By Dan Kervick
Paul Krugman made a remarkable assertion last week about the dwindling legacy of Milton Friedman:
… Friedman has vanished from the policy scene — so much so that I suspect that a few decades from now, historians of economic thought will regard him as little more than an extended footnote.
Krugman’s efforts to deliver a disparaging judgment on the Friedman legacy in macroeconomics may be appreciated, but I’m not sure his critique digs very deep. Friedman was not just a macroeconomist; he was also an important figure in the history of American political thought who left a deep conservative impact on the minds and attitudes of people whose intellectual development occurred during the Friedman heyday. Consequently, Friedman helped define the boundaries of the rigid neoliberalism that still seems to reign supreme among US politicians of both parties, and among elite opinion-makers in the ranks of the professional economists and technocrats. He was possibly more responsible than any other figure for converting a generation of policy makers and pundits to a more conservative, market oriented approach to political economy, an approach that goes beyond the specifics of Friedman’s own macroeconomic theorizing. So I think Krugman overestimates the damage that has been done to Friedman’s legacy. Aspects of Friedman’s macroeconomics might be in trouble; but Friedman’s broader paradigm for political economy is still, regrettably, too much with us. In fact, Krugman himself doesn’t seem to have moved much outside that paradigm, as I will try to show.
Let’s begin with the macroeconomics. Krugman makes two important central points about the ways in which Friedman’s model of the macroeconomic world has collapsed intellectually. The first has to do with the ability of the central bank to control the money supply:
First, on monetary policy: Even if you give him a pass on the 3 percent growth in M2 thing, which was abandoned by almost everyone long ago, Friedman was still very much associated with the notion that the Fed can control the money supply, and controlling the money supply is all you need to stabilize the economy. In the wake of the 2008 crisis, this looks wrong from soup to nuts: the Fed can’t even control broad money, because it can add to bank reserves and they just sit there; and money in turn bears little relationship to GDP. And in retrospect the same was true in the 1930s, so that Friedman’s claim that the Fed could easily have prevented the Great Depression now looks highly dubious.
There are three distinct issues to untangle here, which Krugman briefly compresses in his “soup to nuts” condemnation. First, if we take monetary policy to be the entire collection of government policies that have a significant impact on changes in the broad money supply – that is, the supply of bank deposit balances and physical currency in the hands of households and non-banking businesses – then one thing that has become clearer throughout the current crisis is that monetary policy is not identical to central bank policy. The central bank is a key participant in setting monetary policy, but does not unilaterally direct it. Congress and the Treasury play a role as well.
A second issue, though, is whether any realistic combination of government policies can control the money supply. Bank lending in the aggregate, responding to the demand for credit, continually creates new deposits for willing borrowers. That in turn means an expansion of broad money. This growth in bank deposits results in a greater net demand placed upon the payment system for interbank settlements. The assets banks use to settle those payments are primarily their deposit balances at the Federal Reserve banks. So realistically, the central bank must accommodate most of this independent private sector activity in order to maintain stable interest rates and facilitate the smooth functioning of the payments system. As a result, the central bank makes the corresponding changes to the monetary base required to achieve these goals. It thus looks like the private sector is doing the real driving here: changes in private sector demand for credit and bank issuance of credit come first; changes in the monetary base follow along after. Government policies can certainly influence the private sector demand for credit, but they can’t control it. The central bank can regulate or modulate activity in the market for bank credit, but it can’t determine it.
And finally, even if the government could control the money supply, a third issue is whether that would be a particularly important and decisive thing to do. How many of the major macroeconomic issues concerning growth, employment, income distribution, financial stability and innovation really depend fundamentally on what is happening with the money supply? What Krugman might have pursued further here is that not only have Friedman’s views about central bank policy been proven wrong, but his broader views on the decisive role of monetary aggregates and monetary policy on economic activity are flawed as well.
Unfortunately, Krugman doesn’t really pursue these broader questions. What he does is argue that Friedman was wrong to rely on the hypothesis of a natural rate of unemployment in thinking about labor market conditions during severe downturns:
Second, on inflation and unemployment: Friedman’s success, with Phelps, in predicting stagflation was what really pushed his influence over the top; his notion of a natural rate of unemployment, of a vertical Phillips curve in the long run, became part of every textbook exposition. But it’s now very clear that at low rates of inflation the Phillips curve isn’t vertical at all, that there’s an underlying downward nominal rigidity to wages and perhaps many prices too that makes the natural rate hypothesis a very bad guide under depression conditions.
Here Krugman touches on what seems to be one of his favorite themes: that the conventional conservative frameworks are more-or-less fine until they break down in rare depression conditions. It seems to me that at this point Krugman’s criticisms of Friedman really peter out, and he has left an awful lot of the Friedman legacy standing. Much of that monetarist legacy has in fact been incorporated into New Keynesian thinking where it is supplemented with an emphasis on sticky wages and prices. (This framework doesn’t have all that much to do with Keynes, since Keynes had stressed that even if wages were not sticky, it could be a very bad idea to let them fall during a recession since the result would not be to clear the labor market and put the country back on a growth path, but to suppress aggregate demand further, leading to a vicious downward cycle.)
What I am calling the Friedman paradigm is the view that markets and private enterprise can be left more or less alone to determine the shape and direction of our economy. The only government role we need under normal conditions is a central banker behind the scenes twiddling the monetary knobs to smooth out the bumps in the business cycle. This is an enormously appealing approach to those economic conservatives who are suspicious of activist government participation in the economy, who are attracted to laissez faire economics, and who are more or less satisfied with the socioeconomic status quo – but who also recognize that both ordinary business cycles and more extreme financial crises can cause economic hardships that in turn pose populist political threats to the established economic system.
I think it is fair to say that Krugman has gone beyond this paradigm in only very modest ways. On the whole, his view seems to be that central bank management of macroeconomic affairs is effective except in the unique circumstances of a liquidity trap. Krugman’s liquidity trap story has been laid out in many places, but representative discussions can be found here:
A liquidity trap, on Krugman’s account, is something that happens at the zero lower bound of nominal interest rates. One thing that he says happens is that there is no longer any significant difference, from the point of view of earnings, between holding non-interest-bearing money and holding interest-bearing securities. Another thing that happens is that the central bank is unable to push interest rates down further. Even if they attempted the very unconventional step of establishing a negative rate of interest on deposit balances, the result would only be that people would convert those deposits into currency. So long as currency earns a zero nominal rate of interest and people are free to exchange their deposit balances for currency, there is no way to get a nominal rate of interest that is significantly below zero.
But Krugman’s description of how things work when interest rates are above the zero bound puzzles me. He says the way these operations usually work in those more normal conditions are as follows:
… people are making a tradeoff between yield and liquidity – they hold money, which offers no interest, for the liquidity but limit their holdings because they pay a price in lost earnings. So if the central bank puts more money out there, people are holding more than they want, try to offload it, and drive rates down in the process.
This comment employs a Friedman-style “hot potato” framework that some monetarists employ. But what in the world can it mean to say the central bank “puts money out there” that people then try to “offload”? How can that happen? The central bank doesn’t stuff money into people’s pockets, and it doesn’t force them to hand over their financial securities in exchange for money. It offers money in the open market in exchange for securities. So if people preferred the securities to the money, they would’t have traded the securities for the money in the first place. It makes little sense to say that financial institutions first seek money for their securities on the open market, and then having too much unwanted money hanging around seek to dump it by obtaining securities for their money.
There is a very simple model of the Fed and its operations that is sometimes employed among the punditry – even by economists – but doesn’t seem to make much contact with the actual institutional, functional and legal status of our central bank. The pundits often ignore the fact that the Fed is fundamentally a bank, the central bank, and that it interacts with the rest of the economy almost entirely through the banking system and other large financial institutions, and via the mechanisms of credit. These pundits instead employ a model of the Fed as a kind of disembodied “monetary authority” that has the ability to put money out there in some more generic sense. The question for them then becomes whether or not putting the money out there will have the desired effects on demand and spending. But for the most part, the only world that is out there from the standpoint of central bank operations is the world of commercial bank reserve accounts, and the securities accounts of major financial institutions with the government. The Fed has no helicopters or universal money dispensers. It is not a supreme monetary authority. This is the fundamental flaw of monetarist-inclined economists who think macroeconomic aggregates can be managed and stabilized by the central bank. They are imagining a universal monetary control institution, a kind of People’s Directorate of Money, that doesn’t exist.
So returning to Krugman’s analysis, let’s leave that odd aspect of his liquidity trap story aside. The more viable point he makes is that if interest rates are already at zero, then the central bank can’t push interest rates down any further. This is important for Krugman because he is working within a framework that is based on a natural real equilibrium rate of interest. The natural rate is the rate at which the demand for loanable funds and the supply of loanable funds reaches an equilibrium, and the credit markets then clear. Krugman also believes it is possible for that natural rate to be negative, so that if artificial structural factors in credit markets prevent the real rate of interest from falling to the natural rate, credit markets will under-perform, financing for investment will be under-supplied and the economy will struggle and sputter.
Since the nominal rate of interest can’t fall below zero, then if the natural real rate of interest is below zero, the only way for the actual real rate of interest to get down to the natural rate is if there is a significant gap between the real rate and the nominal rate. So the only way for the market to achieve the natural rate is to have significant inflation. If inflation is 4%, for example, and if the lowest achievable nominal rate of interest is 1/4 of 1%, then the real rate of interest is negative 3.75%. So if 3.75% is indeed the natural rate of interest, it would be good if the monetary policy makers could set the nominal rate at 1/4 of 1% and then engineer something like a 4% inflation. Or more accurately, they at least want to engineer an expectation of a 4% inflation, since the rates of interest that are charged will be determined by what lenders expect inflation to be over the course of the loan, not what it has been at the time the loan is made.
So taking stock of the story so far, Krugman’s account seems to be central bank-administered monetary policy is usually effective in most ordinary situations, but its effectiveness is turned off in liquidity trap situations. And this happens when the natural rate of interest is negative, and so the Fed cannot push interest rates down further. But there is an escape hatch for this central bank-oriented framework if the Fed can engineer inflation expectations so as to get the real rate of interest down to the natural rate of interest. Can the Fed do that? Krugman seems to think that the Fed can control inflation expectations in most ordinary situations. But problems occur if the natural rate of interest is too far down into negative territory. The problem then is that the Fed might then need to get the public to expect a sustained rate of inflation that is much higher than the rate that inflation-phobic central banks are usually willing to accept. So when the Fed announces its plans for a higher rate of inflation, the public might not believe them!
And yet still, all is not lost for the Friedman paradigm on Krugman’s account. There still might be a central bank policy solution if the bank can achieve a certain kind of credibility:
The trouble is that central bankers have a credibility problem – one that’s the opposite of the traditional concern that they might print too much money. Instead, the concern is that at the first sign of good news they’ll revert to type, snatching away the punch bowl. You can see in the figure above that the Bank of Japan did just that in the 2000s.
The hope now is that things have changed enough at the Bank of Japan that this time it can, as I put it all those years ago, “credibly promise to be irresponsible”.
(Those of us old enough to remember the Cold War nuclear standoff, and the many debates about nuclear deterrence that era engendered, will probably be put in mind here of the doctrine held by some that a state can only succeed in deterring a nuclear first strike if it can make a credible commitment to behave irrationally.)
It is important to see here that according to Krugman’s picture of macroeconomics and macroeconomic policy, it is only when all these central bank maneuvers have failed that the government must turn to fiscal policy solutions. Krugman has indeed been arguing for a greater reliance on fiscal policy throughout the present crisis. But he presents fiscal policy as a sort of Red Button marked “for extreme depression circumstances.”
So, in substantial measure, Krugman embraces the Friedman paradigm prescribing central bank direction of macroeconomic policy, but has sought to repair the flaws in that paradigm with the addition of a few epicycles. It’s a remarkable story built on several questionable empirical hypotheses: that the central bank controls inflation expectations, that there is a natural rate of interest, that credit markets are determined by the supply and demand of loanable funds, etc. And underlying all of this seems to be the presupposition that if only the central bank could get the actual real rate of interest to fall down to the current natural rate of interest, the challenges of macroeconomic policy would be met: credit markets would clear, labor markets would clear, the appropriate allocations of income among consumption, savings and investment would be met; our economy would return to full capacity; economic health would be restored.
And in fact, if Krugman’s fundamental picture is accurate, the whole central bank-domianted paradigm could be fully reinstated with a few innovations in monetary policy. If we went to a system with 100% electronic money, for example, so that people could no longer convert deposit balances into non-interest-bearing physical currency, the Fed could push nominal interest rates down into negative territory. And as far as I can tell, Krugman would have no principled objection at that point to leaving macroeconomic policy in the hands of the central bank once again. The need for the fiscal policy Red Button would be eliminated. For my tastes, there is far too much of the ghost of Friedman lingering about in all of this. Taking in the whole model and its epicycles, the only thing standing between the current system and effective central bank control is that pesky physical currency, which is responsible for the existence of the nominal zero bound. So Krugman seems to say.
So the Friedman paradigm lives. But it needs to die completely.
As the post-2008 crisis has progressed, I have come to feel that there is something bizarrely, uncannily inadequate about the response of the economics profession to the crisis. Note that Krugman’s rather conservative framework is regarded in most places where economics is discussed among serious policy makers and established media figures as defining the left end of the spectrum. As far as Washington and Wall Street are concerned, Krugman is a dangerous radical. And most of the economics profession and blogosphere does not seem to recognize the existence of any viable alternatives to the left of Krugman. Our current President seems to stand among this crew of stolid conservatives.
I have been following economic discussions fairly closely now for about four years, and the intense, single-minded, nearly inescapable fixation on monetary policy and the Fed among economists and pundits has astonishing. There seems to be a palpable desperation among professional economists to uphold the independence, power, authority and policy-making self-sufficiency of the central bank. It is an extraordinarily anti-democratic and conservative paradigm, but adherence to it seems to be de riguer in the profession, universally adopted by any US economist considered mainstream. We will need some future sociologist or anthropologist to diagnose fully the causes of the early 21st century economic profession’s deep hatred of activist government, and the social stagnation and failure this hatred is engendering. But it appears to me that the cold, dead hand of an oppressive ideology, an ideology which took decisive hold in the hyper-capitalist triumphalism and extremism accompanying the end of the Cold War, is pressed down over everything and is smothering progress.
And whether they are defenders of single-minded central bank-driven policy, or see some role for the Red Button of fiscal policy, almost all of the thinking of mainstream macroeconomists is underpinned by the idea that the role of government in our economy should consist only in something called “stabilization”, which essentially means preserving some kind of supposedly normal conditions, and taking remedial steps to return to those normal conditions in the event of a crisis or shock. The idea that an empowered democratic government might drive progress and social transformation, and disrupt the status quo rather than stabilize it, seems utterly alien to these mainstream thinkers.
In my view, these mainstream views represent a fossilized dinosaur economics born out of an historically transient, late 20th century western temperament: a complacent, satisfied social lassitude indulging the fantasy of an “end of history”. These attitudes are being perpetuated past their shelf life by an affluent and secure technocratic policy class committed to preserving the status quo, and their own secure positions in that status quo, for as long as possible. The economic and professional security of this privileged class is underwritten by a destructive plutocracy that is rotten to the core and is cannibalizing our society, and in return for the underwriting they get safe and non-threatening conservatism, a conservatism that devises complex intellectual tools to fight off democratic challenges to entrenched wealth and political power, and is committed to the self-sufficiency of private enterprise, and the established structures of ownership and wealth that command it, to determine our future.
I believe this ossified consensus ideology is dead wrong, and that its continued hegemony is toxic to our future. It’s alread laying waste to a rising young generation across the United States and Europe. Private enterprise alone, aided only by the fine-tuning of a central bank, will never achieve full employment; such a system will never achieve a just distribution of the nation’s economic product; it will never achieve the strategic purpose and coherence of effort that enables a society to advance beyond the massive waste of an aimless, decadent consumerism; and the mainstream techniques of status quo stabilization will never thwart the inherent predatory drives and tendencies toward inequality and serfdom built into financial capitalism.
The Friedman paradigm must be displaced entirely, and not just modified with tweaks and epicycles and exemptions for special occasions. We need a Copernican Revolution in our economic thinking, which reverses the polarity in the dominant economic framework, puts an engaged democratic citizenry and activist government at the center of things, and leaves to central banks the important but subordinate tasks of regulating and managing the banking system while accommodating the economic policies and strategic direction set by the public through their government. It’s not just that we need to rely more on “fiscal policy” for the task of stabilization. We need to rely more on engaged public activism and invigorated government to move beyond stabilization into transformation, and toward real social progress.
We are also facing a long, vital battle between the democratic mode of organization and the corporate mode of organization. The ideal of government by equals in the pursuit of social justice and shared prosperity stands on one side if the struggle, and the forces of hierarchical command and control in the service of concentrated private wealth and power stand on the other. I’m convinced this struggle will define the coming century. History hasn’t ended. It’s just getting started.
Cross-posted from Rugged Egalitarianism