Friedman and the Enigma of Money
The first and most important lesson that history teaches about what monetary policy can do…is that monetary policy can prevent money itself from being a major source of economic disturbance.
—Milton Friedman (1968)
The government solution to a problem is usually as bad as the problem.
—Milton Friedman (1975)
In early 1988, under the auspices of the Cato Institute, I visited China with the world’s leading expert on the theory of money, Milton Friedman. More than a decade earlier, Friedman had won a Nobel Prize for his influential theory of monetarism, which holds that central banks’ regulation of the supply of money is a key to growth.
At the time, China’s economy seemed to be on the verge of enormous growth, but it was hampered by a simultaneous surge of inflation. Prices were soaring, and poverty was rampant. One year later China’s rulers would dispatch tanks against student protesters at Tiananmen Square. The most conspicuous Chinese prosperity was in offshore islands such as Hong Kong and Taiwan, with lower inflation rates and per capita money supplies that dwarfed China’s. Nearby Japan commanded the largest money supply per capita in the world and was rich. Was that a clue? Who knew?
Surely Milton Friedman knew. I thought I would ask the world’s greatest monetary economist to explain some of these enigmas of money. As the billion Chinese emerged from forty years of Maoist oppression, however, Friedman had other ideas, chiefly some advice for the Chinese government. He counseled the communist leaders, as a top priority, “to get control of their money supply.”
No one ever won an argument with Milton Friedman, so I readily confess that I did not win one then, or later, over the power of government-controlled money in an economy. As we bounced in buses through the streets of Shanghai, Milton answered my every question with peremptory aplomb: “Inflation is always and everywhere a monetary phenomenon.” But what if government spending and taxes were the fastest-growing prices, as I had written in Wealth and Poverty? Friedman insisted: “Control the money supply and you can control inflation, regardless of government fiscal policy.”
I continued to resist the idea that the Chinese economy would benefit from advice from the world’s leading libertarian thinker to a communist regime full of control freaks to grab control of anything, especially money. But at that time, I could summon neither the words to refute Friedman nor the insights to grasp the enigmas of money.
Nonetheless, China was soon launched on the world’s greatest economic growth spurt. What does this success have to do with monetary policy? I had learned from the late Stanford professor Ronald McKinnon that “financial development”—the entrepreneurial creation of banks and other financial infrastructure—is vital to economic development.1 But aggregate numbers such as the money supply produced by the power of government are far less important. What matters are freedom, property rights, tax rates, and the rule of law, which enable the growth of knowledge and wealth.
Milton Friedman has passed away, but he continues to win arguments in his great books about the free market, from Capitalism and Freedom to Free to Choose, which still outsell mine by large margins.2 But with all due respect for the great economist, I would now like to point out that on the issue of money, despite his formidable forensic prowess and his Nobel-burnished credentials, he has been proved wrong.
The new information theory of money explains how and why. It also explains alternative monetary systems that can fulfill Friedman’s libertarian dreams far better than his own “monetarism.” It will resolve many of the enigmas of justice and growth that currently stultify the political debate.
State control of money has become a force for government economic centralization, wreaking havoc on economies around the globe, whether capitalist or socialist. By controlling money supplies, central banks and their political sponsors determine who gets money and thus who commands political and economic power. Unsurprisingly, these establishments back entrenched economic and political interests against their rivals, contributing to new unchallengeable concentrations of wealth. Reinforced with arachnoid webs of government regulation and control, these combinations of economic and political power are the primary cause of economic stagnation in the world.
Since the economic crisis of 2008, Washington has used monetary policy to effectively nationalize the Wall Street banks and subsidize their borrowing. Enormous sums of investment money are diverted from the real work of learning that builds wealth into currency manipulations and “investments” in government debt. The once-great Wall Street banks in turn subsidize the political campaigns of their Washington benefactors. If Friedman had lived to see what monetarism has begotten, he would disown it. Refuting this rare error of Friedman’s is therefore essential to saving the very freedoms that he dauntlessly championed throughout his career.
The economic theory of monetarism is based on the famous equation MV=PT, which is even emblazoned on a Milton Friedman T-shirt that I run in. “MV” is total output—that is, the money supply times its velocity or rate of turnover. “PT” is prices times transactions, or, very roughly, nominal gross domestic product. Money supply is “purchasing media,” what you use to buy stuff, liquid funds. The number of times a dollar is spent over a stipulated period represents its velocity.3
To simplify a bit, the money supply is usually defined as cash, checking deposits, and money market accounts. Supporting these is the Fed’s monetary base, consisting of bank reserves (partially backing up deposits) and all the cash (“Federal Reserve notes”) in the economy—often termed “high-powered money.” The bank reserves support bank loans, which can multiply the money supply and support economic expansion. The cash can be turned over an arbitrary number of times. Many bank loans, however, have been boomeranging back to Washington to sustain government consumption.
The turnover of money of all definitions sustains GDP, or more accurately GDE (gross domestic expenditures), Mark Skousen’s valuable measure of all spending across the economy. Renamed gross output (GO) and adopted by the Federal Bureau of Economic Analysis in December 2013, GDE includes intermediate spending on capital goods and commodities, not just the final sales indexed in GDP.4 This advance is important to the economic debate because as a share of Skousen’s larger metric, consumption diminishes from 70 percent of the economy to around 40 percent.
Friedman and his many disciples persuaded economists across the political spectrum to believe that in the equation MV=PT, the ruling factor is “M.” Control the money supply and you command a lever that can move the entire economy in a desired direction. You can maintain nominal or measured GDP (without adjusting for inflation) at any desired rate of growth. Hence Friedman’s advice to the Chinese leaders, “Get control of your money supply.”
Friedman’s monetarist theory explains why the Federal Reserve Board has a mandate from Congress not just to serve as a “lender of last resort” in crises but also to combat inflation and promote full employment. These goals imply that the Fed controls the effective money supply. By manipulating this lever, the theory goes, central bankers both determine the level of prices (inflation) and influence the level of employment and at least nominal growth. That is the creed of monetarism, suggesting that even in a fully free-market economy the central bank is the one institution that must maintain top-down control.
Since every currency has a central bank, the prevailing monetarism enables a different monetary policy in each nation or region. Separating national economies, this system favors currencies floating against one another, with their values reconciled by a global market of currency exchange. Thus, a global currency is “minted” by currency traders in a strange new form of seigniorage. Under the prevailing theory, money becomes a self-referential system ultimately controlled by each sovereign that issues currency. Sovereign moneys compete with one another in markets around the globe.
By assuming that control over the money supply gives the government power to provide jobs and lower prices in each country, monetarism, like Keynesianism, not only invites but virtually requires a government monopoly on money.
But because we don’t trust politicians with a weapon as powerful as monetary policy, we take that power from the voters and diffuse it among independent panels of experts and trusted third parties, such as the European Central Bank and the Board of Governors of the Federal Reserve System. Thus monetary theory not only denies free enterprise, it also impugns democracy.
For “M” to rule, however, money must have an inelastic element to multiply or push against. Velocity (or money turnover) must be reasonably stable and unaffected by changes in “M.” That is, people must spend their currency at a relatively even and predictable rate, regardless of the supply of money, and banks must loan money chiefly as it is made available by the central bank rather than as it is demanded by entrepreneurs with promising ideas. Otherwise the people (including bankers) could counteract any given monetary policy merely by changing the rate at which they spend or invest the dollars. Why monetary theory disregards this possibility has long been an enigma to me.
Friedman developed a shrewd and plausible answer. He posited that annual velocity is reasonably constant at around 1.7 times per year. He explained this number as a reflection of deep-seated human psychological propensities, summed up in his famous “permanent income hypothesis”: “liquidity preferences” (desire for cash) and their inverse, the savings rate, depend on lifetime savings and income targets. That is, you save until you hit your target, and then you spend. During your youth you tend to save; in your old age you tend to dissave. Savings is determined not by the availability of investment opportunities or changes in interest rates or tax rates or exciting new consumption goods or inviting savings vehicles but by the immutable psychology of human beings.
The permanent income hypothesis seems plausible on the surface—No one in here but us sociologists. But another word for liquidity preference is velocity or turnover. Friedman thus supplied a sociological explanation for velocity that put it outside economic policy. With velocity more or less fixed, the money supply rules. So despite his acute misgivings about government power and his superb critiques of government programs, Friedman ended up encouraging the idea that the federal government’s control of money provides a lever for federal experts to regulate and stabilize the economy. (Shrinking from the elitist implications of Fed control, Friedman himself proposed binding the central bank to a predetermined monetary rule, such as annual increases in the money supply of 3 percent, reflecting average economic growth.)
Liberal economists like Paul Krugman eagerly accept the implication of the monetarist creed. Conservative economists pile on. The eminent John Taylor of Stanford wants to tie the Fed to a Taylor Rule, based on announced targets for inflation and unemployment.5 Even National Review’s Ramesh Ponnuru and former Republican Treasury economist David Beckworth have strongly endorsed monetarism in America’s flagship journal of conservative opinion.6 In an article on the crash of 2008, they impugned the Fed for inadequate expansion of the money supply through the “Great Recession” beginning in 2007, when the monetary base of the Fed’s so-called high-powered money began an expansion from $800 billion to $4 trillion.
In 1976 Friedman suffered a crippling intellectual trauma that for the rest of his life seriously affected his thinking. The king of Sweden awarded him a Nobel Prize for economic science, specifically for his errors—his monetary theory and his permanent income hypothesis. In an intellectual lapse common among Nobel laureates, Friedman continued to defend these ideas long after their validity had collapsed empirically.
The one thing we know from empirical experience is that velocity is not constant. Not even close. Through most of the twenty-first century, velocity has fallen like a rock one year and soared like a rocket the next. The money multiplier—a velocity enabler measuring how much economic activity the Fed’s monetary base or “high-powered money” supports—swings between 3.1 and 12. Over the seven years following the 2007–2008 financial crisis, the U.S. monetary base rose, as just noted, from $800 billion to $4 trillion, but velocity plummeted. In Japan velocity has been sinking for two decades after soaring wildly in the 1980s. In the United States, as Louis Gave of Hong Kong’s Gavekal economics asserts, “velocity is eminently volatile and impossible to forecast.”7
Jacques Rueff is widely known as “one of the best central bankers France ever had” and the author of the immortal line, “Inflation consists of subsidizing expenditures that give no return with money that does not exist.”8 In a speech about Rueff to the French parliament in 1996, the champion of the gold standard Lewis Lehrman explained, “All of Jacques Rueff’s experience as a central banker had taught him . . . that no central bank, not even the mighty Federal Reserve, can determine the quantity of bank reserves or the quantity of money in circulation. . . . In a free society, only the money users—consumers and producers in the market—can determine the money they desire to hold [or] vary the currency and bank deposits they wish to keep. . . .”9
But if velocity is not constant, then consumers and investors and lenders could counteract any given monetary policy merely by changing the rate at which they spend or invest the dollars. In recent decades, this is what we seem to have done, compensating for and neutralizing every change in the money supply with a nearly equal and opposite change in turnover. Indeed, in an interview in 2003, three years before his death, Friedman finally acknowledged, “The use of quantity of money as a target has not been a success. I am not sure that I would as of today push it as hard as I once did.”10
Velocity is not an effect of psychological forces outside the economy. It is the active means by which economic agents—people—control money. Velocity is freedom. It expresses the public’s appraisal of economic opportunities and opportunity costs. Velocity comes in two forms—pro-growth and anti-growth rises. In anti-growth moves, people flee from financial assets to consumables and collectibles, real estate, and financial shuffles in zero-sum inflationary surges that are not technically measured as velocity but certainly reflect monetary turnover. Positive accelerations of velocity come when investors plunge into actual companies and drive a rapid learning curve of opportunity and progress. In neither case does the central bank control money. We the people control it.
If we control money, then money does not require a sovereign source. Its source can reside outside the political system. It does not need central bank management. Currencies around the world do not have to be separated and allowed to float against one another.
As an almost-forgotten history teaches, it is possible to have centuries of expanding trade under a stable monetary standard, a monetary system that rewards work, savings, and enterprise over politics and pull. With a stable monetary standard, trade almost never balances.
The needed reforms entail treating money not chiefly as power but as information. While government power can increase the volume of money, it cannot enhance the value of money. And oddly it is the Chinese who most dramatically laid bare the limits of the monetarist creed.