Friday, November 16, 2018

Solow on Friedman's 1968 Presidential Address and the Medium Run

Fifty years ago in 1968, Milton Friedman's Presidential Address to the American Economic Association set the stage for battles in macroeconomics that have continued ever since. The legacy of the talk has been important enough that in the Winter 2018 issue of the Journal of Economic Perspectives, where I work as Managing Editor, we published a three-paper symposium on "Friedman's Natural Rate Hypothesis After 50 Years."
Likewise, the Review of Keynesian Economics has committed now most of its October 2018 issue to a nine-paper symposium on the issues raised by Friedman's presidential address. The first two papers in the issue, by Robert Solow and Robert J. Gordon, are freely available on-line, with the rest of the issue requiring a library subscription. Here, I'll focus mainly on Solow's comments.

What was the key insight or argument in Friedman's 1968 address? Friedman offers a reminder that interest rates and unemployment rates are set by economic forces. Friedman uses this idea to build a distinction between the long-run and the short-run. In the short run, it is possible for a central bank like the Federal Reserve to influence interest rates and the unemployment rate. In the long run, there is a "natural" rate of interest and a "natural" rate of unemployment which is trying to emerge, gradually, over time from all the various forces in the economy

This short-run, long-run distinction then led to differing views over the appropriate role of government macroeocnomic policy. In the magisterial Monetary History of the United States that Friedman had published in 1963 with Anna J. Schwartz, they make a powerful case that the effect of monetary policy in the past had often been to make the macroeconomic situation worse, rather than better. Given the practical imperfections faced by monetary policy (including time lags and political biases in the the policy response and the long and variable lags in how monetary policy affects macroeconomic variables),  Friedman argued that the “first and most important lesson” is that “monetary policy can prevent money itself from being a major source of economic disturbance.” While Friedman was open to the idea of macroeconomic policy responding to extreme economic situations, he worried about policy mistakes and overreactions.

One standard counterargument was that monetary policy and the macroeconomy had become much better understood over time, thanks in part to Friedman's work. Thus, example of past misguided policy should not immobilize central bankers thinking about future policy choices.

Robert Solow is a notable player in these disputes: in particular, in his 1960 paper with Paul Samuelson, "Analytical Aspects of Anti-Inflation Policy" (American Economic Review, 50:2, pp. 177-194). In an essay in the Winter 2000 issue of the Journal of Economic Perspectives, "Toward a Macroeconomics of the Medium Run,"  Solow addressed this question of thinking about macroeconomic policy in the short- and the long-run. He wrote:
I can easily imagine that there is a “true” macrodynamics, valid at every time scale. But it is fearfully complicated, and nobody has a very good grip on it. At short time scales, I think, something sort of “Keynesian” is a good approximation, and surely better than anything straight “neoclassical.” At very long time scales, the interesting questions are best studied in a neoclassical framework, and attention to the Keynesian side of things would be a minor distraction. At the five-to-ten-year time scale, we have to piece things together as best we can, and look for a hybrid model that will do the job.
In this most recent essay, "A Theory is a Sometime Thing," Solow pushes this idea of medium-run thinking harder. He acknowledges that if a central bank can only cause the interest rate and unemployment rate to shift for a year or two, in the short-run before a rebound to what is determined in the long run, then when problems of lags in timing are included, macroeconomic policy might be dysfunctional. But if a central bank can affect the interest rate and the unemployment rate for a medium-run period of, say 5-7 years, then even with some uncertainty and lags, macroeocnomic policy may be quite relevant and possible. At one point, Solow writes: "The medium run is where we live."
On the issue of interest rates, Solow points out in the late 1970s and early 1980s, Paul Volcker's actions pushed up interest real interest rates substantially, such that the real federal funds interest rate "rose sharply to about 5 percent and fluctuated around that level for the next six years ...This sustained 5 percentage point increase in the real funds rate was not a random event. It was a deliberate intervention, designed to end the ‘double-digit’ inflation of the early 1970s, and it did so, with real side-effects. ... So the Fed was in fact able to control (‘peg’) its real policy rate, not for a year or two but for at least six years, certainly long enough for the normal conduct of counter-cyclical monetary policy to be effective. 
The history of the Bernanke/Yellen Fed is more complicated ..... The Fed was apparently able to lower the real ten-year Treasury bond rate for half a dozen years, 2011–2016. Of course there are many influences on the real long interest rate; it is at least plausible that large Fed purchases contributed to the outcome that the Fed was consciously seeking. The difference between ‘a year or two’ and ‘half a dozen years’ is not a small matter.
What about the natural rate of unemployment? One implication of Friedman's arguments was that if the government used macroeconomic policy in an attempt to hold the unemployment rate below it's natural rate in the long-run, it would lead to surges of ever-higher inflation. As Solow notes, in the 1970s and early 1980s, sharp drops in the unemployment rate do seem associated with rising inflation. But the main story about inflation in the last 20-25 years is that it doesn't seem to react to much: it doesn't get a lot higher or a lot lower as the unemployment rate rises and falls. Solow goes so far as to claim: "[T]there is no well-defined natural rate of unemployment, either statistically or conceptually."

For a more positive gloss on the legacy of Friedman's argument and its applications to modern macroconomics, I commend your attention to the JEP articles listed above. Here, Solow ends  his note with the kind of elegant rhetorical flourish that he brings to so much of his writing:
"A few major failures like those I have registered in this note may not be enough for a considered rejection of Friedman's doctrine and its various successors. But they are certainly enough to justify intense skepticism, especially among economists, for whom skepticism should be the default mental setting anyway. So why did those thousand ships sail for so long, why did those ideas float for so long, without much resistance? I don't have a settled answer.
One can speculate. Maybe a patchwork of ideas like eclectic American Keynesianism, held together partly by duct tape, is always at a disadvantage compared with a monolithic doctrine that has an answer for everything, and the same answer for everything. Maybe that same monolithic doctrine reinforced and was reinforced by the general shift of political and social preferences to the right that was taking place at about the same time. Maybe this bit of intellectual history was mainly an accidental concatenation of events, personalities, and dispositions. And maybe this is the sort of question that is better discussed while toasting marshmallows around a dying campfire."
Here's a Table of Contents for the relevant papers in the October 2018 issue of the Review of Keynesian Economics:
Along with the JEP papers mentioned earlier, those interested in the subject may also want to consult the paper by Edward Nelson, “Seven Fallacies Concerning Milton Friedman’s `The Role of Monetary Policy,'" *Finance and Economics Discussion Series 2018-013, Board of Governors of the Federal Reserve System,