Wonking Out: Money Isn’t Everything

On Wednesday, Jerome Powell, the chair of the Federal Reserve, testified before
Congress — always a chancy enterprise, because some politicians have strong
opinions about monetary policy that have little to do with expertise or evidence. Sure
enough, one Republican member of the House advised Powell to read Milton
Friedman — which one suspects he has. I assume that the questioner was suggesting
that printing money always causes inflation, which is the moral that casual readers of
Friedman usually take from his work.

Powell’s response was good as far as it went. “The connection between monetary
aggregates and either growth or inflation was very strong for a long, long time, which
ended about 40 years ago …. It was probably correct when it was written, but it’s
been a different economy and a different financial system for some time.”

What Powell didn’t point out was that while there was historically a strong
correlation between growth in the money supply and other economic indicators, in
many cases the causation ran from the economy to the money supply rather than the
other way around. This was especially true during the Great Depression. And that
matters, because Friedman’s claim that monetary policy caused the Depression was
central to his whole argument that governments, not the private sector, are
responsible for economic instability, that depressions are caused by governments,
not the private sector.
To be sure, when governments print huge amounts of money to pay their bills, so
that the money supply grows by hundreds or thousands of percent per year, high
inflation is inevitable. Here, for example, is Brazil’s experience in the first half of the
1990s:
Image

Inflation, old style.Credit...FRED

But matters are much less clear when monetary growth is less extreme. And the
connection between monetary policy and either inflation or growth more or less
disappears when interest rates are near zero — as they were during the Depression
and have been again since 2008:

Image

Zero, again.Credit...FRED
Let’s talk about the 1930s. The U.S. economy plunged between 1929 and 1933; gross
domestic product measured in dollars fell almost in half, reflecting both a huge drop
in real output and large-scale deflation. This plunge was associated with a large drop
in the money supply:

Image

Did the Fed do it?Credit...FRED

Friedman insisted that the Fed was responsible for this monetary contraction,
leading him to assert, for example in “Free to Choose,” a book he wrote with Rose
Friedman, that “the depression was not produced by a failure of private enterprise,
but rather by a failure of government.”

But if you read his argument carefully, it’s actually quite slippery, in fact borderline
disingenuous.

For as Friedman knew perfectly well, what economists call the “money supply” is, as
Powell said, a “monetary aggregate,” combining currency in circulation — pieces of
green paper bearing portraits of dead presidents — with bank deposits. (There are
several definitions of the money supply that differ in which deposits they count.) The
Fed doesn’t directly control this aggregate. All it can do is determine the size of the
“monetary base,” which is bank reserves plus currency.
And during the Depression, the monetary base didn’t shrink as the economy cratered
— it actually grew, a lot:
Image

Money that went nowhere.Credit...FRED

Why, then, did the money supply shrink? Partly because bank failures made people
nervous about the safety of bank deposits; partly because in a shrinking economy
people and businesses needed less money on hand for doing business. That is, the
economic implosion caused the decline in money rather than the other way around.

Friedman didn’t actually deny this. Although his rhetoric suggested that the
Fed caused the slump, if you look closely at his analysis, it says that the Fed could have
prevented the slump — a pretty big distinction.

And how could the Fed have prevented the slump, when a large increase in the
monetary base didn’t seem to prevent a sharp decline in both the money supply and
G.D.P.? Friedman’s claim was that if the Fed had engaged in sufficiently large
purchases of government bonds, that is, if it had increased the monetary base even
more — and if it had carried out those purchases early enough — it would have
headed off the monetary collapse.

But he wasn’t very clear about how, exactly, that would have worked. When the Fed
buys government debt from a bank, what does the bank do with the cash? In normal
times, we might assume that the bank would lend it out to the private sector, helping
to boost the economy. But in the Depression, interest rates were very low and the
perceived risks high. Why wouldn’t banks have just sat on extra cash, adding it to
their reserves?

Of course, we can’t rerun the history of the 1930s. As it happens, however, the 2008
financial crisis gave the Fed an opportunity to do what Friedman said it should have
done in the 1930s. The Fed hugely expanded the monetary base, and banks … just
added the money to their reserves:
Cash piles up at the banks.Credit...FRED

So the Fed found itself in the classic position of “pushing on a string”: It could print
money (well, actually create digital deposits, but never mind), but had no easy way to
get that money into the economy.

To be fair, the Fed took some crucial actions to stabilize financial markets early on,
and some economists believe that its asset purchases did help the economy. But
extraordinary monetary expansion didn’t prevent a severe slump. And if we didn’t
experience a full replay of the Great Depression, the main reason was probably that
we were willing to run big budget deficits — that is, we were saved from a worse
slump by the policies Friedman claimed were unnecessary.

So while Powell was right in saying that the correlation between money and growth
broke down after 1980, monetarism — roughly speaking, the doctrine that says the
money supply rules everything — was never supported by the evidence.

Paul Krugman has been an Opinion columnist since 2000 and is also a
Distinguished Professor at the City University of New York Graduate Center. He won
the 2008 Nobel Memorial Prize in Economic Sciences for his work on international
trade and economic geography. @PaulKrugman