have monetory policy failed

8/2/2019 Have Monetory Policy Failed

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American Economic Association

Have Monetary Policies Failed?Author(s): Milton FriedmanReviewed work(s):Source: The American Economic Review, Vol. 62, No. 1/2 (Mar. 1, 1972), pp. 11-18Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/1821518 .

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HAVE FISCAL AND/OR MONETARYPOLICIESFAILED?

H a v e Monetary P o l i c i e s F a i l e d ?By MILTON FRIEDMAN *

The topic for this session reminds me ofthe first of the four questions that theyoungest male at the Jewish PassoverSeder traditionally asks the head of thehousehold: "Why is this night differentfrom all other nights?" In like fashion, weare asked: "Are this recession and expan-sion different from all other recessions andexpansions?"It is widely believed that the answer isyes. For example, in testifying before theJoint Economic Committee on July 23,1971, Arthur F. Burns remarked that,"The rules of economics are not workingin quite the way they used to. Despite ex-tensive unemployment in our country,wage rate increases have not moderated.Despite much idle industrial capacity,commodity prices continue to rise rap-idly." He went on to refer to a "new rigid-ity in our economic structure." (Fed. Res.Bull., Aug. 1971, 656.)

Whatever may be true about theeconomy, the propensity of economists toappeal to a change in our economic struc-ture whenever they are puzzled worksquite the way it used to. Dr. Burns' re-marks, both in phrasing and content, areeerily reminiscent of statements made byJames Laurence Laughlin, the first chair-man of the Department of Economics of

the University of Chicago, in a paper in the1909 Journal of Political Economy and ata session of the 1910 annual meeting of ourAssociation that is a precise parallel to thepresent session. That session sixty-oneyears ago had as its title "Causes of theChanges in Prices Since 1896;" Laughlinand Irving Fisher were its chief protago-nists. Chicago versus Yale but with thesides reversed!

Said Laughlin: The old theory ofRicardo and Hume no longer holds un-disputed sway.... There can be noquestion that the causes for the re-markable rise in prices in the last decadecannot be looked for in those influencesdirectly affecting gold [or, as we wouldnow say, money]....There has been a marked advance inwages . . which has had its effects inraising prices.... Once that a high rateof wages has been granted, it is not easyfor employers to force a reduction. Thishas been abundantly shown in the after-effects of the recent panic of 1907....There seems to be an influence inde-pendent of prices which has acted toraise the rate of wages. And that in-fluence undoubtedly is due in greater orless part to the pressure of labor unions.Let me interject that, when Laughlin

spoke, there were 2.1 million members oflabor unions or less than 6 percent of allgainful workers.Laughlin, like Burns, did not of courserestrict himself to wage-push. He went onto remark that "The formation of combi-nations is unquestionably the strongestforce in this period working for higherprices." (See Laughlin, 1909, 257, 263, 266,

* Professor of economics, University of Chicago, andmember of research staff, National Bureau of EconomicResearch. As always, I am indebted to Anna J. Schwartzfor compiling much of the evidence referred to in thispaper, for helpful suggestions and criticisms, and espe-cially for calling my attention to the confrontation ho-tween Laughlin and Fisher.

11


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12 AMERICAN ECONOMIC ASSOCIATION267, 270.) "The whole raison d'etre ofmonopolistic combinations is to controlprices and prevent active competition. Asevery economist knows, in the conditionsunder which many industries are todayorganized, expenses of production have nodirect relation to prices." (See Laughlin,1911, 35.)

Irving Fisher began his response, "I findmyself unable to agree with most of thepositions taken by Professor Laughlin inhis able paper. In my opinion," Fisherwent on, "the old quantity theory is inessence correct. What it needs is to be re-stated, not rejected" (p. 35). And now Imust cease quoting from Fisher, withwhom I am in full agreement, and proceedinstead to plagiarize him-albeit withmodifications to bring him down to date.That economists have often believedthat "rules of economics are not workingin quite the way they used to" and haveoften been wrong does not of course provethat those who make such assertions todayare wrong. So I turn to the substance ofmy assignment, which I shall interpret asdealing only with monetary policy.In one sense, monetary policy has clearlyfailed. It has not produced nirvana. It hasnot stopped inflation without a recession.From a scientific point of view, this is atrivial and uninteresting answer. It isequivalent to saying, medicine has failedbecause men still die. From a politicalpoint of view, it is not at all a trivial an-swer. A major problem of our time is thatpeople have come to expect policies toproduce results that they are incapable ofproducing.To make scientific sense of our questionwe must break it into two subsidiary ques-tions: first, did the actual monetary policyfollowed have the effects on income, out-put, and prices that could have been ex-pected from past experience-i.e., did thedrugs taken by the patient have the ex-pected effects; second, was the correct

monetary policy followed-i.e., did thephysician give the patient the right drugs?The period 1929-33 dramatically illus-trates the importance of distinguishingbetween these two questions. The actualmonetary policy produced a decline of one-third in the quantity of money. This de-struction of money had the effects to beexpected. It produced a major contractionin output, employment and prices. In thatsense, monetary policy succeeded. Thedrugs had the expected effect.But the monetary policy followed wasthe wrong policy. There was no need forthe monetary authorities to permit a de-cline of one-third in the quantity of money.They could have prevented the declineand produced an increase. If they had, Ido not believe the great depression wouldhave occurred. In that sense, monetarypolicy failed. The physician prescribed thewrong drugs.In the past three years, too, the mone-tary policy followed, while much closer tothe correct policy than from 1929-33, wasdeficient. The monetary authorities con-tinued, as so often in the past, to let mone-tary growth swing from one extreme to theother. In the two years prior to January1969-which I shall take as the beginningof the period under discussion-Ml hadrisen at the rate of 7.4 percent per year,M2, at the rate of 9.4 percent per year.From January 1969 to July 1969, thegrowth rates were brought to 4.7 and 4.0percent-about the rates of growth that iflong maintained would be consistent withsteady noninflationary economic growth.But, seeing no immediate results, theauthorities then stepped too hard on thebrake, bringing the growth rates down to1.5 and 0.2 percent from July 1969 toFebruary 1970, thereby setting the stagefor a sharper recession in 1970 than wasnecessary to restrain inflation. After theonset of recession, they reversed theircourse, raising the growth rates to 5.8 and


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14 AMERICAN ECONOMIC ASSOCIATIONPer cent per year14

12 _

10 18~~~~~~~~~~~~~~~~

jPredicted4 -~~~~~~~~~~~~~~~~~~'

1967 1968 1969 1970 1971 1972Note: Rates of change,on annuolbasis, computed romsix-monthmovingaverageof month-to-monthates of change.

CHART 1Personal Income: Percentage Rates of Change, Actual and Predictedfrom Changes in M2 Nine Months Earlier, 1967-1972

roughly 4 percent in the first six months of1971. The charge of failure is that the rateof inflation was unusually slow to respondto the monetary changes and that an ab-normal part of the change in nominal in-come was absorbed by the change in out-put that the response was too late andtoo small. On this issue, I must confessthat I made overly optimistic predictionsin 1969 about how soon inflation could beexpected to respond to the monetary slow-down. Inflation clearly did not react asrapidly as I predicted that it would.Chastened by this experience, I havereexamined the evidence for the postwarperiod on the separate response of pricesand output to monetary change. This evi-dence demonstrates that I seriously under-estimated in 1969 the typical time lag be-

tween monetary acceleration or decelera-tion and the subsequent acceleration ordeceleration of prices. I was misled by themost recent experience the mini-reces-sion in 1967. That episode, not the pastfew years, is the exception. In that reces-sion and recovery, and in that one only inthe postwar period, prices reacted aspromptly as production to a change inmonetary growth, and reacted with a lagof six months or less. In every earlier post-war recession and recovery, prices reacteddecidedly later than production, and re-acted with a lag varying from eleven tothirty-one months. In the 1970 recession,prices reacted with a lag of ten monthsafter M1 and twelve months after Al2; inthe current expansion, prices reacted witha lag of seventeen months for both M1 and


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HAVE FISCAL-MONETARY POLICIES FAILED? 15A12. The timing was well within the rangeof earlier postwar experience.3To check the evidence from peaks andtroughs, we have calculated correlationcoefficients from monthly data betweenchanges in money and in industrial produc-tion and consumer prices for a range ofleads and lags. The highest correlation forindustrial production is for money leadingthree months for MA and six months forA12. This was no surprise. What was a sur-prise was to find that the highest correla-tion for consumer prices was for moneyleading twenty months for M1,and twenty-three months for AM2.Quarterly GNP datagive similar results. Clearly, monetary

IHerewith the detailed timing at reference cyclepeaks and troughs of rates of change of industrial pro-duction and consumer prices relative to the rate ofchange of money. All rates of change are calculated overa six-month period from monthly data.LEAD OF RATE OF CHANGE OF MONEY OVER RATE

OF CHANGE OF INDUSTRIALPRODUCTIONAND CONSUMERPRICE INDEX(SPECIFIC CYCLEDATES)

Lead (in Months) of Money OverIndustrial Consumer PriceReference Production IndexDate Ml 312 Ml 1112

Troughs8/54 10 10 13 134/58 1 25 11 312/61 8 6 17 255/67 7 3 6 211/70 9 9 17 17

Peaks7/53 9 9 19 197/57 -1 -1 17 175/60 17 21 22 2611/66 2 2 4 411/69 4 6 10 12Note: For latest trough (11 70) consumer price indexhas been treated as if rate of change reached its troughin January 1971. This may prove to be the first of adouble trough at least in published and calculated CPIbecause of freeze.

changes take much longer to affect pricesthan to affect output-a qualitative resultthat we all expected, and that is entirelyin line with theoretical expectations. How-ever, the quantitative difference is muchlarger than I expected. Clearly, there isnothing in the timing of the reaction inthis episode that is unusual by comparisonwith the rest of the postwar period.The verdict is less clear with respect tomagnitude of response. As Chart 2 shows,predictions of the rate of change of outputand prices for 1969, 1970, and 1971 basedon earlier postwar monetary behavior yieldoverestimates of output changes andunderestimates of price changes.4 The pre-dictions for industrial production largelyparallel the actual changes, but the pre-dictions are consistently too high. Simi-larly, the predictions for prices parallel,though less closely, the actual changes butare consistently too low except for 1967and early 1968. The error is sizable in abso-lute terms. Had the predictions been onthe nose, the maximum rate of price risewould have been 4 to 4.5 percent insteadof 6.5 to 7 percent, and the rate of inflationwould have fallen to something like 1.5 to3.0 percent a year instead of 4 percent.However, two features of these predic-tions require attention before concludingthat they show the response to have beentoo little even if not too late.

First, while sizable in absolute terms,the errors of prediction are not sizable interms of the standard errors of the equa-tions from which they are computed.These equations have a good deal of loose-ness. The errors are mostly less than onestandard error, though some are more than

'This statement is true also for predictions fromsimple correlations between quarter-to-quarter rates ofchange of money (M1 and M2) and of GNP in 1958dollars and the implicit price index, and from the St.Louis model based on equations calculated for theperiod from first quarter 1953 to fourth quarter 1968.


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Per cent per year Per cent per year16

14-

1211o /\ Industrial Production |10 -I

/\Predicted

8~~~~~~~~~~~~~~~~~~~~~~~

Consumer Pricesl

6 -~~~~~~~~~~~~~~~~~~~~~~~~

4~~~~~~~~~~~~~~~~~~~~~~~~~/,ictual { 1

1967 161991970 1971 1972 1973Note Rates of change,on annualbasis, computed rom six-monthmovingaverage of month-to-monthates of change.

CHART 2Industrial Production and Consumer Prices: Percentage Rates of Change, Actual andPredicted from Changes in M2 Six Months Earlier for Production,Twenty-threeMonths Earlier or Prices, 1967-1973


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HAVE FISCAL-MONETARY POLICIES FAILED? 17one. Only a few are more than two stan-dard errors.5It is easy to find in the past record simi-lar periods displaying errors of similar size(for example, 1956 and 1957, or in the op-posite direction, 1963 to 1965). The sizableerror simply reflects the limitations of ourquantitative knowledge.Second, the primary error is not in theprediction of how rapidly inflation wouldabate but in how high it would reach. Therise in the rate of inflation from the end of1967 to 1969 was decidedly larger thanmight have been expected from the priormonetary expansion. However, the declinein the rate of inflation from the peak inearly 1970 to early 1971 is also larger andcomes some seven months earlier than thepredicted decline.6 Hence, even if we ne-glect statistical error completely, the con-clusion is that once monetary restrainttook hold it produced an even more sizableand earlier tapering off of inflation thancould have been expected.To digress for a moment -the typicaltime lags mean that we have just aboutnow come to the end of the anti-inflationeffect of the monetary restraint from Jan-uary 1969 to February 1970. We are nowbeginning to experience the inflationaryeffect of the renewed monetary expansionthat began in February 1970, though notyet of the monetary explosion of the firsthalf of 1971. Unfortunately, we shall havegreat difficulty putting these inferences tothe test. Whatever else a price and wagefreeze or price and wage controls may do,they distort published price indexes and

make them highly unreliable measures ofthe movement of actual prices. A majorchallenge to our ingenuity is to find morereliable measures.7My final conclusion from this reexami-nation of postwar experience is that mone-tary policy did not fail in the past threeyears in the relevant scientific sense. Thedrugs produced the effect to be expected,though the wrong drug was administeredand the patient expected it to be far morepotent than it was capable of being.We have been driven into a widespreadsystem of arbitrary and tyrannical controlover our economic life, not because "eco-nomic laws are not working the way theyused to," not because the classical medi-cine cannot, if properly applied, halt infla-tion, but because the public at large hasbeen led to expect standards of perfor-mance that as economists we do not knowhow to achieve. Perhaps, as our knowledgeadvances, we can come closer to specifyingpolicies that would achieve these highstandards. Perhaps, the random perturba-tions inherent in the economic systemmake it impossible to achieve such stan-dards. And perhaps, even if there arepolicies that would attain them, considera-tions of political economy will make itimpossible for these policies to be adopted.But whatever the future may hold inthese respects, I believe that we econo-mists in recent years have done vast harm-to society at large and to our professionin particular-by claiming more than wecan deliver. We have thereby encouragedpoliticians to make extravagant promises,inculcate unrealistic expectations in thepublic at large, and promote discontentThe predictions for successive months are not ofcourse independent observations. The errors for theprice equations are highly correlated serially.

6 Again, this reflects no peculiarity of this episode.Because the monetary growth rate is only one of thefactors accounting for the rate of inflation, the inflationrate predicted from monetary growth alone is smoothand has a smaller amplitude of fluctuation than theactual inflation rate--the standard regression phenome-non.

I must confess failure, despite much experimenta-tion, centering about the World War II period. At onetime, I thought that the average denomination of cur-rency or the average denomination of a check mightserve as a reliable proxy for a price index during timesof price and wage control. But the experiments reportedby John Klein (1960) dashed this hope. I have been ableto generate no equally promising indirect measure.


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18 AMERICAN ECONOMIC ASSOCIATIONwith reasonably satisfactory results be-cause they fall short of the economists'promised land.

REFERENCESI. Fisher,"Recent Changes in PriceLevels andtheir Causes," Bull. Amer. Econ. Assoc.,Fourth Series, No. 2, 1, Apr. 1911, 36-45.

J. J. Klein, "Price Level and Money Denomi-nationMovements,"J. Polit. Econ., 68, Aug.1960, 369-78.J. L. Laughlin, "Gold and Prices, 1890-1907,"J. Polit. Econ., 17, 1909, 257-71."Causes of the Changes in PricesSince 1896," Bull. Amer. Econ. Assoc.,Fourth Series, No. 2, I, Apr. 1911, 26-36.

have monetory policy failed

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