Vienna vs. Chicago on Monetary Issues

1. Vienna vs. Chicago on Monetary Issues Methods, Theories, and Policies Friday, July 31, 2009

2. Keynes, Friedman, and Hayek in Perspective: Three Views of the Market Economy Capital-based macroeconomics is distinguished by its propitious disaggregation, which brings into view both the problem of inter-temporal resource allocation and the potential for a market solution. F. A. Hayek showed that a coordination of saving and investment decisions could be achieved by market-governed movements in interest rates. He also recognized that this aspect of the market economy is especially vulnerable to the manipulation of interest rates by the central bank. Milton Friedman’s monetarism was based on a still higher level of aggregation. The equation of exchange MV=PQ made use of an all-inclusive output variable (Q), putting into eclipse the issue of the allocation of resources between current consumption and investment for the future. Seeing no problems emerging from the market itself, Friedman focused on the relationship between the government-controlled money supply and the overall price level. Theorizing at a high level of aggregation, John Maynard Keynes argued that market economies perform perversely—especially the market mechanisms that are supposed to bring saving and investment into balance with one another. Seeing unemployment and resource idleness as the norm, Keynes called for countercyclical fiscal and monetary policies and ultimately for a “comprehensive socialization of investment.” M = quantity of money V = velocity of money P = price level Q = real GDP

3. Keynes, Friedman, and Hayek in Perspective Keynes, Friedman, and Hayek in Perspective: A Methodological Reckoning John Maynard Keynes Keynes’s was the type of theorist who developed his theory after he had developed a sense of relative magnitudes and of the size and frequency of changes in these magnitudes. He concentrated on those magnitudes that changed most, often assuming that others remained fixed for the relevant period. Allan Meltzer, Keynes’s Monetary Theory: A Different Interpretation (1988) Further, Keynes evidently did not develop a sense of what was going on within these macro-magnitudes and hence felt quite justified in ignoring all such issues. ---RWG

4. Keynes, Friedman, and Hayek in Perspective: A Methodological Reckoning Milton Friedman I believe that Keynes’s theory is the right kind of theory in its simplicity, its concentration on a few key magnitudes, and its potential fruitfulness. Milton Friedman, “Keynes’s Political Legacy,” in John Burton, ed., Keynes’s General Theory: Fifty Years On (1986) "We're all Keynesians now …. We all use the Keynesian language and apparatus….”; Time Magazine (1968)

5. Keynes, Friedman, and Hayek in Perspective: A Methodological Reckoning Friedrich Hayek The role of the economist, Hayek points out [in his Pure Theory of Capital, 1941], is precisely to identify the features of the market process that are “hidden from the untrained eye.” For Hayek, The cause-and-effect relationship between central-bank policy during the boom and the subsequent economic downturn have a first-order claim on our attention, despite the more salient co-movements in macroeconomic magnitudes that characterize the post-downturn spiraling of the economy into deep depression. Paraphrased from Roger W. Garrison, “Hayek and Keynes: Head to Head,” in The Elgar Companion to Hayekian Economics (forthcoming)

6. Keynes, Friedman, and Hayek in Perspective: A Methodological Reckoning Friedrich Hayek There may well exist better “scientific” evidence [i.e., empirically demonstrated regularities among “key” macroeconomic magnitudes] for a false theory, which will be accepted because it is more “scientific,” than for a valid explanation, which is rejected because there is no significant quantitative evidence for it. Friedrich Hayek, “The Pretence of Knowledge,” Nobel Lecture, 1974

7. Keynes, Friedman, and Hayek in Perspective: A Difference in Focus Keynes, Friedman, and Hayek in Perspective: Keynes attributes the downturn to psychological factors affecting the investment community. His main focus, however, is on the dynamics of the subsequent downward spiral---and on policies that will reverse the spiral’s direction. Friedman is dismissive of the whole issue of the cause of the downturn, referring to it as an “ordinary,” “run-of-the mill,” “routine,” “garden-variety” recession. His focus is on policy blunders after the downturn and the correlation between the decrease in the money supply and the fall in nominal GDP (i.e., in PQ). Friedrich Hayek focuses on the policy-infected aspects of the boom and their implications of the boom’s sustainability. He leaves it to economic historians to detail all the policy perversities and hard times that characterized of the subsequent depression.

8. Friedman’s Monetarism: M V = P Q With a mild upward trend in velocity and Output (Q) growing slowly, the price level (P) moves with the money supply (M). with a lag of 18-30 months.

9. Friedman’s Monetarism: M V = P Q with a lag of 18-30 months. “Inflation is always and everywhere a monetary phenomenon.”

10. Friedman’s Monetarism: M V = P Q Friedman’s Monetary Rule: Increase the money supply at a slow and steady rate to achieve long-run price-level constancy. Friedman’s Monetarism: M V = P Q with a lag of 18-30 months.

11. M V = P Q Friedman’s Monetarism: M V = P Q But what happens within the Q aggregate as a result of the monetary injection? with a lag of 18-30 months. S S +ΔM RATE OF INTEREST D SAVIING (S) INVESTMENT (D)

12. Friedman’s View of a Monetary Contraction M V = P Q A sharp monetary contraction puts downward pressure on P and Q. If P is slow to adjust, Q will fall. Evidence shows that decreasing M is the essential (primary, dominant) cause of the decrease in Q. ( )

13. THE CASE OF THE CABBAGE-EATING MISSISSIPPI MONSTER Austrian and Chicago Methodology in Action Suppose that in late October of 1929, a thousand-pound monster showed up in Mississippi. It spent the next three-and-a-half years eating all the cabbages (and quite a few rabbits) between Jackson and Pascagoula. By early March of 1933, the monster weighed four-thousand pounds. Two investigators are sent to Mississippi to get a handle on the situation. One is from Vienna, the other is from Chicago. The Viennese investigator asks, “Where in the world did this hideous thing come from?” [Here, I seemed to have stacked the cards against the Austrian. It’s hard even to imagine an insightful answer to this question—unless, of course, the monster turns out to be the unintended consequence of some ill-conceived government-sponsored bionics project.

14. THE CASE OF THE CABBAGE-EATING MISSISSIPPI MONSTER Austrian and Chicago Methodology in Action The Chicagoan shows up, shoves the Austrian aside, and says, “Never mind how this thing got here, the REAL question is: How did it grow from 1000 pounds to 4000 thousand pounds? How did an ordinary, run-of-the-mill, garden-variety monster quadruple its weight in 40 months? The Chicagoan’s answer, of course, is: it was all those cabbages. (He couldn’t get good data on the rabbits.) The correlation between cabbage consumption and weight gain leaves not doubt the issue. Do we suspect that data availability is what led The Chicagoan to his conclusion? And that the lack of hard data pertaining to the monster’s origins caused him to be dismissive of questions about where the thing came from? These and related suspicions are what underlie the message in Hayek’s Nobel address on “The Pretense of Knowledge.”

15. Friedman’s View of a Monetary Contraction M V = P Q A sharp monetary contraction puts downward pressure on P and Q. If P is slow to adjust, Q will fall. Evidence shows that decreasing M is the essential (primary, dominant) cause of the decrease in Q. ( )

16. The equation of exchange is so near and dear to Milton Friedman’s heart that he A. has made his wife Rose promise that it will make a tasteful appearance on his headstone. D. has adopted it as his vanity license plate number for his Cadillac Eldorado. C. has written a parody to the popular Y.M.C.A to memorialize the equation in song. B. has had it spelled out in pansies in the flower garden at Stanford’s Hoover Institution.

17. The equation of exchange is so near and dear to Milton Friedman’s heart that he • tasteful appearance on his head stone. • B. spelled out in pansies in flower garden. • C. parody to the popular Y.M.C.A. • D. vanity license plate number. Gribouillis économiques

18. GREG MANKIW’S BLOG Random Observations for Students of Economics September 16, 2006: Curious question from Mankiw: “How can you identify my car?” Gregory Mankiw Former Chairman Council of Economic Advisors George W. Bush Administration

19. mvpy writes: • You know, I hate to spoil things, but I must say, I think Milton Friedman has a better plate. This is from an article I came across:"Years ago, trying to find the Friedman’s apartment in San Francisco, I knew I was in the right location when I spotted a car with a license plate that read “MV = PT." • A. Delaique writes: • Milton Friedman's license plate was MV = PQ, not MV = PT. Picture here : http://gribeco.free.fr/article.php3?id_article=12 • Anonymous writes: • That's pretty ridiculous.. • Canée writes: • I love economists.

21. Friedman’s Monetarism: M V = P Q with a lag of 18-30 months. “Inflation is always and everywhere a monetary phenomenon.”

22. Vienna vs. Chicago on Monetary Issues Monetarist Conclusions Depend on a Constant Or Near-Constant Velocity

23. Inflation (a rising CPI) The Money Supply (M1)

24. --from J. Bradford DeLong’s “The Triumph of Monetarism?” Journal of Economic Perspectives, Winter 2000. The velocity of money became unstable after 1980. Friedman’s policy rule lost its velocity anchor. The Federal Reserve abandoned money-supply targeting in favour of interest-rate targeting.

25. Friedman’s Monetarism: M V = P Q with a lag of 18-30 months. The Irony of Monetarism: The monetary rule that allows the economy to perform at its laissez-faire best presupposes a critical piece of intervention (Regulation Q) that makes the money supply operationally definable.

26. Friedman’s Monetarism: M V = P Q with a lag of 18-30 months. Greenspan: “We don’t know what money is, anymore.” …which explains why the Federal Reserve switched from money-supply targeting to interest-rate targeting in the early 1980’s

27. Vienna vs. Chicago on Monetary Issues The Implementation of the Monetary Rule Requires Fixed and Known Commercial-Bank Operating Ratios

30. Vienna vs. Chicago on Monetary Issues How Did Friedman Account for the Long and Variable Lag between Monetary Expansion and a Rising Prices?

31. Friedman accounts for the M-P lag of 18-30 months: Holders of cash will…bid up the price of assets. If the extra demand in initially directed at a particular class of assets, say, government securities, or commercial paper, or the like, the result will be to pull the prices of such assets out of line with other assets and thus widen the area into which the extra cash spills. The increased demand will spread sooner or later affecting equities, houses, durable producer goods, durable consumer goods, and so on, thought not necessarily in that order…. These effects can be described as operating on “interest rates” if a more cosmopolitan [i.e., Austrian] interpretation of “interest rates” is adopted than the usual one which refers to a small range of marketable securities. Milton Friedman (1969 [1961]), “The Lag Effect in Monetary Policy,” in Miltion Friedman, The Optimum Quantity of Money and Other Essays, Chicago: Aldine.

32. “The key feature of this process [during which interest rates are low] is that it tends to raise the prices of sources of both producer and consumer services relative to the prices of the services themselves…. It therefore encourages the production of such sources and, at the same time, the direct acquisition of the services rather than of the source. But these reactions in their turn tend to raise the prices of services relative to the prices of sources, that is, to undo the initial effects on interest rates. The final result may be a rise in expenditures in all directions without any change in interest rates at all; interest rates and asset prices may simply be the conduit through which the effect of the monetary change is transmitted to expenditures without being altered at all….” Milton Friedman (1969 [1961]), “The Lag Effect in Monetary Policy,” in Miltion Friedman, The Optimum Quantity of Money and Other Essays, Chicago: Aldine.

33. “It may be … that monetary expansion induces someone within two or three months to contemplate building a factory; within for or five, to draw up plans; within six or seven, to get constructions started. The actual construction may take another six months and much of the effect on the income stream may come still later, insofar as initial goods used in construction are withdrawn from inventories and only subsequently lead to increased expenditure by suppliers.” Milton Friedman (1969 [1961]), “The Lag Effect in Monetary Policy,” in Miltion Friedman, The Optimum Quantity of Money and Other Essays, Chicago: Aldine.

34. Vienna vs. Chicago on Monetary Issues Friedman’s Plucking Model

38. Vienna vs. Chicago on Monetary Issues Methods, Theories, and Policies Friday, July 31, 2009