Saturday 4, December 2021

Krugman vs Friedman

Milton Friedman was a formidable economist, and person. I have admired him for most of my adult life. But when it comes to the Fed causing the Great Recession, I think Friedman was wrong. The idea was that the Fed allowed the money supply to collapse (or maybe deliberately tightened monetary theory) because it didn’t know what it was doing. Krugman writes:

Why, then, did the money supply shrink? Partly because bank failures made people nervous about the safety of bank deposits; partly because in a shrinking economy people and businesses needed less money on hand for doing business. That is, the economic implosion caused the decline in money rather than the other way around.

Friedman didn’t actually deny this. Although his rhetoric suggested that the Fed caused the slump, if you look closely at his analysis, it says that the Fed could have prevented the slump — a pretty big distinction.

And how could the Fed have prevented the slump, when a large increase in the monetary base didn’t seem to prevent a sharp decline in both the money supply and G.D.P.? Friedman’s claim was that if the Fed had engaged in sufficiently large purchases of government bonds, that is, if it had increased the monetary base even more — and if it had carried out those purchases early enough — it would have headed off the monetary collapse.

But he wasn’t very clear about how, exactly, that would have worked. When the Fed buys government debt from a bank, what does the bank do with the cash? In normal times, we might assume that the bank would lend it out to the private sector, helping to boost the economy. But in the Depression, interest rates were very low and the perceived risks high. Why wouldn’t banks have just sat on extra cash, adding it to their reserves?

My takeaway from this is that monetary policy is largely a waste of time in terms of managing the economy. Most of economics is about real measures: GDP, productivity, distribution, exports. Eliminating the fluctuations arising from changes in the price level is the natural thing to do. Milton Friedman was a charismatic economist, who came late to the idea that the money supply mattered, and used the fame which followed his being awarded the Nobel Prize for this to advocate a bigger role for the market in allocating resources. This might even be down to his desire to argue against his former classmate, Paul Samuelson, who had received the Nobel for a much more orthodox economic approach.

We’ve had a long time since 2008, and we’ve had terrible productivity growth over that period, together with escalating wealth inequality. It’s time to use fiscal policy, to run the economy hot, to pull more citizens into the workforce and to rebalance the returns to labour and to capital. The Davos set won’t like it, but they know it makes sense.