Monetary policy structures.

• Author: Friedman, Milton

With respect to monetary policy, I only want to say a few words, not about the details of monetary policy, but about how we can get a more satisfactory monetary policy. All of us can agree that it has not been very satisfactory, not simply for the past year or two, but for as far back as you can go. I shall limit my comments mostly to the period since the Federal Reserve System was established in 1914 because most commentary is about that.

But any notion that the period before 1914 was a golden age in the double sense of a properly operated gold standard and in the sense that all went well is a misconception. It was a period that saw its ups and downs. But the period after World War II is a new era in one respect: in 1939 the price level in the United States was lower than it was in 1800. The notion that somehow or other inflation is endemic to the American economy--it's always been in our history--is a bunch of nonsense. The price level doubled during the Civil War; it doubled during the First World War. But each time after the war it returned to the initial level. There was a roughly stable price level. The period since 1960, the past 25 years, is the only period in United States history during which there has been a nearly continuous secular increase in the price level. Again there were ups and downs, but they were around a sharply rising trend.

The monetary policy was unsatisfactory from the very beginning of the Federal Reserve System. The Federal Reserve System presided over a doubling of prices in World War I, a severe recession in 1920-21, then, after a few years of relative stability in the 1920s came the Great Depression of 1929-33. Subsequently, there was a doubling of prices during World War II. So when I talk about poor monetary policy, I am not referring simply to recent policy.

Public Interest Approach

For many years, I and other economists have been trying to improve monetary policy. I now realize in my later years that our approach has been misconceived. It was our view that the way to improve monetary policy was (a) to learn more about how money operated, (b) to construct appropriate rules for the conduct of monetary policy, and (c) to persuade the people who run monetary policy that they were the right rules. We took it for granted that if we could succeed in doing that, they would put them into effect. That is to say our approach was what has come to be known as the public interest approach to the role of government. The idea was that government bureaucrats, government officials were people who were trying to promote the public good. That's not the way we consider businessmen. We don't think that businessmen go into business to promote the public good. They go into business to make money. If we have the right structure of the economy, if we have the free market system that Adam Smith spoke about, then, as he said in his book, people who tend to promote only their own interests are led by an invisible hand to promote a public interest that was no part of their intent to promote.

I have come to the conclusion, belatedly, that we have to look at government in the same way. The people in government--that goes for all of you, me, congressmen, everyone--are here to promote our own interests. Our interests may be broad; we may want to reform the human race. They may be a narrow selfish interest but in either case we are here to promote our interests. And I have come to the conclusion that the political system that has been set up is one in which Adam Smith's invisible hand works in reverse. People who intend to pursue only the public interest end up pursuing private interests which it was no part of their intention to pursue. And so I have come to the conclusion that the way to do something about monetary policy is not to persuade beneficent monetary controllers to do the right thing but to ask a different question: What is the structure of monetary policy that will have the effect of making the political invisible hand work the same way as the economic one? How can we set up a structure of monetary policy under which government officials who intend only to promote their private interests are led by an invisible hand to promote the public interest?

Political Invisible Hand

Let me demonstrate my point with a very simple and obvious example. Let me emphasize this, I'm not criticizing anybody. I'm only trying to describe. We don't criticize businessmen for pursuing their own interests. I don't criticize politicians and others for pursuing their interests; we're humans. We all do the same thing. Suppose that 20 years ago the Federal Reserve had adopted the advice that I was then giving them completely. That advice was that they should adopt procedures that would produce a steady rate of growth in the quantity of money at 3 percent a year. Suppose they had done that. There is not the slightest doubt in my mind that the country would have been far better off. We would have avoided the inflation of the past 20 years entirely. We would still have had a few ups and downs, but they would have been modest. But I ask you a question: Suppose the Federal Reserve had adopted that modest task and suppose you conducted a poll asking: Who are the most important persons in the country? Is there the slightest chance that the chairman of the Federal Reserve Board would be listed as the second most important person in the country? The Federal Reserve would have no great prestige. It would be a modest accounting agency that was carrying out a simple mechanical job. And it would have occurred to more people than me up to now that you might as well replace it with a computer.

So it was not in the self-interest of members of the Federal Reserve System to adopt that policy. The reason they didn't adopt the policy wasn't that I wasn't persuasive enough; perhaps I wasn't. It wasn't that I was wrong; perhaps I was. I don't think so. The fundamental reason was this was not in their self-interest to adopt that policy. Again, don't misunderstand me. You all remember that famous statement that got so much attention during World War II: "What's good for General Motors is good for the country." The one thing every one of us is capable of doing is persuading ourselves of that. So I'm not criticizing anybody for any ulterior motive. But as long as proposed policies were against their self-interest, they would be able to persuade themselves very easily that those policies were not good for the country.

That leads me to the conclusion that the only way to get a sensible monetary policy is to change the fundamental structure of our monetary institutions. We shall not get better policies by appointing better people to the Federal Reserve Board, by changing the chairman. That might make a difference, a marginal difference. Some members of the board are better; some are worse. I've studied for decades the detailed history of the Federal Reserve System, and the last thing I will look at to see what the policy of the Federal Reserve is [is] the name of the chairman. That doesn't matter. It's a major institution that operates under its own terms.

I'm going to suggest what I think is the most promising ultimate reform and say we're a long way from it. We're not going to get there, but we ought to have in mind where we would like to go if we could. My ultimate ideal at the moment--I have changed this over time as I've become more and more persuaded what the real problem is--is to eliminate every element of discretion. At the moment, my ultimate proposal is that we freeze what is called high-powered money, that is to say, current Federal Reserve notes and deposits at the Federal Reserve. To put is more simply, we could replace those notes and those deposits by Treasury notes, just pieces of paper, and then never print another one except to replace those that wear out. Just freeze it, and you don't need a Federal Reserve System. You can cut the work of the Bureau of Engraving and Printing down so they can devote most of their effort to printing your reports instead of money. That really would replace the present discretionary monetary policy apparatus by a pure automatic system. Under those circumstances, what would happen would be that the markets would determine and would adjust the total quantity of money in the sense of the money we use including deposits plus currency. Because then commercial banks and other financial institutions would need to keep some of that high-powered money in reserve in order to be able to meet demands for it and so on. I won't go into details; you're all capable of doing that. In my opinion, the effect would be roughly stable prices. Judging from experience, I would expect the quantity of money as people currently interpret it to go up something like 3 percent a year, which would just roughly keep pace with total output and give a roughly stable price level.

We're not going to get that reform tomorrow, and, indeed, we're not going to get any major change until there's a crisis. You don't get major changes just because somebody believes they're good. You get major changes because there's a crisis. The role of people like myself, who suggest what ought to be done when there is a crisis, is not really to persuade anybody to do anything. It's only to keep options open so that when a crisis emerges, there's something available that can be picked up. The best example of that, of course, was the adoption of floating exchange rates. For decades, I and others had been urging floating exchange rates. We had no effect on anybody until a crisis emerged, and something had to be done. When something had to be done, there was a well thought through approach that could be adopted. The same thing is true in respect to monetary policy. Now some intermediate possible reforms, and then I'll open up for questions and answers.

Intermediate Reforms

One great improvement would be to put the Federal Reserve in the Treasury...