Monetary Central Planning and the State, Part 26: Milton Friedman and the Monetary "Rule" for Economic Stability

In 1967, Milton Friedman delivered the presidential address at the American Economic Association in Washington, D.C. His theme was “The Role of Monetary Policy.” He argued that there was “wide agreement about the major goals of economic policy: high employment, stable prices, and rapid growth.” What separated economists, he said, were their views on the most appropriate methods to bring these desired things about.

Friedman emphasized what he believed an active monetary policy could not succeed in permanently doing. First, monetary policy could not permanently lower interest rates below the level that the market forces of supply and demand would tend to establish. It was true that increasing the money supply could temporarily increase the supply of lendable funds in the banking system and bring about a decrease in the rate of interest.

But in the longer run, the increase in the money supply would result in a general rise in prices. Higher prices would bring about an increased demand to borrow funds for investment and other purposes because borrowers would need a larger sum of money to facilitate the same real activities. At the same time, lenders would be less willing to lend at that lower rate of interest because the rise in prices would require them to hold a larger proportion of their money income as a cash balance to facilitate any desired purchases at those higher prices. Both of these factors would tend to push interest rates back to their previous market-determined levels.

Furthermore, if the monetary expansion were to continue for a long period of time and individuals came to expect a continuing general rise in prices in the future, lenders would begin to tag an “inflation premium” onto the rate of interest at which they were willing to lend because of the loss in purchasing power caused by the price inflation during the period of the loan.

For example, suppose that in a situation of zero price inflation, the market would have set the rate of interest at 5%. Now suppose that price inflation was raising prices in general, at an average annual rate of 3%. If lenders came to know this or believe it, they would begin to demand a rate of interest of 8% — 5% representing the “real” return on lending funds and 3% as compensation for the higher cost of buying goods at the end of the loan’s term. Indeed, inflationary expectations of this type could push interest rates far above what they had been before the monetary expansion had begun.

Second, Friedman argued, monetary policy could not permanently push unemployment below a market-determined “natural rate.” Over any period of time, there is always a certain amount of unemployment owing to several factors. For example, normal changes in supply and demand throughout an economy are always resulting in a certain amount of shifting of the labor force among various sectors of the economy and thus there are always some people between jobs.

Also, there are various institutional rigidities that result in a certain amount of unemployment: minimum-wage laws, trade-union restrictions that limit employment opportunities in occupations, regulatory controls that impose various production costs and restrictions that limit job offerings, and welfare programs that create incentives for people to choose not to work. While institutional reforms that reduced or eliminated these barriers to a more competitive market could reduce unemployment, an activist monetary policy could not.

Suppose that the monetary authority, however, did attempt to reduce the level of unemployment through an increase in the money supply (or an increase in the rate of monetary expansion). The monetary expansion would, indeed, increase the demand for goods and services in general in the economy, which would begin to put upward pressure on the prices of finished goods. If resource prices and labor costs did not immediately rise to reflect the now-higher prices of those finished goods, profit margins would increase. The greater profits to be earned would act as an incentive for employers to try to expand production and increase their sales.

But over time, resource prices and wages would go up as well. With employers throughout the economy all attempting to expand their respective productions, the demand for resources and labor would increase, bringing about a rise in resource prices and wages as those employers bid against each other. At the same time, the higher prices for goods and services in general would be decreasing the real value of the money incomes earned by resource owners and workers. They would now demand higher prices and money wages to compensate for the purchasing power lost because of the price inflation.

These two factors would, over time, result in the elimination of the greater profit margins that had served as the initial stimulus for employers to try to expand output and increase their work forces. In the long run, Friedman insisted, any monetary expansion would fail to reduce unemployment below its “natural rate.” Any “positive” employment effects would only be transitory.

What, then, could monetary policy do?

“The first and most important lesson that history teaches about what monetary policy can do — and it is a lesson of the most profound importance — is that monetary policy can prevent money itself from being a major source of economic disturbance. A second thing monetary policy can do is provide a stable background for the economy…. Our economic system will work best when producers and consumers, employers and employees can proceed with full confidence that the average level of prices will behave in a known way in the future — preferably that it will be highly stable. Finally, monetary policy can contribute to offsetting major disturbances in the economic system arising from other sources.”

By the latter, Friedman stated he meant an active monetary policy to counteract inflationary or recessionary forces that might be at work from nonmonetary sources, such as government budget deficits or a transition from a wartime to a peacetime economy.

Friedman concluded his presidential address by stating that the central monetary authority, therefore, should adopt a public policy of “a steady rate of growth” in the money supply.

“I myself have argued for a rate that would on the average achieve rough stability in the level of prices of final products, which I have estimated would call for something like a 3 to 5 percent per year rate of growth in currency plus all commercial bank deposits. By making that course one of steady but moderate growth in the quantity of money, [the monetary authority] would make a major contribution to avoidance of either inflation or deflation of prices. That is the most that we can ask from monetary policy at our present stage of knowledge.”

But why have a central monetary authority at all? Why not leave money to the market, as would be the case under a completely market-based and market-determined gold standard, for example? Why not have the forces of market supply and demand determine both what shall be used as money and the quantity that it is found most profitable to provide for monetary purposes?

Friedman’s clearest defense of a purely fiat or paper money standard was developed in his book A Program for Monetary Stability (1960). His basic answer is that the mining and supplying of a commodity money, such as gold, takes away resources that could be used for other purposes, and that this is an unnecessary cost to society.

“The maintenance of a commodity standard requires the use of real resources to produce additional amounts of the monetary commodity — of men and other resources to dig gold or silver or copper out of the ground or to produce whatever other commodities constitute the standard…. The use of … resources for this purpose establishes a strong social incentive in a growing economy to find cheaper ways to provide a medium of exchange.”

A paper money, he argued, clearly was that cheaper alternative. The problem, in his view, was that the provision of a fiat or paper money standard could not be left to the private market. First, there was the matter of fraud; a paper money was open to counterfeiting or other failures to meet contractual obligations by any private banks issuing that paper money. Second, private issuers of paper money might create them in such quantities that a serious inflation might be threatened, and when any such inflationary episode finally came to an end it might result in a collapse of the banking system as a whole. And, third, the potential instability from privately issued paper money would fail to provide the necessary institutional framework for general economic stability. Friedman concluded:

Something like a moderately stable monetary framework seems an essential prerequisite for the effective operation of a private market economy. It is dubious that the market can by itself provide such a framework. Hence, the function of providing one is an essential governmental function on a par with the provision of a stable legal framework.

Like his teacher, Henry Simons, Friedman advocated a system of 100% reserve banking. (See “Monetary Central Planning and the State, Part XXIII: Henry Simons and the ‘Chicago Plan’ for Monetary Reform” in Freedom Daily, November 1998.) The monetary authority would raise bank minimum reserve requirements gradually over a period of time, with the monetary authority supplying all required increases in paper money to meet these new higher reserve requirements until they reached 100%.

And the monetary authority, Friedman said, would then follow the “rule” that the stock of money be increased at a fixed rate year-in and year-out without any variation in the rate of increase to meet cyclical needs. This rule could be adopted by the [Federal] Reserve System itself. Alternatively, Congress could instruct the Reserve System to follow it…. The rate of increase should be chosen so that on the average it could be expected to correspond with a roughly stable long-run level of final product prices. To judge from [the historical] evidence, a rate of increase of 3 to 5 percent might be expected to correspond with a roughly stable price level.

But was this, in fact, a monetary system that could provide the necessary framework for general economic stability? Could a central monetary authority be trusted to follow such a “rule” and forgo the temptations of discretionary manipulation of the money supply? Was a paper money standard really less costly than a commodity standard like gold? Even Milton Friedman began to have second thoughts in later years.

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