4
Certain
phenomena do not wash out, however. The alternations of phases of growth and
decline that characterize the business cycle entail the alternation of market psychology from
optimism about the future and debt accumulation to pessimism about the future and debt
deleveraging. Endowing these alternations of market psychology with causal influence motivates
real bills and Keynesian animal-spirits explanations of the business cycle as self-generating cycles of
instability in a capitalist system. Human nature produces periodic bouts of excessive speculation
followed inevitably by a period of purging required in order to eliminate the imbalances created by
prior speculation. Friedman therefore used historical information specific to place and time in order
to argue that the actions of the central bank often arose in response to adventitious events rather than
within a framework of a consistent response to the behavior of the economy.
4
Recognition that the estimation of micro-founded DSGE models defines the research agenda
in macroeconomics is consistent with admission that the models remain misspecified and thus
problematic for identifying the shocks that cause cyclical fluctuations (Chari et al. 2009). For
example, Andrle (2014, 5-6) wrote:
The assumption of uncorrelated structural shocks is always a point of departure when the
models are formulated…. However … it is a rule rather than
exception that the uncovered
shocks are strongly correlated…. The issue is extremely common with DSGE models, where
the positive co-movement of output, consumption, investment, and hours is hard to
achieve…. Economists must work with misspecified models, because there are no other
models.
The historical narrative approach of Friedman and Schwartz to identification probably makes many
uncomfortable because it involves judgment and is not quantitatively replicable. In a world in which
poor experimental design renders purely econometric techniques inconclusive, however, economists
monetary phenomenon using the Civil War, World War I, and World War II. He pointed to the
consistency of money per unit of output as a predictor of the price level while fiscal policy and union
power varied greatly in each wartime instance. One can find another example in a letter that
Friedman (1957b) wrote Arthur Burns criticizing Burns’ manuscript for the book Prosperity without
Inflation. Friedman argued that one should consider the effect of the money stock on nominal
expenditure and prices independently of the operation of the credit market. “[I]t is striking that
changes in the stock of money have had very similar effects under widely different institutional
arrangements for bringing about changes in it, some under which the credit market was of minor
importance....”
4
Friedman (1960, 22-23) wrote:
This sketch of our monetary experience has concentrated on the major economic
fluctuations—those substantial inflations and severe contractions that have from time to time
produced widespread distress…. Every such episode has been accompanied by a significant
monetary disturbance…. The monetary disturbances have had a largely independent origin in
enough cases to establish a strong presumption that they are contributory causes rather than
simply incidental effects of the economic fluctuations….
For more recent examples, see Romer and Romer (1989) and for the United Kingdom, Cloyne and
Hürtgen (2016).
5
should continue to consider as one tool for identification Friedman’s methodology, which treats
recessions as a series of concatenated event studies in which the central bank interferes with the
operation of the price system.
3.
Friedman’s critique of activist policy
Friedman advanced three criticisms of the Fed’s activist policy in the 1970s. The intention
was to achieve low, stable unemployment at an acceptable cost in terms of inflation as measured by
the Phillips curve. First, he associated a policy of aggregate-demand management with a simple
feedback rule running from the economy to the Fed’s instrument—money. Using the price level as
an example, Friedman (1960, 87) argued
that the link between price changes and monetary changes over short periods is too loose and
too imperfectly known to make price level stability an objective….
While the stock of money
is systematically related to the price level on the average…. there is much evidence that
monetary changes have their effect only after a considerable lag and over a long period and
that the lag is rather variable. [Italics in original]
5
Stimulative policy in recession might be appropriate, but attempts to implement such a policy
contemporaneously can destabilize the economy as its effects might emerge only after recovery had
begun. Friedman and Friedman (1984, 100) highlighted the lag in the effect of monetary
accelerations on real output of nine months and on inflation of two years and argued that “using
today’s prices to determine today’s monetary growth is like fighting the last war.” (See Figures 1
and 2.) In the figures, the lag in money starts in 1956 when the lean-against-the-wind (LAW)
procedures of the William McChesney Martin Fed came fully into effect (Hetzel 2008, Ch. 4). Note
that in the stop-go era when inflation did emerge, the Fed responded strongly to it (Figure 3).
Friedman (1980, 270) wrote:
The United States has embarked on rising monetary growth four times during the past twenty
years. Each time the higher monetary growth has been followed first by economic
expansion, later by inflation. Each time the authorities have slowed monetary growth in
order to stem inflation. Lower monetary growth has been followed by an inflationary
recession.... [W]e have overreacted to the recession by accelerating monetary growth, setting
off on another round of inflation, and condemning ourselves to higher inflation plus higher
unemployment.
Friedman (1968 [1969], 109) explained stop-go as follows:
The reason for the propensity to overreact seems clear: the failure of monetary authorities to
allow for the delay between their actions and the subsequent effects on the economy. They
tend to determine their actions by today’s conditions—but their actions will affect the
5
In the context of discussion of the NK model, a later section will return to the Friedman criticism in
the quotation of making “the price level an objective” and the Friedman (1975 [1983]) criticism,
reproduced below, of using the funds rate as an instrument.