“LongandVariable” (Tony Yates) writes: “Market monetarists and the ‘myth’ of long and variable lags“
One of the tenets of market monetarism is that acivist fiscal policy is a waste of time, since monetary policy can do all the stabilisation that’s needed. On Twitter last night Joe Wiesenthal at Bloomberg wondered what MaMos would think of a strict balanced budget rule. Would that leave monetary policy able to achieve nirvana?
I thought: surely, MaMos would accept that monetary policy works with long and variable lags, the phenomenon, emphasised by Milton Friedman, that this blog is named after? And that therefore we’d get macroeconomic volatility from imperfect control?
Believing in Friedman’s dictum would not undermine MaMoism, since if both fiscal and monetary policy worked with the same long and variable lags, and in the same way, ie if they were perfect substitutes as an instrument, then there would be no need for both.
However, Noah Smith pointed me to this post by Scott Sumner, the leading MaMoist, which contains the phrase ‘long and variable lags is a myth’. The argument in this post seems to me to be full of holes. So, while I wait for an anti-MaMo Matlab program to finish, I will explain why.
As far back as 1960, J.M. Culbertson wrote Lag in effect in the December issue of the JPE:
VIRTUALLY all modern discussion postu-lates that the lag in effect of government fiscal, monetary, and debt-management policies is short enough that they can be used in some active manner to dampen economic fluctuations or to offset factors tending to cause them.
Milton Friedman challenges this view, arguing that monetary policy acts with so long and variable a lag that an attempt to use it actively may aggravate, rather than ameliorate, economic fluctuations. Friedman uses this allegation to support his prescription for a constant growth in the money supply in preference to any actively anticyclical monetary policy. This note points out some troublesome implications of the long-lag hypothesis and examines the evidence that Friedman offers in support of it.
The evidence that Friedman offered in support of his testimony on this subject is that described above-the fact that there is a long and variable lag between the peak rate of increase (decrease) in the money supply and the downturn (upturn) in business. This seems so unconvincing that I wonder whether Friedman does not have something else up his sleeve. However, if he does, we should have it, so let me point out some flaws in his case as it stands.
The most promising approach to estimating the lag in effect of government stabilization policies seems to be an analysis of the channels through which they affect the economy and an appraisal on the basis of experience of the time that it takes for effects to pass through each channel.
The broad record of experience seems to me to support the view that anticylical monetary, debt-management, and fiscal adjustments can be counted on to have their predominant direct effects within three to six months, soon enough that if they are undertaken moderately early in a cyclical phase they will not be destabilizing. This is only a permissive conclusion-it does not indicate what stabilization policy should be. But it is a permissive conclusion upon which all building must depend. The lag doctrine would destroy any foundation for an active stabilization policy and would seem to raise serious questions as to the viability of a market economy.
Maybe what Friedman “had up his sleeve” was the desire to discourage government/central bank from trying to fine-tune the economy!
More than 50 years have passed since Culbertson wrote his article. During this time there´s a “lot of experience to be appraised”.
Almost 30 years before Culbertson´s article, in March 1933, when FDR changed the monetary policy regime, he automatically changed expectations of future monetary policy. In the next 4 months, industrial production went up by more than 50% and there´s an immediate reversal of nominal spending and real GDP! With also immediate effect, in July 1933 there was N.I.R.A., which ground the recovery process to a halt!
How long did it take Paul Volcker to break the back of inflation once he clearly put his mind to it and convincingly signaled his intentions? You can see it was “pretty quickly”, with scarcely a “lag in effect”.
Or, quite recently, how long did it take QE (both 1 & 2) to “take hold”? In the opposite direction, how long did it take Trichet (ECB) to “squeeze the chicken’s neck”?