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Wonking out: Money isn’t everything


Holiday shoppers outside of Macy’s department store in Manhattan in 1939.

By Paul Krugman


On Wednesday, Jerome Powell, 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 although 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.


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.


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.


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.


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 GDP? 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.


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, although 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.

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