Transcription
So this is sort of the paradox of monetary policy. When it's happening right, you don't see it; you don't notice it. When it's happening wrong, Friedman argues it can just fundamentally destabilize everything. It can cause a Great Depression, it can cause an artificial boom.
So he's taking monetary policy at a time when most economists think it's completely irrelevant and saying this is the central game of the economy. Now we live in a world where we believe this, and the Federal Reserve chair can't open their mouth without headlines being generated. Friedman is saying this at a time when the Federal Reserve is like a mysterious and secretive organization. It's not well-known; it's not deeply appreciated.
Some of the only people who appreciate the Fed's power are hardcore rural populists who have constituents, you know, who think the banks and money power are the problem. They are like throwbacks from the frontier days. So Friedman, in the beginning, has no constituency for this policy; he has no constituency for this analysis.
And so just going back to summarize monetarism, it's looking, it's using the quantity theory of money to analyze the macroeconomy. It's proposing a policy of slow and steady growth in the money supply, and then it is arguing that inflationary episodes, when they emerge, are profoundly driven by changes in the money supply, not by anything else.
I mean, going even up a level, as we started, how epic is it to develop this idea, to hold this idea, and then to convince the United States of this idea that money matters? That today we believe is mostly correct, for now.
Yeah, and so like just this idea that goes against the experts and then eventually wins out and drives so much of the economy—the biggest, the most powerful economy in the world. So fascinating.
Yeah, so I mean that's a fascinating story. And so what happens is Friedman has advanced all these ideas, he's roiled the economics profession, he's built a political profile, and then he becomes the head of the American Economics Association.
He is asked in that role to give a presidential address, and so he gives this presidential address in December 1967. He says, "I'm going to talk about inflation, and I'm going to talk about the tradeoff between inflation and unemployment." This is what's generally known as the Phillips curve.
The Phillips curve, in its original form, is derived from post-World War II data, so it's derived from about 12 years of data. It shows that when inflation goes up, unemployment goes down. The idea, you know, would make sense that as the economy is heating up and lots of things are happening, more and more people are getting hired.
This relationship has led policymakers to think that sometimes inflation is good, and if you want to lower unemployment, you could let inflation kind of go a little bit. In the crude forms, it becomes to seem like a menu; like you could take your model and you could plug in, "I want this much unemployment," and it would say, "Well great, this is how much inflation you should do."
So then you would target that inflation rate. So Friedman gets up and he says this is wrong. This might work in the short term, but it's not going to work in the long term because in the long term, inflation has, first of all, it has a momentum of its own. Once it gets going, it tends to build on itself—the accelerationist thesis; it accelerates.
Once inflation gets going, the reason it gets going is because, you know, workers go to the store and they see the price level has gone up. Things have cost more; they ask for the wages to go up. Then, you know, eventually the wages will go up too high, and they will no longer be hirable, or companies will decide at these high wages, "I can't hire as many workers; I'd better lay off."
So if inflation keeps going, eventually over the long term, it will result in high unemployment. So he says theoretically you could end up in a situation where you have high inflation and high unemployment. This hasn't been seen, but he says theoretically this could happen.
Then he goes and he says the government has started expanding the money supply. It started expanding the money supply in 1966, so we're going to get a bunch of inflation, and then we're going to get a bunch of unemployment. He estimates about how long it will take, and then he says once this all happens, it will take about 20 years to get back to normal.
He predicts the stagflation of the 1970s. Stagflation is that, for an economist, again against the mainstream belief represented by the Phillips curve.
Yeah, and what's really makes it happen is that many of the economists who most deeply dislike Friedman and most deeply dislike his politics in the 1970s, as they're running their models, start to say, "Friedman's right." They start to see in the data that he's right.
A very parallel process happens in Britain. Britain is going through a very similar sort of burst of spending, burst of inflation. So Friedman is vindicated in this very profound way, in the way that he himself said would be the ultimate vindication, which is my theory should predict.
So that prediction of stagflation is really the sort of final breakthrough of his ideas and also, you know, their importance to policy and to thinking about how we should intervene or not in the economy and what the role of the Federal Reserve is.
Because he's saying the Federal Reserve is incredibly powerful, and finally people start to believe him. I don't know if we said, but to make clear, stagflation means high unemployment and high inflation, which is a thing, like you mentioned, has not been seen before, and he predicted accurately.
It also disproves the sort of the inverse relationship between unemployment and inflation.
Yeah, now I should say the Phillips curve is still out there. It's been expectations-augmented, and it is relevant in the short term. But Friedman's warning is still very much apt that if you get too focused on unemployment, you can let inflation out of the bag.
So until very recently, the Federal Reserve tradition has been focusing on inflation, believing that's fundamental and that will keep unemployment low, rather than trying to lower unemployment at the cost of raising inflation.