Mar 29, 2021

Ed Nelson on Milton Friedman’s Legacy, the Quantity Theory of Money, and His Vision for a Money Supply Growth Rule

Milton Friedman made many significant contributions to monetarist thought throughout his life, and many of those contributions could be applied to macroeconomic policy today.
David Beckworth Senior Research Fellow , Ed Nelson

Hosted by David Beckworth of the Mercatus Center, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Ed Nelson is a Senior Advisor in the Monetary Affairs Division of the Board of Governors of the Federal Reserve System. Ed has also previously been a professor and has worked at the St. Louis Federal Reserve Bank, as well as the Bank of England. Returning to the podcast, Ed re-joins Macro Musings to talk about his new book, *Milton Friedman and Economic Debate in the United States: 1932-1972*. Ed and David specifically discuss the life and work of Milton Friedman, as they explore his journey into monetarism, his contributions to the quantity theory of money, how he envisioned a money supply growth rule, and more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Ed, welcome back to the show.

Ed Nelson: Thank you, David. It's great to be back. Thanks for having me on.

Beckworth: Well, it's great to have you on. Now, Ed, did we ever get you a nominal GDP targeting mug after your last visit?

Nelson: I do. I do have it in my kitchen, Just here.

Beckworth: Fantastic. And it's worth mentioning to our listeners, first go back and listen to that podcast, it was a great show. But two, Ed had the privilege of working with Bennett McCallum, one of the great nominal GDP targeting theorists and advocates. So it's great to have Ed, Ed was there back when nominal GDP targeting was first popular, I guess, and made something of a comeback. But it was great to have you on in our first show, Ed, and I'm excited to talk to you today about your book and man, what a book this is. I was counting the pages, volume one's over 700 pages, volume two's over 500 pages. Would you call this book, your magnum opus piece?

Nelson: Well, I hope so. Bob Lucas once said to me, "This is a book written so that somebody reading it 50 years understands Milton Friedman economics." Which, maybe, doesn't say too much about the next 50 years. I hope it gets some attention in the interim, but, it does reflect a lot of my thoughts over several decades because we were talking before the show about how monetarism has gone in and out of vogue, going out of something people are interested in. And I think the same is true of Milton Friedman, but in my case, I've always been interested in Friedman's monetary economics. So, I have being able to steal that enthusiasm and hopefully my knowledge in Friedman in this two-volume book.

Beckworth: Yes. So this is quite the work and I know you've been working on pieces and you've been reading Milton Friedman for many years. So you could make the case that this is something you've been working on for a lifetime, almost, but when did this project officially start and how long did it take you?

Nelson: It, really, officially started at the end of 2012. So the situation at the end of 2012 was that I'd certainly written papers on Milton Friedman, and I'd done actually a couple of papers on Anna Schwartz and Milton Friedman, but I hadn't written a book length treatment and without wishing to sound critical of what had been written, I think it's accurate to say that until this present book, it's not the case that a book has been written on Milton Friedman by somebody who's in Friedman's field of monetary economics.

Nelson: So we've had books by people who are outside economics, we've had books by people who are historians of thought, all of whom can bring their own perspective on the matter. But I happen to think the monetary economics is quite a specialized field and I think anybody like you and me who's specialized in the field feels a little bit... Takes a bit of umbrage, sometimes, when, let's say a finance professor or something like that opines on monetary economics, we feel that they're, in a sense, making very declarative statements about a field that has a lot of subtleties that maybe they're missing. And I think that's true to some extent of historians of economics.

Nelson: If you say from the day you get a PhD, "I'm now going to be in historian of economics," that is tantamount to saying, "I'm now not going to be a specialist in any particular field of economics. I'm not going to become an expert in a particular field of economics. I'm going to be an expert on," if you like, "What the people who are specialists are saying." So it's quite a different thing from being an expert in monetary economics to be an expert on history of thought.

Nelson: So I came to this project with my monetary economics expertise, I would hope. And that was really the motivation in 2012. I felt there was a gap that I could feel. I'd done a lot of research on the past periods of monetary history, post-Friedman-Schwartz period, so, basically, 1970s inflation. So I had a lot of microfilm coverage from microfilm, such as newspapers, I had a lot of coverage of that period, that I thought I can blend with my knowledge of Friedman's work and also blend with information, I subsequently distilled starting in 2013 in interviews I did with a lot of people who knew Friedman.

Nelson: So, the project really got going at the end of 2012, going to 2013. And I had a full draft really in 2016, I put the full draft on the web in 2016, but of course there's a lot of [inaudible] between it. A draft being ready from the author's perspective have really being ready as a book. And certainly I'm glad that I had a few more years to polish it, even though at the time, it was frustrating not to have it out sooner.

Beckworth: Yeah. It's interesting. So I had a Binyamin Appelbaum, from the New York Times, on, and he's a little critical of Friedman, but he actually read your draft online, he told me. He was like, "Man, that's a labor of love that Ed Nelson has done." And he was really grateful to read it. He really enjoyed it, he said, and I didn't realize this was online. So you had most of the book completed in within a few years, then, and you just had to get it to the finish line.

Nelson: That's right. Getting it from its 2016 version to its published late 2020 version really involved negotiation about how long it could be. And eventually I did cut things out like the coverage of conscription, which was, you could say, it was on the borderline of economics and non-economics, but, the reason I cut it out was really, it was something I could quite easily cover if I were to extended this narrative, which the book ends in 1972, because conscription ends in 1973, in a sense of natural subject for a book that covers the period from 1973 onward. I cut out some of the national economics coverage with the hope of covering that more when I discuss things like a floating rate era, in the next volume. But it was just a lot of work, just getting it into a form that somebody would publish, but also a form that was justifiably short to fit into two volumes.

Beckworth: Well, you answered my next question in your answer, you just gave, and that was, are there going to be subsequent volumes? And it sounds like there are going to be volumes time permitting, and if you're able to do so. Is that correct?

Nelson: That's correct. I wouldn't say that I can promise that there'll be a sequel any particular year, but at the moment, I essentially got draft up till the end of 1978 and put have online, some of the chapters. I think the continuation volumes going to be a little bit different because Friedman's research career was winding down in 1978 at the same time its public policy career was really gaining steam.

Nelson: And so you have a lot more about his interaction with policymakers and his attempts. Some things, actually, were not very, really, objectively speaking, were not very successful, like campaigning for constitutional limits on government spending. He was involved in a lot of that sort of thing, but he was also involved a lot in just commentary on monetary policy and in discussion with policymakers. So a sequel volume would be much more oriented towards his interaction with younger generations of researchers, rather than his own research and also his interaction with policymakers.

Beckworth: Ed, I want to jump into your book, but I have one more question about Milton Friedman before we do that, and who was he as a person? So what was his personality like? I mean, you interacted with him and you've talked to people who've interacted with him. How would you describe him?

About Milton Friedman

Nelson: Well, I think the very first day I met with Milton, shocking as it may sound, it is in my twenties as a new graduate student. I was very enthusiastic about Milton Friedman wanted to talk about him a lot with people who knew him. And so, that's practically the first thing, when I was talking to Bennett McCallum about, was Milton Friedman, and I said that I'd met Friedman and Schwartz and that I had read things that Ben McCallum had written in related areas, and then McCallum said that Friedman and Schwartz were nice people, but less nice when you disagree with them, which I think is probably accurate. It's probably accurate regarding a lot of us, but I think that Friedman was very good, I mean, I benefited from this, he was very good in answering questions for people he didn't know, just random people from the general public writing to him.

Nelson: He was very good in, actually, responding personally to correspondence. And he was, I think reasonably flattering, in talking to non-journalists in terms of their questions, that he would say when something was a sophisticated question which may or may not have been a sophisticated question was certainly a polite way to answer the question, but in terms of his interaction with journalists and economists, he was, and non-economists trespassing on economic issues, he was more acerbic if he disagreed with them and if he thought that they were obviously leaving out... There was an obvious hole in their argument. So I have in the book, I think a chapter four, a sampling of some of the more acerbic statements he's made to people over the years in print or in media.

Nelson: He also had an exchange in 1972 with a symposium of critics. And one of them was Paul Davidson who was really criticizing Friedman in terms of Friedman reading of Keynes, which obviously is a very sensitive issue to some people. People think that Keynes has been misinterpreted, particularly by American economists. And Paul Davidson gave his own, what he felt was an accurate depiction of Keynes's views in a particular chapter and Friedman was replying to it, first quoted Davidson had said, and then said, with regard to what Davidson had said, “Let's take a deep breath and see if we can sort out this jumble of ideas." So he could be very acerbic. But I think he was over criticized for simplifying things because I found in looking at his popular work that it is basically consistent with his research work.

Nelson: So a lot of his critics were negative towards him, because they thought he had a cheapskate version of economics that he was selling to the public that was different from his actual economics or unrepresentative of what economics have to say about something. Whereas I think Friedman actually was more consistent and more subtle than that. So some of his reaction in being acerbic to people was in response to people who were claiming that he was distorting an argument or something like that. So he was in a certain level of indignation in what he was saying on occasion.

I think he was over criticized for simplifying things because I found in looking at his popular work that it is basically consistent with his research work. So a lot of his critics were negative towards him, because they thought he had a cheapskate version of economics that he was selling to the public that was different from his actual economics or unrepresentative of what economics have to say about something. Whereas I think Friedman actually was more consistent and more subtle than that.

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Beckworth: Yeah. You had some great quotes in the book. I believe this is in volume number one, and I encourage the listeners to check them out. I want to read just one though that I thought was really, I think, evident it showed how he was both witty and acerbic, as you said. But there was an economist, I guess, a Keynesian, his name was Nicholas Georgescu-Roegen, if I'm saying his name correctly, and he gave a presentation and Friedman said in response to his presentation which was an application of Keynesian economics, he goes, "This application of Keynesian analysis was unbelievably simple and simply unbelievable." Very witty, very to the point. So he was both a very generous man, but he could be very sharp if he engaged with you in a debate and conversations. What about his family? I mean, what do we know about his family? How did he interact with them? What was his life like there?

Milton Friedman’s Family

Nelson: Well one thing that maybe people are not so aware of was that Friedman, in a sense, his larger family was less his dad, because his dad had passed away when he was a teenager. But in a sense, there were a couple of people who were, to some extent, proxy fathers, or certainly father figures, to some extent, one was Arthur Burns, although Arthur Burns' son, said to me that some accounts have exaggerated the extent to which Arthur Burns was a father figure to Milton Friedman.

Nelson: And Arthur Burns was known famous teacher and undergraduate at Rutgers University. And of course, Arthur Burns was later Chairman of the Federal Reserve. And they had something of a falling out at that point. But the other person who was a father figure, who I think was more of a regular father figure, and was the head of the Friedman family as Anna Schwartz put it, was Aaron Director who was a University of Chicago economist but he was not a very prolific researcher at all.

Nelson: He was known as somebody who really put a large amount of written output and was essentially a micro-economist, but he was evidently very influential on Friedman and on Friedman's family and was obviously not afraid of his Rose's brother. And as far as Rose Friedman is concerned, she ultimately would become known publicly because she and Friedman did *Free to Choose*, the book, together, as well as a couple of other publications together, notably a follow-up book. But in terms of her interaction with Friedman and economics, she was a fellow student of his at University Chicago in the 1930s. And they got married in 1938, I believe it is. They had an, so far as I can tell, a very harmonious and, in a sense, an uneventful marriage in the sense that they were always on very wonderful terms with each other and had a really happy life together.

Nelson: So, that was something I didn't really want to concentrate on the book because I wasn't really that interested in biographical side, but in terms of the economic side, she was very much involved in his popular work. So for the Newsweek columns that he started in the 60s, many of those were produced by a process in which she would sit down with him, have a sit-down conversation tape-recorded about a topic and would urge him to be more clear and more straight forward in the points he was trying to make. And then she would type up the points he'd raised in his words, but synthesize it into a draft column and then he would work on it. So, in a sense, these were [inaudible] products and I believe the same process, really underlay a lot of their joint work.

Nelson: So, she was, really, part of the production function, a large part of the labor in the production function as Jerry Jordan says in a quote in the book. She also was very important in professionally coming research in journal oriented economic research in the area of consumption in her, she'd done work on consumption and part of that, I believe, was quite influential on Friedman's eventual theory of the consumption function.

Nelson: As far as monetary economics is concerned, I don't think she was quite as involved, certainly not in co-authoring and I think even in following his work with Anna Schwartz, for example, he met with one area of economics that she was less on top of, if you like. In terms of their kids, they have two children, David Friedman, who has a degree in physics, but quickly after he got his physics degree, moved into the economics and has been very productive in both economic research and journal publications and prestigious appointments, and he also had written in popular economics for a long time, starting when he was quite young, and I think in 1973, he wrote a book more libertarian oriented, than Milton Friedman, was strictly near zero government libertarian and not a macro-economist, very much a micro-economist. Janet Friedman is their daughter, and she was very kind enough to talk to me about her father. But I think that it's fair to say that she has not had a life outside economics and she's a lawyer. But she shares her parents' interest in bridge playing. The Friedmans were very much into playing bridge.

Beckworth: Bridge playing. So that's an interesting side of a Friedman. So we know he's a great economist, he's very generous with people, and at his time, if you weren't engaging in a debate with him, he was a family man, you mentioned this game he played, and I'll mention another interesting dimension to him, Ed, that my wife discovered of all things, with a pandemic going on, we've done more woodworking projects around the house. So we bought more tools and my wife has really gotten into this almost more so than me, I hate to admit, and so she listens to podcasts about woodworking. And one of these podcasts mentioned that Milton Friedman was quite the woodworker, it was a great distraction for him because he would think so much about economics, he needed something, a healthy diversion and he was quite the woodworker. I did not know this.

Nelson: The Friedman's for a longtime had, well, they had a succession of, I think, two summer homes in the Vermont general area and these were quite rural cottage type properties, and I believe Friedman had a shed or something like that in which he did in his own carpentry. So he was very much into carpentry, and I must say, I have very bad an eye coordination, so that's not something I would ever do myself.

Beckworth: No. Not at all.

Nelson: I set up a recurring Mondays of craft classes in high school. So, carpentry, he's interested in, gardening. He didn’t have much interest in what I would say, non-economics, social science, or science more generally. So, since he was narrowly focused in his intellectual interests. And so to have these hobbies as a side thing, I think was why he had this release from economics rather than having a more general interest in non-economic subjects.

Beckworth: It's just nice to see even the great giants among us, like Milton Friedman was a human too. He gardened, he did carpentry, he played games with his family. It's just neat to see that side of it. So, okay. We've talked about him and his life personally.  Let's move into your book again, a great book and we will provide a link to it. And again, the title is *Milton Friedman and Economic Debate in the United States, 1932-1972*. And one of the things that you highlight in the book, I think many people know this, but Milton Friedman, wasn't always a monetarist. You've mentioned by 1951, he was pretty, full-blown a monetarist, but prior to that, a few decades prior to that, he was, in fact, you could say he's quite the Keynesian. You mentioned Abba Lerner in there, and he said they had some similar views during this time.

Beckworth: And it's interesting just to see his journey and his transformation. And maybe we can just talk briefly about some of his previous views. And I want to bring up in particular his American Economic Review article from 1948. He actually has several, he had a 1942 paper in the AER, a discussion of the Inflationary Gap, but his ‘48 paper was titled *A Monetary and Fiscal Framework for Economic Stability.* And it was pretty surprising to me, when you read through this, he's very much for, now, correct me if I'm wrong, a 100% reserves in banks, he says, "We need to have a counter-cyclical budget balance so we run deficits during a recession," and it was really interesting along those lines as he called for the deficits to be fully monetized. So no bonds. Fully monetized. So there'd be no, I guess, no yield curve. Would he eliminate Treasury bonds, altogether, just have all government liabilities as reserves or currency?

Nelson: I think, asymptotically, bonds would be essentially eliminated. So there would be an existing stock of bonds that you would make long-term bonds, and then they would gradually be eliminated altogether. That's right.

Beckworth: That's fascinating. There's been these calls recently for the government to issue a 50-year bond, 100-year bond, tap into the low rates, use it to fund some new R&D project, get us to Mars, whatever it might may be, a cure for COVID. But there's also been this literature that says, "Look. If you look over time, it's actually cheaper if government had issued more short-term debt."  I mean, you do get these periods where rates are really low and you could tap into longer rates. But if you look over a long, long period of time, it's actually cheaper to keep maturities at the short end. And his proposal would take us all the way there. I don't know if you have any thoughts on that and what people are debating today relative to what he had back then in this proposal?

Friedman’s Bond Market Framework and the Implications for Today

Nelson: Yeah. So in 1948, Friedman had what I call, his proposed rules, but I call in the book monetization, in which he said, "The government would, whenever we are granted surplus, that would be used to reduce the money stock, whenever it ran a deficit, that would be used to increase the money stock." So you would have in great contrast a notion that you separate monetary and fiscal policy by just having monetary policy go over on its own path and not be linked to debt management or fiscal policy. You would actually have current fiscal policy driving monetary policy. And in this view it would be stabilizing because the fiscal policy strategy would be one that would aim to have a full employment balance. And so it would be running deficits, but running deficits when Keynesian type economics suggested you should be running deficits, or in fact, a lot of economics says, you should be running deficits in recessions.

Nelson: So, that was probably regarded at the time as somewhat, in the University of Chicago tradition, even though it was very influenced by Keynesian economics simply because he was proposing a policy rule. And he was also, to some extent using wealth effects of money balances as one way in which you achieved stabilization of the economy and wealth of fixed money balances was seen as somewhat of an anti-Keynesian argument, at the time, because they were associated with the Pigou effect and the early countercurrent against General Theory type arguments.

Nelson: But it was essentially a Keynesian analysis he was using. One in which fiscal policy was very important for aggregate demand in its own right, and the main… certainly monetized fiscal deficits had more power than debt financed fiscal deficits, but fiscal deficits in their own had a lot of effects on aggregate demand in this framework, and it was one in which monetary policy would be totally subordinate, totally beholden to fiscal policy. So it was very different from his later rule [inaudible].

Beckworth: You mentioned Abba Lerner and of course he has the famous Functional Finance, which is, I don’t know if it’s the predecessor, but it's definitely a key part of what MMT is today and what Post-Keynesian economics is. So, would it be fair to say that Friedman's 1948 rule or his framework was similar in spirit to what MMT is advocating today?

Nelson: It was suddenly a cousin of some of those ideas, Friedman himself was very critical of Lerner, but not really on the ground of fiscal versus monetary policy was more on the grounds of the extent to which Lerner was having for a very activist policy. So, that's why I say that in a sense, the 1948 paper was trying to be more in line with pre-Keynesian views by advocating a rule-based more automatic type policy, but it was the MMT literature, certainly, as you say, puts a lot of emphasis on monetizing deficits. And in fact, I'm hoping that eventually one benefit of MMT, it's a little bit disappointing to see a lot of momentum in economic thought be driven by contributions that are not really vetted research contributions.

Nelson: But if we're going to try and be positive about MMT, one positive aspect of it will be, it will force people, if you like, [to defend] more orthodox or conventional ideas in economics, force them to be more clear in their head about how money and budget deficits fit together. Because, obviously, the dwindling of references to the money stock into monetary base in mainstream monetary research has reduced the natural scope of economists who respond to MMT type arguments, because the MMT arguments… one aspect of it is that it does bring the money stock and monetary base back into the analysis.

But if we're going to try and be positive about MMT, one positive aspect of it will be, it will force people, if you like, [to defend] more orthodox or conventional ideas in economics, force them to be more clear in their head about how money and budget deficits fit together. Because, obviously, the dwindling of references to the money stock into monetary base in mainstream monetary research has reduced the natural scope of economists who respond to MMT type arguments.

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Beckworth: Yeah, I think MMT has been good because it's forced us to think more carefully about the consolidated balance sheet of government. Now I know in standard macro models in graduate school, we're taught this, you look at that intertemporal government budget constraint, which captures the idea, but you're right, you take for granted, there's a separation and MMT has maybe forced us to think more carefully about that.

Beckworth: Okay, let's go back to Friedman. So Friedman, you say by '51 is all in on monetarism, and you mentioned that some people incorrectly attributed his monetarist birth to his 1956 paper, *The Restatement of the Quantity Theory*, you say by '51, he's all in. So, when does this transformation take place, in the late 40s? I mean, we just mentioned his '48 paper. Of course, that could have been written well before '40. It just got published in '48. So is it the late 40s he's transforming? And then what are the key events or paths that lead him into this journey of monetarism?

Friedman’s Transition into Monetarism

Nelson: Well, just to give a couple, let's bring to mind. One is to work with Anna Schwartz. So Anna Schwartz and Friedman, although *Monetary History* came out in 1963, they released a joint work on money in 1948. So one thing to understand about the National Bureau of Economic Research in the 40s was that it’s very different from today's NBER, which is a clearing house for research by university departments, especially in the US and you sort of establish yourself as a researcher in the NBER, maybe invites you to be a member on NBER working papers, but it's a very decentralized, not directed organization.

Nelson: And in 1940, the NBER was actually a research unit and had directed research, it only did directed research, and it was a sort of repertory company atmosphere. So they had people on staff and they then, if you'd like, pick a number you'll study money, you'll study investment, you'll study consumption. And so, Friedman was brought in when Anna Schwartz had already been assigned money. Friedman was sporadically affiliated with the NBER and he came back more or less as a permanent, but not onsite member of the NBER around 1948. And Arthur Burns, who was head of the NBER, certainly was a very senior over this whole period, assigned him to do jointly with Anna Schwartz, the work on the money stock.

Nelson: So, the NBER’s mission, in a sense, was to publish books that were studying a particular series in light of the business cycles of the United States. So the Friedman and Schwartz study was essentially supposed to talk in broadly statistical terms about how money had behaved over time and compare its behavior across business cycles. But Friedman and Schwartz in a sense, found that they could do something more ambitious, because they found that monetary policy, as measured by money, was very important for the overall business cycle. It wasn't just, one of these sundry series that the NBER had to look at, or to assign themselves to look at, it was, in their interpretation, was a very important series for understanding why business cycles were actually occurring.

Nelson: And so, this disabused freedom, this finding that money was very closely related to the business cycle, disabused Friedman of his earlier view, which was a standard Keynesian position at the time, which was that, money did not have much to do with economic activity, particularly in the depression period. And so, once he and Schwartz had decided, or we're shocked in a sense by their early findings, that money and economic activity were very closely related, that I think produced a revival in Friedman's own mind of the importance of the quantity theory of money, which he'd been taught as a student, but which he, like so many others, had relegated into the category of a discredited theory.

Nelson: So, he was now reawakened to the importance empirically of the quantity theory. Concurrent with that, he’d done work already on, if you like, restrictive labor practices, because he'd done work on the medical profession and he and Kuznets had interpreted medical professions behavioral in licensing, especially, as a restriction on labor supply.  So, he was interested in the labor market from that perspective, and he started doing work, not that large amount of work in terms of papers, but very important in terms of the content of the papers ,on unions, labor unions, and came to the conclusion that labor unions generally should not be regarded as responsible for inflation or for unemployment, but especially for inflation.

Nelson: So he became, very early on, a defender of unions against wage push views of inflation, and so, concurrently with his work with Anna Schwartz on the business cycle and money, he became convinced that prices, or the behavior of inflation was well understood by monetary policy and money, rather than by cost push factors like wages.  So those things were going on in the early 50s… late 40s, early 50s. So even by the time he'd written the, or publishes as the editor, and written the introductory chapter for the studies of the quantity theory of money, he didn't really [inaudible] a lot with the quantity theory of money by then. And in fact, late 40s, he was one of the people pushing for the Federal Reserve to adopt a policy oriented towards price stability, instead of just trying to peg longer-term interest rates.

He became, very early on, a defender of unions against wage push views of inflation, and so, concurrently with his work with Anna Schwartz on the business cycle and money, he became convinced that prices, or the behavior of inflation was well understood by monetary policy and money, rather than by cost push factors like wages.

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Beckworth: What about other intellectual influences? So, the story you're telling is that a path of self-discovery, right? He sees what's happening with these monetary time series in his research with Anna Schwartz at the NBER. He sees the relationships in prices and wages through his work with unions and labor, but you mentioned your book, one prominent, I don't know if it's a contemporary, if it was before Milton Friedman, but Clark Warburton, did his work have any influence on Milton Friedman or were they more contemporaneous?

Clark Warbuton and Possible Friedman Influences

Nelson: I think that Clark Warburton was a very important precursor to Friedman's-Schwartz' type arguments. I think, I, like many other people, read Friedman's work before one really knew about Warburton. And I think the first time I even read about Warburton was an article that Michael Bordo and Anna Schwartz wrote on Warburton, but also Thomas Cargill has written about Warburton. He published a paper at the same time. I read the Bordo and Schwartz paper many years after it appeared, or several years anyway, but I was struck by how many of the points that Warburton made were subsequently made by Friedman, including recommendation of the constant money growth rule, and the monetary interpretation of the Great Depression.

Nelson: I think that Warburton was very important in getting these things published, he wasn't all that influential in persuading people. Once Friedman had made a big splash, Friedman and Schwartz had made a big splash, I think he was a little bit disgruntled that they had, in a sense, Warburton was a bit disgruntled that they had been given so much credit. But I think that Friedman's own relations with Warburton were very good and that he was aware of Warburton's work, but that Friedman had other influences, including exposure to Irving Fisher exposure to the Marshallian traditions in monetary economics. So, there were other precedents that he was influenced by.

Nelson: I think Warburton is probably not all that influential or doesn't really mark himself out on the cost push versus monetary explanation of the inflation debate, which was a very important debate that Friedman was involved in from the 50s onwards. So, there were some aspects of monetarism, that you’d think would look like Friedman’s work and you would say Warburton just really anticipated it very much, and in other areas less so. But Warburton was in a little bit estranged from the academic world because he worked for the FDIC, which at the time, I believe was not very encouraging to him about getting research published. So he had spells when he wasn't publishing that much.

Nelson: He also was a somewhat more, although he was read very directly and very critically about the Fed, he was also not necessarily the most engaging writer, at least not at the same extent as Friedman was. But I think it's done on the Friedman's... I think, the way Friedman and Schwartz put it is that, in the course of doing their work, they kept finding that they were making discoveries that Warburton had already discovered. But Warburton who was very encouraging to them when they were writing the book. I think, subsequently, he may have been a little bit irritated, but Friedman and Schwartz were seen as “finding that the Fed was responsible for the Great Depression,” but he got on perfectly well with them and actually supplied them with a lot of comments.

Beckworth: Yeah. I mean, sometimes the messenger is more important than the message you write. Who delivers the message can be more effective or less effective and Friedman is a very effective messenger that's for sure. I mean, you've heard these sayings, people would say, "How do we know money matters?" They’d say, “Paul Volcker and the monetary history," right? They don't say Clark Warburton, they say the monetary history. That shows the importance of being a good communicator or finding ways to get your message out there and Milton Friedman was a master of that, for sure.

Beckworth: Alright. Let's move on to his framework. You have a whole section of your book about the Friedman’s framework, multiple chapters, but I'm going to try to keep it narrowed down to monetary policy issues. But in the book you cover consumption functions, and investment and all that good stuff as well. And as you said, at the beginning of the show, you really do get into the details, so, a serious economist will enjoy reading the particulars in it. But let's begin with some of the basic tenants of monetarism and a key one, I believe, would be the quantity theory of money. So how do you explain that? What's the definition of a quantity theory of money that was central to Milton Friedman?

Friedman and the Quantity Theory of Money

Nelson: I would say that one can express the quantity theory of money in terms of the necessary and sufficient conditions for a major change in nominal spending and in prices, sustained large-scale change. I would say that the quantity theory of money tells you that, for an appreciable and sustained increase in nominal spending, nominal GDP, you need an increase in the money stock of a comparable amount and that a further aspect of the quantity theory of money is that, because of the physical limits on real output, but also because of the flexibility of prices over time, that over time control of the quantity of money, and by control of the quantity of money, I don't necessarily mean the central bank is trying to control the quantity of money. I mean, it has instruments that are capable of influencing the quantity of money.

Nelson: Control of the quantity of money is able to give you control of the price level, because the price level dominates the longer-term movements... when nominal spending is rising, the price level will hopefully dominate the long-term movements of nominal spending. Because if we look over centuries, if we look over business cycles, real and nominal spending often move very much close together. Stagflation will be a counterexample, but there are plenty of cycles when real and nominal spending in levels and in growth rates move together. But over longer periods, over centuries, nominal spending looks completely different from real spending because real spending has these physical limits on it, these real limits on it, that basically keep real spending to be equal to the real potential output, which can't grow that much.

Control of the quantity of money is able to give you control of the price level, because... when nominal spending is rising, the price level will hopefully dominate the long-term movements of nominal spending. Because if we look over centuries, if we look over business cycles, real and nominal spending often move very much close together. Stagflation will be a counterexample, but there are plenty of cycles when real and nominal spending in levels and in growth rates move together.

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Nelson: And so, nominal money will be dominant for nominal spending and other nominal variables like prices. Some people have expressed the quantity theory of money, in terms of the neutrality of money, that's another way of putting it. So I know Ben McCallum likes to put it this way that, the quantity theory of money says that if you increase the money stock by 1%, ultimately the price level rise by 1%, basically the neutrality proposition. I think that's fine as a way of presenting it, but I would like to present it more as a way of understanding the business cycle, as well as [inaudible] neutrality.

Beckworth: Okay. Let me ask this question then, what you've said is that one of the criteria was a sustained increase. So I often use the term permanent, or at least it's expected to be permanent. So it's got to be a permanent increase in the money stock, non-reversible, and it also needs to be, I guess, the other characteristic I would put on, I want to get your feedback on, is it needs to be greater than the growth in the demand for money. So you can have a permanent increase in the money stock, but there might be some also some money demand growth that offsets that. So are both those conditions necessary?

Nelson: Yes, absolutely. So, obviously if there's a one-time shift in money demand and much of what I said previously has to qualify. But that could be a reason for maybe wanting to express the quantity theory of money in terms of growth rates, because then you can distinguish between, let's say a one-time change of technology or the payment system that raises a velocity or lowers velocity, or a one-time move in a steady state nominal interest rate that raises or lowers velocity, and he would still get the quantity theory propositions mapping into a unitary relationship between nominal money growth and inflation. But absolutely, money are not meaning to prove through money demand as a factor here. But in terms of ceteris paribus, the fact that money might be moving around doesn't mean we can have any money stock growth we’d like. There is an automated relationship between money stock and nominal spending.

Beckworth: Yes. Okay. So, let's move on then to what money we should be thinking about. So we have the conditions for the quantity theory to hold, and this is where I know there's difference among monetarists, there's also people today who get, we mentioned the MMTers, post-Keynesians, they get all worked up about endogenous money and most money is inside money or money created privately by banks and financial firms.  So, when Milton Friedman is thinking about quantity theory and the Federal reserve controlling the path of the price level over the long run, is he thinking about controlling it via the base, which I know Allan Meltzer stressed, or via these broad money aggregates?

Nelson: Almost all his career, Friedman was interested in the aggregate that was broader than the monetary base as the measure of money. He certainly placed a great deal of emphasis on the monetary base as a variable that's important in understanding how money stock behaved and also a variable that ideally you would like to see the central bank use as its policy instrument.  But in terms of the M that matters, if you'd like the LM or money demand inflation, he generally viewed it as a broader series of money because he believes that the monetary series under consideration brought a series of base money because the monetary series duration could basically be the series that households’ demand for money is founded upon.

Nelson: So very early on, he and Schwartz, started using M2 rather than M1. There were cynical interpretations, but that was simply because M2 data went back before the 1900s and M1 data really didn't. But ultimately he and Schwartz started coming up with, I think, reasonably good practical reasons why, or practical/analytical reasons why you would favor M2 over M1. M1 uses to be very, very popular in United States as the measure of money. Friedman and Schwartz were almost heretics when using M2 rather than M1, and even the Federal Reserve for a long time, really in the 80s put a great deal of emphasis on M1 rather than M2.

Nelson: But I think the Friedman/Schwartz position was that the so-called time deposits in M2, aren’t really time deposits in the sense that they are not isolated balances that are put in a cookie jar that you can't use for transactions, that if you need to access them, you basically can, and then subject to the fact that you can, households will act as though they can. And so they'll treat their money stock as including these time deposits.

Nelson: And I think that view has been vindicated at the time by the fact that M2 does seem to have a better relationship with nominal spending than M1, neither of them were perfect. As you say, there's still a lot of controversy and among those of us who like looking at monetary aggregates about what series to use and, obviously, Bill Barnett was a pioneer in trying to get a more theory-based measure of money based on weights changing over time, and more recently with people like Mike Belongia and Peter Ireland who had done a lot of running on those issues, as well as myself.

Beckworth: What do you think Milton Friedman would say today about the Divisia measures, you just mentioned, would he be for those you think?

Nelson: I think he was on the record being pretty positive about it. Even back then, I think in late 50s, early 60s he and his co-authors had made statements to the effect that the idea would be some weighted measure and weighting may not be…

Beckworth: Not a simple sum.

Nelson: So, he was sympathetic even from that earliest stage and in due course by Bill Barnett… And I believe Bill Barnett said somebody who had spoken to Milton Friedman had said, look this up in the Friedman/Schwartz monetary statistic book, because monetary statistic book and actually has spoken really favorably about it in general terms about the idea of the Divisia aggregate. And so Friedman and Schwartz they had no, don't get me wrong, they had absolutely nothing to do with the actual empirical creation of the Divisia of money, but they had made statements that were ex-post [inaudible] support of that literature.

Beckworth: Okay. One other question, tying Milton Friedman to something that happened later in his career here, I just asked about the Divisia. But there's the famous paper by Sargent and Wallace, *Some Unpleasant Monetarist Arithmetic.* How did Friedman view that? Because Friedman was alive when that was written. It was in the early 80s, I think. So Friedman was aware of that and they invoked the name monetarist, but it has more of a flavor of a fiscal theory, or at least fiscal dominance is in that paper, can be in that paper. So how did he respond to that?

Responding to *Some Unpleasant Monetarist Arithmetic*

Nelson: Well he certainly wrote about it. One thing about the title, I've been puzzled over a long period of time by the title because it's called *Some Unpleasant Monetarist Arithmetic.* And I didn't actually write it up in the book, but I write it up in the sequel, but I asked Neil Wallace about the title and I said, " Does it mean the arithmetic is unpleasant for monetarists? What does it mean? This is arithmetic that comes out of monetarist analysis." And he said, "It was deliberately ambiguous." And it is ambiguous, the message of the paper, because it's in a sense saying that, "You can't get inflation without monetary growth." But you could interpret it as saying, "You will get inflation because you won't be able to control monetary growth because you'll be monetizing deficits."

Nelson: Friedman's interpretation was what I would say has become a very prevalent interpretation. Actually, in light of Olivier Blanchard’s paper, the presidential address a couple of years ago, Friedman wrote an article, a book review, in the JPE in, I believe, early 1987. It was a review of a book by Sargent, but the book by Sargent was in fact, a collection of papers, including the Sargent-Wallace paper.  So Friedman’s review was in a sense or a review of the Sargent-Wallace article and Friedman took the view that in practice, the real rate of interest is below the real growth rate. And that is the, if you like the out, both for monetarists and for [inaudible] enthusiasts about fiscal policy because [inaudible] enthusiasts about fiscal policy can say, "We can do a lot in terms of aggressive fiscal policy without creating dangerous public debt because r is less than g.”

Nelson: And, it's a good news for monetarists because you can separate monetary and fiscal policy, even with fiscal policy running large deficits. And so Friedman argued that as a practical manner, other than the early 80s, it was the case that US history was characterized by R being lower than little g, growth rate of government spending.  So when you have that, you had a situation in which you can run deficits, you can accumulate debt and you'll still have debt to GDP, public debt to GDP, often tending to decline. So he regarded that like the practical case. That was his answer to Sargent and Wallace. And in fact, if you look at the Gilder and Fisher textbooks from the 80s, the r less than g edition, and this is something that, has had life breathed into it by Olivier Blanchard’s paper, it's something that's been a textbook point for a long time. And Friedman made the point in 1987. And of course it's basically implicit or explicit in Sargent and Wallace, but anyway, it wasn't what Sargent and Wallace pushed, but it was what Friedman pushed when he read Sargent and Wallace that, "You will be able to separate monetary and fiscal policy because R is less than G."

And so Friedman argued that as a practical manner, other than the early 80s, it was the case that US history was characterized by R being lower than little g, growth rate of government spending.  So when you have that, you had a situation in which you can run deficits, you can accumulate debt and you'll still have debt to GDP, public debt to GDP, often tending to decline.

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Beckworth: Okay. Interesting. I’ll have to go check out that paper, or that review in the JPE. Let's move to his famous rule, his famous constant money supply growth rule. So tell us about that. How did that emerge and, did his thinking evolve on it over time?

Friedman’s Famous Money Supply Growth Rule

Nelson: Sure. Essentially, as we discussed earlier, he started out this monetarist period of his in the late 40s, early 50s, believing in a rule that involved monetization of fiscal deficits as a routine and monetary policy operation. And, for his early years as a monetarist, he stuck to that because it's still regarded as a stabilizing rule, he just pushed the rule as a way of manipulating money, more than he had previously.  But as his work with Anna Schwartz progressed, and they really saw a lot of episodes as characterized by instability and prices and output because money was moving around, not because money was failing to offset other things, he became more enamored of a constant monetary growth rule because he thought that that would switch off money as a source of instability.

Nelson: So if you just put money on a preset path, preset growth path, you would allow money to stop being fluctuations of the money stock, you'd be able to stop that being a source of economic instability. And also, you would greatly simplify the assignment problem because you would have fiscal policy being concerned with the allocation of resources, monetary policy being concerned with the price level, and that's something we haven't talked about because concentrating on in the US, the floating exchange rate being a source of balance of payments [inaudible]. So, this all fitted quite neatly into the separation of monetary and fiscal policy that he was becoming more enamored too. And also, his belief of fiscal policy didn't matter that much by itself for aggregate demand. So, the main governmental instrument for manipulating aggregate demand or influencing aggregate demand, was the money supply or monetary policy.

Nelson: So, he became committed to money growth rule, monetary growth rule, the constant monetary growth rule in 1956. I've seen a couple of people say that he advocated in his 1956 paper on them reciting the quantity theory. He actually didn’t, and he did do so in papers that were contemporaneous with that paper. So, his first on the record public statement, I believe, was published in about February, 1957, advocating constant monetary growth, and he really advocated that on and off, or mostly on actually for the rest of his life.

Nelson: Towards the end of his life, he was much more receptive to the idea that you could do better than a monetary growth rule. It's still a matter of conjecture how much he was persuaded that the particular rule was preferable in the sense of saying, "Yes, I now prefer that rule to the monetary growth rule." It was more a case of him saying, "I can see that it's quite possible, you can do better than this with the practical rules that have been proposed."

Towards the end of his life, he was much more receptive to the idea that you could do better than a monetary growth rule. It's still a matter of conjecture how much he was persuaded that the particular rule was preferable in the sense of saying, "Yes, I now prefer that rule to the monetary growth rule." It was more a case of him saying, "I can see that it's quite possible, you can do better than this with the practical rules that have been proposed."

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Beckworth: Alright, let's flesh out this monetary growth rule. And I want to go back to this point I made earlier about how people would question, well, how would you do this? Most money's endogenous in the sense that's it created by the credit system. So if the Fed were to follow Friedman's rule, is the idea that it would use its instruments to guide the path of a monetary aggregate… and that's an intermediate variable. And then that in turn would then guide the nominal size of the economy. Is that the understanding?

Nelson: Yes. That's a good characterization of his position. There was a sort of two-track approach that Friedman took to his monetary growth. In some of his work he would say you have an intermediate target as well as a monetary growth rule, that is a way that you would have a mechanical, automatic connection between the monetary base and then simply by making it into the monetary base forcing banks whenever they issue deposits to have all the assets counterparts to those deposits be deposits with the Federal reserve.

Nelson: That is not a practical proposal, I think, anymore. Some people are enamored by something like 100% reserves, and I call it narrow money or narrow banking or things like that. But I don't think it's really a very practical proposal. So, the other proposal he had was you would not have narrow banking, you would have low levels of reserve requirements, low levels of required reserves, but you would still be able to have an M2 target.  And the reason he thought an M2 target was feasible is that he thought that the monetary base could be used to manage M2. He believed that there was a ceteris paribus money multiplier relationship between the monetary base and M2. The monetary multiplier is, again, something that gets a lot of trash talking among modern day economists and people who say, “all textbooks are all wrong about the money supply process.”

That is not a practical proposal, I think, anymore. Some people are enamored by something like 100% reserves, and I call it narrow money or narrow banking or things like that. But I don't think it's really a very practical proposal.

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Nelson: I think that that is really doing a disservice to the idea of ceteris paribus. Because if you just look at a world without interest on reserves or without a lot of the complications, there is a logic why a change in reserves would lead to a change in deposits. You can add all sorts of bells and whistles to the money supply function, but that's the basic message that I think is valid.  And so, he was arguing, you should be able to control M2, by offsetting with open-market operations factors affecting the money multiplier. So, you can argue that that was a sense of fine-tuning prescription, the fine tuning would be getting an M2 target, but he believed there was a fairly reliable relationship between the monetary base and M2 and after the 1990s, certainly that was quite accurate.

Beckworth: And I think he would argue, and correct me if I'm wrong here, he would argue that if the Fed had done this, if the Fed had successfully targeted, say, M2 this whole period, this whole time, then velocity would have been more stable. Is that fair? And therefore this breakdown in the money demand relationship with income would be less of an issue.

Nelson: That's right. He believed, for example, in the 1930s, particularly that the big fall in velocity, and it was a big fall in the velocity, even though the money and nominal spending had a big relationship. It was a big fall in velocity, but he thought that was due to big uncertainty engendered by the monetary and economic collapse. So he thought that velocity fluctuations often were triggered by monetary instability. And that certainly is something that will be widely shared when it comes to hyperinflation which is well-known in term, inflation engenders big increases in velocity.

He was arguing, you should be able to control M2, by offsetting with open-market operations factors affecting the money multiplier. So, you can argue that that was a sense of fine-tuning prescription, the fine tuning would be getting an M2 target, but he believed there was a fairly reliable relationship between the monetary base and M2 and after the 1990s, certainly that was quite accurate.

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Beckworth: Ed, one more question about the monetary policy rule, and you alluded to this earlier. He did reference some other approaches later in his life, I just want to mention one that he mentions in his book, *Monetary Mischief,* he talks about targeting the breakevens, the implied expected inflation rate you get out of the bond market. So, if it weren't for liquidity premiums, which we know exist and distort that signal, this is people who have skin in the game, they're people who are making bets on the forecast of inflation. He said, "Maybe targeting that would be a good idea." How serious was he about that? Would he really give up his money growth rule for something like that?

Targeting Inflation Forecasts vs. A Money Growth Rule

Nelson: In terms of his ranking, I think he would have preferred his money growth rule, but you're certainly right that he was enthusiastic about the proposal because he was receptive, I think, ultimately to proposals that tried to bring in more of a quantity theory or nominal anchor type approach to traditions that were [inaudible] on the interest rates. So remember, in the 1940s, the interest rate was targeted by the Federal Reserve without really a macroeconomic rationale, it was regarded as a price they should peg. And the big contrast, or that with modern day analysis of interest rates, in monetary policy analysis is that, it's now very much accepted that interest rates, although set by the central bank, have to be an endogenous variable in the sense that they have to, in order to get price stability, they have to have some particular relationship with the rest of the economy.

Nelson: Otherwise, you will get instability, and prices, and output. So, his former student Bob Hetzel, had, as you say, advanced this proposal that Friedman, as you say, discussed in *Money Mischief*, that was to target a particular interest rate if you like, but target in a way that made the index bond rate equal the, or equal maybe up to a small inflation rate, the expected inflation rate, the market nominal rate of interest. So, in a sense, he was trying to manage inflation expectations, using an interest rate rule and deliver expectations of price stability. Friedman was very interested in the indexed bond market and the US was a little bit of a lag at this in getting into the indexed… into getting the governmental indexed bonds and UK had been ahead of the US in the 80s on that.

Nelson: And, I think to try to force the pace of reform in the US, Friedman published an article in the JPE 1984, arguing for the index bond, for index bonds. He’d argued for it before, but he was arguing, particularly, in that paper saying, this is a way you can get better readings on inflation expectations. So they'd previously been arguing for index bonds on equity grounds, and efficiency grounds, but now he was arguing from a policymakers’ perspective, "This is a way to get a good reading on longer term inflation expectations." And that, obviously, was very much in line with the latest type of thinking to do with the TIPS rule proposal you mentioned.

Beckworth: Alright Ed, we're getting near the end of the program, and one last question before we do that, and that is, do you see any chance of a renaissance in quantity theoretic thinking? I mean, will Milton Friedman's views on the quantity theory be revived in the future. Any sense of that?

A Future Revival of the Quantity Theory?

Nelson: I have on and off thought that the big revival was around the corner and then been disabused of that. So, in 1993, if you'd asked me, then I would've said to you that monetary aggregates are going to make a comeback and I was obviously wrong. And so, there's a certain amount of humility in my perspective that I have to bring now, but I do think what we discussed earlier, the interest in MMT, if I'm going to try to extract a positive aspect of that, it should bring back... It should force mainstream macro-economists to be more literate and more on top of what traditional economics has to say about monetary economics and what it has to say about monetary aggregates in particular.

I do think what we discussed earlier, the interest in MMT, if I'm going to try to extract a positive aspect of that...It should force mainstream macro-economists to be more literate and more on top of what traditional economics has to say about monetary economics and what it has to say about monetary aggregates in particular.

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Nelson: I've just been struck by very eminent economists in rebutting MMT, making statements about the monetary base, and making statements about monetization, about what monetary money finance, fiscal policy, what that does to interest rates or what money does to interest rates in those circumstances, but they are just not accurate if you think of what the old textbooks that did use money would say, and they're not accurate in terms of what standard monetary analysis inclusive of money would say.

Nelson: So, I'm hoping that at least at an analytical level, people will feel that they have to think more about money. Now, in terms of the empirical side, we're always going to face the obstacle, that one of the reasons that monetary aggregates went out of fashion is that there ultimately was a lot of validity and the criticism and the money was becoming harder to define. So, if the Divisia approach really makes a solid break through and establishes an aggregate that people can settle on and believe it's plausible, and it has a good relationship with the rest of the economy, that would be good, but I don't see that happening.

Nelson: I see research being done that is going in that direction, but there's a big slip between research being done and getting a foothold on professional consensus. So I don't yet see interest in money as coming out of the back water, I’m sorry to say. But, I think people who are talking about monetary aggregates should try to get more on top of what literature has to say about monetary aggregates. That'll be a good start.

There's a big slip between research being done and getting a foothold on professional consensus. So I don't yet see interest in money as coming out of the back water, I’m sorry to say. But, I think people who are talking about monetary aggregates should try to get more on top of what literature has to say about monetary aggregates. That'll be a good start.

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Beckworth: Let me throw out another possible path towards people thinking about quantities again, of money. And that is all of this talk and then maybe momentum for central bank digital currencies, or Fed Accounts, to the extent the Fed's balance sheet opens up to the public, I mean, technically, the public does hold physical cash on the Fed's balance sheet, but imagine you open up… you and I could deposit at the Fed, that might mean a lot of disintermediation for normal banks, for, in other words, a collapse in inside money creation. And a lot of it is directly going back to this earlier Friedman argument for a hundred percent reserves, right? It would, in a sense, push us back to a place where the Fed had a lot more control over the monetary aggregates. I mean, that could be another path towards this, right?

Nelson: Yes. I think that unambiguously brings priorities back into the forefront of discussion and makes one, actually, have to think hard about money demand, which is not something that a lot of macro-economists like to think about. They like to think of money demand as this redundant equation that they can forget about.  It also will bring back issues connected with the definition of money, because obviously if you have… if your currency, that's available to the general public and that is issued by the Federal Reserve and you can't just categorize deposits with the Federal Reserve as outside money. Or at least they don't have outside money in the sense that they don’t have reserves… their currency. So, they might be outside money, but they would be currency. And so, their deposits at the Federal Reserve that are not reserves but there's the currency. So, they wouldn't be included in M2 whereas deposits with the Federal Reserve are not included in M2. So, it would bring back issues about measuring money, measuring liquidity, measuring liquidity services.

Beckworth: Okay. Well, with that, our time is up. Our guest today has been Ed Nelson, Ed thanks so much for coming on the show.

Nelson: Thank you, David. Pleasure.

Photo by Alex Wong via Getty Images

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