American Economic Association

Have Monetary Policies Failed? Author(s): Milton Friedman Reviewed work(s): Source: The American Economic Review, Vol. 62, No. 1/2 (Mar. 1, 1972), pp. 11-18 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1821518 . Accessed: 13/03/2012 08:24
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HAVE FISCAL AND/OR MONETARY POLICIES FAILED?

Have

Monetary
By

Policies

Failed?

MILTON FRIEDMAN *

The topic for this session reminds me of the first of the four questions that the youngest male at the Jewish Passover Seder traditionally asks the head of the household: "Why is this night different from all other nights?" In like fashion, we are asked: "Are this recession and expansion different from all other recessions and expansions?" It is widely believed that the answer is yes. For example, in testifying before the Joint Economic Committee on July 23, 1971, Arthur F. Burns remarked that, "The rules of economics are not working in quite the way they used to. Despite extensive unemployment in our country, wage rate increases have not moderated. Despite much idle industrial capacity, commodity prices continue to rise rapidly." He went on to refer to a "new rigidity in our economic structure." (Fed. Res. Bull., Aug. 1971, 656.) Whatever may be true about the economy, the propensity of economists to appeal to a change in our economic structure whenever they are puzzled works quite the way it used to. Dr. Burns' remarks, both in phrasing and content, are eerily reminiscent of statements made by James Laurence Laughlin, the first chairman of the Department of Economics of
* Professor of economics, University of Chicago, and member of research staff, National Bureau of Economic Research. As always, I am indebted to Anna J. Schwartz for compiling much of the evidence referred to in this paper, for helpful suggestions and criticisms, and especially for calling my attention to the confrontation hotween Laughlin and Fisher.
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the University of Chicago, in a paper in the 1909 Journal of Political Economy and at a session of the 1910 annual meeting of our Association that is a precise parallel to the present session. That session sixty-one years ago had as its title "Causes of the Changes in Prices Since 1896;" Laughlin and Irving Fisher were its chief protagonists. Chicago versus Yale but with the sides reversed! Said Laughlin: The old theory of Ricardo and Hume no longer holds unThere can be no disputed sway.... question that the causes for the remarkable rise in prices in the last decade cannot be looked for in those influences directly affecting gold [or, as we would now say, money].... There has been a marked advance in wages . . which has had its effects in raising prices.... Once that a high rate of wages has been granted, it is not easy for employers to force a reduction. This has been abundantly shown in the aftereffects of the recent panic of 1907.... There seems to be an influence independent of prices which has acted to raise the rate of wages. And that influence undoubtedly is due in greater or less part to the pressure of labor unions. Let me interject that, when Laughlin spoke, there were 2.1 million members of labor unions or less than 6 percent of all gainful workers. Laughlin, like Burns, did not of course restrict himself to wage-push. He went on to remark that "The formation of combinations is unquestionably the strongest force in this period working for higher prices." (See Laughlin, 1909, 257, 263, 266,

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AMERICAN ECONOMIC ASSOCIATION

did the monetary policy followed-i.e., physician give the patient the right drugs? The period 1929-33 dramatically illustrates the importance of distinguishing between these two questions. The actual monetary policy produced a decline of onethird in the quantity of money. This destruction of money had the effects to be expected. It produced a major contraction in output, employment and prices. In that sense, monetary policy succeeded. The drugs had the expected effect. But the monetary policy followed was the wrong policy. There was no need for the monetary authorities to permit a decline of one-third in the quantity of money. They could have prevented the decline and produced an increase. If they had, I do not believe the great depression would have occurred. In that sense, monetary policy failed. The physician prescribed the wrong drugs. In the past three years, too, the monetary policy followed, while much closer to the correct policy than from 1929-33, was deficient. The monetary authorities continued, as so often in the past, to let monetary growth swing from one extreme to the other. In the two years prior to January 1969-which I shall take as the beginning had of the period under discussion-Ml risen 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, the growth rates were brought to 4.7 and 4.0 percent-about the rates of growth that if long maintained would be consistent with steady noninflationary economic growth. But, seeing no immediate results, the authorities then stepped too hard on the brake, bringing the growth rates down to 1.5 and 0.2 percent from July 1969 to February 1970, thereby setting the stage for a sharper recession in 1970 than was necessary to restrain inflation. After the onset of recession, they reversed their course, raising the growth rates to 5.8 and

267, 270.) "The whole raison d'etre of monopolistic combinations is to control prices and prevent active competition. As every economist knows, in the conditions under which many industries are today organized, expenses of production have no direct relation to prices." (See Laughlin, 1911, 35.) Irving Fisher began his response, "I find myself unable to agree with most of the positions taken by Professor Laughlin in his able paper. In my opinion," Fisher went on, "the old quantity theory is in essence correct. What it needs is to be restated, not rejected" (p. 35). And now I must cease quoting from Fisher, with whom I am in full agreement, and proceed instead to plagiarize him-albeit with modifications to bring him down to date. That economists have often believed that "rules of economics are not working in quite the way they used to" and have often been wrong does not of course prove that those who make such assertions today are wrong. So I turn to the substance of my assignment, which I shall interpret as dealing only with monetary policy. In one sense, monetary policy has clearly failed. It has not produced nirvana. It has not stopped inflation without a recession. From a scientific point of view, this is a trivial and uninteresting answer. It is equivalent to saying, medicine has failed because men still die. From a political point of view, it is not at all a trivial answer. A major problem of our time is that people have come to expect policies to produce results that they are incapable of producing. To make scientific sense of our question we must break it into two subsidiary questions: first, did the actual monetary policy followed have the effects on income, output, and prices that could have been expected from past experience-i.e., did the drugs taken by the patient have the expected effects; second, was the correct

HAVE FISCAL-MONETARY POLICIES FAILED?

9.2 percent from February 1970 to January 1971. These rates, though definitely too high for the long run, were at least understandable in light of the excessive earlier tightness. But then from January 1971 to July 1971 there was a veritable monetary explosion, with M1 growing at an annual rate of over 9.8 percent and M2 of over 13.8 percent. This was followed by another jamming on of the brakes, so that from July 1971 to November 1971, M1 actually fell at the annual rate of -0.2 percent and M2 rose at the rate of 3.9 percent. I have no doubt that we shall soon see another lurch to the opposite side of the road. This failure of monetary policy, too, like the failure to meet unrealistic expectations, has had enormous political importance. It also has scientific interest because the erratic and destabilizing monetary policy has largely resulted from the acceptance of erroneous economic theories. However, the key scientific issue, and the one to which I shall devote the rest of this paper, is whether monetary policy failed in the sense that the effects of monetary changes on economic magnitudes were different than might have been expected from past experience. Three magnitudes are of central interest: nominal income, real income or output, and prices. We can deal summarily with nominal income because it clearly responded to the monetary changes very much in accordance with earlier U.S. postwar experience, both in timing and in magnitude. During the postwar period-and I may say also for the past century and for many foreign countries-the rate of change of the quantity of money has tended to lead the rate of change of nominal income by some two or three quarters on the average, i.e., six to nine months, depending on the precise concepts of money and income. And of course there is considerable variability about this average.

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In this episode, the lead at the peak in 1969 was four quarters for M1, three quarters for M2; at the trough in 1970, it was one quarter for M1, two quarters for M2, if we adjust for the GM strike; four quarters for M1, five quarters for M2, if we do not adjust for the strike. These leads are all clearly within the range of past experience.1 Not only was timing strictly in line with past experience, so also was the magnitude of the change. Chart 1 shows the actual rate of change of personal income and the rate of change prtdicted solely on the basis of the behavior of money (M2) nine months earlier. The predicted rates of change clearly trace the actual course of personal income changes, with respect to both pattern and level, with remarkable fidelity except only for sharp deviations attributable to the rise in federal pay rates in early 1970, the GM strike in late 1970, and the fear of a steel strike in 1971.2 The controversy is not about nomirral income but about the division of the change in nominal income between output and prices. Inflation did respond to the monetary slowdown from January 1969 to February 1970, whether judged by the consumer price index or the implicit GNP deflator or a variety of other price indexes. For example, consumer prices rose at a rate of 6.4 percent per year in the six months ending April 1970; at a rate of
1 To avoid misunderstanding, let me stress that I am considering rates of change, not levels of income. On the National Bureau reference cycle basis, which emphasizes primarily levels, both peak and trough come later. than the dates that I have used in the text, except for the trough if no adjustment is made for GM, when it comes in the fourth quarter of 1970. The National Bureau reference dates are November 1969 for the peak and November 1970 for the trough. 2 On a more sophisticated basis, the changes in GNP predicted for these quarters by the St. Louis monetarist model computed from data for 1953 to 1968 are, if allowance is made for the GM strike, very close to the actual and well within the range to be expected from the standard error of the equation.

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Per cent per year 14

AMERICAN ECONOMIC ASSOCIATION

12 _

10

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

jPredicted
4

-~~~~~~~~~~~~~~~~~~'

1967

1968

1969

1970

1971

1972

Note: Rates of change, on annuolbasis, computedfromsix-monthmovingaverage rates of change. of month-to-month CHART 1

Personal Income: Percentage Rates of Change, Actual and Predicted from Changes in M2 Nine Months Earlier, 1967-1972

roughly 4 percent in the first six months of 1971. The charge of failure is that the rate of inflation was unusually slow to respond to the monetary changes and that an abnormal part of the change in nominal income was absorbed by the change in output that the response was too late and too small. On this issue, I must confess that I made overly optimistic predictions in 1969 about how soon inflation could be expected to respond to the monetary slowdown. Inflation clearly did not react as rapidly as I predicted that it would. Chastened by this experience, I have reexamined the evidence for the postwar period on the separate response of prices and output to monetary change. This evidence demonstrates that I seriously underestimated in 1969 the typical time lag be-

tween monetary acceleration or deceleration and the subsequent acceleration or deceleration of prices. I was misled by the most recent experience the mini-recession in 1967. That episode, not the past few years, is the exception. In that recession and recovery, and in that one only in the postwar period, prices reacted as promptly as production to a change in monetary growth, and reacted with a lag of six months or less. In every earlier postwar recession and recovery, prices reacted decidedly later than production, and reacted with a lag varying from eleven to thirty-one months. In the 1970 recession, prices reacted with a lag of ten months after M1 and twelve months after Al2; in the current expansion, prices reacted with a lag of seventeen months for both M1 and

HAVE FISCAL-MONETARY POLICIES FAILED?

A12. The timing was well within the range of earlier postwar experience.3 To check the evidence from peaks and troughs, we have calculated correlation coefficients from monthly data between changes in money and in industrial production and consumer prices for a range of leads and lags. The highest correlation for industrial production is for money leading three months for MA and six months for A12. This was no surprise. What was a surprise was to find that the highest correlation for consumer prices was for money leading twenty months for M1, and twentythree months for AM2. Quarterly GNP data give similar results. Clearly, monetary

15

I Herewith the detailed timing at reference cycle peaks and troughs of rates of change of industrial production and consumer prices relative to the rate of change of money. All rates of change are calculated over a six-month period from monthly data.
LEAD OF RATE OF CHANGE OF MONEY OVER RATE OF CHANGE OF INDUSTRIALPRODUCTION AND CONSUMERPRICE INDEX (SPECIFIC CYCLE DATES)

Lead (in Months) of Money Over Reference Date Industrial Production Ml 312 Consumer Price Index Ml 1112

Troughs 8/54 4/58 2/61 5/67 11/70 10 1 8 7 9 9 -1 17 2 4 10 25 6 3 9 Peaks 7/53 7/57 5/60 11/66 11/69 9 -1 21 2 6 19 17 22 4 10 19 17 26 4 12 13 11 17 6 17 13 31 25 2 17

changes take much longer to affect prices than to affect output-a qualitative result that we all expected, and that is entirely in line with theoretical expectations. However, the quantitative difference is much larger than I expected. Clearly, there is nothing in the timing of the reaction in this episode that is unusual by comparison with the rest of the postwar period. The verdict is less clear with respect to magnitude of response. As Chart 2 shows, predictions of the rate of change of output and prices for 1969, 1970, and 1971 based on earlier postwar monetary behavior yield overestimates of output changes and underestimates of price changes.4 The predictions for industrial production largely parallel the actual changes, but the predictions are consistently too high. Similarly, the predictions for prices parallel, though less closely, the actual changes but are consistently too low except for 1967 and early 1968. The error is sizable in absolute terms. Had the predictions been on the nose, the maximum rate of price rise would have been 4 to 4.5 percent instead of 6.5 to 7 percent, and the rate of inflation would have fallen to something like 1.5 to 3.0 percent a year instead of 4 percent. However, two features of these predictions require attention before concluding that they show the response to have been too little even if not too late. First, while sizable in absolute terms, the errors of prediction are not sizable in terms of the standard errors of the equations from which they are computed. These equations have a good deal of looseness. The errors are mostly less than one standard error, though some are more than
'This statement is true also for predictions from simple correlations between quarter-to-quarter rates of change of money (M1 and M2) and of GNP in 1958 dollars and the implicit price index, and from the St. Louis model based on equations calculated for the period from first quarter 1953 to fourth quarter 1968.

Note: For latest trough (11 /70) consumer price index has been treated as if rate of change reached its trough in January 1971. This may prove to be the first of a double trough at least in published and calculated CPI because of freeze.

Per cent per year 16

Per cent per year

14-

121
0 1o

10 -I

/\

Industrial Production /\Predicted

8~~~~~~~~~~~~~~~~~~~~~~~
6 -~~~~~~~~~~~~~~~~~~~~~~~~

4~~~~~~~~~~~~~~~~~~~~~~~~~
/,ictual

ConsumerPricesl

1967

161991970
CHART 2

1971

1972

1973

rates of change. Note Rates of change, on annualbasis, computedfromsix-monthmovingaverage of month-to-month

Industrial Production and Consumer Prices: Percentage Rates of Change, Actual and Predicted from Changes in M2 Six Months Earlier for Production,

Twenty-threeMonths Earlierfor Prices, 1967-1973

HAVE FISCAL-MONETARY POLICIES FAILED?

one. Only a few are more than two standard errors.5 It is easy to find in the past record similar periods displaying errors of similar size (for example, 1956 and 1957, or in the opposite direction, 1963 to 1965). The sizable error simply reflects the limitations of our quantitative knowledge. Second, the primary error is not in the prediction of how rapidly inflation would abate but in how high it would reach. The rise in the rate of inflation from the end of 1967 to 1969 was decidedly larger than might have been expected from the prior monetary expansion. However, the decline in the rate of inflation from the peak in early 1970 to early 1971 is also larger and comes some seven months earlier than the predicted decline.6 Hence, even if we neglect statistical error completely, the conclusion is that once monetary restraint took hold it produced an even more sizable and earlier tapering off of inflation than could have been expected. To digress for a moment -the typical time lags mean that we have just about now come to the end of the anti-inflation effect of the monetary restraint from January 1969 to February 1970. We are now beginning to experience the inflationary effect of the renewed monetary expansion that began in February 1970, though not yet of the monetary explosion of the first half of 1971. Unfortunately, we shall have great difficulty putting these inferences to the test. Whatever else a price and wage freeze or price and wage controls may do, they distort published price indexes and
I The predictions for successive months are not of course independent observations. The errors for the price equations are highly correlated serially. 6 Again, this reflects no peculiarity of this episode. Because the monetary growth rate is only one of the factors accounting for the rate of inflation, the inflation rate predicted from monetary growth alone is smooth and has a smaller amplitude of fluctuation than the actual inflation rate--the standard regression phenomenon.

17

make them highly unreliable measures of the movement of actual prices. A major challenge to our ingenuity is to find more reliable measures.7 My final conclusion from this reexamination of postwar experience is that monetary policy did not fail in the past three years in the relevant scientific sense. The drugs produced the effect to be expected, though the wrong drug was administered and the patient expected it to be far more potent than it was capable of being. We have been driven into a widespread system of arbitrary and tyrannical control over our economic life, not because "economic laws are not working the way they used to," not because the classical medicine cannot, if properly applied, halt inflation, but because the public at large has been led to expect standards of performance that as economists we do not know how to achieve. Perhaps, as our knowledge advances, we can come closer to specifying policies that would achieve these high standards. Perhaps, the random perturbations inherent in the economic system make it impossible to achieve such standards. And perhaps, even if there are policies that would attain them, considerations of political economy will make it impossible for these policies to be adopted. But whatever the future may hold in these respects, I believe that we economists in recent years have done vast harm -to society at large and to our profession in particular-by claiming more than we can deliver. We have thereby encouraged politicians to make extravagant promises, inculcate unrealistic expectations in the public at large, and promote discontent
II must confess failure, despite much experimentation, centering about the World War II period. At one time, I thought that the average denomination of currency or the average denomination of a check might serve as a reliable proxy for a price index during times of price and wage control. But the experiments reported by John Klein (1960) dashed this hope. I have been able to generate no equally promising indirect measure.

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J. J. Klein, "Price Level and Money Denomination Movements,"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 Prices Since 1896," Bull. Amer. Econ. Assoc., Fourth Series, No. 2, I, Apr. 1911, 26-36.

with reasonably satisfactory results because they fall short of the economists' promised land. REFERENCES I. Fisher, "Recent Changes in Price Levels and their Causes," Bull. Amer. Econ. Assoc., Fourth Series, No. 2, 1, Apr. 1911, 36-45.