Tuesday, November 25, 2014

Is Milton Friedman the Direct Cause of the Current Crazed Fed "Inflation Targeting"?

By Robert Wenzel

I have been trying to trace back where this crazed notion, that there should be a "target inflation" rate, developed.

For sure. it launched as policy at the Federal Reserve under Fed chairmanship of Ben Bernanke. He even edited a book, Inflation Targeting: Lessons from the International Experience. I find no record of Alan Greenspan advocating inflation targeting while he was Fed chairman.

In fact, he argued against it:
Federal Reserve Chairman Alan Greenspan rejected the idea of using an inflation target to set U.S. interest rates, saying it is ``highly doubtful'' such a policy would improve policy making.
The U.S. economy is too complex to reduce monetary policy to a rule-based model, Greenspan told a Kansas City Fed conference in Jackson Hole, Wyoming.

But where did this idea originally come from that there should be an inflation target in the first place?

In his book,  IMF Essays from a Time of Crisis: The International Financial System, Stabilization, and Development, current Fed vice chairman Stanley Fischer suggests that it occurred as a riff off of Milton Friedman's monetary rule and his erroneous notion of a tradeoff between inflation and output:
In the 1950s, Milton Friedman made the case for the use of a simple money-growth rule...The nature of the tradeoff between inflation and output was clarified in the 1960s, with one of the key contributions here also being Friedman, along with Edmund Phelps...As these developments were absorbed into economics, the case for the inflation targeting approach to monetary policy clarified.
Murray Rothbard knew way back that Friedman's theories (and those of his Chicago School predecessor, Irving Fisher)  were trouble. In 1971, he wrote:
[T]he key problem with Friedman’s Fisherine approach is the same orthodox separation of the micro and macro spheres that played havoc with his views on taxation. For Fisher believed, again, that on the one hand there is a world of individual prices determined by supply and demand, but on the other hand there is an aggregate "price level" determined by the supply of money and its velocity of turnover, and never the twain do meet. The aggregate, macro, sphere is supposed to be the fit subject of government planning and manipulation, again supposedly without affecting or interfering with the micro area of individual prices.

Fisher on Money

In keeping with this outlook, Irving Fisher wrote a famous article in 1923, "The Business Cycle Largely a ‘Dance of the Dollar’ " – recently cited favorably by Friedman – which set the model for the Chicagoite "purely monetary" theory of the business cycle. In this simplistic view, the business cycle is supposed to be merely a "dance," in other words, an essentially random and causally unconnected series of ups and downs in the "price level." The business cycle, in short, is random and needless variations in the aggregate level of prices. Therefore, since the free market gives rise to this random "dance," the cure for the business cycle is for the government to take measures to stabilize the price level, to keep that level constant. This became the aim of the Chicago School of the 1930s, and remains Milton Friedman’s goal as well.

Why is a stable price level supposed to be an ethical idea, to be attained even by the use of governmental coercion? The Friedmanites simply take the goal as self-evident and scarcely in need of reasoned argument. But Fisher’s original groundwork was a total misunderstanding of the nature of money, and of the names of various currency units. In reality, as most nineteenth century economists knew full well, these names (dollar, pound, franc, etc.) were not somehow realities in themselves, but were simply names for units of weight of gold or silver. It was these commodities, arising in the free market, that were the genuine moneys; the names, and the paper money and bank money, were simply claims for payment in gold or silver. But Irving Fisher refused to recognize the true nature of money, or the proper function of the gold standard, or the name of a currency as a unit of weight in gold. Instead, he held these names of paper money substitutes issued by the various governments to be absolute, to be money. The function of this "money" was to "measure" values. Therefore, Fisher deemed it necessary to keep the purchasing power of currency, or the price level, constant.

This quixotic goal of a stable price level contrasts with the nineteenth-century economic view – and with the subsequent Austrian School. They hailed the results of the unhampered market, of laissez faire capitalism, in invariably bringing about a steadily falling price level. For without the intervention of government, productivity and the supply of goods tends always to increase, causing a decline in prices. Thus, in the first half of the nineteenth century – the "Industrial Revolution" – prices tended to fall steadily, thus raising the real wage rates even without an increase of wages in money terms. We can see this steady price decline bringing the benefits of higher living standards to all consumers, in such examples as TV sets falling from $2000 when first put on the market to about $100 for a far better set. And this in a period of galloping inflation.

It was Irving Fisher, his doctrines, and his influence, which was in large part responsible for the disastrous inflationary policies of the Federal Reserve System during the 1920s, and therefore for the subsequent holocaust of 1929. One of the major aims of Benjamin Strong, head of the Federal Reserve Bank (Fed) of New York and virtual dictator of the Fed during the 1920s, was, under the influence of the Fisher doctrine, to keep the price level constant. And since wholesale prices were either constant or actually falling during the 1920s, Fisher, Strong, and the rest of the economic Establishment refused to recognize that an inflationary problem even existed. So, as a result, Strong, Fisher, and the Fed refused to heed the warnings of such heterodox economists as Ludwig von Mises and H. Parker Willis during the 1920s that the unsound bank credit inflation was leading to an inevitable economic collapse.

So pig-headed were these worthies that, as late as 1930, Fisher, in his swansong as economic prophet, wrote that there was no depression, and that the stock market collapse was only temporary.
And so now we have a Fed that has upped the madness, not only must policy aim at preventing prices from falling, as was the policy under the Fisher influenced Fed, but with the introduction of new macro-tinkering ideas developed by Friedman, the Fed now has a target positive inflation rate---that completely ignores the distortions such a policy causes at the fundamental business cycle level  (SEE: Austrian School Business Cycle Theory). And ignores the benefits of naturally falling prices. Further, the Fed is completely oblivious to the fact that price inflation does not have to continue along the current slow trend line. A point I warn about in the EPJ Daily Alert  and a point that Greenspan now seems willing to admit. Just recently, he said:
Ultimately, inflation will eventually rise. It has to rise...
The current inflation target policies at the Fed are ignoring many fundamentals that Friedman obscured with his incorrect monetary theories and it is likely to result in extreme volatility in the economy and price inflation in the not too distant future.

 Robert Wenzel is Editor & Publisher at EconomicPolicyJournal.com and at Target Liberty. He is also author of The Fed Flunks: My Speech at the New York Federal Reserve Bank. Follow him on twitter:@wenzeleconomics

1 comment:

  1. Robert: This may your best post ever. See the first 50 pages or so of Hayek's "Monetary Theory of the Trade Cycle".