Sargent on Friedman

I ran across a little gem by Tom Sargent, "The Evolution of Monetary Policy Rules." Alas, it's gated in the JEDC so you'll need a university IP address to read it, and I haven't found a free copy. It's a transcript of a talk, so doesn't have Tom's usual prose polish, but insightful nonetheless.

Milton Friedman, like the rest of us, changed his mind over the course of a lifetime.

Coordinating monetary and fiscal policy:

...At different times, Friedman advocated two apparently polar opposite recommendations. In Friedman (1948), he proposed the following rule. He recommended to the fiscal authorities that they run a balanced budget over the business cycle. And he said what the monetary authorities should do, whatever the fiscal authority does, is to monetize 100% of government debt. That monetary rule implies that the entire government deficit is going to be financed with money creation. That is it.

It is interesting to contemplate what Friedman׳s monetary policy rule would imply if the fiscal authority chooses to deviate from Friedman׳s fiscal recommendation by running sustained deficits over the business cycle. Friedman׳s monetary rule then throws responsibility for inflation control immediately at the foot of the fiscal authority. Friedman׳s (1948) monetary rule tells the fiscal authority that if it wants stable money, then it better do the right things. If you want a stable price level, you had better recognize that you need a sound fiscal policy, period.  The division of responsibilities between monetary and fiscal authorities is clearly and unambiguously delineated. It is a completely clean set of rules. And this is what Friedman advocated until 1960.

Friedman (1960) advocated what looks to be exactly an opposite set of rules for coordinating monetary and fiscal policy. Friedman now advocated that the Federal Reserve, come hell or high water – it is not a Taylor Rule (for technical reasons) – should increase high-powered money, or something close to it, at k-percent a year, where k is the growth rate of the economy. The Fed is told to stick to the k-percent rule no matter what, recession or no recession. Under this rule, the arithmetic of the government budget constraint will force the fiscal authority to balance its budget in a present value sense.

What is beautiful about both sets of rules, the 1948 set and the 1960 set, is that they are both very clear descriptions of the lines between monetary and fiscal policy. But the rules ascribe quite different duties to the monetary [and fiscal! - JC] authority.

The line between money and credit

... In his 1960 A Program for Monetary Stability, and also earlier, Friedman embraced the Chicago tradition of 100% reserves for banks, namely, institutions that offer perfect substitutes for government currency. This amounts to setting an iron curtain line between money and credit. Here is the classic Chicago justification: If you want price level stability, you want to prevent shocks that originate in the borrowing and lending markets from impinging on the supply or demand for money. If you want to do that, just do it: 100% reserves basically puts anybody who issues anything that looks like money out of the business of intermediating. But then who intermediates? It would be firms that engage in the business of servicing lenders who are willing to chase higher returns than offered by money by taking term structure and investment risks. That is a socially desirable business, but according to the 100% reserves rule, it is not what banks or the monetary authority should do.

As someone given to qualifying his recommendations, on the very page that he recommends the 100% reserves rule, Friedman cites in a footnote an unpublished paper by Becker (1956) that convinced Friedman that 100% reserves may be exactly the opposite of what you should do. Instead, you should have free banking, but not like Michael Bordo (2014) described in this conference volume. Becker and Friedman really meant free banking. No charters. Free entry. Let anybody issue bank notes if that they want and let the market value them. That is very much like Adam Smith׳s recommendation in the “Wealth of Nations”. In the footnote, Friedman said Becker and Smith might be correct. Then in the text, Friedman proceeded to discuss how you might finance the interest at a market rate that he recommended be paid on those 100% reserves. He said that how you finance those interest payments is an important issue that will affect outcomes.

So even when he recommended one position, Friedman respectfully entertained a diametrically opposed one. Actually, near the end of his professional life, in one of the last papers he wrote with Anna Schwartz, Friedman virtually endorsed free banking, adding some nice words about Hayek (Friedman and Schwartz, 1986).

Is this waffling? No.

Again, the reason I mention Friedman׳s shifting positions is that superficially they seem to be diametrically opposed. They are united at a deeper level by their respect for government inter-temporal budget constraints and their clear division of responsibilities. They are very clear proposals. They’re not ambiguous. They are definite rules. You do not need a dynamic stochastic general equilibrium model to write them down or describe them. But technically, in the instructions to monetary authorities and regulators, they seem to be opposite.

Notice that Friedman does not recommend adopting “something in the middle” – that would confuse issues and only expand a mischievous role for exceptions and “judgment”.

What I take away from all of this is that if Milton Friedman thought that these are tough questions to decide, then they probably are. And they are not going to go away. And if Milton Friedman chose to spend a lot of time thinking about them, then they are probably very important problems to study and resolve.

The rest of the talk is good too, but I've surely exceeded the proper limit for lifting quotes.