Letter from Milton
Two of Milton's commandments show his continued commitment to small government and passive monetary policy: Thou shalt abolish the Federal Reserve. Thou shalt maintain a constant level of high-powered money.
Here is the letter in its entirety, followed by my response:
HOOVER INSTITUTION ON WAR, REVOLUTION AND PEACE
Stanford, California, 942305-6010
August 14, 2006
Professor N. Gregory Mankiw
Department of Economics
Cambridge, MA 02138
I enjoyed reading your working paper article on the macroeconomist. It is an excellent survey and well written. But you will not be surprised that I come not only to praise but also to suggest and criticize.
My suggestion has to do with the early work on business cycles. You have omitted the person who I believe played the greatest role in the early work , namely Wesley C. Mitchell whose book Business Cycles was published in 1913. As you know, Mitchell went on to found the National Bureau of Economic Research primarily to study cycles. At the Bureau he published two more books on business cycles, the second jointly with Arthur Burns.
As to comment or criticism, I take a slightly different view than you do of the reason for the better performance in monetary policy over the past twenty years or so. I believe it derives primarily from the recognition by central banks worldwide that they have responsibility for inflation. The Great Depression on the one hand and the inflation of the seventies on the other reinforced earlier theoretical and historical work . My aphorism, “Inflation is always and everywhere a monetary phenomenon,” was converted from an object of derision to a near truism. This experience was of course strongly reinforced by the leadership shown by Alan Greenspan in the United States, but also I believe by the leadership shown by Donald Brash in New Zealand.
New Zealand was the first country to introduce inflation targeting and it arose out of the contract which Donald Brash arranged with the central government under which he committed himself to keeping inflation between I believe it was one and 3 percent. The arrangement was that if he did not do that he could and presumably would be fired. Volcker and Greenspan in the United States brought down inflation without stating any numerical targets. Brash introduced the term “inflation targeting” and succeeded in keeping his position by achieving his targets. The example was followed as you know by Australia, Britain and many other countries.
In the great deflation of the 1930s there were many economists and non-economists who were aware of the deficiency of monetary policy, but it was not the main explanation which was offered for the depressed economic conditions. That was attributed to a market failure. Similarly, in World War II, inflation was attacked primarily by price controls and was not widely attributed to excessive increase in the quantity of money. Of course what is important is not only that the central bankers learned the lesson and came to accept responsibility for inflation, but that the public at large did and will hold the monetary authorities responsible if and when any significant inflation develops.
The role of the theoretical work that you discuss was to provide central bankers with a greater understanding of the process and more tools for deciding what should be done. The Taylor rule is a clear example of the impact of macroeconomics in that respect.
One more side point. I have come to the conclusion that the central bankers did a marvelous job of pulling the wool over the eyes of economists. They led us all to believe that maintaining a relatively stable price level is a very difficult problem that requires the judgment of the wisest of experienced bankers and business people. The ease with which New Zealand, Australia, Britain, etc., have maintained relatively stable prices, have reduced greatly the variability of inflation, suggests that maybe it isn’t such a hard job at all, that the cycles of the past were not attributable to the difficulty of achieving price stability, but to the mistakes of the central bankers in not achieving price stability. Nothing that I have observed in recent decades has led me to change my mind about the desirability of a monetary rule which simply increased the quantity of money at a fixed rate month after month, year after year. That rule would get rid of the mistakes and that is probably about all you could expect to get from a monetary system.
Even better would be to abolish the Fed and mandate the Treasury to keep highpowered money at a constant numerical level.
Best wishes and regards.
Senior Research Fellow
Here is my response:
August 15, 2006
Thank you for your comments. I am delighted to hear that you enjoyed the paper, and I appreciate your taking the time to write me.
The paper is already past galleys and on its way into the Journal of Economic Perspectives. However, I would love to share your insightful letter with my blog readers. Would you mind if I posted it there?
You are right that I should have mentioned Mitchell. That was an oversight on my part.
Let me make a few points about monetary policy.
I agree that the historical events of the 1970s taught central bankers about the importance of keeping inflation under control. But, more precisely, what did they learn? Here are two possible lessons:
(1) Central bankers should give inflation a greater weight in their objective functions.
(2) Central bankers can control inflation only with a commitment to a policy rule.
I believe the Greenspan experience argues for lesson (1). Some economists argue for lesson (2). By the way, my paper is being paired in the journal with one by V.V. Chari and Pat Kehoe. They seem to argue for (2) over (1).
Although I agree with you about the importance of controlling inflation, I am not persuaded that the task is quite as easy as you suggest. In another paper, called “A Letter to Ben Bernanke,” I write that Burns’s bad outcomes and Greenspan’s good outcomes were in part attributable to the fact that Burns had to deal with more adverse shocks than Greenspan did. Perhaps Burns played a bad hand badly, and Greenspan played a good hand well. I wonder how Greenspan would have handled the circumstances that Burns faced: volatile food and energy prices coupled with a productivity slowdown and an increasing natural rate of unemployment. (FYI, that paper was published in the May 2006 AER, but you can find it online here.)
Your comments on the virtues of constant high-powered money surprised me. On the one hand, high-powered money is the measure with the clearest definition, especially in light of the growth of many “near monies” that complicate the measure of broader aggregates. On the other hand, I would have thought that the experience of the 1930s argues against such a rule. If I recall correctly, most of the decline in the monetary aggregates during that period was attributable not to high-powered money but to inside money and the money multiplier. If we abolished the Fed and kept high-powered money constant, it seems that a similar set of events could potentially unfold.
Again, thank you for your comments. And please let me know if I can post your letter. I am sure my blog readers, many students and professors of economics, would enjoy reading it.
With best wishes,
PS Let me thank you and Rose again for the wonderful lunch at your home some years ago. Please convey to her my regards and best wishes for continued prosperity.
Milton emailed me back, giving me permission to share all this with you. I trust you enjoyed it as much as I did.