Like Yoda, Milton Friedman Crusades Against the Dark Side

25 years ago Milton Friedman was an economic Yoda teaching that money supply was an ever-present “Force” controlling the economy. With a new financial Death Star threatening, Friedman is remembered by the Federal Reserve’ Jedi Knights of money supply.

Before his death, Master Friedman was the “monetarists” leader. He taught that money supply determines economic activity and changes in the amount of money directly affects inflation, GDP and employment.

Like Jedi Knights in hiding, Friedman’s disciples are quietly emerging and using money supply as a light saber to avoid an economic catastrophe created by the banking crisis and defeat inflation caused by soaring commodity prices.

The Quantity Theory of Money

Monetarists’ unifying theory is called the “quantity theory of money” which states that GDP and inflation are directly affected by changes in the level of money supply. The quantity theory of money holds that GDP is equal to the amount of money available multiplied by the velocity of money. The velocity of money is the speed that money turns over or is spent and respent.

As an example, if a consumer has $100 that is used to buy dinner at a restaurant, $100 of GDP is created. When the restaurant respends the $100 to pay for food and electricity, GDP is $200 (the original $100 purchase and the respending of the $100) and the velocity is 2x. If the restaurant’s food suppliers and electric company respend the $100, GDP increases by another $100 and velocity is 3x. Every time the $100 is respent, GDP increases by $100 and the number of times it is respent is the velocity of money. As such, monetarists believe that GDP must equal the amount of money multiplied by the number of times it is respent.

Also, monetarists believe that there is a maximum velocity that money can be respent based upon practical and real world limits on how fast people can spend money. Monetarists teach that velocity will accelerate to the theoretical maximum rate and therefore is more or less constant. As a result, if the Federal Reserve sets the amount of money and the velocity is constant, then the Federal Reserve can determine GDP through monetary policy.

Monetarists believe that increasing money supply is the only way to have growing GDP (so if the consumer has $125 to spend rather than $100, GDP will be greater). Monetarists also believe that if money supply grows faster than the growth rate in GDP, then inflation will result. Similarly, if money supply grows slower than GPD growth, monetarists believe that deflation will be the consequence.

The Limits of Monetarism

While monetarism is a powerful economic force, in the 1970s and 1980s Friedman’s Jedi Knights at the Federal Reserve used money supply growth as their primary policy tool with poor results.

There were two principal problems with the Fed’s overreliance on monetarism. First, the amount of money in “money supply” is uncertain and changes for reasons beyond the Federal Reserve’s control. Second, the velocity of money is variable and also outside the Federal Reserve’s control. Since GDP is a combination of two factors beyond the Federal Reserve’s control, targeting money supply growth didn’t work well.

Monetarism and the Federal Reserve Today

Master Friedman wrote in Two Lucky People about a cause of the Great Depression:

“The Fed was largely responsible for converting what might have been a garden-variety recession, although perhaps a fairly severe one, into a major catastrophe. Instead of using its powers to offset the depression, it presided over a decline in the quantity of money by one-third from 1929 to 1933…Far from the depression being a failure of the free-enterprise system, it was a tragic failure of government.”

The Federal Reserve Jedi Knights know that without intervention, the current credit crisis will destroy money supply just like in the Depression. With aggressive action the Federal Reserve has preserved money supply and avoided disaster. The measurement problems of the 1970s and 1980s are irrelevant when money supply is being destroyed in an uncontrolled meltdown.

Also, Friedman warned that controlling money supply is the only way to control inflation. In A Monetary History of the United States 1867 – 1960, Friedman wrote

Inflation is always and everywhere a monetary phenomenon.

Since March, the money supply (as measured by M2) has been essentially unchanged and has shrunk in real terms. While holding short term interest rates low, the Federal Reserve used tight money supply to control inflation, promote a strong dollar and prick the commodity bubble.  The Fed seems to have adopted a “new way” of applying the old principals of the monetarists with good results to date. 

Just Luke Skywalker blowing up the Death Star, the money supply Jedi Knights have shown creativity as they honor their own personal Yoda, Master Milton Friedman.

Comments

[Umm, yeah:]

Or you could just lie about the gov't data including Inflation and GDP by stating hendonics and other Jedi mind tricks.

2008 Aug 19 04:22 PM

[pockyclips ...:]

That's like saying if the IRS withholds part of my paycheck for income tax, and then taxes me again on whatever I save, I should come out ahead. Morons!

2008 Aug 19 04:50 PM

[David Lentz:]

Actually, pockyclips, the evil gummint does NOT tax what you save, it only taxes the gains from your savings -- i.e., the money you make by saving.

And it even allows you to use misfortunes in your saving, the losses, to offset gains in other savings income, and to a limited extent, the income your employer gives you for showing up at work!

If you have been paying taxes on the amount that you save, then it is you who are the moron, and you should be filing for a refund.

If you are being taxed on your investing gains, then you should be coming out ahead, as the tax rate is less than 100%.

You actually get something for this bounty of taxation, you get the right to live in a society with laws and rules, without needing to dig your own well, farm/hunt for your own food, purchase a lot of goods and services protected by regulations and standards, and yet are still allowed to express most opinions and outright nonsense in public forums, and even read pretty much anything that anyone else writes. You most likely owe your ability to read at all to government-funded schools.

While it is certainly true that government taxation gets spent in ridiculous in sloppy ways, managing to stick to the fingers of our elected representatives, their friends, and anyone who is likely to that said elected reps for that largesse, the blame for that lies largely at the hands of the voters, who persist on being clueless idiots and re-electing the same crooks to office, over and over again.

2008 Aug 20 09:36 AM

[David Lentz:]

sorry for the incoherent gobblygook toward the end of the previous post. I blame Seeking Alpha's tiny input field, the lack of a preview or edit capability, and my own clumsiness.

2008 Aug 20 09:39 AM