Federal Reserve Chairman Jerome Powell testified before Congress on Wednesday – a business always risky, as some politicians have strong views on monetary policy that have little to do with expertise or evidence. Sure enough, a Republican member of the House informed Powell to read Milton Friedman – what one suspects he has. I guess the questioner was suggesting that printing money always causes inflation, which is the moral that casual readers of Friedman generally take from his work.
Powell’s response was good as far as she went. “The link between monetary aggregates and growth or inflation has been very strong for a long, long time, and ended about 40 years ago…. It was probably correct when it was written, but it’s been a different economy and a different financial system for some time.
What Powell failed to point out is that while there was historically a strong correlation between money supply growth and other economic indicators, in many cases the causality ran from economy to economy. money supply rather than the other way around. This was especially true during the Great Depression. And that matters, because Friedman’s claim that monetary policy caused depression was central to his whole argument that governments, not the private sector, are responsible for economic instability, that depressions are caused by governments, not the private sector.
Certainly, when governments print huge sums of money to pay their bills, so that the money supply grows by hundreds or thousands of percent a year, high inflation is inevitable. Here is, for example, the experience of Brazil in the first half of the 1990s:
But things are much less clear when monetary growth is less extreme. And the link between monetary policy and inflation or growth more or less disappears when interest rates are close to zero – as they were during the Depression and have been again since 2008:
Let’s talk about the 1930s. The American economy plunged between 1929 and 1933; gross domestic product measured in dollars almost halved, reflecting both a dramatic drop in real output and large-scale deflation. This plunge has been associated with a sharp drop in the money supply:
Friedman insisted that the Fed was responsible for this monetary contraction, leading him to assert, for example in “Free to Choose,” a book he wrote with Rose Friedman, that “the depression was not produced by a failure of private enterprise, but rather by a failure of government.
But if you read his argument carefully, it’s actually quite slippery, in fact bordering on dishonesty.
For, as Friedman was well aware, what economists call “money supply” is, as Powell put it, a “monetary aggregate,” combining currency in circulation – pieces of green paper bearing portraits of deceased presidents. – with bank deposits. (There are several definitions of money supply that differ depending on the deposits they have.) The Fed does not directly control this aggregate. All it can do is determine the size of the “money base”, which is made up of bank reserves and money.
And during the Depression, the monetary base did not decline as the economy collapsed – it actually increased a lot:
Why, then, has the money supply shrunk? Partly because bank failures have made people nervous about the safety of bank deposits; in part because in a declining economy, people and businesses needed less money to do business. That is, the economic implosion caused the currency to fall rather than the other way around.
Friedman didn’t really deny this. Although his rhetoric suggested that the Fed caused the slump, if you look closely at his analysis, we say that the Fed could have prevented the doldrums – quite a big distinction.
And how could the Fed have prevented the slump, when a sharp increase in the monetary base did not appear to prevent a sharp decline in both money supply and GDP? 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 made those purchases soon enough – it would have avoided the monetary collapse.
But he wasn’t very clear on how, exactly, it would have worked. When the Fed buys government debt from a bank, what does the bank do with the money? In normal times, one would assume that the bank would lend it to the private sector, helping to stimulate the economy. But during the Depression, interest rates were very low and the perceived risks high. Why would the banks not be content to sit on additional liquidity, adding it to their reserves?
Of course, you can’t do the history of the 1930s again. It turns out, however, that the 2008 financial crisis gave the Fed an opportunity to do what Friedman said it should have done in the 1930s. The Fed significantly broadened the monetary base and the banks… simply added the money to their reserves:
So the Fed found itself in the classic “pulling a string” position: it could print money (well, create digital deposits, but whatever), but had no easy way to inject it. money in the economy.
To be fair, the Fed took crucial steps to stabilize financial markets early on, and some economists believe its asset purchases have helped the economy. But the extraordinary monetary expansion did not prevent a severe recession. And if we didn’t go through a full replay of the Great Depression, the main reason was probably that we were ready to run big budget deficits – that is, we were saved from a worse crisis by the policies Friedman claimed were unnecessary.
So while Powell was correct that the correlation between money and growth collapsed after 1980, monetarism – roughly speaking, the doctrine that money rules everything – has never been substantiated by evidence. .