Lend Me Your Ears: Friedman and The Role of Financial Policy

I was invited by Matías Vernengo, Co-Editor of the Review of Keynesian Economics, to write a paper, 'The Role of Financial Policy' in honour of the 50th anniversary of Friedman's Presidential Address to the American Economic Association. The Review will be publishing a special edition later this year and I am honoured to be writing in the distinguished company of many fine economists. 

Invited contributors that I am aware of include Brad DeLong, James Forder, Robert Gordon, David Laidler, Rober Pollin, Louis-Philippe Rochon, Sergio Rossi, Antonell Stirati, Servaas Storm and Nathan Perri.  

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I opened my essay with a quote from Shakespeare's play, Julius Caesar.

Friends, Romans, countrymen, lend me your ears; I come to bury Caesar, not to praise him.
The evil that men do lives after them;
The good is oft interred with their bones;
So let it be with Caesar.

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Opening an essay to honour the work of a great man by quoting from Marc Anthony’s words at Julius Caesar’s funeral, may appear to some to be a boorish opening gambit. But I do not mean disrespect. Milton Friedman was one of the greatest economists, if not the greatest economist, of the twentieth century. Friedman’s views of the appropriate role of monetary policy have become accepted wisdom and they form the core belief of every practicing central banker in the world today. That does not make them right. I come to bury some, but not all, of Friedman’s ideas. And as for Friedman himself, unlike Marc Anthony, I come to praise him.

My praise is for the influence of Friedman's ideas on the operation of monetary policy. Although his advocacy of a money supply rule was a failure in practice, his focus on rules evolved into the adoption of inflation targeting, implemented by interest rate control, that was a pillar of monetary policy in the last thirty years and was, arguably, responsible for the long period of economic stability that we refer to as the Great Moderation.

My critique of Friedman is of his insistence on the free market as a self-stabilizing system. The  Great Recession is just the latest example of the failure of that idea. Friedman was the greatest monetary economist of his generation. But the natural rate hypothesis, introduced in his 1968 Presidential Address, was a spectacular failure and we are only now digging out of the rubble of the New-Keynesian edifice that was constructed on this concept.

My solution, discussed in this essay, is to supplement inflation targeting with a new kind of financial policy that institutionalizes the role of the central bank as the lender of last resort.

Taming the Lion

In the nineteenth and early twentieth centuries the business cycle was a wild ride. Part of the damage inflicted by financial crises was caused by price instability. That problem was successfully solved in the 1980s when the Fed adopted inflation targeting. The success proved chimeric.  My last post argued for a second policy, designed to stabilize the stock market. This policy, in combination with an inflation targeting rule, would effectively dampen financial cycles. 

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My previous post provoked a number of responses on Twitter that I will respond to here.  Sanjay Mittai, @sanjmitt asked;

"What about stabilizing employment? Or are workers to be regarded as trash as long as the stock market is doing OK?"

My proposal to stabilize the stock market is based on two research papers, here, and here,  in which I show that there has been a strong and stable connection between the stock market and the unemployment rate in six decades of US data. Stock market crashes, when they are sustained for six months or more, lead to recessions. Persistent bull markets lead to unsustainably low unemployment rates and the creation of unsustainably high levels of capital creation. The euphoria always eventually comes to a painful end for the average worker when the market crashes and he or she is out of a job.

The proposal, explained in my book Prosperity for All, is to stabilize the asset markets with the ultimate goal of maintaining full employment. Part of my argument is aimed at my fellow economists. I explain why financial markets do not work well, even when everyone alive today can trade assets contingent on every conceivable future event. And part of my argument is aimed at my fellow citizens. I seek support to create an institution that is not aimed to improve the lives of the rich and powerful: it is aimed to improve the lives of all of us.

A second point was raised by John the Blind, @Athena_Alithis who is concerned that low volatility is the calm before a future storm. Here is John;

By stabilising the stock market, the system becomes more unstable and risky. Less vol means higher leverage and larger risk portfolios building up as ‘what could possibly be wrong.’

To which I respond: The world we live in today is not the same world that our Mothers and Fathers inhabited. It is not the world that our Grandmothers and our Grandfathers inhabited. It has evolved in ways that none of us, even ten years ago, could have foreseen. The institutions that we built to tame financial cycles have been, at least partially, successful. That success is evidenced by a fall in the frequency of financial panics which occurred far more often in the nineteenth and early twentieth centuries.

We achieved increased stability by creating new institutions like the Federal Reserve System which learned successfully to manage price stability for more than three decades from 1980 through 2007, a period we now call the ‘Great Moderation’. That stability was not an illusion. It was a creation of improved monetary management. It ended in 2008 because the tool we had used to manage markets, control of the short rate of interest, hit zero and could be lowered no further.

The Great Recession was a large natural experiment that we can, and should, learn from. The lesson is not that we must tear up existing institutions and go back to the Gold Standard. It is that we must develop new institutions. By managing the short rate of interest we tamed the lion of inflation. By managing the risk composition of the average market portfolio we can tame the lion of unemployment and help to bring Prosperity for All.

 

 

Bulls and Bears: Why central banks should stabilize the stock market

My paper, Pricing Assets in a Perpetual Youth Model was recently published in the Review of Economic Dynamics. The paper uses mathematics to make a point.  But the idea is simple and worth explaining in English.  

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The paper constructs a formal mathematical model to capture the idea that free trade in capital markets does not lead to optimal outcomes. We would all be better off if national governments were to regulate the capital markets through counter cyclical trades of debt for equity. 

Ever since Adam Smith, economists have sought to explain why market systems provide outcomes that improve our lives. If I have a good that you want and you have a good that I want, we should be allowed to exchange one good for the other. The power of that idea was demonstrated most recently by the growth of China as 1.5 billion Chinese were pulled from poverty by the move from social planning to a market economy.

The benefit of free exchange is captured by economists in the theory of general equilibrium. That theory, developed by Walras and Pareto in the nineteenth century, was atemporal. The market takes place at a single point in time. In modern macroeconomics, exchange takes place in a sequence of markets and the trades we make are with people we may never have met. Each human being is connected with every other human being on the planet. From the urban centers of London, Paris, Tokyo and New York to remote areas like the Brazilian rain forest and the Australian outback; we are connected by free trade in markets. And through free trade in the capital markets, we are connected with people who are not yet born.

The most important idea to emerge from Adam Smith is, in the immortal words of Gordon Gekko, that ‘greed is good’. Selfish behavior by greedy people seeking to improve their own lives will, inevitably, improve the lives of everyone else on the planet. That idea is encapsulated in the first welfare theorem of economics which explains why markets, most of the time, work well. So why doesn't that idea apply also to the financial markets?

The answer is simple. For markets to work well, everyone affected by price movements must be able to trade in those markets. The first welfare theorem does not apply to the financial markets because not everyone is alive to participate in them.  We cannot trade in markets that open before we are born.

I show in my published paper that the fact that we cannot insure over the state we are born into can explain why markets are so volatile. Markets go up and markets go down simply because people become enthused with waves of optimism or waves of pessimism. Most, if not all, stock markets movements are caused by contagious waves of self-fulfilling prophecies and we would all be better off if they were eliminated by treasury or central bank intervention.

Animal Spirits, IS-LM-NAC and Keynesian Economics without the Phillips Curve

Last night, several people expressed positive interest in the link to my blog Reinventing IS-LM: The IS-LM-NAC Model and How to Use It that I tweeted out it in response to this Sri Thiruvadanthai tweet at Matthew Boesler of Bloomberg.

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Here is a way to make sense of IS-LM. The paper I discuss in the following post, Animal Spirits in a Monetary Model, was inspired by my own interactions with Axel. The theory in this paper is backed up by empirical work in my newly published paper Keynesian Economics without the Philips Curve, joint with Giovanni Nicolò. I greatly appreciate all those who are taking the time to read and process these papers and to look at the ideas expressed in them with fresh eyes and fresh enthusiasm. Together we are moving the Overton window.

Here is the original post: enjoy...

I have been critical of the IS-LM model in earlier posts. My paper with Konstantin Platonov fixes some of the more salient problems of IS-LM by reintroducing two key ideas from Keynes. 1. The confidence fairy is real. 2. If confidence remains depressed, high unemployment can exist forever.  My new Vox piece, coauthored with Konstantin Platonov, presents the key findings of the paper in simple language. Here is a link to our paper, Animal Spirits in a Monetary Economy.VOX piece...

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Larry Summers has argued that market economies may get stuck in permanently inefficient equilibria. He calls this 'secular stagnation' (Summers 2014). In this equilibrium, unemployment may be permanently ‘too high’ and output may remain permanently below potential, because private investors are pessimistic about the prospects for future growth. Our most recent research attempts to explain why secular stagnation occurs and how economic policy may be used to escape it (Farmer and Platonov 2016)

In the wake of the Great Recession, macroeconomic orthodoxy is under attack. Paul Krugman (2011) has called for a return to the IS-LM model, an approach that was developed by Sir John Hicks (1937). We are sympathetic to that call but we believe that the IS-LM model needs to be redesigned. We suggest a different way of thinking about the effect of monetary policy that we call the 'IS-LM-NAC' model. It is part of a broader research agenda ( Farmer 2010201220142016a2018) that studies models in which beliefs independently influence outcomes.... continue reading

Here is a link to our paper, Animal Spirits in a Monetary Economy.

 

 

 

Moving the Overton Window: Let the Debate Continue

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The NIESR Rebuilding Macroeconomics project is stirring a great deal of controversy. And that’s a good thing. I am part of the management team. But I can only speak for myself here. In my opinion,  we should be generating dialogue between heterodox non-mainstream groups and conventional macroeconomists. Mainstream economists, and heterodox economists alike, should each stop being so certain that they are guardians of the sole correct approach.

Our goal is not to fund a set of projects that is non-intersecting with the mainstream. It is to move the Overton Window. We seek risky projects that would be unlikely to be funded by mainstream funding agencies. Sometimes this means that the projects we fund will overlap with existing extant agendas but originate from communities of scholars that are non mainstream. Sometimes it means they follow approaches that originate in other social sciences and are not currently part of economics.

We have funded two projects so far. One is an example of the first kind. It involves research that has some overlap with existing mainstream research. The other is an example of a project that originates from social psychology and that has little or no overlap with existing research. Our management team includes a complexity theorist, an anthropologist and a social psychologist. Economists have historically maintained an ideological purity that borders on arrogance. I think it’s time for cross fertilization of ideas.

The internet discussion on the project we are funding by Özlem Onaran is, by this criterion, already showing signs of success. There is a range of heterodox economics that stretches from Post Keynesians through agent based models, Modern Monetary Theory, institutional economics etc etc to approaches using indeterminacy and sunspots of the kind I have personally worked with.  This latter example, sunspot theory, is a fundamental building block of modern macroeconomics that is influential, but only occasionally invited to the table at NBER macro conferences. Other approaches like behavioural macroeconomics were once fringe but are now mainstream.

It would be naive, and obviously false, to think that by including a post Keynesian group in the dialogue, Rebuilding Macroeconomics will lead to research on topics that are excluded entirely by the mainstream. But the approach followed by a PK economist like Özlem is unlikely to be a mirror of that followed by mainstream economists like Mathias Doepke and Michèle Tertilt.

In the mainstream, it would be difficult (but admittedly not impossible) to bring in ideas from mainstream sociology. We are still, after all, wedded to the nineteenth century notion that individual preferences are independent of social trends. The economics of the family, as Doepke and Tertilt refer to it, or feminist economics, the label preferred by the heterodox, will, I hope, lead to a breaking down of some of the barriers that were erected by economists in the nineteenth century when we formalized the welfare theorems.

I have no illusion that all of the projects we fund will succeed in leading to a new ‘policy relevant macroeconomics’. But that is not my expectation. Our remit is to take risks. By funding projects from people or groups that inject new genes into the pool I hope we will seed the development of ideas that might otherwise take much longer to emerge. Many of these projects will likely fail. But there is a widespread feeling amongst the general public, those who pay for our research, that mainstream macroeconomics has itself failed in a spectacular way. While I do not fully subscribe to that view, I do feel that the existing institutional structures have led to the dominance of a small subset of ideas whose success has depended more on historical circumstance than to any obvious claim to truth.

I see one of my major responsibilities in my roles as a member of the Rebuilding Macroeconomics  management team, a co-leader of the RM instability Hub, and as Research Director at NIESR, to contribute meaningfully to moving the Overton Window. We are engaged in a non-experimental science that sometimes needs to be shaken up a little by bringing in fresh approaches. Let the debate continue.