Imagined horrors: Additional notes on the Friedman interview

In a footnote in Breit and Ransom's The Academic Scribblers at Google Books, the authors quote from the “Has the New Economics Failed?” interview with Milton Friedman, and write:

In this interview, Friedman repeated one of his favorite propositions, "The best is often the enemy of the good," to point out that the use of both monetary and fiscal policy according to the well-intentioned precepts of functional finance has made the economy more erratic rather than smoother.

It's not simply fiscal policy Friedman is criticizing. He has a problem with any policy -- fiscal or monetary -- that attempts to "fine tune" the economy. In the interview he said

I’m not in favor of fine-tuning in that sense. I don’t believe we know enough to be able to do it. I don’t object to the aim; it would be very desirable to have an instrument that would enable us to keep the economy on an even keel. But I don’t think there is any. We do not know enough about either fiscal or monetary policy to enable us to make delicate adjustments from time to time that are going to offset other forces and make for greater stability in the economy.

Powerful stuff. With the interviewer's next question, focus returns to fiscal fine tuning: the tax cut of 1964. Friedman describes the performance of the economy before the tax cut became law:

There was a slowing off in the economy in late 1962 and early 1963, and there was a picking up of steam in the economy in late 1963 and early 1964— all of which happened prior to the tax cut.

"That steam kept on picking up at the same rate after the tax cut," he adds. This is where he says

some people will say that the economy moved ahead in late 1963 in anticipation of the tax cut. But then they also say that the actual occurrence of the tax cut fostered the growth afterwards.

And he dismisses that view as double-counting.

But then Friedman says:

If you want to explain the behavior of the economy during those periods, there is a much simpler explanation. In the middle of 1962 there was a sharp tapering off in monetary growth; some time in early 1963 there was a sharp speeding up of monetary growth. About six months after each of these, the economy showed the same movements. In a nutshell, the characteristic feature of this whole period, except for the 1962 interruption, was a steady rate of growth in the quantity of money.

In other words, the appropriate method of fine-tuning the economy is to keep "a steady rate of growth in the quantity of money."

So much for not knowing enough to make the delicate adjustments that offset other forces and increase the stability of the economy.


Premise: The use of fiscal policy (like the 1964 tax cut) to smooth the economy's performance is an unacceptable delicate adjustment.

I have to ask: How is it not also an unacceptable delicate adjustment to use monetary policy to smooth the economy's performance by maintaining a steady rate of growth in the quantity of money?

Observation: Friedman says neither fiscal nor monetary policy should engage in fine tuning, but he doesn't really mean it. He wants to fine-tune the growth of money so it is steady.

He doesn't want to turn tax policy "on and off like a faucet." But he definitely wants to step on the gas -- or the brake -- if money growth deviates from a straight and narrow path.


Two questions later the interviewer asks: "You would rely, then, entirely on monetary policy?" Friedman responds:

It depends on what you wish to rely on it for. I would not use monetary policy as it was used in the 1920s in any futile effort to fine-tune the economy. I bring out this comparison because at that time they were trying to do with monetary policy exactly what the New Economists are now trying to do with fiscal policy. To say that it didn’t work is to understate the case.

By understating the case Friedman appears to mean forgetting to mention that monetary policy in the 1920s created the Great Depression. But Friedman understates his case.

The best zingers are understated, no?

What really bothers me here is that Friedman says in the 1920s "they were trying to do with monetary policy exactly what the New Economists are now trying to do with fiscal policy." But he's offers no specifics. Friedman reminds us that the monetary policy of the 1920s created an economic disaster, then says fiscal policy of the 1960s is doing "exactly" the same.

It's innuendo. Friedman is not specific. We are left to fill in the blanks for ourselves, like a Hitchcock movie. And the human mind is very good at filling-in those blanks with imagined horrors.

Me, I don't know much about what else Friedman might have meant. So I turned to The Federal Reserve in the 1920s at New World Economics, which shows this graph:

Graph #1

And from that same page:

... by the early 1920s, the Fed had already gotten into the habit of being involved in the lending market on a day-to-day basis. During WWI, the Fed had been pressured by the Treasury to keep a lid on short-term and long-term interest rates to allow the Federal government to more easily finance its big wartime deficits. This of course required daily action. The Treasury stopped telling the Fed what to do after the war, but by then the Fed had become accustomed to being regularly involved. Bureaucratic expansion itself would have prevented any migration to the kind of largely dormant institution as the Fed was originally envisioned.

That's the context. Here's the policy the Fed pursued:

The Fed’s discount rate was kept at a level that made the Fed competitive with other potential lenders in the market. This was actually quite similar to the regular operating conditions of the Bank of England at the time. The Bank of England was also a private profit-making commercial bank, and thus made loans regularly. The Bank of England was not at all a dormant institution that only leapt into action during a once-a-decade crises. The Bank of England thus also had to keep its discount rate in line with other banks’ lending rates to stay competitive. In practice, the amount of actual loans made by the Fed or Bank of England was somewhat up to the discretion of the bank managers. If their rates were competitive and there was regular demand for borrowing, the Fed or the BoE could decide how much it actually wanted to lend.

In those early days, the Fed relied on the discount rate rather than the federal funds rate. They kept the discount rate "competitive": They let it vary with the rates of "other potential lenders". From the graph, this evaluation of early Fed policy appears correct.

So the Fed kept the discount rate competitive, and Friedman calls this a "futile effort to fine-tune the economy."


I could easily be wrong, and Friedman right. I know he studied this a lot more than I have. But here's the thing: He's only stating overviews. He provides no evidence. No examples. Nothing to let me understand why he says what he says. And when I go looking to see for myself, I don't see what I would see if Friedman was right.


After Friedman's understated zinger about understating the case, the next interview question is this:

You would merely expand the money supply by a certain rate and not concern yourself about the discount rate, open market operations or the other monetary powers of the Federal Reserve?

Friedman's response:

Not exactly. While I am opposed to using these weapons to fine-tune, under our present financial institutions having the quantity of money increase at a steady rate requires a great deal of intervention and action by the Federal Reserve. As it happens, I’m in favor of much more fundamental changes in our financial institutions. But under our present institutions, we can only get a steady rate of increase in the money supply if the Federal Reserve takes that as its objective and works on it. At certain times it would have to buy government bonds on the open market, at other times it would have to sell. It would also have to keep its discount rate in line with market rates, and so on.

I think that a misleading impression is given unless I add one thing: I’m in favor of a stable fiscal policy too. My view is that the problem with our fiscal and monetary policies is that the objective has been to offset other forces and thus insure stability. The actual result has been to introduce new instabilities. There’s the old saying—I’ve forgotten to whom it is attributed—that the best is often the enemy of the good. That is the case here. The attempt to use both monetary and fiscal policy for delicate adjustments in the economy has made the economy more erratic rather than smoother.

Again: Friedman objects to the idea of trying to "offset other forces and thus insure stability" because the "attempt to use both monetary and fiscal policy for delicate adjustments in the economy has made the economy more erratic rather than smoother."

He's comfortable with the idea that if you do nothing you don't introduce instability. And yet, he doesn't want to see money growth slow down as it did in the middle of 1962. He wants to prevent the erratic growth of money.

The other guys talk of fine-tuning the growth of the economy; Friedman's idea is to fine-tune the growth of money. But he pretends the other guys are fine tuning and he is not.

Friedman is interfering, the same as the other guys. But he pretends he is not.


Let's go back to that "stability" thing:

• The zinger is about policy creating the Great Depression. That's not stability.
• The whole interview is about policy trying to attain "greater stability in the economy."

It seems that by "stability" we mean minimizing recessions and eliminating depressions.

Here's a picture showing the duration and frequency of recessions since 1854:

Graph #2

The left half of the picture is mostly gray; the right half is mostly white.

The left half is mostly recession; the right half is mostly growth.

The dividing line appears to occur at the end of the Great Depression (March 1933). If recession is the measure of economic instability, our economy has been noticeably more stable since the end of the Great Depression.


I'll re-quote from "The Kennedy Tax Cut of 1964":

The economists in the Kennedy administration observed that there had been three recessions in the two Eisenhower administrations (1952–1960): one from 1953 to 1954 after the Korean War, one from 1957 to 1958, and one in 1960.

And from Time magazine of December 31, 1965:

They began to use Keynes's theories as a basis not only for correcting the 1960 recession, which prematurely arrived only two years after the 1957-58 recession, but also to spur an expanding economy to still faster growth.

There were three recessions in Eisenhower's eight years, the last of them in 1960 as Kennedy came into office. These recessions were fresh in the minds of Kennedy's Council of Economic Advisors, and they set to work shortening that 1960 recession.

And there wasn't another recession until 1969. A long stretch. You can see it on Graph #2: the three close recessions of the Eisenhower years, followed by a clear span till 1969. So it looks like the "fine tuning" of the 1960s had the desired effect. (Along with some side effects, perhaps, like rising inflation.) But if the measure of economic instability is recession, then there is evidence that economic stability has increased.


And after ruminatin, I can't really see that Friedman "has a problem with any policy -- fiscal or monetary -- that attempts to 'fine tune' the economy." I can see that he says he has a problem with it. But I don't see it in the other things he says.