(9) this takes the form of requiring the governor and other members of
the Bank's Monetary Policy Committee testify before the relevant
committees of parliament, having an inflation objective set by the
Chancellor of the Exchequer, and requiring that the governor provide a
written explanation of when inflation deviates by more than a prescribed
amount from the government's target.
Addressing Friedman's technical arguments against central bank
independence is more difficult. Friedman's concern was that
mistakes were inevitable when policy actions were dependent on accidents
of personality. (10) While monetary policy in the United States is made
by a committee, the Federal Open Market Committee (FOMC), the Chairman
of that committee wields significant power, and is often seen as the key
personality. Chairmen inevitably wield more power than other committee
members, but the global trend towards greater central bank independence
in the 1990s has also seen a tendency to hand responsibility for
monetary policy over to committees. In the UK, monetary policy is made
by the Monetary Policy Committee of the Bank of England, which includes
technical experts presumably to minimize the risk of errors.
Of course, whether a central bank can ever be truly independent is
an open question. As many students of monetary policy have noted,
independence that is conferred by legislation can be just as easily
revoked by subsequent legislation. Coleman (2004) is an interesting
study of how fleeting independence can be when the monetary authority
falls foul of powerful business interests. Enshrining independence in a
constitutional document or, as in the ECB's case, an international
treaty, is likewise no guarantee that independence will last.
Constitutional amendments can always be undone by subsequent amendments.
Rules based monetary policy
One area where Friedman has had a lasting impact is in terms of his
arguments for rules-based monetary policy. As noted above, Meltzer
(2004) argues that this is the most famous of Friedman's many
policy proposals. However, we need to distinguish between
Friedman's arguments for rule-based policy making and the specific
rule Friedman proposed. The X-percent rule has been much debated in the
practical literature on monetary policy, yet has never been fully
adopted. The closest any country or central bank has come to adopting
the rule has been to use monetary targets in setting monetary policy.
Monetary targets became popular with many central banks following the
collapse of the Bretton Woods system in the 1970s. The Fed started to
specify explicit targets for the monetary aggregates in 1975, and these
targets became enshrined in law with the Full Employment and Balanced
Growth Act of 1978. From 1974 until the establishment of EMU, the
Bundesbank announced annual targets for the rate of growth of M3. The
ECB's publication of a reference value for M3 growth is a relic of
Friedman's proposed rule. No other major central bank continues to
report targets or reference values for monetary aggregates. This is due
to the experience with money targets in the 1970s and 1980s: as one
former Governor of the Bank of Canada famously put it, "We did not
abandon M1, M1 abandoned us." (11)
What is no longer in dispute is that central bank policy making
should be guided by rules rather than discretion, or rather, that the
discretion that central banks enjoy should be in some sense constrained.
While the particular rule favored by Friedman has never been widely
used, others have. In this sense, Friedman may be said to have lost the
battle but won the war. Friedman's arguments for rules followed in
many ways from Simons (1948). Kydland and Prescott (1977) strengthened
the argument for rules by showing that even a benevolent monetary policy
maker will generally produce too much inflation if allowed full
discretion. Woodford's
(2003) treatise reviews the recent debates about the role of rules in
monetary policy and clarifies what it means for policy to be rule based.
Woodford's treatise is also important in illustrating the
shift away from an emphasis on money (the quantity theory view) and
towards a neo-Wicksellian approach to monetary policy. As Poole (2004)
has noted, money now plays very little role in the deliberations of the
Fed, or of other major central banks for that matter. The ECB is an
anomaly in this regard in that it still assigns a prominent role to
money in its deliberation, but it is not clear whether the monetary
pillar has been all that important in practice.
Contemporary discussions of rules-based monetary policy are cast in
terms of a reaction function for the interest rate controlled by the
central bank. The interest rate is specified to be some function of
inflation and indicators of real economic activity, and possibly other
macroeconomic indicators. The best known such rule is the Taylor (1993)
rule, which specifies how the central bank should change interest rates
in response to deviations of inflation, x, from some target and output,
y, from potential output, [bar.y] :
i = 0.04 + 1.5([pi] - 0.02) + 0.5(y - [bar.y])
Friedman, of course, was famously skeptical of central bank efforts
to control interest rates. In his 1967 presidential address to the
American Economic Association, Friedman (1968) outlined how attempts to
peg interest rates could lead to explosive inflations or deflations. If
nominal rates are pegged at a level below the natural rate, inflation
will rise, which will lead to higher inflation expectations. With pegged
nominal rates, this causes real interest rates to decline, further
stimulating demand and adding to inflation. The same line of argument
implies accelerating deflation when nominal rates are pegged above the
natural rate.
Woodford (2003) argues that this line of reasoning may be correct
as far as it goes, but it is critically dependent on the assumption that
the central bank does not alter its setting for its interest rate in
response to inflation developments. Once this assumption is relaxed,
interest rates rules of the sort now widely studied in the literature on
monetary policy are quite compatible with stable prices.
Optimal rules
No central bank has ever adopted the X-percent rule for monetary
policy proposed by Friedman in Capitalism and Freedom, and it has
received relatively little attention in the academic literature.
However, academics continue to debate the merits of the other
"Friedman rule" that Friedman put forward in his classic essay
on The Optimum Quantity of Money (Friedman (1969). (12) This Friedman
rule, the Friedman rule in the eyes of many, called for contracting the
stock of money at a pace sufficient to drive the nominal interest rate down to zero. The rationale for the rule is simple: since money yields
useful services (by facilitating transactions) but does not pay
interest, consumers will hold less of it than they otherwise would if
nominal interest rates were zero. Furthermore, since under a flat
standard money is essentially costless to produce, it is welfare
improving to equalize the returns on money and alternative assets. This
requires contracting the stock of money at a pace sufficient to induce
deflation at a rate equal to the real rate of interest, thus making
nominal interest rates equal to zero.
Unlike the rule proposed in Capitalism and Freedom, this particular
rule for monetary policy was shown by Friedman to be optimal (welfare
maximizing) on the basis of basic economic principles. Subsequent
analysis of this rule has shown it to be optimal in a wide range of
circumstances. Early critics of the rule argued that it might not be
optimal in situations where the government has to rely on distorting
taxes to fund government programs; in such a situation, it was argued
that optimal public finance considerations would call for some revenue
to be raised by inflation taxes. Mulligan and Sala-i-Martin (1997)
review the literature on the Friedman rule and show that the optimality
of the rule cannot be decided on theoretical grounds alone. Rather, as
with many other things in economics, it depends on assumptions. They
show that existing evidence on key parameters of consumer preferences
suggests that the optimal inflation rate is positive, but small. Lucas
(2000) reviews some of these arguments and concludes that the needed
qualification to the Friedman rule that the presence of taxes or other
distortions requires is trivially small. The Friedman rule has also
attracted renewed attention from central bankers (or at least from their
staffs), given the recent deflation scare in the United States in 2003
and the more protracted experience of Japan. However, the prospects of
any central bank adopting this rule any time soon are remote. In the
eyes of many central bankers, the models that yield the Friedman rule as
the optimal prescription for monetary policy over emphasize the shoe
leather costs of inflation and ignore the other costs of inflation. In
addition, these models tend to have a limited role for counter-cyclical
policy.
In the conclusion to his 1969 essay Friedman addressed the conflict
between the Friedman rule, an optimal rule for monetary policy worked
out from basic principles of economic theory, and the X-percent rule
proposed in Capitalism and Freedom. Friedman advanced two reasons for
the differences between the two. The first is that the X-percent rule
was proposed "... with an eye primarily to short-run
considerations" (Friedman, 1969, 48) whereas the optimal rule
"... puts more emphasis on long-run considerations."
(Friedman, 1969, 48) The second and more fundamental reason was that at
the lime A Program for Monetary Stability was written, Friedman had not
yet worked out the theory in the optimum quantity paper. In concluding
Friedman noted that "The gain from shifting to the [X]-percent rule
would.., dwarf the further gain from going to the 2 percent rule, even
though that gain may well be substantial enough to be worth pursuing.
Hence I shall continue to support the 5 percent rule as an intermediate
objective greatly superior to present practice."
The importance of money in economic fluctuations
Friedman and Schwartz' Monetary History convinced many of the
importance of money in economic fluctuations. As Robert Lucas noted in
his 1994 review of Monetary History after 30 years, it constituted a
"... remarkable and durable achievement of historical and economic
scholarship" and "... played an important--perhaps even
decisive--role in the 1960s debates over stabilization policy between
Keynesians and monetarists" (Lucas, 1994). In Capitalism and
Freedom, Friedman was primarily concerned with the role of money in
generating business cycles, and argued based on the Monetary History
that the Great Depression was due to the shortcomings of monetary policy
at that time. Indeed the view that monetary policy is the primary cause
of business cycles has become mainstream, with the late Rudiger
Dornbusch famously quipping that "Expansions do not die of old age:
they are murdered by the Fed."
In the past two decades, economists have begun to pay more
attention to the importance of real shocks as sources of business
fluctuations. In a seminal paper, Kydland and Prescott (1982) argued
that almost all of the business cycle fluctuations observed in the
postwar US economy could be accounted for by real shocks, with only a
small role for money. Whatever one may think of the ability of real
business cycle models to explain postwar business cycles in the US, most
mainstream economists still subscribe to the Friedman and Schwartz view
of the Great Depression as being the result of bad monetary policy.
Speaking at a University of Chicago conference held in 2002 to honor
Friedman on his ninetieth birthday, Federal Reserve Governor Ben
Bernanke concluded on the Fed's role in the Great Depression
"You're right, we did it. We're very sorry. But thanks to
you, we won't do it again." (13) In his review of Monetary
History on its thirtieth anniversary, Lucas (1994) argued that
"Viewed as positive theory, real business cycles do not offer a
serious alternative to Friedman and Schwartz's monetary account of
the early 1930s." (Lucas, 1994, 13) He argues that the relative
success of real business cycle models in accounting for postwar
fluctuations in the US may simply be a reflection of the fact that the
conduct of monetary policy has been so much better in the postwar
period, not that money doesn't matter.
However, recent research has begun to challenge Friedman and
Schwartz' explanation of the Great Depression as being due
primarily to monetary policy. Cole and Ohanian (1999, 2000) show that
while monetary shocks might be able to account for the decline in output
during the Great Depression, they cannot account for the slow pace of
the recovery after 1933. Likewise they find that bank failures and the
increases in reserve requirements in 1936 and 1937 cannot account for
the slow pace of the recovery. They conclude by suggesting, very much in
the sprit of Friedman, that the New Deal policies introduced to end the
Depression, specifically the National Industrial Recovery Act of 1933,
may have played an important role in prolonging the recovery by allowing
many sectors of the economy to cartelize. (14) Cole and Ohanian (2001)
evaluate this idea about New Deal cartelization policies and find that
it can account in a quantitative sense for the slow pace of the recovery
after 1933.
Flexible exchange rates
As noted above, Meltzer (2004) counts the decision to float the
dollar as one of Friedman's great policy successes. As Figure 2
shows, there has been a steady increase in the number of countries with
some form of floating exchange rates since the demise of the Bretton
Woods system in the early 1970s. In many cases the decision to let a
currency float was taken after a financial crisis precipitated by an
attempt to defend an unsustainable peg. Many countries continue to peg
their currencies to the dollar or the euro or a basket of major
currencies as a way to limit discretionary monetary policy. Some have
gone even further an adopted currency boards or dollarized outright,
effectively outsourcing monetary policy and thereby completely removing
any scope for discretionary domestic monetary policy.
The most important intellectual challenge to Friedman's
argument for flexible exchange rates is probably that posed by Wallace
(1979) and Kareken and Wallace (1981). These authors pointed out that
under a fiat money standard and with no controls on currency holdings,
the exchange rate between currencies is indeterminate: any exchange rate
will serve to equate the world supply and demand for money. The reason
for the indeterminacy is that fiat currencies have three important
features that distinguish them from other goods or assets, namely that
they are intrinsically useless, they are unbacked and they are
essentially costless to produce. As a result there are no fundamentals
of tastes and technology to determine the relative prices of fiat
currencies if individuals are free to use any currency.
[FIGURE 2 OMITTED]
The only way to resolve this indeterminacy is to impose
restrictions on currency holdings, which are also costly. The
alternative is a system of fixed exchange rates where central banks
agree to trade unlimited amounts of each other's obligations at a
fixed rate at any time, and agree on the total amount of obligations to
be issued and the allocation of seigniorage. As Wallace (1979) notes,
none of the feasible options is without drawbacks. A system of fixed
exchange rates requires international coordination of monetary policies,
which means that monetary policy can no longer be directed exclusively
at the attainment of domestic objectives. If the determination of
exchange rates is to be left to free markets, the only way exchange
rates can be made determinate is through the imposition of capital
controls or legal restrictions on the use of currency.
Conclusion
Writing in the Wall Street Journal in 1988, Friedman asserted
"No major institution in the U.S. has so poor a record of
performance over so long a period as the Federal Reserve, yet so high a
public recognition." (15) Fifteen years later, in the same forum,
he essentially retracted this view, noting that in the intervening
period the Fed seemed to have gotten its act together. Friedman
attributed this to the Fed's adoption of price stability as its
primary goal and the use of better economic theory. (16) The improved
performance of the Fed was matched by improved performance by central
banks in almost all countries, due in no small part to the influence of
Friedman's ideas.
Of the two key monetary policy proposals put forward in Capitalism
and Freedom, only floating exchange rates have been widely adopted.
After a brief experiment with monetary targeting in the 1970s and 1980s
central banks have adopted other strategies for monetary policy, with
inflation targeting now the preferred strategy of many central banks.
Friedmans' arguments against commodity standards are now part of
the conventional wisdom: with central banks around the world gradually
disposing of their remaining stocks of gold, the last vestiges of the
gold standard are disappearing. The use of currency boards in some
emerging market economies can be viewed as a manifestation of the
acceptance of the idea that monetary policy needs to be rule based,
which is arguably Friedman's most important legacy in the monetary
arena. Economists continue to debate the causes of the Great Depression,
but the thesis advanced by Friedman that it was first and foremost a
failure of government rather than a failure of capitalism remains
integral to most of the stories. Most economists now accept that money
plays an important role in economic fluctuations, but money itself is no
longer center stage in central bank deliberations about policy. While
the rule proposed by Friedman in Capitalism and Freedom was never
adopted, Friedman's later work on the optimum quantity of money
continues to inspire research and was the earliest attempt to pose
policy questions in what is now the dominant approach.
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Mark A. Wynne
Federal Reserve Bank of Dallas
(1) Friedman's discussion of independent central banks drew
heavily on Friedman (1960b).
(2) Friedman had first advocated flexible exchange rates in
Friedman (1953).
(3) Bernanke (2004) refers to the Great Inflation as the second
most important monetary policy mistake of the twentieth century, after
the Great Depression.
(4) The convertibility of the dollar into gold was suspended in
August 1971. The Smithsonian Agreement of December 1971 provided for a
multilateral realignment of exchange rates and a devaluation of the
dollar against gold. In April 1973 the currencies of the major
industrial countries were allowed to float.
(5) As indicated by the responses to the proposition, "The Fed
has the capacity to achieve a constant rate of growth of the money
supply if it is desired."
(6) Alston et al. also find that economists who received their
highest degree either prior to 1961 or during the 1960s had the greatest
tendency to disagree with the proposition that economies have a natural
tendency to return to their equilibrium growth paths following
disturbances.
(7) The seven departments were Chicago, Harvard, MIT, Yale,
Princeton, Columbia and Stanford.
(8) As decreed by L. Paul Bremer in Coalition Provisional Authority Order Number 18, dated July, 2003.
(9) Subsequently confirmed by the Bank of England Act 1998, which
came into force on June 1, 1998.
(10) Friedman (1985) later argued that subsequent experience led
him to alter his views about the importance of personalities in monetary
policymaking, noting that Fed policy had shown remarkable continuity
despite major differences in the personalities and backgrounds of the
key players.
(11) Attributed to Gerald Bouey, Governor of the Bank of Canada,
1973-1987. The source is Canada: House of Commons Standing Committee on
Finance, Trade and Economic Affairs: Minutes of Proceedings and
Evidence, No. 134, 28 March 1983, 12.
(12) A quick search on Google for "The Friedman Rule"
turned up nearly 6,000 hits, all of which seem to refer to the 1969
Friedman Rule.
(13) See McLane (2002).
(14) Higgs (1997) provides a different take on why the recovery
from the Great Depression took so long: he emphasizes the role of regime
uncertainty (in particular uncertainty about property rights) as a
factor depressing private investment.
(15) Wall Street Journal, April 15, 1988.
(16) Wall Street Journal, August 19, 2003.
Table 1. Professional Support for Friedman's X-percent Rule
The central bank (Fed) should be instructed to increase the money
supply at a fixed rate
Year(s) Generally Agree with Generally
Country of Survey Agree Provisions Disagree
us 1976 14 25 61
1990 13.4 30.6 54.1
US 1985 9 34 45
(graduate
students)
2001-2003 7 22 50
Canada 1986 13.5 29.1 54.9
Austria 1981 5.5 24.2 68.1
France 1981 32.7 32.7 28.4
Germany 1981 9.5 26.7 62.6
Switzerland 1981 15.1 34.2 44.7
Agree Agree with Neither Agree
Strongly Reservations nor Disagree
UK 1989 3.1 13.6 28.0
Generally Disagree
Disagree Strongly
UK 1989 37.4 17.2
Notes to Table: Sources: US: Kearl, Pope, Whiting and Wimmer (1979),
Table 1 for 1976 data; Alston, Kearl and Vaughn (1992), Table 1, for
1990 data; US graduate students: Colander and Klamer (1987), Table 4,
for 1985 data; Colander (2005), Table 6, Walker (1988), Table 2;
Austria, France, Germany and Switzerland: Pommerehne, Schneider,
Gilbert and Frey (1984), Table A.
Table 2. Professional Support for Friedman's Flexible Exchange Rate
Proposal
Flexible exchange rates offer an
effective international monetary
arrangement
Year(s) Generally Agree with Generally
Country of Survey Agree Provisions Disagree
US 1976 61 34 5
1990 56 33.6 8.4
2000 61.4 31.5 5.0
Canada 1986 57.6 35.9 5.9
Austria 1981 34.1 49.4 16.5
France 1981 11.1 38.3 44.4
Germany 1981 62.0 30.0 5.1
Switzerland 1981 52.3 38.7 7.5
Notes to Table: Sources: US: Kearl, Pope, Whiting and Wimmer (1979),
Table 1, for 1976 data; Alston, Kearl and Vaughan (1992), Table 1,
for 1990 data; Fuller and Geide-Stevenson (2003), Table 1, for 2000
data; Canada: Block and Walker (1988), Table 2; Austria, France,
Germany and Switzerland: Pommerehne, Schneider, Gilbert and Frey
(1984), Table A.
http://www.thefreelibrary.com/Thecontrolofmoney.-a0170928557
markets. In Capitalism and Freedom, Milton Friedman addressed the
questions of the monetary arrangements most consistent with economic
freedom within individual countries and between countries. In Chapter
III Friedman took on the issue of how monetary policy should be made in
a free society. Acknowledging a legitimate role for government in the
management of money, Friedman posed the challenge as being that of
coming up with "... a stable monetary framework for a free
society" and more specifically "to establish institutional
arrangements that will enable government to exercise responsibility for
money, yet at the same time limit the power thereby given to government
and prevent the power from being used in ways that will tend to weaken
rather than strengthen a free society" (39). He assessed the
relative merits of commodity standards and independent central banks,
and concluded by arguing that a rule prescribing that the Federal
Reserve System (Fed) keep some measure of the money stock growing at
some constant rate is preferable to either.
In Chapter IV, Friedman took on the question of international
monetary arrangements. At the time, the Bretton Woods system of fixed
exchange rates was still in place. Friedman argued that "... the
most serious short-run threat to economic freedom in the United States today ... is that we shall be led to adopt far-reaching economic
controls to 'solve' balance of payments problems" (57).
In the international arena, Friedman saw the main challenge as being not
to solve a balance of payments problem, but to solve the balance of
payments problem. Reprising the arguments of Friedman (1953), he argued
for freely floating exchange rates. This paper reviews Friedman's
proposals, and assesses their impact on domestic and international
monetary arrangements in the four decades since Capitalism and Freedom
was published.
The Control of Money
Friedman's discussion began with a review of commodity money
standards. At the time he was writing, the world had not completed the
transition from the gold standard to a fully fiat standard: the major
currencies all retained a partial link to gold through the fixed
exchange rate arrangements of the Bretton Woods system. It is well known
that most early forms of money were commodity moneys. Precious metals in
particular have a long history of use as money, due in no small part to
their desirable characteristics as media of exchange (portability
divisibility, etc.). In Capitalism and Freedom, Friedman acknowledged
the important advantages possessed by pure commodity money standards.
Indeed, pure commodity standards where changes in the money stock are
governed by changes in the technology for producing the monetary
commodity and changes in the demand for money can, in principle,
function without any government involvement. Friedman noted that
automatic commodity standards, if feasible, would provide an excellent
solution to the liberal's dilemma by providing a stable monetary
environment free of the risk of instability due to government
mismanagement of the money stock. However, automatic commodity standards
are neither feasible nor desirable. The primary drawback of commodity
standards is the real resources that are needed to maintain them. The
monetary commodity is a real resource that has value in other uses, and
real resources are needed to add to the stock of the monetary commodity
over time. These real resource costs make commodity standards
undesirable since fiat money standards can facilitate the same volume of
monetary exchange without incurring these resource costs. Commodity
standards are also infeasible because they inevitably evolve to
incorporate fiduciary elements so as to economize on the real resources
needed to operate them. The introduction of fiduciary elements
inevitably opens the door to the involvement of government, be it simply
to prevent counterfeiting or enforce contracts, or to issue fiduciary
money itself.
Friedman then proceeded to a discussion of the management of money
by a discretionary monetary authority. His analysis focused on the
performance of the Federal Reserve System since its creation in 1914.
Friedman argued that the behavior of the stock of money, prices and
output in the United States had been decidedly more unstable since the
creation of the Fed than before, and that this instability was
attributable first and foremost to errors of omission and commission by
the Fed. To support these claims, Friedman drew heavily on the evidence
that he and Anna Schwartz had gathered in the then-unpublished Monetary
History. He paid particular attention to the role of the Fed in making
the Great Depression a more severe downturn in economic activity than it
otherwise would have been. Given the importance of the Depression in
shaping (or, as he put it, "deforming") the public's
ideas about the stability of capitalism and the appropriate role of
government in the economy, this line of argument was quite
controversial. He famously concluded:
"The Great Depression in the United States, far from being a
sign of the inherent instability of the private enterprise system, is a
testament to how much harm can be done by mistakes on the part of a few
men when they wield vast power over the monetary system of a
country" (50).
Friedman dismissed the argument that the mistakes of the Fed during
this period might be attributable to an imperfect understanding of the
workings of monetary policy as being beside the point. Independent
central banks, such as the Fed, are undesirable on political and
technical grounds: on political grounds because they put too much power
in the hands of a few individuals without "... any effective check
by the body politic" (50); and on technical grounds because of the
inevitability of mistakes in any system where responsibility is
dispersed. (1)
So if commodity standards and independent central banks are not the
answer, what is? The challenge, as Friedman saw it, was to legislate "... rules for the conduct of monetary policy that will have the
effect of enabling the public to exercise control over monetary policy
through its political authorities" while at the same time
preventing "... monetary policy from being subject to the
day-to-day whim of political authorities" (51). Friedman dismissed
a price-level rule as being "... the wrong kind of rule because it
is in terms of objectives that the monetary authorities do not have the
clear and direct power to achieve by their own actions" (53). What
was needed, rather, was a rule stated in terms of the stock of money.
Friedman referenced Program for Monetary Stability (Friedman, 1960a) for
details, summarizing by stating:
"I would specify that the Reserve System shall see to it that
the total stock of money ... rises month by month, and indeed, so far as
possible, day by day, at an annual rate of X percent, where X is some
number between 3 an 5. The precise definition of money adopted, or the
precise rate of growth chosen, makes far less difference than the
definite choice of a particular definition and a particular rate of
growth" (54).
Friedman did not see this as "... a be-all and end-all of
monetary management," but rather something that could be used to
develop better rules as our knowledge advanced.
With domestic monetary policy determined by such a rule, how should
international monetary relations be conducted? Friedman turned to this
issue in chapter IV of Capitalism and Freedom, and began his discussion
by noting how the controls on foreign exchange necessitated by
international monetary arrangements then in place (i.e., the Bretton
Woods system of fixed exchange rates) posed a serious threat to economic
liberty. Again Friedman noted that a fully automatic commodity standard
could, in principle, provide a stable architecture for international
monetary arrangements, but noted that the same factors that made it
undesirable and infeasible at the national level also applied at the
international level. Furthermore, even if it were desirable and feasible
for the US to move to a commodity standard on its own, it would not
facilitate adjustment in the international arena unless other countries
adopted the same standard. "The discussion then proceeded to a
further analysis of the role that gold then played in the U.S. monetary
system, with Friedman noting that there was no substantive difference
between the nationalization of the gold stock that took place in the
United States in 1933 and 1934, and Fidel Castro's nationalization
of Cuba's land and factories. After explaining the susceptibility
of fixed exchange rate systems to crises by drawing an analogy to bank
runs, Friedman then laid out the various ways in which countries can
achieve balance in their payments to the rest of the world, namely
changes in reserves, changes in domestic price levels, changes in
exchange rates or controls on trade. He concludes that "... a
system of freely floating exchange rates determined in the market for
private transactions ... is the proper free market counterpart to the
monetary rule advocated in the preceding chapter. If we do not adopt it,
we shall inevitably fail to expand the area of free trade and shall
sooner or later be induced to impose widespread direct controls over
trade" (67). (2) Friedman then laid out the steps he thought would
be necessary for the United States to promote a free market on dollars
and gold. As if to anticipate later developments. Friedman noted that
there should be no reason for the United States to object to other
countries pegging their currencies to the dollar, as long as the United
States did not make any commitment to buy or sell the currencies of such
countries at a fixed price.
Milton and Rose Friedman revisited the issue of the conduct of
monetary policy in a free society in their 1980 book http://waynelippman.blogspot.com/ and TV series Free
to Choose (Friedman and Friedman, 1980). Chapter 3 of Free to Choose,
titled "The Anatomy of Crisis," restated Friedman's view
that the Great Depression was primarily a failure of government (and
specifically a failure of the Fed) rather than a failure of capitalism.
Chapter 9 of Free to Choose was titled "The Cure for
Inflation," which had by then become a much greater problem than it
was when Capitalism and Freedom was published. Both the Great Depression
of the 1930s and the Great Inflation of the 1970s were due to a failure
of government, and could have been avoided by conducting monetary policy
according to a rule. (3) In Free to Choose the Friedmans took the
proposal for a constant money growth rate rule one step further and
argued that a money growth rule, specified in terms of the monetary
base, should be enshrined in the U.S. Constitution. With the Bretton
Woods system largely dismantled by the time Free to Choose appeared, the
Friedmans did not spend any time discussing international monetary
arrangements in that volume.
So what did the reviewers think? Capitalism and Freedom was not
widely reviewed when it was first published, but reviews by John Hicks,
Abba Lerner and Paul Baran were published in Economica, the American
Economic Review and the Journal of Political Economy, respectively. In a
generally favorable review, Nicks spent some time addressing the
monetary prescriptions in Capitalism and Freedom, noting that "A
really thoroughgoing Economic Liberal must surely maintain that the only
sound money is hard money (or commodity money); that the less the state
has to do with money the better" (Hicks, 1963, 319). How then to
make the national money systems that have emerged since the demise of
the gold standard more automatic? Hicks found Friedman's
prescription of an X-percent rule "very unappetizing" and
questioned the basis for the specific rates of growth suggested by
Friedman. Hicks also wondered about how binding such rules would be if
ever established. Hicks was also unsympathetic to Friedman's
prescriptions for international monetary, arrangements, flexible
exchange rates, noting that it appeared to be a "... very
nationalistic form of economic liberalism," which would deprive the
world of the benefits of international money (such as existed under the
Gold Standard). The reviews by Baran and Lemer were less favorable, and
did not pay as much attention to the monetary proposals in Capitalism
and Freedom.
Assessment
Assessing Friedman's influence on public policy, Allan Meltzer (2004) cites the decision to float the dollar in 1971 and 1973 (4) as
one of Friedman's major successes (the others being ending the
military draft and the repeal of interest rates ceilings). Meltzer cites
Friedman's proposal for a constant money growth rule as his most
famous proposal, but notes that it was never adopted. Nevertheless it
helped shape the debate about monetary policy in subsequent decades.
What follows are some observations about the arguments made in
Capitalism and Freedom to support the specific proposals made there
about monetary policy and how the debate subsequently evolved.
Impact on the Economics Profession
Before considering the ideas in the abstract, it is worth asking to
what extent the key proposals regarding money in Capitalism and Freedom
were accepted by members of the economics profession. As show in Table
1, a 1976 survey by Kearl et al. asked a sample of economists whether
they agreed or disagreed with a number of basic economic propositions,
including "The Fed should increase the money supply at a fixed
rate." In 1976 and in a follow up survey in 1990 (Alston et al.,
1990) Kearl et al. found a relatively strong consensus among economists
disagreeing with this proposition. A key difference between the
authors' 1976 and 1990 surveys is that in the 1990 survey they
found less agreement on the ability (as opposed to the desirability) of
the Fed to control the growth of money. (5) Nevertheless, the same
surveys found a growing consensus among economists on a key Friedman
proposition, that inflation is a monetary phenomenon. In 1976, 43
percent of the economists surveyed disagreed with this proposition, as
opposed to 29 percent in 1990, and 17 percent in 2000 (according to
Fuller and Geide-Stevenson, 2003).
While only 14 percent of the economists surveyed by Kearl et al. in
1976 were in general agreement with the prescription of a constant
growth rate rule for the money stock, 61 percent of the respondents in
the same survey agreed with the proposition that, "Flexible
exchange rates offer an effective international monetary
arrangement." The later surveys of Alston et al. and Fuller and
Geide-Stevenson found comparably large percentages of economists
agreeing with this proposition. Interestingly, Alston et al. also
document significant vintage effects in the extent of agreement with the
key Friedman propositions. They find that the older one's highest
degree, the greater the tendency to disagree with the proposition that
inflation is a monetary phenomenon and the proposition that the Fed
should follow a constant money growth rule. (6)
Given the existence of such vintage effects, it is interesting to
see how the views of graduate students on these propositions have
evolved. In their 1985 survey of graduate students at seven major
economics departments, Colander and Klamer (1987) assessed the degree of
agreement with the propositions, "The FRB should maintain a
constant money growth," and "Inflation is primarily a monetary
phenomenon." (7) Only 9 percent agreed with the money growth
proposition without reservations; 34 percent agreed with some
reservations. As to the proposition that inflation is a monetary
phenomenon, almost equal proportions of graduate students agreed, agreed
with reservations, and disagreed. Perhaps not surprisingly, agreement
with both propositions was strongest at the University of Chicago.
Colander (2005) reports findings from a follow-up survey conducted among
students at the same schools between 2001 and 2003. In the later survey,
Colander found fewer students agreeing with the constant money growth
prescription for monetary policy, with the number of students in
agreement at Chicago declining from 41 percent to 18 percent. There was
more agreement among students on the proposition that inflation is a
monetary phenomenon, except at Chicago. In the earlier survey 84 percent
of students agreed with the proposition without reservations; that
number fell to 44 percent in the later survey, with 25 percent of
Chicago students agreeing with reservations and 21 percent in outright
disagreement. (At all the other schools, the percentages disagreeing
with the inflation proposition declined between the two surveys.)
What about economists in other countries? Surveys of
economists' opinions similar to those just reviewed for the United
States have been carried out in a number of other countries. Block and
Walker (1988) surveyed economists in Canada; Ricketts and Shoesmith
(1990) surveyed economists in the UK; Pommerehne, Schneider, Gilbert and
Frey (1984) surveyed economists in a number of continental European
countries. In their surveys of European economists in 1981, Pommerehne
et al. found a relatively high degree of disagreement (close to
two-thirds of respondents) with the X-percent rule proposal in Austria
and Germany, with somewhat less disagreement in Switzerland. However,
almost two-thirds of the French economists in their survey either agreed
or agreed with provisions with the X-percent proposal, a higher fraction
than in any of the U.S. surveys. Block and Walker found more than half
of Canadian economists disagreeing with the proposal, while Ricketts and
Shoesmith found relatively little support among UK economists for the
X-percent rule.
Table 2 summarizes support for the proposition that "Flexible
exchange rates offer an effective international monetary
arrangement" from the same surveys of economists. Support for the
flexible exchange rate proposal is a lot stronger in these surveys than
for the X-percent rule, and also quite widespread. The exception seems
to be France, where only 11.1 percent of economists were in general
agreement, as opposed to close to two-thirds of economists elsewhere.
Commodity Standards
Friedman published a lengthy discussion of commodity standards
topic in his paper "Commodity Reserve Currency," which was
published in the Journal of Political Economy in 1951 and reprinted in
Essays in Positive Economics in 1953. Much of what Friedman had to say
about the resource costs of commodity standards is now conventional
wisdom. Indeed, in a comparison of the competing merits of commodity and
fiat money standards, it is generally accepted that flat standards win
every time because of their lower real resource costs. In recent years
the central banks of most industrial countries have been selling off
their gold stocks, thereby eliminating the last vestiges of any
commodity backing of currencies.
However, in a 1986 paper, Friedman revisited the issue and noted
that fiat standards have real resource costs as well, especially when
they are associated with long run price uncertainty. In the mid-1980s it
was still far from clear that inflation had been tamed, although
inflation had fallen dramatically in the United States. Friedman (1986)
noted that under commodity standards, the price level had a physical
anchor which generated long-run price stability. He noted "The
price level in Britain in 1930 was roughly the same as in 1740; in the
United States in 1932, it was roughly the same as in 1832"
(Friedman, 1986, 643). Friedman (1986) gave a number of examples of the
real resource costs that long-run price level uncertainty under fiat
standards generated: real resources are consumed in financial planning,
as well as in the development of financial markets to allow businesses
and households to insulate themselves against high and variable
inflation. The same price level uncertainty also leads private
individuals to hold precious metals to hedge against uncertainty under
fiat standards, and Friedman speculated that the real resource costs of
these precious metal holdings "... may have been as great as or
greater than it would have been under an effective gold standard"
(Friedman, 1986, 644). Friedman concluded that measurement of the real
resource costs of irredeemable paper money and comparison of these costs
with the better-understood resource costs of commodity money was an open
question for economic research. However, this is not an issue that
economists seem to have embraced: A recent citation search for
Friedman's 1986 article turned up only 3 citations in the SSCI.
Part of the reason for the lack of research on the resource costs
of fiat money, no doubt, is the success central banks have had in the
intervening period in bringing inflation under control. Figure 1 shows
the number of countries experiencing quarterly inflation rates in excess
of 50 percent (a commonly used definition of hyperinflation). Note the
steady increase in the number of high inflation countries following the
collapse of the Bretton Woods system. At the time, Friedman wrote his
1986 article, it was far from obvious that central banks would be as
successful as they subsequently turned out to be in lowering inflation.
Many industrial countries made significant progress in lowering
inflation in the 1980s, with the developing countries catching up in the
1990s. By the turn of the new century, only one or two countries were
experiencing inflation rates in excess of 50 percent a quarter.
[FIGURE 1 OMITTED]
Central Bank Independence
Friedman's discussion of independent central banks runs
contrary to much of the contemporary conventional wisdom on central
banking. Developing ideas expressed in Friedman (1960a, 1960b), as well
as in Capitalism and Freedom and elsewhere (Friedman, 1985) went on to
advocate ending independence of the Federal Reserve by making it a
bureau of the Department of the Treasury. However, subsequent
developments have tended to convince most economists of the need for
greater rather than lesser central bank independence. In an influential
paper, Alesina and Summers (1993) pointed out a remarkable correlation
between central bank independence and inflation outcomes: specifically,
independent central banks seem to deliver better inflation performance
over time, and this better performance comes at no cost in terms of real
growth. This finding and its confirmation by many subsequent studies
motivated the global trend towards granting central banks greater
independence in the 1990s (starting with the Reserve Bank of New Zealand in 1990, the Bank of France in 1994, the Bank of England in 1997, the
European Central Bank in 1998, and most recently, the Central Bank of
Iraq). (8)
Friedman's two major concerns about independent central banks
(the political and technical) have been addressed in recent years by a
variety of means. It is generally accepted that when central banks are
granted independence, mechanisms should be put in place to ensure that
they are held accountable. In many cases the granting of independence to
a central bank has been accompanied by the adoption of some form of
inflation targeting as a monetary policy strategy. This serves to focus
central bank deliberations on the one thing it can consistently deliver
over time, and provide a ready metric by which its performance can be
judged. In the case of the Bank of England, for example, which was
granted operational independence by the Labour government in May 1997,
(9) this takes the form of requiring the governor and other members of
the Bank's Monetary Policy Committee testify before the relevant
committees of parliament, having an inflation objective set by the
Chancellor of the Exchequer, and requiring that the governor provide a
written explanation of when inflation deviates by more than a prescribed
amount from the government's target.
Addressing Friedman's technical arguments against central bank
independence is more difficult. Friedman's concern was that
mistakes were inevitable when policy actions were dependent on accidents
of personality. (10) While monetary policy in the United States is made
by a committee, the Federal Open Market Committee (FOMC), the Chairman
of that committee wields significant power, and is often seen as the key
personality. Chairmen inevitably wield more power than other committee
members, but the global trend towards greater central bank independence
in the 1990s has also seen a tendency to hand responsibility for
monetary policy over to committees. In the UK, monetary policy is made
by the Monetary Policy Committee of the Bank of England, which includes
technical experts presumably to minimize the risk of errors.
Of course, whether a central bank can ever be truly independent is
an open question. As many students of monetary policy have noted,
independence that is conferred by legislation can be just as easily
revoked by subsequent legislation. Coleman (2004) is an interesting
study of how fleeting independence can be when the monetary authority
falls foul of powerful business interests. Enshrining independence in a
constitutional document or, as in the ECB's case, an international
treaty, is likewise no guarantee that independence will last.
Constitutional amendments can always be undone by subsequent amendments.
Rules based monetary policy
One area where Friedman has had a lasting impact is in terms of his
arguments for rules-based monetary policy. As noted above, Meltzer
(2004) argues that this is the most famous of Friedman's many
policy proposals. However, we need to distinguish between
Friedman's arguments for rule-based policy making and the specific
rule Friedman proposed. The X-percent rule has been much debated in the
practical literature on monetary policy, yet has never been fully
adopted. The closest any country or central bank has come to adopting
the rule has been to use monetary targets in setting monetary policy.
Monetary targets became popular with many central banks following the
collapse of the Bretton Woods system in the 1970s. The Fed started to
specify explicit targets for the monetary aggregates in 1975, and these
targets became enshrined in law with the Full Employment and Balanced
Growth Act of 1978. From 1974 until the establishment of EMU, the
Bundesbank announced annual targets for the rate of growth of M3. The
ECB's publication of a reference value for M3 growth is a relic of
Friedman's proposed rule. No other major central bank continues to
report targets or reference values for monetary aggregates. This is due
to the experience with money targets in the 1970s and 1980s: as one
former Governor of the Bank of Canada famously put it, "We did not
abandon M1, M1 abandoned us." (11)
What is no longer in dispute is that central bank policy making
should be guided by rules rather than discretion, or rather, that the
discretion that central banks enjoy should be in some sense constrained.
While the particular rule favored by Friedman has never been widely
used, others have. In this sense, Friedman may be said to have lost the
battle but won the war. Friedman's arguments for rules followed in
many ways from Simons (1948). Kydland and Prescott (1977) strengthened
the argument for rules by showing that even a benevolent monetary policy
maker will generally produce too much inflation if allowed full
discretion. Woodford's
(2003) treatise reviews the recent debates about the role of rules in
monetary policy and clarifies what it means for policy to be rule based.
Woodford's treatise is also important in illustrating the
shift away from an emphasis on money (the quantity theory view) and
towards a neo-Wicksellian approach to monetary policy. As Poole (2004)
has noted, money now plays very little role in the deliberations of the
Fed, or of other major central banks for that matter. The ECB is an
anomaly in this regard in that it still assigns a prominent role to
money in its deliberation, but it is not clear whether the monetary
pillar has been all that important in practice.
Contemporary discussions of rules-based monetary policy are cast in
terms of a reaction function for the interest rate controlled by the
central bank. The interest rate is specified to be some function of
inflation and indicators of real economic activity, and possibly other
macroeconomic indicators. The best known such rule is the Taylor (1993)
rule, which specifies how the central bank should change interest rates
in response to deviations of inflation, x, from some target and output,
y, from potential output, [bar.y] :
i = 0.04 + 1.5([pi] - 0.02) + 0.5(y - [bar.y])
Friedman, of course, was famously skeptical of central bank efforts
to control interest rates. In his 1967 presidential address to the
American Economic Association, Friedman (1968) outlined how attempts to
peg interest rates could lead to explosive inflations or deflations. If
nominal rates are pegged at a level below the natural rate, inflation
will rise, which will lead to higher inflation expectations. With pegged
nominal rates, this causes real interest rates to decline, further
stimulating demand and adding to inflation. The same line of argument
implies accelerating deflation when nominal rates are pegged above the
natural rate.
Woodford (2003) argues that this line of reasoning may be correct
as far as it goes, but it is critically dependent on the assumption that
the central bank does not alter its setting for its interest rate in
response to inflation developments. Once this assumption is relaxed,
interest rates rules of the sort now widely studied in the literature on
monetary policy are quite compatible with stable prices.
Optimal rules
No central bank has ever adopted the X-percent rule for monetary
policy proposed by Friedman in Capitalism and Freedom, and it has
received relatively little attention in the academic literature.
However, academics continue to debate the merits of the other
"Friedman rule" that Friedman put forward in his classic essay
on The Optimum Quantity of Money (Friedman (1969). (12) This Friedman
rule, the Friedman rule in the eyes of many, called for contracting the
stock of money at a pace sufficient to drive the nominal interest rate down to zero. The rationale for the rule is simple: since money yields
useful services (by facilitating transactions) but does not pay
interest, consumers will hold less of it than they otherwise would if
nominal interest rates were zero. Furthermore, since under a flat
standard money is essentially costless to produce, it is welfare
improving to equalize the returns on money and alternative assets. This
requires contracting the stock of money at a pace sufficient to induce
deflation at a rate equal to the real rate of interest, thus making
nominal interest rates equal to zero.
Unlike the rule proposed in Capitalism and Freedom, this particular
rule for monetary policy was shown by Friedman to be optimal (welfare
maximizing) on the basis of basic economic principles. Subsequent
analysis of this rule has shown it to be optimal in a wide range of
circumstances. Early critics of the rule argued that it might not be
optimal in situations where the government has to rely on distorting
taxes to fund government programs; in such a situation, it was argued
that optimal public finance considerations would call for some revenue
to be raised by inflation taxes. Mulligan and Sala-i-Martin (1997)
review the literature on the Friedman rule and show that the optimality
of the rule cannot be decided on theoretical grounds alone. Rather, as
with many other things in economics, it depends on assumptions. They
show that existing evidence on key parameters of consumer preferences
suggests that the optimal inflation rate is positive, but small. Lucas
(2000) reviews some of these arguments and concludes that the needed
qualification to the Friedman rule that the presence of taxes or other
distortions requires is trivially small. The Friedman rule has also
attracted renewed attention from central bankers (or at least from their
staffs), given the recent deflation scare in the United States in 2003
and the more protracted experience of Japan. However, the prospects of
any central bank adopting this rule any time soon are remote. In the
eyes of many central bankers, the models that yield the Friedman rule as
the optimal prescription for monetary policy over emphasize the shoe
leather costs of inflation and ignore the other costs of inflation. In
addition, these models tend to have a limited role for counter-cyclical
policy.
In the conclusion to his 1969 essay Friedman addressed the conflict
between the Friedman rule, an optimal rule for monetary policy worked
out from basic principles of economic theory, and the X-percent rule
proposed in Capitalism and Freedom. Friedman advanced two reasons for
the differences between the two. The first is that the X-percent rule
was proposed "... with an eye primarily to short-run
considerations" (Friedman, 1969, 48) whereas the optimal rule
"... puts more emphasis on long-run considerations."
(Friedman, 1969, 48) The second and more fundamental reason was that at
the lime A Program for Monetary Stability was written, Friedman had not
yet worked out the theory in the optimum quantity paper. In concluding
Friedman noted that "The gain from shifting to the [X]-percent rule
would.., dwarf the further gain from going to the 2 percent rule, even
though that gain may well be substantial enough to be worth pursuing.
Hence I shall continue to support the 5 percent rule as an intermediate
objective greatly superior to present practice."
The importance of money in economic fluctuations
Friedman and Schwartz' Monetary History convinced many of the
importance of money in economic fluctuations. As Robert Lucas noted in
his 1994 review of Monetary History after 30 years, it constituted a
"... remarkable and durable achievement of historical and economic
scholarship" and "... played an important--perhaps even
decisive--role in the 1960s debates over stabilization policy between
Keynesians and monetarists" (Lucas, 1994). In Capitalism and
Freedom, Friedman was primarily concerned with the role of money in
generating business cycles, and argued based on the Monetary History
that the Great Depression was due to the shortcomings of monetary policy
at that time. Indeed the view that monetary policy is the primary cause
of business cycles has become mainstream, with the late Rudiger
Dornbusch famously quipping that "Expansions do not die of old age:
they are murdered by the Fed."
In the past two decades, economists have begun to pay more
attention to the importance of real shocks as sources of business
fluctuations. In a seminal paper, Kydland and Prescott (1982) argued
that almost all of the business cycle fluctuations observed in the
postwar US economy could be accounted for by real shocks, with only a
small role for money. Whatever one may think of the ability of real
business cycle models to explain postwar business cycles in the US, most
mainstream economists still subscribe to the Friedman and Schwartz view
of the Great Depression as being the result of bad monetary policy.
Speaking at a University of Chicago conference held in 2002 to honor
Friedman on his ninetieth birthday, Federal Reserve Governor Ben
Bernanke concluded on the Fed's role in the Great Depression
"You're right, we did it. We're very sorry. But thanks to
you, we won't do it again." (13) In his review of Monetary
History on its thirtieth anniversary, Lucas (1994) argued that
"Viewed as positive theory, real business cycles do not offer a
serious alternative to Friedman and Schwartz's monetary account of
the early 1930s." (Lucas, 1994, 13) He argues that the relative
success of real business cycle models in accounting for postwar
fluctuations in the US may simply be a reflection of the fact that the
conduct of monetary policy has been so much better in the postwar
period, not that money doesn't matter.
However, recent research has begun to challenge Friedman and
Schwartz' explanation of the Great Depression as being due
primarily to monetary policy. Cole and Ohanian (1999, 2000) show that
while monetary shocks might be able to account for the decline in output
during the Great Depression, they cannot account for the slow pace of
the recovery after 1933. Likewise they find that bank failures and the
increases in reserve requirements in 1936 and 1937 cannot account for
the slow pace of the recovery. They conclude by suggesting, very much in
the sprit of Friedman, that the New Deal policies introduced to end the
Depression, specifically the National Industrial Recovery Act of 1933,
may have played an important role in prolonging the recovery by allowing
many sectors of the economy to cartelize. (14) Cole and Ohanian (2001)
evaluate this idea about New Deal cartelization policies and find that
it can account in a quantitative sense for the slow pace of the recovery
after 1933.
Flexible exchange rates
As noted above, Meltzer (2004) counts the decision to float the
dollar as one of Friedman's great policy successes. As Figure 2
shows, there has been a steady increase in the number of countries with
some form of floating exchange rates since the demise of the Bretton
Woods system in the early 1970s. In many cases the decision to let a
currency float was taken after a financial crisis precipitated by an
attempt to defend an unsustainable peg. Many countries continue to peg
their currencies to the dollar or the euro or a basket of major
currencies as a way to limit discretionary monetary policy. Some have
gone even further an adopted currency boards or dollarized outright,
effectively outsourcing monetary policy and thereby completely removing
any scope for discretionary domestic monetary policy.
The most important intellectual challenge to Friedman's
argument for flexible exchange rates is probably that posed by Wallace
(1979) and Kareken and Wallace (1981). These authors pointed out that
under a fiat money standard and with no controls on currency holdings,
the exchange rate between currencies is indeterminate: any exchange rate
will serve to equate the world supply and demand for money. The reason
for the indeterminacy is that fiat currencies have three important
features that distinguish them from other goods or assets, namely that
they are intrinsically useless, they are unbacked and they are
essentially costless to produce. As a result there are no fundamentals
of tastes and technology to determine the relative prices of fiat
currencies if individuals are free to use any currency.
[FIGURE 2 OMITTED]
The only way to resolve this indeterminacy is to impose
restrictions on currency holdings, which are also costly. The
alternative is a system of fixed exchange rates where central banks
agree to trade unlimited amounts of each other's obligations at a
fixed rate at any time, and agree on the total amount of obligations to
be issued and the allocation of seigniorage. As Wallace (1979) notes,
none of the feasible options is without drawbacks. A system of fixed
exchange rates requires international coordination of monetary policies,
which means that monetary policy can no longer be directed exclusively
at the attainment of domestic objectives. If the determination of
exchange rates is to be left to free markets, the only way exchange
rates can be made determinate is through the imposition of capital
controls or legal restrictions on the use of currency.
Conclusion
Writing in the Wall Street Journal in 1988, Friedman asserted
"No major institution in the U.S. has so poor a record of
performance over so long a period as the Federal Reserve, yet so high a
public recognition." (15) Fifteen years later, in the same forum,
he essentially retracted this view, noting that in the intervening
period the Fed seemed to have gotten its act together. Friedman
attributed this to the Fed's adoption of price stability as its
primary goal and the use of better economic theory. (16) The improved
performance of the Fed was matched by improved performance by central
banks in almost all countries, due in no small part to the influence of
Friedman's ideas.
Of the two key monetary policy proposals put forward in Capitalism
and Freedom, only floating exchange rates have been widely adopted.
After a brief experiment with monetary targeting in the 1970s and 1980s
central banks have adopted other strategies for monetary policy, with
inflation targeting now the preferred strategy of many central banks.
Friedmans' arguments against commodity standards are now part of
the conventional wisdom: with central banks around the world gradually
disposing of their remaining stocks of gold, the last vestiges of the
gold standard are disappearing. The use of currency boards in some
emerging market economies can be viewed as a manifestation of the
acceptance of the idea that monetary policy needs to be rule based,
which is arguably Friedman's most important legacy in the monetary
arena. Economists continue to debate the causes of the Great Depression,
but the thesis advanced by Friedman that it was first and foremost a
failure of government rather than a failure of capitalism remains
integral to most of the stories. Most economists now accept that money
plays an important role in economic fluctuations, but money itself is no
longer center stage in central bank deliberations about policy. While
the rule proposed by Friedman in Capitalism and Freedom was never
adopted, Friedman's later work on the optimum quantity of money
continues to inspire research and was the earliest attempt to pose
policy questions in what is now the dominant approach.
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Mark A. Wynne
Federal Reserve Bank of Dallas
(1) Friedman's discussion of independent central banks drew
heavily on Friedman (1960b).
(2) Friedman had first advocated flexible exchange rates in
Friedman (1953).
(3) Bernanke (2004) refers to the Great Inflation as the second
most important monetary policy mistake of the twentieth century, after
the Great Depression.
(4) The convertibility of the dollar into gold was suspended in
August 1971. The Smithsonian Agreement of December 1971 provided for a
multilateral realignment of exchange rates and a devaluation of the
dollar against gold. In April 1973 the currencies of the major
industrial countries were allowed to float.
(5) As indicated by the responses to the proposition, "The Fed
has the capacity to achieve a constant rate of growth of the money
supply if it is desired."
(6) Alston et al. also find that economists who received their
highest degree either prior to 1961 or during the 1960s had the greatest
tendency to disagree with the proposition that economies have a natural
tendency to return to their equilibrium growth paths following
disturbances.
(7) The seven departments were Chicago, Harvard, MIT, Yale,
Princeton, Columbia and Stanford.
(8) As decreed by L. Paul Bremer in Coalition Provisional Authority Order Number 18, dated July, 2003.
(9) Subsequently confirmed by the Bank of England Act 1998, which
came into force on June 1, 1998.
(10) Friedman (1985) later argued that subsequent experience led
him to alter his views about the importance of personalities in monetary
policymaking, noting that Fed policy had shown remarkable continuity
despite major differences in the personalities and backgrounds of the
key players.
(11) Attributed to Gerald Bouey, Governor of the Bank of Canada,
1973-1987. The source is Canada: House of Commons Standing Committee on
Finance, Trade and Economic Affairs: Minutes of Proceedings and
Evidence, No. 134, 28 March 1983, 12.
(12) A quick search on Google for "The Friedman Rule"
turned up nearly 6,000 hits, all of which seem to refer to the 1969
Friedman Rule.
(13) See McLane (2002).
(14) Higgs (1997) provides a different take on why the recovery
from the Great Depression took so long: he emphasizes the role of regime
uncertainty (in particular uncertainty about property rights) as a
factor depressing private investment.
(15) Wall Street Journal, April 15, 1988.
(16) Wall Street Journal, August 19, 2003.
Table 1. Professional Support for Friedman's X-percent Rule
The central bank (Fed) should be instructed to increase the money
supply at a fixed rate
Year(s) Generally Agree with Generally
Country of Survey Agree Provisions Disagree
us 1976 14 25 61
1990 13.4 30.6 54.1
US 1985 9 34 45
(graduate
students)
2001-2003 7 22 50
Canada 1986 13.5 29.1 54.9
Austria 1981 5.5 24.2 68.1
France 1981 32.7 32.7 28.4
Germany 1981 9.5 26.7 62.6
Switzerland 1981 15.1 34.2 44.7
Agree Agree with Neither Agree
Strongly Reservations nor Disagree
UK 1989 3.1 13.6 28.0
Generally Disagree
Disagree Strongly
UK 1989 37.4 17.2
Notes to Table: Sources: US: Kearl, Pope, Whiting and Wimmer (1979),
Table 1 for 1976 data; Alston, Kearl and Vaughn (1992), Table 1, for
1990 data; US graduate students: Colander and Klamer (1987), Table 4,
for 1985 data; Colander (2005), Table 6, Walker (1988), Table 2;
Austria, France, Germany and Switzerland: Pommerehne, Schneider,
Gilbert and Frey (1984), Table A.
Table 2. Professional Support for Friedman's Flexible Exchange Rate
Proposal
Flexible exchange rates offer an
effective international monetary
arrangement
Year(s) Generally Agree with Generally
Country of Survey Agree Provisions Disagree
US 1976 61 34 5
1990 56 33.6 8.4
2000 61.4 31.5 5.0
Canada 1986 57.6 35.9 5.9
Austria 1981 34.1 49.4 16.5
France 1981 11.1 38.3 44.4
Germany 1981 62.0 30.0 5.1
Switzerland 1981 52.3 38.7 7.5
Notes to Table: Sources: US: Kearl, Pope, Whiting and Wimmer (1979),
Table 1, for 1976 data; Alston, Kearl and Vaughan (1992), Table 1,
for 1990 data; Fuller and Geide-Stevenson (2003), Table 1, for 2000
data; Canada: Block and Walker (1988), Table 2; Austria, France,
Germany and Switzerland: Pommerehne, Schneider, Gilbert and Frey
(1984), Table A.
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