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Milton’s on the Money
The Fed should tune in to Friedman.


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Larry Kudlow

Milton Friedman believes the Federal Reserve can afford to be very generous with the money these days. The brilliant economist is right again.

Over the past ten or fifteen years some supply siders have ridiculed Friedman’s brand of monetarism. But they shouldn’t have. In Friedman’s proven view, shifts in the money supply affect changes in national income (as measured by the gross domestic product) and prices. While the speed at which money changes hands is seldom exactly steady, the relationship between money and GDP holds up over long periods of time. And sometimes even shorter periods of time.

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Perhaps today’s disappointing economic recovery and stock-market decline can be traced to a recent growth slump in the money supply.

Here are some facts. The Fed provides the raw material (or cash) to create the monetary base. The base, in turn, feeds or restrains the growth of M2 — a conventional measure of money that includes currency, checking accounts, money market funds, and savings accounts. From the autumn of 2000 to the autumn of 2001, this measure of money roughly doubled to 12% from 6% as the Fed sent fresh cash into the economy. This set the stage for economic recovery in 2002.

However, from the autumn of 2001 to the summer of 2002, M2 growth slipped all the way down to 4%. This nine-month decline in money growth parallels the devastating stock-market plunge and raises big questions about profits and the whole economic rebound.

The money slump has also released a new round of deflationary pressures. As Friedman has written throughout his career, money matters for prices as well as GDP. Inflation, or deflation, is a monetary phenomenon.

Prices of tradable goods have suffered as the Fed’s money spigots have closed. Yearly price declines have shown up in food (-2.4%), energy (-5.8%), gasoline (-3.6%), natural gas (-12%), and computers (-21.8%). And in the commodity sector, crude-material prices have deflated by 4.2% — so it’s getting to a point where monetary declines are coinciding with drops in commodity prices.

More broadly, price indexes for capital goods and consumer goods have fallen 1.5%. Even the badly flawed consumer price index shows the deflationary impact of slumping money growth, with computers, televisions, software, cellular-phone services, toys, coffee, apparel, and camera equipment all deflating. In fact, nearly one third of the components of the CPI are declining according to economy.com. Only the service sector has been immune from price drops, but this is largely because of government interference.

Headline writers and talking heads will tell you that the Fed remains accommodative to this economy because the fed funds interest rate policy target remains at a four-decade low of 1.75%. But money flows are much more important to the economy than the fed funds rate.

Yes, Alan Greenspan & Co. can control the funds rate, as well as the money supply. But they can’t control both at the same time. Therein lies the single biggest conundrum for policymakers.

When economic activity slows, and consequently bank-reserve demands come down, the Fed sells Treasury securities from its portfolio in order to take cash out of the economy and stabilize the fed funds rate. So while the Fed’s target interest rate doesn’t change — tricking the headline writers and talking heads — the money supply is reduced. This appears to be the exact case today.

When the Fed takes cash out of the system it shrinks the reserve base and restrains bank deposits, loans, and investments, creating a credit crunch for small and large businesses. The Fed may think policy is loose, but in fact policy as defined by money-supply trends is actually getting tighter. There really is no other explanation for this year’s economic slowdown and price deflation.

More important than Iraq, or even a handful of corporate crooks, is the slumping money supply. Investors have become increasingly fearful that the outlook for profits gets worse without sufficient money to fuel the economy and stabilize prices.

The greatest reform Alan Greenspan could make in his remaining tenure at the Fed would be to downplay the interest-rate target and re-emphasize the importance of money. Right after the September 11 bombings, the Fed did exactly that. “The Federal Reserve will continue to supply unusually large volumes of liquidity to the financial markets,” read the Fed’s policy statement of September 17, 2001. “[We recognize] that the actual federal funds rate may be below its target on occasion in these unusual circumstances.”

Unfortunately, the Fed quickly returned to its old ways. By stubbornly maintaining a fed funds rate of 1.75% instead of fortifying the money supply, economic recovery hopes are fading. Until the central bank comes to its senses, both the stock market and the economy will continue to disappoint. Prices will continue to deflate. Business profits will continue to disappear.

You say it can’t happen here? That’s what Japan said. Commentators continue to warble on about oil, war, accounting fraud, and all the rest. But money is the key to where we are today. That’s Milton Friedman’s lesson.



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