Category Archives: Milton Friedman

Helicopter money – An introduction


Your humble narrator recently had an article in the Wall Street Journal about the new idea in monetary policy, ‘helicopter money’. An earlier draft had a rather tedious discussion of what it was. Mercifully excised from the printed version, I still thought it might be worth sharing. I’ve little doubt you’ll be hearing more about it soon…

Helicopter money takes its name from a 1969 paper by Milton Friedman called The Optimum Quantity of Money. In it Friedman set out to investigate just that. To analyse how people would adjust their cash holdings to achieve this optimum if the money supply were increased, he conducted a thought experiment in which a helicopter flew over a country dropping newly printed money. The point was simply to model an exogenous increase in the money supply, much as David Hume had in his 1752 essay Of Money. Indeed, Friedman also imagined a furnace destroying piles of cash in an effort to model the effects of an exogenous decrease in the money supply. The key point is that when Friedman wrote about helicopter money, he was not advocating anything like the policies currently bearing that title.

How has it come to this? Since the crash of 2008-2009, developed country economies have been stuck with sluggish growth. Their governments also have historically high peacetime levels of debt and new borrowing. With fiscal policy thus constrained, if stimulus is to be administered it is the central banks who will have to do so using monetary policy. Still others think that fiscal policy would be ineffective in any event. Either way, central banks are, as Mohamed El-Erian has written recently, the only game in town.

But the record of monetary policy’s impact is mixed. In 2002, Bernanke gave a speech frequently cited by advocates of activist monetary policy in which he argued that “under a paper-money system, a determined government can always generate higher spending and hence positive inflation”. But in recent years it hasn’t worked like that. Central banks have churned out new base money and pumped it into the banking system in return for (government) bonds, Quantitative Easing. As a result, in Britain, the monetary base has risen by 516% since May 2006. But, for the most part, this money has just sat on bank balance sheets; they have not used it as the basis for the creation of new credit. Hence, over the same period, broad money has risen by just 53%. The transmission mechanism of monetary policy via the banking system is blocked and increases in base money have not filtered through to increases in spending, also known as nominal GDP or aggregate demand. JK Galbraith’s old quip about expansive monetary policy “pushing on a string” has never been truer.

To look at it another way, consider the equation of exchange from your economics textbooks, one form of which is MV=Py. This says that the money supply (M) multiplied by the velocity of circulation (V) equals the price level (P) multiplied by output (y). Velocity of circulation – how many times in a given period a unit of money is spent – can serve as a useful proxy for the demand for money. If the demand to hold money increases, its velocity (V) falls. Conversely, if that demand falls and people want to swap their money holdings for goods or services, V rises. Velocity is the inverse of the demand for money.

When mortgage backed assets tanked in 2008, banks saw their balance sheets ravaged. They desperately demanded cash to shore them up, their V had fallen, in other words. In an effort to ward off a fall in prices and/or output (Py), central banks offset this by increasing M via low interest rates and QE.

But if the aim is to use increases in M to boost Py then the new money must be given to people whose demand to hold money has either fallen or not risen (their V is constant or rising); to put money in the hands of those who would spend it and boost prices rather than hold it as banks have done. This is where the helicopter comes in.

The success of this policy all depends on whether raising a nominal variable (the price level, P) will also raise a real variable (output, or y), that there is a Phillips’ Curve relationship, in other words. This is the notion of an inverse relationship between inflation and employment, which was long presumed dead among the rubble of the Stagflationary 1970s.

This is a point I intend to return to soon. 


The economics of Ghostbusters – Harold Ramis, 1944-2014

Ghostbusters was a favourite film of mine as a kid, so much so that when I was off school ill once I got a pad of paper and a pen and wrote out the whole script from memory. That script was co-written by Harold Ramis who died this week. As a tribute here is an extract from something I wrote on 2012

A different attitude to wealth creation (from Brewster’s Millions) is on display in one of the classics of 1980s cinema, Ghostbusters.

Three government employees spend their days trying to seduce their female students with phony experiments and running away from ghosts. When this dismal level of productivity proves too low even for the public sector they are sacked and go private, though not without misgivings.

As Ray Stanz (Dan Aykroyd) warns Peter Venkman (Bill Murray), “Personally, I liked the university. They gave us money and facilities. We didn’t have to produce anything! You’ve never been out of college. You don’t know what it’s like out there. I’ve worked in the private sector. They expect results.”

Spotting a gap in the market (“We are on the threshold of establishing the indispensable defense science of the next decade. Professional paranormal investigations and eliminations. The franchise rights alone will make us rich beyond our wildest dreams”) the three borrow some money and set up the Ghostbusters.

Soon they are raking in $5,000 a night, getting coverage from Larry King and Time magazine, and taking on a black member of staff, no affirmative action needed.

Then up pops Walter Peck of the Environmental Protection Agency. “I want to know more about what you do here” he demands. “Frankly, there have been a lot of wild stories in the media and we want to assess for any possible environmental impact from your operation, for instance, the presence of noxious, possibly hazardous waste chemicals in your basement. Now you either show me what’s down there or I come back with a court order!”

With Venkman an unlikely John Galt the government steps in, shuts down the thriving private sector enterprise, and the town is flooded with ghosts.

Where Brewster’s Millions is an object lesson in the wasteful uselessness of Keynesian economics, Ghostbusters is one of the most pro free market films ever made, a hymn to the genius of capitalism and the clumsy damage wrought by government.

Or, to quote another economist, Milton Friedman, “If you put the federal government in charge of the Sahara Desert, in five years there’d be a shortage of sand”

Milton Friedman and the rise and fall of the Phillips Curve

AW Phillips with ‘the economy’

David Ricardo’s idea of the impossibility of general gluts, John Maynard Keynes wrote, “conquered England as completely as the Holy Inquisition conquered Spain.” The triumph of the Phillips Curve in post war economics was not quite so complete but its rise, fall, and fallout, is a fascinating intellectual episode. It shows how Keynesianism died the last time and its defenestration marked one of the most stunning achievements of Milton Friedman who was born a century ago this year.

In 1958 AW Phillips, a New Zealander working at the London School of Economics, published The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957. Based on data going back nearly a century, Phillips discovered a close inverse relationship between unemployment and percentage changes in the average nominal wage rate; as one rose, the other fell.

If the percentage change in money wages was taken as a proxy for inflation (a big assumption) then the curve which emerged from this inverse relationship, which Phillips gave his name to, offered a choice to policymakers: they could trade higher unemployment for lower inflation and, vice versa, they could trade higher inflation for lower unemployment. Economic policy was reduced to a simple choice between these two options.

In 1968, at the height of the Phillips Curve’s influence, Friedman gave the Presidential lecture to the American Economic Association titled The Role of Monetary Policy. The Curve was nonsense, he said, at least in anything but the very short term.

The Phillips Curve offered lower unemployment at the price of higher inflation. But, if economic agents became aware of this, that the new nominal wealth represented no increase in real wealth, they would adjust their expectations accordingly.

phillipsSo, on this graph, you have an initial Phillips Curve Pe=0% with an unemployment rate of U. You decide, in Keynesian fashion, to juice the economy to reduce this rate. Unemployment falls to V and inflation rises to 5 percent.

But, Friedman argued, when it became apparent that only nominal values had changed real values would adjust to accommodate. This meant unemployment rising again to W. Friedman said that once economic agents – workers, bosses, trade unions etc – came to factor an inflation rate of 5 percent into wage bargains only by increasing the inflation rate above this could policymakers exert any traction over unemployment. Ever higher rates of inflation would be necessary to generate even short term falls in unemployment and that short term would get shorter all the time.

So, above, they could increase inflation to 8 percent and see unemployment fall from W to X. But, as before, once real values adjusted, unemployment would rise again to Y.

The values for unemployment U, W, and Y, form, in fact, a new vertical curve representing the ‘natural’ rate of unemployment. That this rate (technically called the Non-Accelerating Inflation Rate of Unemployment – NAIRU) was called ‘Natural’ did not mean it couldn’t be changed. But it was set by microeconomic factors such as wage flexibility and labour mobility and labour market reforms became a major policy theme of the 1980s.

Friedman’s prediction, made in 1968, was that the coming years would see inflation and unemployment rise together, something the dominant Keynesian paradigm, of which the Phillips Curve was part, said was impossible. Yet this is exactly what happened. Between 1969 and 1975 inflation in the United States rose from 5.9 percent to 9.1 percent while unemployment rose from 3.8 percent to 8.5 percent.

phillips2Keynesians were at a loss to understand it. In 1971 Arthur Burns, Chairman of the Federal Reserve, complained that “The rules of economics are not working in quite the way they used to. Despite extensive unemployment in our country, wage rate increases have not moderated. Despite much idle industrial capacity, commodity prices continue to rise rapidly.”

By 1976 even Labour Prime Minister Jim Callaghan had recognised the truth of Friedman’s 1968 insight, saying

“We used to think that you could spend your way out of a recession, and increase employment by cutting taxes and boosting Government spending. I tell you in all candour that that option no longer exists, and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step. Higher inflation followed by higher unemployment”

Curiously, despite the fact that trade unions are still blamed for the inflation of the 1970s, Friedman completely exonerated them. They were simply acting to restore their real wealth in the face of inflation (up to a point anyway). It was the Keynesians with their ‘cost push’ theory of inflation (that prices rise because prices rise) who pinned the blame on the trade unions.

The same applied to the other popular inflationary bogeyman, oil prices. Theoretically Friedman argued that an increase in the price of one good, if consumption was to remain constant, meant a reduction in spending on other goods and a fall in their prices. Only with an expanded money supply could a rise in the price of oil not cause offsetting price falls elsewhere.

Empirically he showed that countries like Germany and Japan, which imported more of their energy than Britain or the US but had tighter monetary policies, experienced lower inflation after the ‘oil shocks’. Inflation was, to Friedman, “always and everywhere a monetary phenomenon.”

The Phillips Curve lay dead amid the Stagflation of the 1970s just as Milton Friedman had predicted it would. Keynesian fiscal tools of demand management gave way to Supply Side policies aimed at reducing the NAIRU. Monetary tools were replaced by bastardised versions of another Friedman idea, monetarism.

An ironic post script to this story is Friedman’s own Phillips Curve moment. In his Monetary History of the United States, 1867 – 1960, he found that fluctuations in the money supply on the M2 measure were correlated with fluctuations in output. Thus he proposed his k-percent rule which proposed that expansion of the money supply should be fixed at some percentage figure corresponding to underlying productivity growth to give a stable price level.

Little of what was done in monetarism’s name followed this prescription. Even Margaret Thatcher’s supposedly monetarist government adopted a succession of varying, pre-announced targets for various money supply measures much as the Federal Reserve did under Paul Volcker. “If this is monetarism” Friedman said “I am not a monetarist”.

But even so, the statistical correlation between M2 and output upon which Friedman had based his theory collapsed as had the statistical correlation between unemployment and changes in money wage rates which Phillips had observed. A British monetarist, Charles Goodhart, coined Goodhart’s law which stated that “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”

Keynes wrote in 1931 that “If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid.”

By contrast, writing in 1988 Friedrich von Hayek reflected that “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” But then Hayek had the benefit of 50 years experience of ‘economic management’. This 50 years covered the ascendancy of the Phillips Curve and then monetarism and it showed that economists are no better at economic management than politicians.

This article originally appeared at The Commentator