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Can Friedman's Money Rule Stabilize the Economy?

November 12, 2008

Tags Booms and BustsGold StandardMoney and Banking

 

In the midst of the most serious financial crisis since the Great Depression, some economists are currently trying to come up with answers as to how to stabilize the financial system. Most experts are of the view that greater control of financial markets is the answer. The late professor Milton Friedman would have been dismayed by such ideas. He held that the root of financial instability is the central banks' reactive policies, or countercyclical monetary policies.

Friedman held that such policies are the key factor behind fluctuations in money supply and thus fluctuations in economic activity. According to Friedman, what is required for the elimination of fluctuations is for the central-bank policy makers to aim at a fixed rate of growth of the money supply:

My choice at the moment would be a legislated rule instructing the monetary authority to achieve a specified rate of growth in the stock of money. For this purpose, I would define the stock of money as including currency outside commercial banks plus all deposits of commercial banks. I would specify that the Reserve System should see to it that the total stock of money so defined rises month by month, and indeed, so far as possible, day by day, at an annual rate of X per cent, where X is some number between 3 and 5. The precise definition of money adopted and the precise rate of growth chosen make far less difference than the definite choice of a particular definition and a particular rate of growth.[1]

Now if economic fluctuations or boom-bust cycles are caused by fluctuations in money supply, then it makes a lot of sense to eliminate such fluctuations in the rate of growth of money. So in this sense, the fixed-money rate-of-growth rule is the perfect solution.

Contrary to Friedman however, we suggest that the boom is not just about an increase in the rate of growth of the money supply; it is also about various nonproductive activities that spring up on the back of the expanding money-supply rate of growth. Furthermore, we maintain that an economic bust is not about a fall in the rate of growth of the money supply; it is about the elimination of various nonproductive activities on account of the decline in the rate of growth of the money supply.

An increase in the money supply out of thin air sets in motion the so-called "counterfeit effect." It lays the foundation for nonproductive activities, which consume and add nothing to the pool of real funding or real wealth. These activities divert real funding from wealth generators, thus weakening their ability to grow the economy.

The diversion occurs once various individuals that are the early receivers of newly printed money are able to push the prices of goods higher. Wealth generators that didn't receive the newly printed money discover that they can now secure fewer goods than before.

A fall in the money supply out of thin air undermines various nonproductive activities. Their ability to divert real funding from wealth generators is curtailed.

Note that, since nonproductive or bubble activities do not generate any real wealth, they cannot secure the goods they require in an honest way without the support from money out of thin air.

A major problem with the Friedman rule is that we are still going to have an expansion in the money supply out of thin air. (Remember, Friedman advocates the expansion of money at a constant percentage.) This in turn means that various nonproductive activities will be generated.

Once the percentage of nonproductive activities out of all activities starts to increase, this raises the likelihood of an increase in banks' bad assets. Consequently, banks' expansion of credit is likely to slow down and this in turn will weaken the rate of growth of money supply.

A fall in the rate of growth of money will undermine various nonproductive activities. This will set in motion an economic bust.

From this we can infer that, because of banks' conduct, it is not possible to sustain a constant-money rate of growth. This means that Friedman's rule cannot be implemented. Indeed, the Federal Reserve tried to implement Friedman's rule in the early '80s but was unsuccessful.

Let us, however, make the unrealistic assumption that the central bank is successful in maintaining the money-supply rate of growth at a fixed number. Will this lead to economic stability as suggested by Milton Friedman?

We have seen that printing money always creates false nonproductive activities. So if the fixed-money rule were to be enforced, over time it would lead to the expansion of false nonproductive activities. This, as we have seen, is going to weaken the wealth generators and thus undermine the real economy.

The longer that Friedman's rule is implemented, the worse it is going to be for wealth generators and hence for the foundations of the economy. At some stage, once the percentage of false activities surpasses the 50% mark, the economy is going to collapse.

We can thus conclude that Friedman's monetary rule is another way of tampering with the economy; it cannot lead to economic stability.

The better solution—offered by the Austrian School of economics, aims at bringing back the market-chosen money, which is gold.

But even if we bring back the gold standard, the money-supply rate of growth is going to fluctuate. Remember that fluctuations in money supply are associated with fluctuations in economic activity. From this, one may be tempted to conclude that even on the gold standard boom-bust cycles can't be eliminated. But is it true that increases in the supply of gold will generate similar distortions that money out of thin air does? We suggest that this is not the case. Here is why.

The Gold Standard and Boom-Bust Cycles

Let us start with a barter economy. John the miner produces ten ounces of gold. The reason why he mines gold is because he believes there is a market for it. Gold contributes to the well-being of individuals. He exchanges his ten ounces of gold for various goods such as potatoes and tomatoes. Note that the fact that John can exchange his gold for other goods means that gold offers benefits to the buyers. (For instance, people use gold for making jewelry.)

Now people have discovered that gold, apart from being useful in making jewelry, is also useful for some other applications. They now assign a much greater exchange value to gold than before. As a result, John the miner can exchange his ten ounces of gold for more potatoes and tomatoes.

Should we condemn this as bad news because John is now diverting more resources to himself? This, however, is just what is happening all the time in the market. As time goes by, people assign greater importance to some goods and diminish the importance of some other goods. Some goods are now considered as more important than other goods in supporting one's life and well-being.

Furthermore, people now discover that gold is useful for another use such as to serve as the medium of exchange. Consequently they lift further the price of gold in terms of tomatoes and potatoes. Gold's most prominent  demand currently is for its services as a medium of exchange. The demand for its other services—e.g., for ornaments—is now much lower than before.

The benefit that gold now supplies people is by providing the services of the medium of exchange. In this sense, it is a part of the pool of real wealth and promotes people's life and well-being. When John the miner exchanges gold for goods he is engaged in an exchange of something for something. He is exchanging wealth for wealth.

Let us see what happens if John increases the production of gold. One of the attributes for selecting gold as the medium of exchange is that it is relatively scarce. This means that a producer of a good who has exchanged this good for gold expects the purchasing power of his effort to be preserved over time by holding gold.

If, for some reason, there is a large and persistent increase in the production of gold, the exchange value of the gold will be subject to a persistent decline versus other goods, all other things being equal. As the supply of gold starts to increase, its role as the medium of exchange is likely to diminish, while the demand for it for some other uses is likely to be retained or to increase.

So in this sense, the increase in the production of gold adds to the pool of real wealth. (People might abandon gold as a medium of exchange but still find it useful for other applications.) Note that the increase in the supply of gold is not an act of embezzlement or fraud. The increase in the supply of gold doesn't produce an exchange of nothing for something.

Contrast all this with the printing of gold receipts, i.e., receipts that are not backed 100% by gold, i.e., money out of thin air. This is an act of fraud, which is what inflation is all about; it sets a platform for consumption without making any contribution to the pool of real wealth. Empty certificates set in motion an exchange of nothing for something, which in turn leads to boom-bust cycles.

Again in the case of the increase in the supply of gold no fraud is committed here. The supplier of gold—the gold mine—has increased the production of a useful commodity. So in this sense we don't have here an exchange of nothing for something. Consequently, we also don't have an emergence of bubble activities. Again the wealth producer, because he has produced something useful, can exchange it for other goods. He doesn't require empty money to divert real wealth to him.

On the gold standard an increase in the rate of growth of money, which is gold, will not set in motion the emergence of bubble or false activities, i.e., an economic boom. A fall in the money rate of growth is not going to trigger an economic bust—no bubble or false activities were created that are going to be busted by a slower money rate of growth.

Note that the disappearance of money out of thin air is the major cause of an economic bust. The injection of money out of thin air generates bubble activities while the disappearance of money out of thin air destroys these bubble activities.

On the gold standard this cannot take place. On a pure gold standard, without the central bank, money is gold. Consequently, on the gold standard, money is unlikely to disappear since gold cannot disappear unless it is physically destroyed. We can thus conclude that the gold standard, if not abused, is not conducive to boom-bust cycles.

Conclusions

The famous economist Milton Friedman observed that fluctuations in the rate of growth of money supply could be an important factor behind boom-bust cycles. He suggested that central banks should aim at stabilizing the money rate of growth at some percentage, and keep it at this number for an indefinite time. Friedman held that by maintaining the money-supply rate of growth at a fixed percentage, the Fed could keep the economy on a path of stable growth without boom-bust cycles. Friedman's money rule however is still about printing money, and in this sense it is going to generate the same effect as any money printing does, i.e., boom-bust cycles. We have shown that only a pure gold standard is immune to boom-bust cycles.

Notes

[1] Friedman, Milton, Dollars And Deficits, Prentice Hall, 1968, p. 193.

 


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