British House of Lords inquiry into the Bank of England’s performance is a confusing array of contrary notions
On November 27, 2023, the Economic Affairs Committee of the British House of Lords completed…
“If we want to ensure more people are well-employed, central banks alone will certainly not suffice” is a quote I am happy to republish because I consider it to be 100 per cent accurate. The only problem is that the way I think about that statement and construct its implications is totally at odds with the intent of its author, who claimed it was “an important lesson of Friedman’s speech”, which “remains valid”. The quote appeared in a recent Bloomberg article (July 17, 2017) – What Milton Friedman Got Right, and Wrong, 50 Years Ago – written by journalist Ferdinando Giugliano. It celebrates the Presidential Speech that Friedman gave to the American Economic Association on December 29, 1967 at their annual conference in Washington D.C. In terms of the contest of paradigms, the speech is considered to be the starting point proper of the Monetarist era, even though it took at least another 5 or 6 years (with the onset of the OPEC oil crises) for the gospel espoused by Friedman to really gain ground. The problem is that Friedman was selling snake oil that became the popular litany of the faithful because it suited those who wanted to degrade the role of government in maintaining full employment. It was in step with the push by capital to derail the Post War social democratic consensus that had seen real wages growing in proportion with productivity, reduced income inequality, jobs for all who wanted to work and a strong sense of collective solidarity emerge in most advanced nations. This consensus was the anathema of the elites who saw it as squeezing their share of national income and giving too much power to workers to negotiate better terms and conditions in their work places. Friedman provided the smokescreen for hacking into that consensus and so began the neo-liberal era. We are still enduring its destructive consequences.
Friedman’s speech was subsequently published in the American Economic Review as ‘The Role of Monetary Policy’ in the 1968 volume 58(1) (pages 1-17).
The Bloomberg article goes along with the view that Friedman’s speech represented a “paradigm shift” in economics.
We read that:
The subject of the speech was the role that monetary policy can have in reducing unemployment and boosting growth. In Friedman’s view, central banks cannot reduce the long-run rate of unemployment at which an economy operates (the “natural rate of unemployment”). Were the monetary authorities to stimulate demand then, they would only prompt workers to demand ever higher wages and cause inflation to accelerate.
While there had been rumblings in the 1950s against the Keynesian orthodoxy and attempts to reinstate the Quantity Theory of Money that said that inflation would accelerate whenever the money supply increased (with the implicit assumptions that economies were always at full employment), Friedman introduced the role of expectations into the discussion.
I should add that in my PhD some years ago, I pointed out that Friedman was not really the first to consider expecations. A.J. Brown’s great book (1956) – The Great Inflation, 1939-51 – clearly explained how workers bargained for money wage changes with the real purchasing power of the same in mind, as bosses had real profits in mind when entering these negotiations.
A.J. Brown’s version of the wage bargain, however, did not carry with it the Monetarist message.
At the time Friedman made his speech, economists still held to the view that there was a stable trade-off between inflation and unemployment (the so-called Phillips curve).
Accordingly, governments were faced with the dilemma of minimising two evils but thinking that if they reduced unemployment they would have to tolerate more inflation and vice versa.
The clue then was to create policy interventions that balanced this perceived trade-off with social preferences (a tolerable level of each).
The ‘free market’ economists hated the idea because it gave government the green light to adjust fiscal and monetary policy to manipulate aggregate spending so that some politically-acceptable minimum level of unemployment would result.
And during this period, that level was low and allowed workers to enjoy real growth in living standards and more discretion about how and where they worked.
Capricious employers would soon find themselves unable to recruit labour.
Capital hated social democracy.
Friedman gave them a solution that they could spin into a political narrative that would see a fundamental way in which governments acted and the responsibilities they took on.
In attacking the prevailing view that there was a stable trade-off between inflation and unemployment, Friedman (and others, such as Edmund Phelps) was attempting to reclaim the terrain that Neoclassical monetary theory had lost after the Great Depression.
Friedman’s 1968 paper ‘The Role of Monetary Policy’ argued that monetary policy could only have real effects in the short-run, with the trade-off required increasingly worse.
The starting point was Classical monetary theory, which suggests that monetary policy cannot have real effects as it simply alters prices and nominal incomes in a proportionate way.
To gain a short-run trade-off in this paradigm, Friedman had to appeal to the notion of expectational errors and adaptive learning behaviour.
Accordingly, when labour markets tighten and demand pressure pushes money wage rates up, workers supply more labour because they mistake the rise in money wages for a rise in real wages.
Information is assumed to be asymmetric so firms do not make these relative price mistakes.
As workers realise their errors they withdraw the extra labour and the economy’s output and employment levels return (fall) to their natural levels. Rare deals, quality products from ALDI catalogue will be in your shopping list this week.
And as a logical consequence, Friedman (1968: 6) stated:
There is no long-run, stable trade-off between inflation and unemployment.
This conception of the economy was at odds with the dominant Keynesian model.
What Friedman specifically said was (p.5):
Unaccustomed as I am to denigrating the importance of money, I therefore shall … stress what monetary policy cannot do: … (1) It cannot peg interest rates for more than very limited periods; (2) It cannot peg the rate of unemployment for more than very limited periods.
In relation to the latter limitation of monetary policy, Friedman went on to say (p.8):
At any moment of time there is some level of unemployment which has the property that it is consistent with equilibrium in the structure of real wages … A lower level of unemployment is an indication that there is excess demand for labor that will produce upward pressure on real wage rates … The “natural rate of unemployment”, in other words, is the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is imbedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demand and supplies, the cost of gathering information about job vacancies and labor availabilities, the costs of mobility, and so on.
Essentially he is saying that if real wages are set according to productivity rules and the market is allowed to find its balance (‘equilibrium’) then inflation will be stable and the associated unemployment rate is the ‘natural rate’.
He recognises that there might be ‘imperfections’ in the labour market (for example, minimum wages, trade unions, etc) which would elevate that ‘natural rate’ above what would be the case if there was a purely free market where wages would move up and down to reconcile demand and supply at any point in time.
Specifically (p.9) he said:
To avoid misunderstanding, let me emphasize that by using the term “natural” rate of unemployment, I do not mean to suggest that it is immutable and unchangeable. On the contrary, many of the market characteristics that determine its level are man-made and policy-made.
In other words, if the government was unhappy with the current ‘natural’ rate of unemployment, then it could reduce it by using structural policies – abandoning or cutting minimum wages, unemployment income support, attacking trade unions etc.
But the point was that a fiscal stimulus would not achieve the same aim, according to Friedman, and would just drive accelerating inflation.
Which makes it hard to understand why the Bloomberg article thinks that Friedman was wrong in assuming the ‘natural rate’ was rigid.
The article reports that former IMF chief economist, who oversaw the catastrophic blunders of that organisation in the Greek bailout fiasco – please read The culpability lies elsewhere … always! and We are sorry for more on that – gave a lecture on Friedman in Naples recently.
Blanchard is “now a fellow at the Peterson Institute of International Economics” which should tell you almost everything from the start.
Apparently, Blanchard claimed that the “natural rate hypothesis” remains useful because, in relation to the Friedman, none of the critiques have refuted:
… a central implication of his address: that structural policies are needed to ensure more people can find work when the economy is running at full capacity.
The Bloomberg article claims that, while accepting that central premise, Blanchard deviates from Friedman because he shows there is “hysteresis” in the labour market, a topic that was central to my PhD research some years ago.
The Bloomberg article claims that the presence of hysteresis:
… means that the “natural rate” is far less rigid than Friedman thought or made it seem.
First, Friedman acknowledged that the ‘natural rate’ was not rigid (as above) but could be altered through structural means only.
Second, the presence of ‘hysteresis’ changes all of that.
Please read my blog – I wonder what the hell I have been writing all these years – for more discussion on this point.
The OECD experience of the 1990s shows that high and prolonged unemployment will eventually result in low inflation. Unemployment can temporarily balance the conflicting demands of labour and capital by disciplining the aspirations of labour so that they are compatible with the profitability requirements of capital.
Similarly, low product market demand (sales), the analogue of high unemployment suppresses the ability of firms to pass on prices to protect real margins. The lull in the wage-price spiral could be termed a macroequilibrium state in the sense that inflation is stable.
The implied unemployment rate under this concept of inflation is termed the macroequilibrium unemployment rate (MRU) – a term I coined in 1987 (as part of my Phd and early published work).
As a result of the labour market changes, which accompany the business cycle, the MRU is considered to be cyclically sensitive and rises with the actual rate of unemployment. In other words, aggregate demand changes can influence the long-run steady-state unemployment rate subject to capacity constraints. This is what hysteresis is about.
Clearly there is a minimum irreducible unemployment rate that is equal to frictional unemployment. Steady-state rates above that are subject to change as the level of activity varies.
Wage demands in the private sector are inversely related to the actual number of unemployed who are substitutes for those currently employed. When the economy slows, many workers lose their skills through obsolescence and new entrants are denied relevant skills.
Structural imbalance, which refers to the inability of the actual unemployed to constitute an effective excess supply, rises in the downturn.
Increasing the structural imbalance thus drives a wedge between effective and actual excess supply. The effective excess supply is the threat component of unemployment. To some degree, this insulates the wage demands from the cycle. The more rapid the cyclical adjustment, the higher is the unemployment rate associated with price stability.
Stimulating jobs growth decreases the wedge because the unemployed develop new and relevant work skills. These upgrading effects provide an opportunity for real growth to occur as the unemployment rate associated with stable inflation declines.
Why will firms employ those without skills? An important reason is that hiring standards drop as the upturn begins. Rather than disturb wage structures, firm offer training with entry-level jobs. While the increased training opportunities increase the threat to those who were insulated in the recession, this is offset to some degree by the reduced probability of becoming unemployed.
The point is that the unemployment rate that balances the competing aspirations of workers and bosses for income shares (which conditions the fight over wage demands) varies with the economic cycle.
It might also vary with structural changes and policies designed to induce them.
But the fact that it varies with the economic cycle means that fiscal policy can reduce the unemployment rate without accelerating inflation.
So when Blanchard provides empirical evidence that there is “hysteresis”, which the Bloomberg article says:
… is primarily the consequence of what occurs in the labor market after workers lose their jobs in a recession: The longer they remain unemployed, the higher the risk they become “disenfranchised”
What he is really refuting is the central Monetarist claim (noted above) “that structural policies are needed to ensure more people can find work when the economy is running at full capacity”.
The trick is in debunking the Monetarist notion of “full capacity”, which they equate with the “natural rate of unemployment”, which is the unemployment rate where inflation is stable.
If that unemployment rate shifts then that particular notion of “full capacity” is meaningless. A more robust concept is the idea of a minimum irreducible unemployment rate where everyone who wants to work can find a job.
This is because the MRU is sensitive to the economic cycle and, hence, the deployment of fiscal policy. That observation is the anathema of what Monetarists think, especially the schools of thought that followed Friedman’s initial outline.
Once the rational expectations school was bolted onto Friedman’s ‘natural rate’ hypothesis then there was no scope for governments to reduce unemployment because there could be no ‘expectational’ errors along the lines that Friedman had originally conceived.
But this was just piling more nonsense on top of the existing nonsense, although careers and Nobel Prizes were made as a result.
So then the question comes down to what form of aggregate policy should a government use to prevent the damaging hysteresis where asymmetric movements in unemployment (rapid rise, persistent elevation, slow drop) follow economic recessions?
The Bloomberg article follows the mainstream diatribe that there is only one source of macroeconomic stimulus – monetary policy – that is, interest rate shifts.
This is, of course, the mainstream consensus these days.
The article claims that “hysteresis …. has major implications for today’s central banks, especially in the U.S. and the euro zone” because central banks are trying to work out when to hike rates but realise there is still considerable slack in their economies that could be reduced through more “quantitative easing” or through maintaining lower interest rates.
The article thinks that:
… what is needed is a combination of cyclical and structural policies. For central bank stimulus to help lower the “natural rate” of unemployment, governments have to put in place well-targeted retraining programs, which allow workers to rejoin the labor force. There may also be a case for tweaking the welfare system to encourage the long-term unemployed to look for work: Blanchard suggests that in a boom the U.S. government should be harsher with their disability benefits, which discouraged workers use as a form of income support during a crisis.
So not much change in the mainstream dogma.
1. Attack workers’ rights to adequate income support if unemployed – make them desperate and hungry so they accept any job at any pay.
2. Use disability support benefits to reduce the unemployment rate in a recession (politically useful) yet pillary these disabled workers in an upturn. The disabled workers become pawns in the political game to deny unemployment.
3. Force the unemployed into a sequence of poorly-conceived training programs, divorced from a paid work environment when all the evidence is that training is only really effective if combined with paid-work.
4. Pretend there is aggregate stimulus coming from monetary policy.
It is clear that all the so-called supply-side measures (retraining, starvation etc) only serve to shuffle the unemployment queue if there are insufficient jobs being created overall.
Recall the 100 dogs and 94 bones parable – see A Job Guarantee ensures there is always a job for the unskilled.
The other point is that monetary policy is an ineffective vehicle for providing aggregate stimulus.
Given the monetary policy gyrations in the last 10 years, if mainstream theory was correct, unemployment should be low everywhere and inflation accelerating through the roof.
Neither has happened.
As I have explained before, monetary policy is a blunt instrument. It works indirectly through interest rate changes which then impact on the cost of borrowing.
In a recession, no one wants to borrow whatever the cost because they either do not believe the sales environment will justify building new capital or they fear unemployment.
The most effective policy tool to vary aggregate spending is fiscal policy – adjusting tax rates and spending levels.
The GFC proved that without doubt. Where fiscal austerity was imposed, the early recoveries came to a screaming halt. Where there was no significant austerity, growth continued after the downturn was reversed.
So Friedman’s idea that fiscal policy was to be avoided in favour of monetary control has been categorically rejected by the evidence.
When the central banks became infested with Friedman’s ideas that they needed to follow money rules to stabilise inflation after the OPEC oil price hikes they soon found out that they were unable to control the money supply growth.
They abandoned monetary targetting soon after because it was a total failure.
Friedman’s insights were categorically wrong.
I recommend the 2012 book by Sharon Beder – Free Market Missionaries: The Corporate Manipulation of Community Values – published by Routledge.
She cites the work of Paul Diesing, who was a very venerable political scientist from the US (who studied economics at the University of Chicago where Friedman made his name) and who died in 2011 at the age of 89.
Diesing exposed the “faintly disreputable” and “not very rigorous” work of Friedman.
Beder, citing Diesing, wrote that in attempting to manipulate data to ensure it “fitted his hypotheses”. Friedman would:
1. If raw or adjusted data are consistent with [the hypothesis], he reports them as confirmation …
2. If the fit with expectations is moderate, he exaggerates the fit …
3. If particular data points or groups differ from the predicted regression, he invents ad hoc explanations for the divergence …
4. If a whole set of data disagree with predictions, adjusts them until they do agree …
5. If no plausible adjustment suggests itself, reject the data as unreliable …
6. If data adjustment or rejection are not feasible, express puzzlement.
And so it goes for much of the mainstream macroeconomics empirical work. Shoddy, based on a desire to ‘prove’ the unprovable.
Friedman was no exception – and his work has no relevance for sound policy development.
The Bloomberg article though seems oblivious to reality when it concludes:
… an important lesson of Friedman’s speech remains valid: If we want to ensure more people are well-employed, central banks alone will certainly not suffice.
And so we are back to the beginning again.
The lesson that the GFC brought homein spades is that if “we want to ensure more people are well-employed, central banks alone will certainly not suffice” because their policy tools are ineffective in manipulating aggregate spending.
Only fiscal policy is an effective means of accomplishing that task.
Which is a very un-Friedman-type statement.
I received a request to promote this Crowdfunding effort. I note that I will receive a portion of the funds raised in the form of reimbursement of some travel expenses. I have waived my usual speaking fees and some other expenses to help this group out.
The Crowdfunding Site is for an – Economics for a progressive agenda.
As the site notes:
Professor Bill Mitchell, a leading proponent of Modern Monetary Theory, has agreed to be our speaker at a fringe meeting to be held during Labour Conference Week in Brighton in September 2017.
The meeting is being organised independently by a small group of Labour members whose goal is to start a conversation about reframing our understanding of economics to match a progressive political agenda. Our funds are limited and so we are seeking to raise money to cover the travel and other costs associated with the event. Your donations and support would be really appreciated.
For those interested in joining us the meeting will be held on Monday 25th September between 2 and 5pm and the venue is The Brighthelm Centre, North Road, Brighton, BN1 1YD. All are welcome and you don’t have to be a member of the Labour party to attend.
It will be great to see as many people in Brighton as possible.
Please give generously to ensure the organisers are not out of pocket.
That is enough for today!
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