Fighting the Last Monetary War

This article appeared on on October 18, 2011.

In 1896, Williams Jennings Bryan captured the Democratic nomination for the presidency with a rousing speech that ended with a theatrical challenge to advocates of the gold standard: "You shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold."

The United States had adopted a gold standard 20 years earlier, and the supply of gold had not been keeping pace with the rate of economic growth. The result was deflation at an annual rate of 1.7 percent a year. This was particularly hard on farmers, many of whom had mortgages that got harder to pay off as dollars appreciated.

Bryan was calling for a return to the bimetallic monetary standard that had prevailed before the Civil War. Under a bimetallic standard, the government converts either silver or gold into dollars at specified rates. The value of silver had fallen dramatically relative to gold, so Bryan's call for the "free coinage of silver" was essentially a call for inflationary monetary policy.

Bryan's gold-standard-supporting opponent, William McKinley, won the election, and the United States stayed on the gold standard for another four decades. But while the US formally retained its tight-money policy, an improvement in mining technology sharply increased the gold supply, producing de facto easy money. Prices rose, rather than falling, for the next two decades.

The expansion of the gold supply ended the deflation — and Bryan's presidential aspirations — and, ironically, cemented the establishment view that the gold standard was essential for monetary stability. The US stayed on the gold standard until the early 1930s, when the United States (and other countries) experienced a severe deflation that helped trigger the Great Depression. President Franklin Roosevelt made the controversial decision to go off the gold standard, allowing a more expansionary monetary policy that many economists credit with spurring a recovery.

The Great Depression toppled the old orthodoxy of the gold standard and tight money. It was replaced by a new orthodoxy, summarized by the Phillips Curve, that held that governments face a trade-off between inflation and unemployment. It was widely believed that a bit of inflation was a small price to pay to keep people employed and to ward off another Great Depression. This worked pretty well for the first couple of decades after World War II, but the Federal Reserve started to overdo it in the late 1960s. In the 1970s, the US started to experience high inflation and high unemployment, something the Phillips Curve suggested should be impossible.

The causes of this "stagflation" were widely debated, with various people blaming OPEC, unions, deficit spending, and so forth. Milton Friedman was one of the most prominent advocates for the view that inflation was simply the result of the Federal Reserve creating too much money. Drawing an analogy to drinking, he argued that a boost in the money supply produced a short-term boost in economic output followed by a "hangover" period in which prices rose and output fell. A central bank could soften the impact of the "hangover" with another dose of easy money, but over time the "patient" builds up a tolerance, and the result is high inflation and high unemployment.

Friedman argued that the only cure was sobriety: the Federal Reserve needed to stop printing so much money and the nation needed to suffer through the inevitable withdrawal symptoms. In 1979, Jimmy Carter appointed Paul Volcker as Fed chairman, and he pursued a policy of tight money. Just as Friedman predicted, the result was a severe recession, followed by a quarter-century of low inflation and robust economic growth.

I don't think it's a coincidence that America's major monetary crises have happened at roughly 40-year intervals — 1896, 1933, 1971, 2008. Forty years is the length of a typical policymaker's career. In the 1930s, virtually everyone in positions of authority had been trained in the hard-money orthodoxy of previous decades. It took several years of severe deflation before they started to seriously consider abandoning the gold standard. Conversely, the Great Depression loomed large in the imaginations of senior policymakers in the 1970s. That caused them to be slow to recognize the dangers of too much inflation. Conversely, today's policymakers vividly remember the stagflation of the 1970s, and the result has been a Federal Reserve well-stocked with inflation hawks.

I just finished reading Money Mischief, a collection of essays by Milton Friedman published in the early 1990s. One of the striking things about Money Mischief is how much more attention it devotes to the dangers of too much inflation than too little. Friedman famously blamed the Federal Reserve's deflationary policies for the Great Depression, so he was certainly cognizant of dangers of deflation. But his analysis of the Great Depression gets only passing mention in Money Mischief. The phrase "liquidity trap" does not appear in the book's index, and there's no discussion of what a central bank should do in a situation like today when conventional monetary easing fails to spark a robust recovery.

Friedman's focus on inflation made sense in 1991, because inflation was still relatively high and there was a real danger that the Federal Reserve would relapse into excessive money printing. Yet the Federal Reserve has been steadily reducing inflation over the last year. Still, there's a significant faction on the Fed, and among conservative politicians more broadly, that continues to worry about the dangers of inflation despite the nation's high unemployment rate.

Indeed, there's evidence that Friedman himself would be with the inflation doves if he were alive today. In 2000, Friedman argued that the Bank of Japan, which had already pushed nominal interest rates down to zero, should buy long-term government securities to further expand the money supply — a policy strikingly similar to the QE2 policy that inflation hawks have warned will spark inflation.

Monetary policymakers have a tendency to fight the last war, making mistakes opposite to the ones made by their predecessors a few decades earlier. In the 1970s, a Federal Reserve terrified of another Great Depression gave us a decade of stagflation. Is today's Fed, terrified of stagflation, giving us an unnecessarily long and severe recession?