by Serban V.C. Enache
Milton Friedman, a great American economist. He received the 1976 Nobel Memorial Prize in Economic Sciences. The father of the Monetarist current. Avid supporter of the so-called Free Market. His work influenced policy makers far and wide. Milton Friedman, a gentleman, a liar… His most precious contribution to the field of economics? The Quantity Theory of Money (QTM).
The famous equation reads as, MV = PQ. The money stock (M) times the velocity of money (V) is equal to the price level (P) times real output (Q). Perfectly straight forward with the equation. But what about the theory? Economists David Hendry and Neil Ericsson shall enlighten us.
Looking at the graph above we see Friedman and Anna Schwartz claiming that V (velocity) is stable, and we see Hendry and Ericsson claiming it’s not. Both groups used the same data. How come they came to different results? The answer lies in the vertical left sides of the graphs. The first graph is stretched upward, and causes a clear visual effect, it appears flatter.
Hendry told Ericsson that: “The graph in Friedman and Schwartz […] made UK velocity look constant over their century of data. I initially questioned your plot of UK velocity – using Friedman and Schwartz’s own annual data – because your graph showed considerable non-constancy in velocity. We discovered that the discrepancy between the two graphs arose mainly because Friedman and Schwartz plotted velocity allowing for a range of 1 to 10, whereas UK velocity itself only varied between 1 and 2.4.”
Testing Friedman and Schwartz’s equations revealed a considerable lack of consistency. They had phase-averaged their annual data in an attempt to remove the business cycle, but phase averaging still left highly auto-correlated, non-stationary processes. Friedman and Schwartz tried to mold reality to fit their theory and their attempt left footprints.
The following account by David Hendry makes it crystal clear. “Margaret Thatcher – the Prime Minister – had instituted a regime of monetary control, as she believed that money caused inflation, precisely the view put forward by Friedman and Schwartz. From this perspective, a credible monetary tightening would rapidly reduce inflation because expectations were rational. In fact, inflation fell slowly, whereas unemployment leapt to levels not seen since the 1930s. The Treasury and Civil Service Committee on Monetary Policy (which I had advised in) had found no evidence that monetary expansion was the cause of the post oil-crisis inflation. If anything, inflation caused money, whereas money was almost an epiphenomenon (a secondary effect, a byproduct). The structure of the British banking system made the Bank of England a lender of the first resort, and so the Bank could only control the quantity of money by varying interest rates.”
In the book by J.D. Hammond (1996) Theory and Measurement: Causality Issues in Milton Friedman’s Monetary Economics, published by Cambridge University Press (page 199) we see the letter that Hendry wrote to Friedman on July 13, 1984. “[…] if your assertion is true that newspapers have produced ‘a spate of libellous and slanderous’ articles ‘impugning Anna Schwartz’s and [your] honesty and integrity’ then you must have ready recourse to a legal solution.”
Unsurprisingly, Milton Friedman never sued.
Hendry notes that it was “unacceptable for Friedman and Schwartz to use their data-based dummy variable for 1921-1955 and still claim parameter constancy of their money-demand equation. Rather, that dummy variable actually implied non-constancy because the regression results were substantively different in its absence. That non-constancy undermined Friedman and Schwartz’s policy conclusions.”
In plain English, Friedman and Schwartz’s conclusions are invalid due to biases. The Monetarists claim that velocity of money is constant and that output is inelastic. So naturally, from these assumptions, any increase in M (money) will lead to an increase in P (price). When you build your conclusions into your assumptions, you end up with a tight knit theory that isn’t representative of the real world. The Friedman-Schwartz model is not a truthful characterization of the data and is inconsistent with the hypothesis of a constant money-demand equation.
Empirical work is definitely not kind to QTM. In 2005, economists Paul De Grauwe and Magdalena Polan subjected the Monetarist claims to empirical tests, using a sample that covered most countries in the world. When the full sample of countries was analyzed, they found a strong positive relation between the long-run growth rate of money and inflation. However, this relation was not proportional. The strong link between inflation and money growth was almost entirely due to the presence of hyperinflation countries in the sample. The relation between inflation and money growth for stable (low-inflation) countries was weak, if not absent.
In an interview with the Financial Times on June 7th 2003, Friedman himself admitted that monetary targeting as central bank policy had failed. “The use of quantity of money as a target has not been a success. I’m not sure I would as of today push it as hard as I once did.”
Milton Friedman’s lie was that inflation was a monetary phenomenon irrespective of context. In reality, though, inflation isn’t always everywhere a monetary phenomenon. Tragically, QTM is still the basis of mainstream economics.
Serban V.C. Enache is a Romanian journalist and indie author. Though interested in history, politics, and economics, his true passion is for medieval fantasy fiction. https://www.amazon.com/Serban-Valentin-Constantin-Enache/e/B00N2SJD6O/ He can be reached over Twitter. https://twitter.com/SerbanVCEnache