Why do central bankers never learn?
Fifty years ago today, a diminutive, softly spoken man in his mid-50s gave a speech to his peers. That man was Milton Friedman and his speech, The Role of Monetary Policy, would change the face of economics profession. And, half a century later, its insights remain important.
What Friedman did then
When Friedman rose to give his address, most economists believed in a concept called the Phillips Curve. It was named after the economist A.W. Phillips who, in 1958, found a correlation in a century’s worth of British data between unemployment and the ‘rate of change of money wage rates’. In 1960, economists Paul Samuelson and Robert Solow elevated this into a tool for macroeconomic management. Policymakers could buy lower unemployment at the price of higher inflation and they could buy lower inflation at the price of higher unemployment. Through the 1960s, the economy behaved as the Phillips Curve predicted.
In his address that December night in 1968, Friedman refuted that. The essence of the Phillips Curve lay in using increases in a nominal variable – prices – to fool producers into increasing real variables, such as output and employment. But, Friedman argued, at some point economic agents would wise up to this. They would start to take expected inflation into account, by such methods as indexing contracts. Monetary policy would lose its traction on employment and, indeed, inflation and unemployment could rise together.
Despite much initial skepticism from his peers, Freidman quickly came to seem clairvoyant. Through the 1970s, the Phillips Curve started shifting around. In 1971, Arthur Burns, Chairman of the Federal Reserve, complained 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.” The relationship between inflation and unemployment ceased to be a useful policy variable.
This resulted in a complete rethinking of monetary policy. Instead of using monetary policy to stabilize real variables like employment or output, it would be used to stabilize monetary variables, such as inflation. Inflation targeting became the chief goal of monetary policymakers worldwide.
What Friedman means now
And yet, despite all this, in mid-October, a number of the world’s most prominent macroeconomists gathered at a Peterson Institute conference titled Rethinking Macroeconomic Policy. There, they tackled such questions as ‘has the relationship between inflation and unemployment broken down?’ and ‘if so what does that mean for interest rate policy?’
Why are some of our most eminent economists still debating whether this thing that was debunked 40 years ago exists or not? Has the profession really not moved on from Arthur Burns’ befuddlement?
Great things are expected from monetary policy. Politicians, pundits, even much of whatever section of the general public that thinks about such things, want monetary policymakers to use their powers to keep employment and economic growth high. And, despite the breakdown of the Phillips Curve four decades ago, monetary policymakers all too often encourage these expectations. When all is going well, they relish the adulation. In 1999, Larry Summers, who was at the Peterson Institute Conference, was one of three economists who appeared on a cover of Time magazine with the headline ‘The Committee to Save the World’. Ben Bernanke titled his memoir of the financial crisis ‘The Courage to Act’. Robert Graves’ memoir of front line combat in World War One, ‘Goodbye to All That’, was modest by comparison.
But monetary policymakers only have three tools. First, they control of the size of the supply of base money; second, they control the price at which this base money is borrowed (the base rate); third, they set limits on the amount of broad money which can be pyramided out from this base money (reserve ratios).
Each of these has been a primary policy tool at some time in the past. None of them, however, is ‘economic growth’ or ‘employment’. When monetary policy-makers have been tasked with boosting these variables, they have had to do so using instruments which affect it only indirectly; monetary base control, base rates, or reserve ratios.
As Friedman argued, ordinarily monetary policymakers can facilitate economic calculation only by adhering to a predictable rules-based policy. In extremis, they can throw a mattress of liquidity under a collapsing financial system. That is what monetary policy should focus on. The goal of directly growing GDP or raising employment is beyond these tools.
The Phillips Curve lumbers on because it seems to suggest otherwise. It offers a tool to directly control those real variables that matter. Monetary policymakers are loath to give it up. So, when, as now, it ‘disappears’ and full employment coexists with low inflation – the flipside of the problem which foxed Arthur Burns – they don’t abandon it. Instead, they convene conferences and turn mental somersaults trying to relocate it.
The curve doesn’t exist. Its promise is hollow. Our eminent macroeconomists should acknowledge the truth of Milton Friedman’s address half a century ago and stop wasting their time assuming its existence and then trying to figure out why they can’t find it.