“Inflation is always and everywhere a monetary phenomenon.”
—Milton Friedman
Have you ever questioned Milton Friedman’s famous claim about inflation?
Ever heard anyone else question it?
Unless you read obscure stuff written for the academic community, you’re probably not used to Friedman’s quote being challenged. And that’s despite a lousy forecasting record by economists who bought into his Monetarist methods.
Consider the following:
When Friedman’s strict Monetarism fizzled in the 1980s, it was doomed partly by his own forecasts. Instead of the disinflation the decade delivered, he expected inflation to reach 1970s levels, publicizing that prediction in 1983 and then again in 1984, 1985 and 1986. Of course, years earlier he foresaw the 1970s jump in inflation, but the errant forecasts that came later left him wide open to a “clock twice a day” dismissal.
Monetarists suffered an even harsher blow in 2012, when the Conference Board finally threw in the towel on Friedman’s favorite indicator, removing M2 from its Leading Economic Index (LEI). Generally speaking, forecasters who put M2 in their models are like bachelors who put “live with mom” in their dating profiles—they haven’t been successful.
The many economists who expected quantitative easing (QE) to wreak havoc on inflation are, of course, on the defensive. Nine years after QE began, core inflation remains below the Fed’s 2% target, defying their Monetarist beliefs.
When it comes to explaining inflation, Monetarism hasn’t exactly nailed it. Then again, neither has Keynesianism, whose Phillips Curve confounds those who rely on it. You can toss inflation onto the bonfire of major events that mainstream theories fail to explain.
But I’ll argue there might be a better way.
In three articles, I’ll try to convince you that we can develop a better theory by interpreting Friedman’s research differently than he did. Maybe you’ll like the theory, or maybe you won’t, but I promise this: the indicator that falls from it has a better record predicting major inflation trends than any other serious indicator I’ve studied. It’s not the only way to think about inflation, but it’s realistic and practical, and I’m interested in the reader reaction.
They Said, Hey Sugar…
Let’s get started with a walk on the wild side—we’ll walk with the renegades in economics who acknowledge the true role commercial banks play in the monetary system, that of creating money from nothing in the process of making loans. By our choice of company, we’re rejecting mainstream economics, including Monetarism and Keynesianism, which call for banks to be mere conduits in the money creation process. I discussed this topic in “Learning from the 1980s,” and I’ll summarize the key points below:
When Friedman and his coauthor Anna Schwartz published their famous research showing a strong correlation between money growth and GDP growth, they and their followers failed to appreciate the importance of money-creating bank loans.
Instead of allowing that bank lending might explain the historical correlation to GDP, they assumed that the intrinsic characteristics of money—liquidity, stability, and value as a medium of exchange—explained their results, leading them to embrace measures such as M1 and M2.
But in fact, their seminal research had little to do with M1 and M2, because that data didn’t exist over the full period they studied. Instead, they used a measure that was almost exactly equal to the amount of money banks create when they make loans and buy securities.
Loan and behold, when the various measures diverged in the 1980s, M1 and M2 lost their correlations to GDP, whereas the original measure studied by Friedman and Schwartz did not.
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