“Milton Friedman is no longer running the show,” President Biden joked memorably during his campaign in April 2020. More sad. With rising inflation, financial market volatility, and declining productivity, we can use a healthy dose of Friedman’s knowledge.
Monetary policy in particular requires a reset. The way we think about the Federal Reserve’s mission is all wrong. We can begin to fix things by re-introducing ourselves to the greatest diagnosticians of the twentieth century.
Economists, policy makers and financial journalists discuss how monetary policy affects the economy in different ways. When the Federal Reserve buys assets, it expands the financial base, which strengthens production and trade through various channels. The first is the interest rate. Simple money can reduce rates, which stimulates investment. The second is the exchange rate. Easy money often weakens the dollar against other currencies, stimulating exports. The third is the price of assets. Easy Money frequently increases wealth, stimulates consumption. After all, simple money usually boosts overall demand, stimulating total spending.
Central bankers often try for four. Here’s the problem: it’s better to keep the first three alone. In fact, the ideal monetary policy will not affect them at all. This is only the last one, the total expenditure, it properly concerns the monetary policy. An important difference from Friedman’s work shows us why.
Friedman divides economics into price theory and monetary theory. Price theory, or microeconomics, explains how markets determine the “value of one thing relative to another.” Currency theory, or macroeconomics, focuses on how “cyclical and other fluctuations” determine the purchasing power of dollars, general unemployment, and output. This difference depends on the definition of money: as the medium of exchange of the economy, money is common to all markets. So things that affect the economy as a whole, such as inflation, are basically financial.
Since the 2008 financial crisis, central bankers have sought unconventional monetary stimulus. They clearly praised the innovation of policies such as “quantitative easing” and “Operation Twist” for their impact on asset prices and interest rates. But if you take Friedman’s difference seriously, it’s a serious mistake. Interest rates, asset prices and exchange rates are all relative values that indicate the supply and demand of important assets. These values send important information about resource deficits and encourage market participants to use those resources wisely. Unless you think policymakers are smarter than the market, and we’ve learned a thing or two about that deadly arrogance in the last century, you want to avoid interfering in the pricing process.
In contrast, aggregate demand (total expenditure) is not a price. This is simply the amount of economic activity valued in current dollars. Policymakers should pay attention here. By increasing or decreasing the financial base, central bankers can influence the overall economic activity and reduce the impact on the relative price. This is a good thing. Relative value determines the use of efficient resources. By messing with prices you inject noise into the signal business and householders use it to adjust their plans. Instead, the Fed could keep the economy close to its potential by stabilizing total spending. This is the most reliable way to achieve the Fed’s goal of full employment and price stability. Although real-world monetary policy will always have some relative-price effect, we can keep it as small as possible by keeping overall spending stable.
Taking Friedman seriously means a complete change in how we view central bankers. We should not consider them as financial engineers. We should not rely on them as world-saviors to adapt to market results. The exact terms of their exchange of work are not determined. Instead, their work is creating a stable foundation for the market to discover those terms in the form of reliable prices. If central bankers appreciate Friedman’s distinction between price theory and financial theory, they are much more likely to be in their lap.
Focusing on total spending is not a biased proposal. It is not the right wing or the left wing. The dismissal of Friedman’s work by progressives, reflected in President Biden’s speech, is due to his failure to acknowledge the valuable knowledge he has left us about how the economy works. We want to learn this quickly again. Monetary policy should be about money – not specific markets, but their general function. The sooner we enlist the help of Friedman to “run the show,” the sooner we’ll be able to clear our financial mess.