Monetary Economics: Trends, Tools, Framework Changes, and Challenges Facing...
Monetary Economics: Trends, Tools, Framework Changes, and Challenges Facing Policymakers
--An exclusive interview with Benjamin M. Friedman, the William Joseph Maier Professor of Political Economy and formerly Chairman of the Department of Economics at Harvard University
Author: Dr. GAO Zhanjun Benjamin M. Friedman
In an exclusive interview with China Forex, Benjamin M. Friedman, William Joseph Maier Professor of Political Economy and formerly Chairman of the Department of Economics at Harvard University, shared his views with GAO Zhanjun, Executive Editor-in-Chief of China Forex, on issues at the forefront of monetary policy.
Benjamin M. Friedman is the William Joseph Maier Professor of Political Economy, and formerly Chairman of the Department of Economics, at Harvard University. He is a fellow of the American Academy of Arts and Sciences and a member of the Council on Foreign Relations. His current professional activities include serving as a director of the Council for Economic Education. He is also a long-time director and member of the editorial board of the Encyclopaedia Britannica.
Among other distinctions, Mr. Friedman has received the George S. Eccles Prize, awarded annually for excellence in writing about economics; the John R. Commons Award, given every two years in recognition of contributions to economics; and the Medal of the Italian Senate.
Mr. Friedman’s latest book, published by Knopf in January 2021, is Religion and the Rise of Capitalism. This book, a fundamental reassessment of the foundations of current-day economics, is about to come out in Chinese translation. His two other general interest books have been The Moral Consequences of Economic Growth (Knopf) and Day of Reckoning: The Consequences of American Economic Policy Under Reagan and After (Random House).
In addition to these works for the general public, Mr. Friedman has also written and/or edited fourteen other books, and more than 150 articles in professional journals, aimed primarily at economists and economic policymakers.
Much of this work has focused on economic policy, and in particular on the role of the financial markets in shaping how monetary and fiscal policies affect overall economic activity. Specific subjects of this work have included the effects of government budget deficits, guidelines for the conduct of US monetary policy, and appropriate policy actions in response to crises in a country's banking or financial system. Mr. Friedman is also a frequent contributor to publications reaching a broader audience, including especially The New York Review of Books.
The conversation, which follows in edited form, has documented a variety of crucial issues at the forefront of monetary policy.
Discussion 1
Inflation, Unemployment, and Monetary Policy
Dr. Gao: I'm thrilled to have you today, Ben, and thank you very much for accepting my invitation to do this interview.
Professor Friedman: Delighted to be with you, Zhanjun.
Dr. Gao: Ben, your work is well known to our Chinese readers. We often refer to you as "little Friedman," a title borne out of our deep respect for you. Although you may not always agree with Professor Milton Friedman's theories or opinions, we highly value and appreciate your contributions to the field of economics. August 22nd marks an additional special day today. Quite fascinating to know, the prestigious Kansas City Federal Reserve's Jackson Hole Economic Policy Symposium–a renowned annual economic event—will commence in a few hours. It is even more interesting to note that the theme of this symposium is "Reassessing the Effectiveness and Transmission of Monetary Policy", which aligns seamlessly with our core theme for this discussion today.
Let's start with your research. Over the past five decades or so, you have continued throughout to write books and articles which reflect the impressive scope of your research and its considerable impact on monetary economics, public economics, and financial economics, to name just three fields which you have made important and durable contributions.
Among the books, one titled Inflation, Unemployment and Monetary Policy (published in January of 1999) was translated into Chinese as early as 2004. This important book, focusing on the fundamental issues facing monetary policy, including the connection between price inflation and real economic activity, the Phillips curve, the effects of monetary policy actions, and dilemmas facing US monetary policymakers, reflected the famous debate and discussions on monetary policy back in the 1990s and have had tremendous influence.
As the Chair of the discussions and editor of the book, could you please tell us more about the background of this debate back then? To what extent is this still relevant and meaningful for today's monetary policy making?
Professor Friedman: To address your question, Zhanjun, we have to go back to before the beginning of this millennium.
In the last, I would say, three decades of the 20th century, the overwhelming task of central banks around the world, especially in the industrially advanced countries, was to reign in and then keep under control what had been high and chronic price inflation virtually throughout the world.
There was debate over how much responsibility central banks played for the inception of the inflation, but virtually everybody agreed that it was the responsibility of central banks to get the inflation under control.
And indeed they did, so that by the time we got to the end of the 20th century, we were back in a world of relatively stable prices in most of the industrial countries.
That was the setting for the book and discussions that you described. They came out of a symposium that I chaired here at Harvard.
The main issue at that time, I believe, was whether central banks should lock themselves into some kind of fixed, rule-based monetary policy, and if so, what the rule should be, or, alternatively, preserve wide latitude of discretion in adjusting policy to circumstances as they saw them, and then in that case, what the discretion should be based on.
My own view always was and continues to be that the world is simply too complicated for any kind ofstrict rule-based monetary policy to be effective.
And I have to tell you that the experience in the 20 years or so since that book was published has strengthened my view along those lines.
I think in the first instance of the Great Financial Crisis (GFC) of 2007, 2008, and 2009, and the severe economic downturn which followed. In the United States, it was the worst economic recession we've had since the Great Depression of the 1930s.
I think next of the crisis in the euro area, which the European Central Bank under Mario Draghi addressed in the five or six years following the Great Financial Crisis.
And then thirdly, I think of the strains created by the coronavirus, the pandemic beginning in 2020 and on into 2021.
I simply do not see how central banks operating under some fixed rule could have done an effective job in either preventing inflation in some episodes or preventing severe declines in economic activity in others.
That debate over what we would compactly call rules versus discretion was the main argument at issue in that Harvard debate from years ago.
But at the same time, another issue was one that has given economists enormous difficulty in the years since. And that is, as you rightly mentioned, the Phillips curve, namely the relationship between utilization of resources in economies, certainly including labor resources but not limited to labor resources, andwhat happens to prices and wages.
Basic economic logic suggests that the nature of competitive markets is such that when there is greater strain on the utilization of resources, again both labor and other, that's when prices, including wages, will rise.
The truth of the matter is that in the most recent decades it has been very difficult to pin down with any precision a clear relationship between resource utilization, say the unemployment rate, on one side and price inflation on the other.
So, if we were to go back to just as recently as say five years ago, right before the pandemic, one frequently heard -- not from economists, but in the popular press -- the idea that the Phillips curve is dead.
Now, I don't think anybody really believed that, because if we really thought that there was no relationship between resource utilization and price inflation, why shouldn't a central bank drive the unemployment rate all the way to zero?
We stew a lot in the United States about whether three and a half percent or four and a half percent is the right in unemployment rate to aim for. Why not two? Why not one? Why not zero point one? If we really thought that the Phillips curve didn't apply, why not get every last American on the job?
Now, clearly, we don't think that. And so, my suggestion is next time you hear somebody say the Phillips curve is dead, a good reply is,do you think the unemployment rate the central bank should aim for is zero point one? And see what the person says.
But I think you rightly point out that the whole issue ofthe Phillips curve has been very fraught in recent years. People thought that the relationship was very weak.
Now, in the recent period, we had a round of unacceptably high inflation in the United States and other countries. Economists have yet to sort out to what extent that was due to Phillips curve type issues, again including excessive employment of labor.
The situation is wildly distorted by the pandemic. So it's going to take a long time to figure it out.
But I would say, in contrast to the rules versus discretion issue that was one of the elements underlying that Harvard discussion years ago to which you point, and which I think has now been more or less resolved,I think the Phillips curve issues remain and will likely be the major subject of debate among economists in the central banking area for quite some years to come.
Discussion 2
New trends in thinking about the monetary policy transmission mechanism
Dr. Gao: Monetary policy transmission mechanism is the main theme of this year’s Jackson Hole Economic Symposium. Truly, monetary policy transmission mechanism has always been a focus of research for so many years. Why is it so important?
Professor Friedman: Nobody cares what the central bank does per se. That's not interesting. What matters, and the reason we have a central bank in the first place, is to influence what happens in the economy that in turn affects the lives of hundreds of millions of people in our country and comparably large groups of people elsewhere. What matters is whether people have jobs, whether they're earning incomes, whether businesses have profits, whether businesses are investing, whether prices are stable or rising.
That's what people care about.And if we go through that list of what people care about, itis quite far removed from the actions that central banks are taking in adding reserves to the banking system or changing some interest rate.
So there has to be some story by which the actions that the central bank takes have an effect on these ultimate economic outcomes that people care about.
Otherwise, why bother? Why has central bank in the first place? The answer is that they are connected. And the process by which they are connected is what you're referring to as the transmission mechanism.
I don't like the word mechanism, but you're right, it is the standard phrase that people have used for decades. I don't like the word because it implies, well, something mechanistic, something deterministic. It makes it sound as if the process is as straightforward as you put your foot on the accelerator in your car, and we all know that that causes gasoline to be fed into the carburetor of your engine, and the carburetor puts the gasoline into the engine in a particular way, and the engine runs faster, and then there are a bunch of gears that connect the engine to the wheels and the driveshaft of your car, and the car moves forward. That isn't a good metaphor in any way for the very complicated and often hard to understand process by which the central bank's actions affect the economic activities that we care about.
The process starts, to repeat, with the central bank either adding reserves or withdrawing reserves through the purchase or sale of bonds in the financial market. That affects the balance sheet positions of banks. That in turn affects their willingness to lend, or to acquire securities. That then affects the interest rates on various kinds of debt instruments. It also affects the prices of equities and other financial instruments. That in turn has an effect on broader classes of financial instruments and even non-financial assets like real estate including people's houses. All of that affects the wealth that ordinary people havein their personal balance sheets. It also affects the value of business assets. It affects business prospects too.
All of that determines spending decisions by individuals and families, spending decisions by firms hiring employees, spending decisions by other firms deciding whether to build a new plant or to modernize an existing plant. All of that together in a large modern sophisticated economy determines things like how many people are at work, what are they earning, what is the level of economic activity, and how fast are prices going up.
So it's a long and involved process with many pieces that are sometimesdifficult to understand and certainly very difficult to predict in real time.
But nevertheless, that is the assignment of central banks and economists who work for them, because if we disregard that process, then we have to ask why do we bother having a central bank? Why do we have a monetary policy in the first place?
It's very important and economists are always and continually focusing on this process precisely because of how central it is.
Dr. Gao: How do you make sense of the current state of research in this field?
Professor Friedman: In the area of the monetary transmission mechanism, I would cite two main trends.
One is that people have increasingly seen the need to take account of the large and growing role played in the credit markets by non-bank financial institutions.
The United States is not the only economy in which institutions that is not banks, and therefore does not deal directly with the Federal Reserve and are not directly subject to the Federal Reserve's actions, extend credit especially to businesses but also to ordinary consumers.
This matters because our traditional theories of how monetary policy works come out of an earlier, simpler era in which it was not a bad approximation to think of the banks as playing a very large and dominant role in the financing of economic activity.
They play much less of a role today, and so, to their credit, I think economists working in this area and are working hard to take account of this development.
The second aspect I would like to emphasize is that ever since the Great Financial Crisis, central banks have operated in a different mode in their relationship with the banks and the financial markets.
It always used to be the case that, while the banking system was not short of reserves in the sense of an outright shortage, the amount of reserves held by the banks was a binding constraint on banks' ability to lend. And therefore, it was straightforward that if the central bank would provide more reserves to the banking system, then the banks could lend more to businesses and consumers. The process had a certain simplicity to it.
Today this isn't true because, ever since the Great Financial Crisis -- and the period when this began in the United States, for example, is the very end of 2008 and beginning of 2009 --we now have large amounts of excess reserves in the banking system.
This does not mean that the central bank is impotent. Under a simplistic view of how central banks affect the economy, having ample excess reserves would have rendered the central bank impotent. That simple view is wrong, and the central bank is not impotent. Central banks have the ability to affect the economy and the volume of bank lending. But they now have to do that in different ways.
Now, for more than a decade and a half, we've operated in what central banks call an “ample reserves” framework. And therefore the process by which what they do affects the banking system, and therefore the thought process of economists in analyzing it, has to be different than it was many years ago.
I'd say those are the two primary changes that I would highlight from recent experience.
Dr. Gao: Yes, they are really crucial.
Discussion 3
Tools of monetary policy
Dr. Gao: The tools of monetary policy have changed a lot since the 2008 financial crisis. Immediately after the financial crisis, the short-term interest rates were down near the effective floor of zero or even a bit lower in some countries. But central banks around the world could not push short-term interest rates in a meaningful way much below zero. So, they introduced and put into use two new monetary policy tools, i.e. large-scale asset purchases and forward guidance. These two tools are still evolving, especially in the United States.
After so many years of practice, how do you assess the effectiveness of these tools and their place in the monetary policy toolbox in the future?
Professor Friedman: I would draw a sharp distinction between the two tools that you mentioned.
I think the experience of using large-scale asset purchases, and more recently asset sales, as a tool of monetary policy has proved reasonably effective.
The empirical estimates differ, but I would say a reasonable consensus in the United States is that after short-term interest rates hit the effective lower bound ofapproximately zero, the Federal Reserve, by buying large amounts of Treasury-issued securities of long maturity, managed to reduce the 10-year treasury interest rate by somewhere between 50 and 75 basis points.
Is that a huge amount? No, it's not huge, but it's certainly enough to make a difference for all sorts of decisions that consumers and businesses make.Not because consumers and businesses are borrowing in the treasury market -- they're not -- but because the rates at which they do borrow are typically tied to treasury ratesby manykinds of arbitrage-like transactions that various financial institutions are making. So I would give the use of large-scale asset purchases a pretty good mark. I think it was a useful thing to have done.
Indeed, I'm always puzzled by people who say that it worked in practice but there's no theory for it. I don't understand that because going back to the work of people like James Tobin many years ago, and also Franco Modigliani and my own work, we do have a theory for this. We understand why it works. The only issue was how large the effect would be. And to repeat, I think a reasonable estimate for the United States was about 50 to 75 basis points, and that's sufficient to make a difference for the central bank’s purposes.
Moreover, in the United States
the central bank is able to buy mortgage-backed securities, which it did, and it's clear that by doing so the Federal Reserve was able to get mortgage lending rates down compared to what they otherwise would have been by more than 50 to 75 basis points, because they were buying not only Treasury-issued securities but private securities that were backed by residential mortgages.
So, all of this was to the good. I therefore thinkthis is a useful tool for monetary policy to be deployed in both directions.
Further, it's not just that by buying these securities the central bank can help to stimulate the economy by getting long-term interest rates lower, at times when the central bank is fighting inflation, as ours recently was and still is, it can help to restrain the economy by selling these securities.
Now, that's an important consideration because you can't sell something you don't own. And therefore, if this tool is to be available to be used symmetrically, then it says something about the size of the balance sheet that the central bank should continue to carry.
So, all in all, I'm in favor of the use of the asset purchases, and sales.
By contrast, the second unconventional monetary policy tool that has grown up in recent years that you mentioned is so-called forward guidance. It means the central bank making explicit public statements with the goal of shaping the public's expectation of future monetary policy actions. In short, statements made today were meant to shape expectations of actions to be taken in the future.
I am not aware of any evidence that the central banks that used this policy, including our own in the US, got any benefit from it. I regard this in the same way as the asset purchases, as an empirical question.If somebody produces credible evidence that this policy worked, well, good.But I have not seen such evidence. And there are also costs associated with the central bank saying explicitly what it plans to do in the future. Since there are some costs and not any visible benefits, at least none that I've seen, my recommendation would be not to use forward guidance in the future, or at least to use it very, very sparingly.
Discussion 4
What is the optimal size of central bank’s balance sheet?
Dr. Gao: So, this leads to the issue of the central bank's balance sheet. To your point, you mean that we should not go back to the size of balance sheet that was more like what they had before the financial crisis, is that right?
Professor Friedman: Yes, that's what I had in mind. Again, to take the United States as the example. Before the Great Financial Crisis in 2008, the Federal Reserve's balance sheet was less than US$1 trillion. And over time, this got up to nearly 10 times that, almost multiplied by a factor of 10.
You mentioned Milton Friedman. Many of Milton Friedman's followers believed, and many said, that if you increase the size of the central bank's balance sheet by a factor of 10, prices will go up by a factor of 10. And people who said that are mighty embarrassed by how foolishly wrong they were.
But your question is about where we should take the balance sheet now.
The Federal Reserve, like many other central banks, has been selling off, or allowing to run off, the securities that it bought, so that its balance sheet has been shrinking.
What you said is exactly right about the implication of my view that this new tool of monetary policy should be able to be used symmetrically.
I have favored the shrinking of the balance sheet so far, but I would not continue it to the point where the central bank’s balance sheet is backwhere it was before the financial crisis. That’s because I would like the Federal Reserve to be able to sell securities when it wants to raise long-term interest rates.
I'll give you a very concrete example of where this would have been useful. Go back to the early years of this century, before the Great Financial Crisis. Everybody knew that the housing market in the United States was overheated. We were, for several years in a row, building 2 million new houses per year in the United States. That may not sound like a lot to you, but remember that we're a small populationcompared to China. And so for us, 2 million new houses a year is really a lot. Most people were also aware of a whole raft of excesses and abuses that were taking place in the residential mortgage market -- things like subprime mortgages, lending on the basis of no statement of income, lending with no evaluations, and the like. I thinkeverybody understood these things.
At the time, many people called for an increase in short-term interest rates to try to slow down what was happening in the mortgage market. Ben Bernanke, at that time the chairman of the Federal Reserve, opposed this. And what Ben said publicly was that raising short-term interest rates would be, in his phrase, a “blunt instrument” with which to combat an excess in one particular sector of the economy or one particular portion of the financial markets.
That was probably true. I don't disagree with his assessment. But now imagine that at the time the Federal Reserve would have had in its portfolio a trillion dollars or so of residential mortgage-backed securities that it could have sold into the market in order to widen out the spread between mortgage lending rates and treasury rates. That would not have been a blunt instrument at all. That would have been quite precise.
And looking back on this experience, whichalas came to a bad end when the financial crisis hit, which happenedin the mortgage market to begin with, I think such a policy action would have been very useful.
But the Federal Reserve could not have done that. If anybody had suggested it at the time, it would have been a foolish thing to say because they owned no mortgage-backed securities and therefore they could not have sold them.
By contrast, today they do own mortgage-backed securities, and therefore I would retain a sizeable holding of them in the portfolio precisely so that if that kind of circumstance occurs in the future, the central bank can sell them in order to blunt the effect of what's happening in the mortgage market.
Dr. Gao: That's a good point. And to go a little further, do you think there could be an optimal size for the central bank balance sheet?
Professor Friedman: I don't know. I can imagine research being done to shed light on the optimal size of the balance sheet. But I have not done that research, and I am not aware of anybody else who's done it. So, I think the honest answer has to be we don't know.
But for sure, my view is that going back to the size of balance sheet that we had 15 years ago is not what we ought to be doing.
Discussion 5
Inflation targeting: framework of monetary policy
Dr. Gao: Inflation targeting has become one of the most significant developments of recent decades in both the theory and the practice of monetary policy. Since 1990s, many countries have adopted inflation targeting framework. The first one is New Zealand (1990), and then Canada (1991), the United Kingdom (1992), Sweden (1993) and the Euro area (1999), and numerous others.
As for the United States, since 1996 or so, the Federal Reserve was pushed by Congress to follow the same path. After a long period of tremendous debate, the Fed finally adopted its 2% inflation targeting regime in 2012. Following the United States, Japan in 2013 also adopted the same framework.
I know that you are one of the key economists who are not in favor of inflation targeting. In fact, since as early as the 1980s, you have written substantially about your reservations in that regard. In your paper (Friedman. Why the Federal Reserve Should Not Adopt Inflation Targeting?Presented at the annual meeting of the American Economic Association, San Diego, January 4, 2004.), you urge policy makers at the Federal Reserve to reject those calls “to join the parade and restructure US monetary policy too, within the guidelines of some form of inflation-targeting rubric.” You believe that “the claims commonly made for inflation targeting at the conceptual level – in particular, that inflation targeting usefully enhances the transparency of monetary policy – are not just unproved, but false.” Could you please tell us why?
Professor Friedman: The place to begin in addressing the subject you've raised is whether the central bank has any responsibility for the level or rate of growth of non-financial economic activity.
In the United States, the answer is yes, it does. I wouldn't call what we have in the United States inflation targeting in the standard economic sense. We do have an inflation target. But in the governing legislation in the United States, the Federal Reserve Act, as amended by Congress, it is explicit that the Federal Reserve is charged not only with maintaining stable prices but also with maintaining maximum sustainable employment. The difference is very important. Moreover, of those two objectives, Congress mentions the maximum stable employment first and the stable prices second.
So, I'm going to address your question from the perspective of an American, because my country has charged its central bank with responsibility for real economic activity, and because I believe that's the right thing to do.
Now, if that's so, then the question is what consequences follow from organizing monetary policy around an objective, namely inflation that has no reference to levels of economic activity.
One of the supposed advantages held out for inflation targeting by its advocates is that it forces the central bank to be accountable.
You mentioned the New Zealand central bank under the governor at the time,