The genius that was Milton Friedman

Going back over old posts, I found one from 6 years ago that covered Milton Friedman. That was in Portuguese, and here I have more.

This is taken from the Q&A following Friedman´s Keynote Address at a Bank of Canada Conference in 2000. Here´s Friedman, on the hot topics of today: The Euro, Inflation Targeting operated primarily through interest rates, and Japan

Michael Bordo: Do you think the recent introduction of the euro will lead to the formation of other common-currency areas?

Milton Friedman: That’s an extremely interesting question. I think that the euro is one of the few really new things we’ve had in the world in recent years. Never in history, to my knowledge, has there been a similar case in which you have a single central bank controlling politically independent countries.

The gold standard was one in which individual countries adhered to a particular commodity—gold—and they were always free to break or to leave it, or to change the rate. Under the euro, that possibility is not there. For a country to break, it really has to break. It has to introduce a brand new currency of its own.

I think the euro is in its honeymoon phase. I hope it succeeds, but I have very low expectations for it. I think that differences are going to accumulate among the various countries and that non-synchronous shocks are going to affect them.

Right now, Ireland is a very different state; it needs a very different monetary policy from that of Spain or Italy. On purely theoretical grounds, it’s hard to believe that it’s going to be a stable system for a long time. On the other hand, new things happen and new developments arise.

The one additional factor that has come out that leads me to raise a question about this is the evidence that a single currency—currency unification— tends to very sharply increase the trade among the various political units. If international trade goes up enough, it may reduce some of the harm that comes from the inability of individual countries to adjust to asynchronous shocks. But that’s just a potential scenario.

You know, the various countries in the euro are not a natural currency trading group. They are not a currency area. There is very little mobility of people among the countries. They have extensive controls and regulations and rules, and so they need some kind of an adjustment mechanism to adjust to asynchronous shocks—and the floating exchange rate gave them one. They have no mechanism now. If we look back at recent history, they’ve tried in the past to have rigid exchange rates, and each time it has broken down. 1992, 1993, you had the crises. Before that, Europe had the snake, and then it broke down into something else. So the verdict isn’t in on the euro. It’s only a year old. Give it time to develop its troubles.

(Note)

Malcolm Knight: Countries with a flexible exchange rate need a nominal target for monetary policy to anchor expectations. Do you feel that inflation targeting provides a useful nominal target?

Milton Friedman: As I mentioned earlier, I think it’s a good thing to have a nominal target, to say that you’re not going to try to fine-tune, and to indicate what you aren’t going to do.

The problem I have is this: the current mechanism for all of the central banks who are inflation targeting is a short-term interest rate—as in the United States—in all of the central banks.

We know from the past that interest rates can be a very deceptive indicator of the state of affairs. A low interest rate may be a sign of an expansive monetary policy or of an earlier restrictive policy. And similarly, a high rate may be a sign of restriction, of trying to hold things down; or it may be a sign of past inflation.

The 1970s offer the classical illustration in which there were high interest rates that were reflecting the Fisher effect of inflation expectations. So I’m a little leery of operating primarily, or almost primarily, via interest rates. But, I think that having a given inflation target is a good objective. The question is, how long will you be able to keep it?

David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero, monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?

Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.

The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.

Blissful Ignorance

Janet Yellen:

And, as ever, the economic outlook is uncertain, and so monetary policy is not on a preset course. Our ability to predict how the federal funds rate will evolve over time is quite limited because monetary policy will need to respond to whatever disturbances may buffet the economy. In addition, the level of short-term interest rates consistent with the dual mandate varies over time in response to shifts in underlying economic conditions that are often evident only in hindsight.

For these reasons, the range of reasonably likely outcomes for the federal funds rate is quite wide–a point illustrated by figure 1 in your handout. The line in the center is the median path for the federal funds rate based on the FOMC’s Summary of Economic Projections in June.1 The shaded region, which is based on the historical accuracy of private and government forecasters, shows a 70 percent probability that the federal funds rate will be between 0 and 3-1/4 percent at the end of next year and between 0 and 4-1/2 percent at the end of 2018.2

The reason for the wide range is that the economy is frequently buffeted by shocks and thus rarely evolves as predicted. When shocks occur and the economic outlook changes, monetary policy needs to adjust. What we do know, however, is that we want a policy toolkit that will allow us to respond to a wide range of possible conditions.

The range of reasonably likely outcomes for the FF rate is so wide it´s useless.

Blissful Ignorance

One property NGDP targeting (in fact NGDP LEVEL Targeting) is that it is the appropriate framework for “all seasons”, i.e. you don´t need to keep tinkering with monetary policy. In addition to keeping the central bank from mishandling supply shocks, it keeps the central bank from generating demand shocks, which throws both inflation and real growth in the same direction, up as during the “Great Inflation” and down as in the “Great Recession”.

Yellen: “We will keep plodding”

In her opening remarks at Jackson Hole:

…my primary message today is that I expect monetary policy will continue to play a vital part in promoting a stable and healthy economy. New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns. Additional tools may be needed and will be the subject of research and debate. But even if average interest rates remain lower than in the past, I believe that monetary policy will, under most conditions, be able to respond effectively.

Unfortunately, that is not happening. As illustrated in the charts, monetary policy has been overly tight, with a brief respite.

NGDP Saga

Why they don´t perceive this and make a real effort to overhaul the monetary policy framework is beyond comprehension!

Brexit is noise in the bigger picture of monetary strangulation

A James Alexander/Marcus Nunes post

Independent of Brexit, the bigger issue remains that all three currency blocs – USD, Euro and British Pound – are seeing low NGDP growth, too low for comfort. Small real shocks like Brexit (let´s call them, à la Robert Higgs, actual and/or potential institutional discontinuities) cause market mayhem precisely because NGDP growth is too low and thus rather fragile and easily knocked lower.

Why is NGDP level and growth so low? Because central banks seem to like it that way. Their 2% inflation targets dominate their discourse and all their internal projections show them on course to meet their targets in two years’ time – and to hell with NGDP growth. The result is slow monetary strangulation; Brexit is mere noise in this bigger picture.

Nevertheless, given the nature of Brexit, that mixes Supply and Demand shocks, some clarification is in order.

  1. Brexit caused a (global) fall in velocity (AD shock). This requires an offsetting rise in money supply
  2. Brexit caused a (less global) fall in trend real growth (AS shock). Given that monetary policy is synonimous with interest rate policy, this requires a fall in interest rate (because the neutral rate has fallen), which at the ZLB is not forthcoming. In that case, a negative AS shock automatically turns into a negative AD shock.

Solution: Forget interest rate targeting and concentrate on nominal stability (NGDP-LT)

However:

If the negative AS shock is permanent, for nominal stability to be maintained you require a lower trend growth in NGDP.

But

Permanent AS shocks tend to be rare!