Economics One

We can still learn much from Milton Friedman, as we celebrate his 105^th birthday today.  Here I consider what we can learn from his participation in the monetary policy debates in the 1960s and 1970s. I draw from a 2002 paper that I presented to lead off his 90^th birthday celebration in Chicago in 2002  and from two 2012 pieces: a paper I presented at the centennial of his birth in 2012 and an article written on his 100th birthday in 2012.The lessons are very relevant to the debates raging during the last 15 years and continuing today.

Back in the early 1960s, the Keynesian school first came to Washington led by Paul Samuelson who advised John F. Kennedy during the 1960 election campaign and recruited Walter Heller and James Tobin to serve on the Council of Economic Advisers. The Keynesian approach received its official Washington introduction when Heller, Tobin, and their colleagues wrote the Kennedy Administration’s first Economic Report of the President, published in 1962. The Report made the case for discretion rather than rules. For monetary policy it said that a “discretionary policy is essential, sometimes to reinforce, sometimes to mitigate or overcome, the monetary consequences of short-run fluctuations of economic activity.”

In that same year Milton Friedman published Capitalism and Freedom (1962) giving the competing view. He argued that “the available evidence . . . casts grave doubt on the possibility of producing any fine adjustments in economic activity by fine adjustments in monetary policy—at least in the present state of knowledge . . . There are thus serious limitations to the possibility of a discretionary monetary policy and much danger that such a policy may make matters worse rather than better . . .”

So there were two different views, and the fundamental difference was over discretion versus rules-based policies. From the mid-1960s through the 1970s the Samuelson view was winning with practitioners putting discretionary monetary policies into practice, mainly the go-stop policies that led to both higher inflation and higher unemployment. Friedman remained a persistent and resolute champion of the alternative view. Fortunately, Friedman’s arguments eventually won the day and American economic policy moved away from an emphasis on discretion in the 1980s and 1990s. Paul Volcker, who as chair of the Fed implemented the more rules-based policy, had to confront the disparity of views as he did so as I described here.

But this same policy debate is back today. Economists on one side push for more discretionary monetary policy such as the quantitative easing actions and resist the notion of rules-based monetary policy. Other economists argue for a return to more predictable and rule-like monetary policy. They argue that the bouts of quantitative easing were not very effective, and that deviations from rules-based policy helped worsen the great recession.

Of course there are many nuances today, some related to the difficulty of distinguishing between rules and discretion when the zero lower bound is thought to be a constraint. Interestingly, you frequently hear people on both sides channeling Milton Friedman to make their case.

The debate is not merely academic. Rather it is a debate of enormous practical consequence with the well-being of millions of people on the line. The House of Representatives has passed a bill calling for the Fed to describe its policy rule and recent Fed reports have talked about normalization raising questions about a return to rules-based policy.  The same issues arise in discussions of unconventional monetary policy in Europe and Japan.

Can the disagreements be resolved? Milton Friedman was optimistic that debates could be resolved, and I am sure that this is one reason why he kept researching and debating the issue so vigorously.

Today people on both sides can learn from him. First, while a vigorous debater he was respectful, avoiding personal attacks. Second, he had a strong believe that empirical evidence would bring people together. Yes, people would come to the issue with widely different prior beliefs, but their posterior beliefs—after evidence was collected and analyzed—would be much closer. In this way the disagreement would eventually be resolved.

Although posterior beliefs in the monetary area now seem just as far apart as prior beliefs were 50 years ago, I sense that empirical work on the policy decisions of recent years, like the empirical paper by Alex Nikolsko-Rzhevskyy, David Papell, Ruxandra Prodan, can bring about more convergence of views.  As I said at the time of his 100^th birthday, clearly we can learn a lot from Milton Friedman in deciding how to proceed.

The Federal Reserve Board’s semi-annual Monetary Policy Report issued by Chair Janet Yellen last Friday contains a whole new section called “Monetary Policy Rules and Their Role in the Federal Reserve’s Policy Process.” The section contains new information and is well worth reading. Below is an excerpt which first lists three “key principles of good monetary policy” that the Fed says are incorporated into policy rules; it then lists five policy rules, including the Taylor rule and four variations on that rule that the Fed uses, with helpful references in notes which are also excerpted below.

The three principles sound quite reasonable: on the third–called the “Taylor Principle” by Mike Woodford and others–the Fed is quite specific in that it gives the numerical range for the response of the policy rate–the federal finds rate–to the inflation rate. The policy instrument is not mentioned specifically for the other two principles

More information, including some algebra, is given in Figure A which is reproduced below. It is good that one of the five policy rules–which the Fed calls the “Taylor (1993) rule, adjusted”–is based on the important 2000 research paper by David Reifschneider and John Williams on the zero lower bound which I have written about here. Note that the Fed describes these rules using the unemployment rate rather than real GDP, relying on an empirical connection between the real GDP/potential GDP gap and the unemployment rate (Okun’s law). Note that what the Fed calls the “balanced-approach rule” is the Taylor rule with a different coefficient on the cyclical variable

The Fed’s Report then goes on to compare the FOMC’s settings for the federal funds rate with the rules as summarized in the next chart. It shows that the interest rate was too low for too long in the 2003-2005 period according to the Taylor rule (not sure if the Fed was looking at the other rules back then), and that according to three of the rules the current fed funds rate should be moving up. (The Fed makes these calculations using its estimate of time variation in the neutral rate of interest ).In reporting on well-known policy rules, the Fed is doing part of what is called for in the legislation which recently passed the House as Title X, Section 1001 of H.R. 10. However, aside from being positive about the three principles, it does not say much about its own policy strategy in the document as also called for in the legislation.

In addition, the report focuses extensively on differences, rather than similarities, in the policy rules, and on the differences in inputs to the policy rules. The differences in measures of inflation, the neutral interest rate, and other variables are part of monetary policy making and always will be. In reality they are a reason to use policy rules as a means of translating these differences in measurement into differences about policy in a systematic way. Such differences do not imply that policy rules or strategies are impractical, as the Report seems to suggest, at least based on some financial reporting.

Chair Yellen will testify at the Financial Services Committees of the House on Wednesday and at the Banking Committee of the Senate on Thursday of this week on the Report and other matters. The testimony and the questions and answers about the Report at the hearings will be well worth following.