Milton Friedman, the 1976 Nobel laureate in economics, identified through an
exhaustive analysis of historical data the potential role of monetary policy as
a key factor in shaping the course of inflation and business cycles, with the
counterfactual conclusion that the Great Depression of the 1930s could have
been avoided with appropriate US Federal Reserve monetary easing to counteract
destructive market forces.
Friedmanís counterfactual conjecture, though not provable, has been accepted by
central bankers as a magic monetary formula
to rid capitalism of the curse of business cycles. It underpins Greenspan-led
Fedís "when in doubt, ease" approach of the past two decades which had led to
serial debt bubbles, each one bigger than the previous one.
Macroeconomists, including current Fed chairman Ben Bernanke, focus their
attention on the structure, systemic performance and behavioral interactions of
the component parts of the economy. While they defend the merits of market
fundamentalism, most neoclassical macroeconomists subscribe to the
debt-deflation view of the Great Depression in which the collateral used to
secure loans or, as in the current situation, the backing behind their
derivative instruments will eventually decrease in value, creating losses to
borrowers, lenders and investors, leading to the need to restructure the loan
terms or even loan recalls.
When that happens, macroeconomists believe that government intervention is
necessary to keep the market from failing.
The term debt-deflation was coined by Irving Fisher in 1933 and refers to the
way debt and deflation destabilize each other. De-stability arises because the
relation runs both ways: deflation causes financial distress, and financial
distress in turn exacerbates deflation. This debt-deflation cycle is highly
toxic in a debt-infested economy.
Hyman Minsky in The Financial-Instability Hypothesis: Capitalist processes and
the behavior of the economy (1982) elaborated the debt-deflation
concept to incorporate its effect on the asset market. He recognized that
distress selling reduces asset prices, causing losses to agents with maturing
debts. This reinforces more distress selling and reduces consumption and
investment spending, which deepens deflation.
Bernanke wrote in 1983 that debt-deflation generates wide-spread bankruptcy,
impairing the process of credit intermediation. The resultant credit
contraction depresses aggregate demand. Yet in a later paper: Should Central
Banks Respond to Movements in Asset Prices? (2002) coauthored with Mark
Gertler, Bernanke concludes that inflation-targeting central banks need not
respond to asset prices, except insofar as they affect the inflation forecast.
The paper refers to a 1982 paper by Oliver Blanchard and Mark Watson: Bubbles,
Rational Expectations, and Financial Markets, with the general conclusion that
bubbles, in many markets, are consistent with rationality, that phenomena such
as runaway asset prices and market crashes are consistent with rational
Friedmanís conjecture on the effect of monetary policy on economic cycles drew
on the ideas of neoclassical welfare economist Arthus Cecil Pigou (1877-1959)
who asserted that governments can, via a mixture of taxes and subsidies,
correct market failures such as debt-deflation by "internalizing the
externalities" without direct intervention in markets. Pigou also proposes "sin
taxes" on cigarettes and alcohol and environmental pollution.
However, Pigouís Theory of Unemployment (1933) was challenged conceptually
three years after publication by his personal friend John Maynard Keynes in the
latterís highly influential classic: General Theory of Employment, Interest and
Money (1936). Keynes advocated direct government interventionist policies
through countercyclical fiscal and monetary measures of demand management, ie
Macroeconomists are also influenced by the work of Irving Fisher (1867-1947): Nature
of Capital and Income (1906) and elaborated on in The Rate of Interest
(1907 and 1930), and his theory of the price level according to the Quantity
Theory of Money as express by an equation of exchange: MV=PT ; where M=stock of
money, P=price level, T=amount of transactions carried out using money, and V=
the velocity of circulation of money. Fisherís most significant theoretical
contribution is the insight that total investment equals total savings (I=S), a
truism that all debt bubbles violate.
The 1990s appeared to be a replay of many aspects of the 1920s when consumers
and businesses relied on cheap and easy credit in a deregulated market to fuel
an extended debt-driven boom which became toxic when an inevitable debt crisis
caused asset price deflation. Federal Reserve banking regulations to prevent
panics were ineffective and widespread debt defaults led to the contraction of
the money supply. In the face of bad loans and worsening future prospects,
banks abruptly became belatedly conservative in their lending while they
scrambled to seek additional capital reserves which intensified deflationary
pressures. The vicious cycle caused an accelerating downward spiral, turning an
abrupt recession into a severe depression.
Legal limit on credit
Bernanke points out in his Essays on the Great Depression (Princeton
University Press, 2000) that Friedman argues in his influential Monetary History
of the United States that the Great Depression was caused by monetary
contraction which was the consequence of the Fedís failure to address the
escalating crises in the banking system by adding needed liquidity. One of the
reasons for the Fedís inaction was that it had reached the legal limit on the
amount of credit it could issue in the form of a gold-backed specie dollar by
the gold in its possession. Today, the Fed has no such limitation on a fiat
dollar, a condition that permits Bernanke to suggest the metaphor of dropping
money from helicopters on the market to fight deflation caused by a liquidity
crunch. Free from a gold-backed dollar, the Fed is now armed with a printing
machine the ink for which is hyperinflation to fight deflation.
Yet in the popular press, Friedman was known also for his advocacy of a
deregulated free market as the best option for sustaining economic growth,
which raises the question of the need for central banking intervention to
replace specie money of constant value with fiat currency of flexible
elasticity. A free money market under a central banking regime is an oxymoron.
Betting on Fed interest moves is the biggest speculative force in the market.
Friedman apparently did not extend his love for free trade to the money market.
The Friedman compromise was to manage the structural contradiction with a
proposed steady expansion of the money supply at around 2%.
Still, Friedmanís love of free markets does not change that fact that totally
free markets always lead to market failure. Free markets need regulation to
remain free. Free market capitalism, the faith-based mantra of Larry Kudlow
notwithstanding, is not the best path to prosperity; it is the shortest path to
Unregulated markets in goods have a structural tendency towards monopolistic
market power to reduce price competition and to inch towards rising inflation.
On the other side of the coin, unregulated money markets can lead to liquidity
crises that cause deflation. The fundamental contradiction about central
banking is that the central bank is both a market regulator and a market
participant. It sets the rules of the money market game while it pretends to
help the market to remain free by distorting the very same rules through the
use of its monopolistic market power as a market participant not driven by
The Fed is a believer of free markets who at the same time does not trust free
markets. The response by ingenious market participants to the Fedís
schizophrenia is to set up a parallel game in the arena of structured finance
in which the Fed is increasingly reduced to the role of a mere passive
Robert Lucas, the 1995 Nobel laureate economist, also made fundamental
contributions to the study of money, inflation, and business cycles, through
the application of modern mathematics. Lucas formed what came to be known as
the "rational expectations" theory.
In essence, the theory asserts that expectations about the future can influence
economic decisions by individuals, households and companies. Using complex
mathematical models, Lucas showed statistically that individual market
participants would anticipate and thus could easily counteract and undermine
the impact of government economic policies and regulations. Rational
expectations theory was embraced by the Reagan White House during its first
term, but the doctrine worked against the Reagan "voodoo economics" instead of
In a debt bubble, an escalating rate of inflation to devalue the accumulated
debt is needed to sustain the bubble. Thus conventional wisdom moves toward the
view that the overriding purpose of monetary policy is to keep market
expectations of price inflation anchored at a relatively benign rate to ward
off hyperinflation. This approach is known in policy circles as inflation
targeting, on which Fed chairman Ben Bernanke is an acknowledged academic
authority and for which he had been a forceful advocate before coming to the
In May 2003, Pimco, the nationís largest bond fund headed by Bill Gross, having
earlier pronounced a critical view on the unrealistically low yield of General
Electric bonds in the face of expected inflation, came out in support of
inflation targeting. Fed economist Thomas Laubach, a recognized inflation
targeting advocate, estimates in a paper that every additional $100 million
increase in projected Federal annual fiscal budget deficit adds one quarter
percentage point to the yield on 10-year Treasury bonds, albeit that this
estimate has been rendered inoperative since the 1990s by dollar hegemony
through which the US trade deficit is used to finance the US capital account
surplus, reducing the impact of US fiscal deficits on long-term dollar interest
rates. Global wage arbitrage also kept US inflation uncharacteristically low,
albeit at a price hollowing the US manufacturing core.
Laubach was part of the Princeton gang that included John Taylor of the
celebrated Taylor Rule, and Bernanke, the money printer of late at the Fed. (Inflation
Targeting: Lessons from the International Experience by Ben S Bernanke,
Thomas Laubach, Frederic S Mishkin and Adam S Posen; Princeton University Press
2001). The Fedís long-held position is that Federal budget deficits raise
long-term interest rates, over which Fed monetary policy as currently
constituted has little control.
The Taylor Rule
Economist John Taylor was the editor for Monetary Policy Rules (National Bureau
of Economic Research Studies in Income and Wealth - University of Chicago Press
1999) in which he put forth the Taylor Rule.
The Taylor Rule states: if inflation is one percentage point above the Fedís
goal, short-term interest rate should rise by 1.5 percentage points to contain
it. And if an economyís total output is one percentage point below its full
capacity, rates should fall by half a percentage point to compensate for it.
The rule was designed to provide "recommendations" for how a central bank
should set short-term interest rates as economic conditions change to achieve
both its short-run goal for stabilizing the economy and its long-run goal for
Specifically, the rule states that the real short-term interest rate (that is,
the interest rate adjusted for inflation) should be determined according to
three factors: (1) where actual inflation is relative to the targeted level
that the Fed wishes to achieve, (2) how far economic activity is above or below
its "full employment" level, and (3) what the level of the short-term interest
rate is that would be consistent with full employment.
The rule "recommends" a relatively high interest rate (a tight monetary policy)
when inflation is above its target (normally below 2%) or when the economy is
above its full employment level (normally defined as 4% unemployment, but this
figure has risen in recent years to 6%), and a relatively low interest rate (a
loose monetary policy) in the opposite situations. Under stagflation, when
inflation may be above the Fed target when the economy is below full
employment, the rule provides guidance to policy makers on how to balance these
competing considerations in setting an appropriate level for the interest rate.
The answer is a neutral interest rate. Yet as a practical matter, the only way
to counter stagflation is to lean on the anti-inflation bias as Paul Volcker
did during the Carter years because a neutral interest rate may extend
stagflation longer than necessary.
Although the Fed does not explicitly follow the rule, analyses show that the
rule does a fairly accurate job of describing how monetary policy actually has
been conducted during the past decade under chairman Greenspan. This is in fact
one of the criticisms of the Taylor Rule in that it tends to reflect Fed action
rather than to guide it. On the question of whether the Fed should have leaned
against accelerating home prices during 2003-2005,