Saturday, July 30, 2016

How are Milton Friedman's ideas holding up?

I recently wrote a Bloomberg View post about consumption Euler equations, and how these are increasingly being targeted as a broken piece of macroeconomics. I traced the idea back to Milton Friedman and the Permanent Income Hypothesis, and Bloomberg decided (wisely) to go with Friedman for the headline. "Economists Give Up on Milton Friedman's Biggest Idea" is probably going to get orders of magnitude more clicks than "Economists Search for Replacement for Infinitely Lived Perfectly Far-Sighted Model of Consumption Smoothing".

BUT, anyway, Emily Skarbek decided that Uncle Miltie needed some defending, and wrote a blog post praising his legacy. Most of the post discusses stuff that I didn't touch on in my Bloomberg post, since I was only talking about the PIH. So I decided to do a post about Milton Friedman's overall legacy - actually, much too big a topic to do justice to in one post, but hey, that never stopped anyone before, so what the heck! I pitched it to Bloomberg, and they said "But didn't you just do a Milton Friedman post??", so on the blog it goes.

For some reason, Friedman is treated a bit like a secular saint in policy discussions. If you criticize "Idea X", fine. We can have an argument. But if you criticize "Milton Friedman's Idea X", then WHO ARE YOU, LOWLY WORM, to criticize the great FRIEDMAN?? If you say government is a lot more useful and important than Reagan and Thatcher and Art Laffer and Friedrich Hayek and Ed Prescott and Greg Mankiw think, well, fine, that's your opinion. But if you say government is a lot more useful and important than Milton Friedman thought, then you're wrong wrong wrong and don't you know that Friedman proved government was bad in the 70s?? Etc.

OK, I might be exaggerating as an excuse to use lots of capital letters and italics, but Friedman is such a towering intellectual that criticizing him does feel a bit like tipping a sacred cow. Fortunately I'm from Texas, where cow-tipping is a way of life.

So I, a nobody, shall proceed to grade the multifarious ideas of the great Friedman. Let's start with his macroeconomic ideas, and leave the policy ones for a follow-up post. As of 2016, how is each of Friedman's ideas holding up?


1. Permanent Income Hypothesis

As I wrote for the Bloomberg post, economists figured out by the 90s that the PIH doesn't look strictly true - there are lots of hand-to-mouth consumers out there. And natural experiments tend to find that people consume windfalls to a fair degree. What we don't know is why some consumers smooth and some consume hand-to-mouth, or whether and how it's state-contingent. Yes, the idea of a mechanical hand-to-mouth consumption function is dead - many people obviously are forward-looking to some degree under many conditions. But the strong form of the PIH - perfectly forward-looking consumption smoothing - doesn't look like a good approximation to reality.

Oh, and here's Skarbek's defense of the concept:
It seems to me that the PIH is a useful way to understand personal investments decisions over one's lifetime. For example, why young people who expect (even if inaccurately in many cases) to have high earnings after college incur student loans instead of directly entering the workforce. Or why people take out 30 year mortgages to buy homes.
Sorry, but "I have seen instances of people borrowing large amounts of money" doesn't tell us much about consumption smoothing. But even if it did, these are not good examples. A mortgage doesn't entail taking on net debt, since the value of the loan is the same as the value of the asset you acquire. And education is generally regarded as investment, not consumption (though some might argue). So, no.

A more sophisticated defense of the PIH is that we can always find some utility function that makes it look like people are smoothing consumption. But this defense is also bad, because A) it makes the PIH totally vacuous, and B) utility-function-mining is just going to get you something that fails out of sample, and you'll have to go mine for a different function, etc.

But the most common defense is: "But the PIH doesn't say all consumers are perfect smoothers, only that people do some amount of consumption smoothing." Fair enough; β>0 is technically a hypothesis, right? But if your hypothesis is only about a sign and not a magnitude, it generally isn't that useful.

Grade: C

2. Money growth targeting/k-percent rule

This idea was adopted in the U.S. between 1979 and 1982. But as Bennett McCallum has documented, the Fed failed to hit its targets:

[T]he Fed did not succeed in improving its record of money stock control. Instead, the realized growth rates for the years ending in the fourth quarter of 1980, 1981, and 1982 were again outside the specified target range, as indicated in Table 1-3. And monthly values of the growth rate were highly variable, as can readily be seen from Figure 1-1. This is especially striking, of course, because the special operating procedures of 1979-1982 were designed precisely for the purpose of improving money stock control so as better to achieve the monetary growth targets!
As it turns out, central banks just aren't very good at controlling the money supply. McCallum also speculates on what effects the failed attempt to target money growth rates might have had:
What, then, were the results of this experiment? In one respect the Fed's attempts were successful: by September 1982 the U.S. inflation rate had been reduced from around 11 or 12 percent (per year) to a magnitude in the vicinity of 4 or 5 percent. Other aspects of the outcome were not as planned, however, and were highly unpopular with the public and with most commentators. Of these undesirable side effects, four will be mentioned. First, short-term interest rates rose to levels unprecedented in U.S. history. Over the month of May 1981, for example, the 90-day Treasury bill rate averaged 16.3 percent. Second, the extent of month-to-month variability of interest rates was greater than ever before. Third, in 1981 a recession began that was the most severe since the Great Depression of the 1930s; the nation's overall unemployment rate climbed over 10 percent in the second half of 1982. So while the economy was relieved -- at least temporarily -- of the inflationary pressures that it had been experiencing for about a decade, this relief was apparently obtained at the cost of an unwelcome recession and the associated loss in output.
In any case, the failure of money supply targeting caused central banks to switch to a mix of interest-rate targeting and inflation targeting. 

Grade: D-

3. Quantity Theory of Money

This is probably Friedman's most famous idea - the notion that "inflation is always and everywhere a monetary phenomenon." Unfortunately, it's hard to tell if it's right, because it's a vague idea. First, you have to define the money supply (Are bonds money? Etc.). Next, you have to specify the lag of the effect - if money has a long and variable lag on inflation, as Friedman thought, it'll be hard to pin it down empirically. But anyway, tests appear to be generally in favor of the hypothesis. Here's an abstract from a 2001 discussion paper by Paul DeGrauwe and Magdalena Polan:
Using a sample of about 160 countries over the last thirty years we test for the quantity theory relationship between money and inflation. When analysing the full sample of countries we find a strong positive relation between the long-run inflation and money growth rate. The relation is not, however, proportional. The strong link between inflation and money growth is almost wholly due to the presence of high (or hyper-) inflation countries in the sample. The relationship between inflation and money growth for low inflation countries (on average less than 10% per annum over the last 30 years) is weak. We find that the long-run average inflation and country-specific factors have a significant influence on the strength of the relationship. We also confirm that money growth and output growth are orthogonal in the long-run; i.e. higher growth rates of money do not lead to higher growth rates of output.
And here is a table from their literature review:

So, generally pretty good support for Friedman's idea in high inflation countries (which are probably the main cases Friedman and everyone else cared about), though not so much when inflation itself is low. In particular, at the Zero Lower Bound (or maybe just more generally in a long disinflationary stagnation after a financial crisis), velocity seems to fall off substantially:

So although high inflation appears to coincide with high money supply growth, the correlation does seem to break down for economies like ours and Japan's.

Also, studies like these can't isolate causality, so there's always the possibility that high inflation itself boosts the money supply, by increasing bank lending and/or politically forcing the central bank to print more money. To my knowledge, this is not well-known.

Grade: B

4. Friedman Rule

This is the idea that nominal interest rates should be set at zero. It generally contradicts the k-percent money growth rule, unless setting rates at zero just happens to make the money supply grow at a constant rate (how much of a PR badass are you if you can get your name on two mutually contradictory rules?). Interestingly, the Friedman Rule is based on Neo-Fisherism - it says that rates should be at zero because in the long run, low interest rates are deflationary and mild deflation is what we want.

The idea that deflation is good has probably not stood the test of time, as most people agree that it has been damaging to Japan's economy. People have generally agreed on inflation targets of 2 percent, rather than negative inflation targets. But interestingly, zero or near-zero nominal interest rates have now become the global norm, at least in the developed world:

So it seems to me that no one really knows what to make of the Friedman Rule. Everyone is doing it, but for essentially the opposite of the reason than Friedman envisioned. It's a weird world out there, folks.

Grade: C+

5. Rejection of Fiscal Stabilization Policy

This appears to have been a big bust. Whatever monetary policy has or hasn't done, it has proven incapable, by itself, of pulling economies out of long slumps. Meanwhile, most of the evidence we have - which is weak evidence, because it's macro, but nevertheless is all we have - seems to indicate that fiscal policy works, even if we don't understand exactly why it works (see here, here, and here for example). Moreover, there is a growing recognition that what often matters is the combination of fiscal and monetary policy, and that fiscal policy can cancel out the effects of monetary policy. This may be why governments around the world still engage in fiscal stimulus when times get rough.

The poor quality of macro data saves Friedman from getting an F on this one.

Grade: D

6. Floating Exchange Rates

Lots of countries have certainly gotten into trouble trying to peg their exchange rate too high - this generally leads to a devaluation, capital flight, and a "sudden stop." But some countries (China) seem to have gotten some good results by pegging their exchange rates low during their catch-up growth phase, while using capital controls to prevent inflation. Also, a lot of countries have "managed floats", where they pretend to float their currencies but don't really do it. Anyway, to my knowledge, the data is just too poor and sketchy here to know which kind of exchange rate regime is really optimal, or whether this depends on the situation. Basically, I think we don't know much more about this now than we did in Friedman's day. Though I could be wrong.

Grade: Incomplete

7. Natural Rate of Unemployment

Basically, this is just the idea that unemployment is mean-reverting to some slow-moving number. Looks pretty true for the U.S., less so for other developed countries:

Of course, you can claim that in the other developed countries, big structural shifts happened that changed the natural rate. Unfortunately, that's just a fudge factor, and attempts to explain these changes with easily observable structural changes (e.g. taxes) haven't gone so well.

One one level, it's pretty obvious that there's some floor to unemployment - there will always be people between jobs, and people who don't want to work but who claim they do. The presence of a natural floor means that if a country keeps trying to put everyone to work, but keeps suffering negative shocks, unemployment will appear to oscillate. You can then draw an average line through that bouncy time series and call it the "natural rate". But in this case, the real things would be the unemployment rate floor and the average size of recessions - not the "natural rate".

So it's just not clear how useful this concept is, without some way to anticipate what the "natural rate" should be.

Grade: C+

8. Adaptive Expectations

This is the idea that people's expectations of future inflation (or other economic variables) is basically just some moving average of recent past inflation.

In fact, we do see that people's past inflation experiences tend to influence their expectations, but at a very very long time lag - basically, people's entire life. And it might be a lifetime average rather than a moving average.

Anyway, it seems to me that if you write down models with a simple, precisely specified model for adaptive expectations, with fixed lags etc. etc., it won't fit the data very well. But things like Bayesian priors and inattention will create learning effects that make expectations look like they have an adaptive component. People don't use Friedman-style adaptive expectations in models anymore, but A) it's unclear whether what they do use works well, and B) more sophisticated learning-based models seem to be popular. So this seems like a case where a simple Friedman idea contains an important principle that shouldn't be taken too far, and inspired a line of work that is interesting and still in progress.

Grade: B

9. Friedman-Savage Utility Function

Most decision theory researchers now realize that risk aversion can be positive or negative depending on the size of the gamble. Friedman's specific form for the utility of consumption is probably not that useful, but the basic idea - which has persisted into theories like prospect theory, salience theory, and others - is sound. People definitely do seem to buy both life insurance and lottery tickets.

Grade: B

10. Friedman Test

Sure, looks legit.

Grade: A

Overall Grade: C+

Friedman's macro ideas were enormously influential, and probably made very crucial points at the time they were introduced. However, they suffer from one fatal flaw: They are macro ideas. Macreconomics does not easily yield its truths to the probing mind, given uninformative data and the complexity of the thing. Plus, it's likely that big structural changes make it such that the discipline has few eternal verities - what describes the economy well in 1976 might have little to do with the events of 2016. So while "C+" looks like a harsh grade, I'm not sure what other macroeconomic thinker has done better. My favorite macroeconomists, like Bob Hall or Chris Sims, tend to be much more cautious and circumspect than Friedman - the smartest researchers seem to have realized that big, Friedman-style ideas will almost always fail to a substantial degree.

Coming up next: Friedman's policy ideas!


  1. Anonymous6:37 PM

    Do you kiss your mother with that filthy blasphemous mouth of yours?

    1. Anonymous9:48 PM

      I was new to the blog when I posted that. I enjoy your blog and am sorry for posting that. Didn't realize till flipping through earlier posts your mother had passed. It would have been tasteless regardless. I am sorry.

    2. No worries at all. :-)

  2. Anonymous7:03 PM

    "For some reason, Friedman is treated a bit like a secular saint in policy discussions. If you criticize "Idea X", fine. We can have an argument. But if you criticize "Milton Friedman's Idea X", then WHO ARE YOU, LOWLY WORM, to criticize the great FRIEDMAN??"

    Brad Delong is prone to this annoying rhetorical tic, e.g.:

    Though normally quite irritating to hear an "argumentum Friedman", it is doubly so when the person doing so disagrees with Milton Friedman on many issues and would be presumably unimpressed by such an invocation elsewhere.

  3. Anonymous11:54 PM

    There's a lot to be said about Friedman, and the policy school of thought that flowed from his ideas, but from the point of view of science and scholarship, this is a silly, condescending piece. You could similarly "grade" Kepler, Newton or Flemming and conclude that their work "suffered from one fatal flaw": from our current point of view, some of their methods and perspectives are outdated. There is much value in revisiting the mythologized "greats" with a critical eye, but the superficial treatment here, combined with the "grade report" format makes this frankly ridiculous.

  4. Alexander Graham Bell
    No one seems to use this anymore, it's fallen out of policy discussions.
    Grade: F -

    Samuel Morse
    Morse Code
    People use it, but emoticon theory really delivered a huge blow.
    Grade: C +

    Remember context doesn't matter, nor how these lead to other ideas!

  5. Noah writes: "high inflation countries (which are probably the main cases Friedman and everyone else cared about)"

    High inflation, yes. Substantial inflation. The famous quote "inflation is always and everywhere a monetary phenomenon" has been shortened by the omission of the word "substantial": Friedman explicitly identified "substantial inflation" as the monetary phenomenon he was describing, and then generalized his statement by omitting the one word.


    More significantly, the problem with Friedman's work on the cause of inflation is simple arithmetic. He creates a ratio -- the quantity of money relative to output -- and compares this ratio to inflation, finding strong similarity between his ratio and inflation.

    But of course the similarity is strong! His "output" number has inflation removed, while his "quantity of money" number does not. His ratio skews upward like inflation because in a roundabout way he factors inflation into it.

  6. I wouldn't be surprised to see a rebirth of the PIH now that people have different lifetime expectations. With the dearth of well paid, but relatively unskilled jobs, most people will assume flat lifetime incomes. Even a lot of college graduates are facing this realization. There is also the expected kick in the guts as one approaches fifty, and not just for manual workers but for educated white collar workers as well. We are already starting to see pushback against the idea that anyone can benefit from getting a college degree.

    Also, it isn't fair to compare Newton, Kepler or Fleming to Friedman. Most of Newton's stuff is still taught in modern physics classrooms, though with much improved notation. Kepler's laws are still in use, even when doing general relativity. While penicillin is no longer the go to drug, except for syphilis, Fleming's work has held up pretty well. If you've been following that booger antibiotic story, you'd recognize Fleming's methods still in use, though with some modern techniques added.

    Economics still hasn't found its Newton. To be honest, I don't think it has found its Galileo. There is still way too big an ideological component in its theories which leaves it inconsistent with accounting, a well proven field.

    1. Anonymous9:47 AM

      There is no doubt that Friedman's importance pales in comparison to the other three, but actually, surprisingly little of "Newton's stuff" survives in recognizable form in modern classrooms. The three laws were well understood before him (as he acknowledges right after stating them). The mathematical derivations using conic sections in Book I are far too complicated to be taught in high schools, or even a freshman mechanics course. By the time the typical physics student has taken such a course, they are unlikely to encounter the subject again. A thorough belongs in a graduate celestial mechanics text, likely with a completely different approach. His ideas on fluids were much less clear, and are largely forgotten. Similar remarks apply to Kepler and Flemming.

      Indeed, the vast majority of working scientists nowadays couldn't tell you exactly what it is Newton discovered or wrote (vs. what was later added by Euler and his many other interpreters). They just know the vague outline of some of his ideas, and that they were important. So it is with Friedman, as well.

      Your remark concerning accounting is essentially self-contradictory: the only reason we have data to check theory against is the careful empirical work of thousands or economists who think about what to measure and how.

  7. A few things:

    1) I might rate NAIRU even lower, perhaps a D or worse. Believers in the theory kept on saying throughout the 80s, "the new NAIRU is 6.5%!" well, it went below 6%. In they 90s they said "the new NAIRU is 5.5%" then "5%!" then "4.5%", and yet it went below 4%. It's kind of an idea without basis, and was used primarily to replace the Philips curve, which while it had some significant flaws (supply shocks! like oil shocks). The world, outside of those significant supply shocks, operates in a mostly Philips curve-like way, although today is another diversion from the Philips curve: the Philips curve's internal belief is that lowering unemployment will increase wage growth, which will translate into inflation. Well, that has not happened in this recovery, since in part unemployment was high to begin with (and you could list other factors, like lower power of labor unions, or that much of the drop in unemployment has been to the drop in the participation rate).

    NAIRU was basically an idea that justified a philosophy that lowering unemployment, or creating "full employment", was a dangerous idea to avoid, and so that the Federal Reserve and other policy makers should instead keep a larger army of the unemployed to keep wages lower.

    2) I'd give Floating Exchange Rates somewhere around a B. Clearly, in a world with capital mobility (and absent capital controls, see: Mundell-Fleming Trilemma), Floating Exchange Rates are the better policy to pursue than fixed exchange rates. However, managed pegs can work as China has shown, as can managed floats, like Switzerland has done recently. I think the problems inherent in Floating Exchange Rates exist because of Friedman's other philosophy, i.e. the notion that "Trade Deficits Don't Matter", which is us giving other countries a bunch of goods we want for pieces of paper! Which is terribly naive for a variety of reasons (and something that strangely the MMTers repeat as well).

    On that philosphy I'd give him a D (I'm talking about this one: ). Basic economic formulas say that more net imports leads to less GDP (which can be offset by higher consumption or higher government spending). Sectoral balance accounting basically says that a higher trade deficit means you either need higher public spending or lower national savings (which can also mean more private debt) in order to keep GDP from shrinking from its potential, or, conversely, less GDP.

    Further, in order to keep BoP straight, you need to receive inflows of capital. That basically involves countries investing in Treasury bonds, which means the taxpayer is effectively paying foreign bondholders instead of paying national savers, or investing in stocks and real estate, which means that you can have stock and real estate bubbles... similar to the ones we saw in the late 1990s and 2000s (and what we somewhat see today as well). All of that may be well and good for owners of assets and capital (who, ultimately, are the ones Prophet Friedman is most concerned about), but it's certainly not good for domestic manufacturers, workers, wages, or people looking to rent or buy homes.

    Further, if you accept Verdoorn's Law (I know Noah is naturally skeptical to it, since ebil Post-Keynesians like Kaldor contributed to it), then by lowering output, particularly in the export sector, you also lower the rate of productivity, thus lowering the future long-term rate of the country.

    So, lot's of bad things going on with Friedman's "Trade Deficits Don't Matter" line of thinking.


  8. 3) Also Friedman's major thesis of "Monetary History of the United States" doesn't hold up very well in the face of the Great Recession. Fundamentally, the two causes of the Great Depression, an asset bubble followed by debt-deflation, and the Gold Standard, which not only forced the economy to rebalance to the price of gold, but also made it impossible to run an independent fiscal policy or have a needed foreign devaluation. Friedman kind of ignores that the increase in interest rates during the beginning of the recession was in large part to stick to the Gold Standard, and Friedman ultimately did not understand how the money supply worked with regards to the Central Bank (he believed it to be exogoneously supplied by the central bank, and blamed central bankers incompotence when money targets could not be reached, because he didn't understand that the money supply was endogenous). He has to have some kind of D-C rating here, albeit it's fair to say that monetary tightening did make it worse, and knowing what we now know, government policy of balanced budgets and adherence to the gold standard ultimately made the Great Depression Great.

    4) It's sort of part of money growth targeting, but as mentioned above, Friedman didn't understand how the money supply, central banks, or banking in general worked from an operational standpoint.

    Here, it's worth reading Nicholas Kaldor's "The Scourge of Monetarism", which in real-time debunked Milton Friedman's Monetary philosophy of the day, and in the process of writing it came up with an alternative hypothesis of reverse causation, which eventually become developed into endogenous money (which Central bankers like the BoE have confirmed).
    (I shudder when I see those prices, given I paid much more for my copy, but oh well. If you really do not want to buy one, I could lend mine)
    (Also, while we are on the subject of Kaldor, apparently he came up with the Sectoral Balance approach that was later perfected by Godley back in the 1930s and 40s! )

    Anyhow, I'll leave it there.

  9. I was a money market economists in the era where the Fed was supposedly targeting money supply growth.

    The perception on the street and among many institutional investors was that the Fed would pretend to target money and that Congress would pretend to believe them. The Fed realized they needed to raise rates extremely high to stop the double digit inflation. So they switched to targeting money supply so they could deny that they were responsible for the high rates -- it s just the markets reacting to the money supply growth.

    In Boston Frank Morris was the Fed of Boston chairman and he regularly had a little too much to drink a private functions and told tales out of school that he shouldn't.
    But there were other knowledgeable individuals who provided the same analysis to the investment community.

  10. I contest 2 grades. PIH ""But the PIH doesn't say all consumers are perfect smoothers, only that people do some amount of consumption smoothing." is OK if it makes the PI story a non hypothesis. Not so much if "some smoothing" is given a definition consistent with the ordinary English meanings of "some" and "smoothing". I think level 0 for the PI non Hypothesis is that the ratio of consumption to current disposable income is high when the ratio of discounted future disposable income to current disposable income is high.

    This is not true of the USA. I think there is nothing there. In particular, I think that Friedman's writing on consumption is totally inferior in every way to Keynes's.

    see (pdf warning)

    I grade PInonH D except for calling it an H while adding weasel words to avoid falsifiability (as Friedman did) which gets it down to F+ (to be generous).

    On the other hand, I think the adaptive expectations model fits the data extremely well. This is true for a very crude simple form.
    This is striking and surprising because it wasn't really a hypothesis -- Friedman and others thought it might be a useful first approximation but didn't think it would fit the data as well as it does)

    Another PDF warning

    I think that one gets an A-

    Finally you are not the first economist to ask what the Romans have ever done for us

  11. Noah, your pithy dismissal of monetary offset of fiscal stimulus is not persuasive. Even Paul Krugman qualifies his arguments in favor of fiscal stabilization by limiting it to when interest rates are near zero. A central bank that can hit its inflation target CAN and WILL offset fiscal stimulus, no?

    And much of the literature fails to control for monetary policy (i.e. looking only at EU countries that are on the Euro).

    And do you really believe that the US economy just coincidentally experienced a boost of demand in 2013 at exactly the time that we slid over the fiscal cliff/sequester? Or do you believe that monetary policy had something to do with the fact that growth and employment accelerated in the fact of contractionary fiscal policy?

    Just because the fiscal multiplier sometimes exists doesn't mean that it couldn't be driven to zero by a competent central bank.

    And he was obviously correct that Japan's massive deficit spending program was a failure.

    1. Or rather, deleveraging stopped nation-wide and businesses/consumers began taking on more debt once again.

  12. Funny, I hardly recognize Friedman's ideas as Noah presents them. Unlike when this economist does it;

    My conclusion is simple. Much of the history of macroeconomic thought is often taught as the rise and fall of alternative schools. Monetarists tend to write of the rise and fall of Keynesian economics--its rise during the Great Depression, and its fall in the 1970s under the pressure of stagflation and the theoretical critiques of Friedman, Phelps, Lucas, Sargent, and Barro. They tend to see this as the rise "interventionism" and then its decline and replacement by a more hands-off view that holds that monetary policy should be "neutral." Keynesians write of the rise and fall of monetarism--its rise during the monetarist counterrevolution, its fall as the instability of velocity and the money multiplier became clear, and its replacement by the modern "new Keynesian" paradigm.

    Neither story appears to me to give an accurate or even a particularly useful vision of how it really happened. The fall of monetarism as a political doctrine was coupled with the victory of "monetarist" ideas and ways of thinking in the mainstream: that was the point of DeLong (2000). And what Friedman and Schwartz (1963) would call a "neutral" hands-off monetary policy during the Great Depression--one that kept the nominal money stock fixed--would have been condemned by pre-World War II over-investment theorists as extraordinarily interventionist. Indeed, it would have been. Between 1929 and 1933 the Federal Reserve raised the monetary base by 15% while the nominal money stock shrunk by a third. The position of Friedman and Schwartz (1963) is that the Federal Reserve should have injected reserves into the banking system much, much faster. Sometimes to be "in neutral" requires that you push the pedal through the floor.

    Earlier, DeLong had written;

    The importance of analyzing policy in an explicit, stochastic context and the limits on stabilization policy that result comes from Friedman (1953a). The importance of thinking not just about what policy would be best in response to this particular shock but what policy rule would be best in general--and would be robust to economists' errors in understanding the structure of the economy and policy makers' errors in implementing policy--comes from Friedman (1960). The proposition that the most policy can aim for is stabilization rather than gap-closing was the principal message of Friedman (1968). We recognize the power of monetary policy as a result of the lines of research that developed from Friedman and Schwartz (1963) and Friedman and Meiselman (1963). And a large chunk of the way that New Keynesians think about aggregate supply saw its development in Friedman’s discussions in Friedman (1970) and Friedman (1971a).

    Thus a look back at the intellectual battle lines between "Keynesians" and "monetarists" in the 1960s cannot help but be followed by the recognition that perhaps "new Keynesian" economics is misnamed. We may not all be Keynesians now, but the influence of "monetarism" on how we all think about macroeconomics today has been deep, pervasive, and subtle.

  13. Anonymous7:04 PM

    Your approval of the headline "Economists Give Up on Milton Friedman's Biggest Idea" is misguided. Yes, as you say, the strong form of the PIH - perfectly forward-looking consumption smoothing seems unwarranted.
    But this claim should not be taken as a criticism of Friedman. His book was subtle and often referred to uncertainty. His concept of transitory income itself reflects uncertainty - look at Figure 2 (p.24). It would be hard to read “perfectly forward-looking consumption smoothing” into his book. Consider the following:
    "Future measured income is uncertain. The scatter of dots for later ages is intended to represent the possibilities as viewed by the unit: for each future date, there is some anticipated probability of measured income…..[T]his scatter diagram seriously misrepresents the situation in one important respect. It suggests that the probability distributions are independent, whereas in general they might be expected to be interdependent(p.20)."
    This is hardly the stuff of “perfectly forward-looking consumption smoothing.” You might amend your grade after a careful reading of his book.
    Your claims “A mortgage doesn't entail taking on net debt, since the value of the loan is the same as the value of the asset you acquire” and “And education is generally regarded as investment, not consumption” both reflect a misunderstanding of the PIH.
    Freidman undermined the Keynesian theory of consumption by arguing that the target of the Keynesian theory –consumption expenditure – is lumpy, erratic and hard to explain. Rather PIH tries to explain the flow of consumption services –services, non-durable goods and the flow of services from durable goods – rather than consumption expenditure.
    Your argument that the value of the loan equals the value of the asset has absolutely no bearing on the PIH. The purchase of the house is not part of Friedman’s consumption measure. The purchase was an expenditure that enabled the person to enjoy a flow of consumption services –Friedman’s measure - now and over the future.
    Many of the critiques of Friedman’s consumption theory make the same mistake. The lottery winner buys a new car. But that’s focussing on the expenditure. The car will provide consumption services over more than the current year.
    Again your argument that “an education is generally regarded as investment, not consumption (though some might argue)” also misses the point. Sure, some of the borrowing does finance the investment. But some pays for the student’s current consumption. The loan enables the student to smooth consumption by financing it by future income.
    It is easy to criticize caricatures of Friedman’s PIH. But it still influences on current approaches to explaining aggregate consumption. And this is, contrary to the claim – which you approve of - that economists have given up on Friedman’s biggest idea.

  14. Anonymous9:49 PM

    I think your assessment of Friedman's contribution re: Floating Exchange rates is harsh. I think the main goal of economic policy-making should be to avoid prolonged periods of mass unemployment. In that regard, the experience of the US and the Eurozone provides about as good a controlled experiment that you can ever hope to get for Fixed vs. Floating exchange rate regimes. The fact that the US got out of the '08-'09 slump as quickly as it did whereas Europe continues to languish provides ample proof that floating exchange rates are better. Not sure if one can use China's limited track record to judge the efficacy of fixed exchange rates.

  15. If your conviction in a given monetary theory is low, then shouldn't point 6, an assertion about fiscal policy, reflect correspondingly low convictions? It doesn't seem possible to measure fiscal effects without baking in monetary effects.

  16. Anonymous2:22 AM

    Just a note on your Bloomberg piece (I don't feel like signing in over there), buying furniture, or any other durable good, does not invalidate the PIH. If I get a tax cut windfall and go out and use it to buy a car, my present consumption does not actually go up - from the point of view of the theory - by the value of the car. It only goes up the per period stream of services that the ownership of a car delivers.

  17. Anonymous6:27 AM

    I think the failure of the PIH to match the data has a lot to do with borrowing constraints. If you are unable to borrow money against future income, and your income is currently lower than what you expect it to be in the future, you will become a hand-to mouth consumer automatically. Of course this does not solve all the empirical problems with the PIH, but it is a simple and persuading way of making the theory more robust. Your failure to mention this well-known fact makes your comments about the PIH seem biased.

  18. I think you touch on the main point nicely at the end.

    Friedman was a catalyst.

    His ideas, like the vast majority of ideas in economics, are intermediate inputs that seek to explain the times and be built in by those that follow. Much in the same way most great macroeconomists deserve to be thought of in the same way.

    Friedman, in 1976, sought to build on the knowledge base and explain the economy of 1976. In that context, and as a catalyst for those that followed, he was and is a titan.

  19. Excellent discussion on his ideas. I recall Paul Krugman also did an overall analysis of his academic work and policy view. While he gave thumbs up his academic ideas, he was very critical if his policies n opinions. Here's the link to his NYT book review

  20. Friedman-Savage Utility Function does not deserve a B. Generally it is difficult to explain anything with upward curving utility functions. In this specific case, Friedman "explains" the purchase of a lottery ticket at the expense of making it difficult to explain why anyone would purchase just one -- indeed if the shape of the utility function explains why some people play the lottery, we should expect most lottery players to spend all of their income on the lottery or close to it.

    If you want to explain lottery ticket purchases as a rational sort of behavior, you need to get past the idea that comparing means of distributions of future possibilities is the one true way to rank them. There are other rational ways to make choices under uncertainty and it's not too hard to come up with ways of ranking that result in people buying insurance and a few lottery tickets without resorting to funky utility curve shapes.

  21. "managed" exchange rate as instrument of monetary policy has been working well for Singapore for over 30 years. Note that SG has a rate crawl, free capital movement, no interest rate control (tends to follow Fed rates + IRP)

  22. Buchanan committee hearings should be a hint....

  23. My rule of thumb is that any Friedman hypothesis is wrong - the problem is that it can be very difficult to prove this.
    Friedman test is not a macro hypothesis so should really not be in this list (and I was not aware of it until now).

  24. This is the most coherent analysis of Milton Friedman I have ever read. Good work Noah Smith. I'm inspired to do this type of analysis for more theories just to figure out what my macroeconomic beliefs are!