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RE: Why Money Matters

In La Bourse on September 16, 2009 at 1:31 PM

The following article is based on a current working paper entitled “An Application of Milton Friedman’s “Why Money Matters” to U.S. Recession 2007:Q4.”

Representing monetary economics, Milton Friedman, the American economist now deceased, published his final article on the subject in the Wall Street Journal on November 17, 2006.  The article, entitled “Why Money Matters”, portrays monetary policy at work in affecting three prominent business cycles: the Great Depression of the U.S. 1920s and 1930s; the Lost Decade of the Japan 1980s and 1990s; and the Dot-Com Bubble of the U.S. 1990s and 2000s. 

That background considered, my estimates update the Friedman analysis by comparing three U.S. business cycles: the Great Depression of the 1920s and 1930s; the Dot-Com Bubble of the 1990s and 2000s; and the current 2007:Q4 recession.  The objective is to do just what Friedman presumably would have been tempted to do, i.e., demonstrate the validity and extent to which monetary policy can solve, dampen or exacerbate a free-fall in the economy.

Many economists have written on the subject of connection between money, prices and product.  Milton Friedman, for instance, firmly declared, “Inflation is, everywhere and always, a monetary phenomenon.”  Federal Reserve Chair Ben Bernanke, another American economist more associated with Princeton University, and others have outlined the break in monetary neutrality occurring in the Great Depression, a time where prices slid persistently as money supply declined over a longer than expected period, more than expected according to conventional wisdom of the time. 

Irving Fisher, the American economist associated with Yale University, personified the moneyed school, writing in 1936 —

 “Though quite ready to change my opinion, I have, at present, a strong conviction that these two economic maladies, which may be called “debt disease” and the “dollar disease” are, in the great booms and depressions, more important causes than all others put together.”

Contrastingly, David Hume, the Welsh philosopher, skeptically portrayed money as a “veil” of abbreviated importance in explaining more underlying fundamental causes of production adjustment.  While New Zealand economist William Phillips, in turn, inspired his Phillips curve representation of the economy, the model demonstrating a short-run tradeoff between unemployment and price level.

Data used in my research is sourced through: the Federal Reserve Board of Governors, Statistical Release, regarding industrial production and M2 money supply; A Monetary History of the United States, 1867-1960, by Milton Friedman and Anna Schwartz, also regarding M2 money supply; and Robert Shiller, regarding S&P stock index prices.  Entire data range consists of monthly figures dating from July 1923 through July 2009.  And methodology is in straight alignment with Friedman’s indexing technique, where the variables are placed over a 6-year leading average measured prior to the peak in order to normalize the different business cycles.

Listed graphics are generated from underlying data sources that are higher frequency than that frequency used in the Friedman analysis, i.e., monthly instead of quarterly.  For money supply, M2 is considered in Figure 1.  Industrial production is measured in Figure 2.  And the S&P stock market index is measured in Figure 3.  Quarters mark the x-axis in all cases.  Tables 1, 2 and 3 provide some additional detail regarding date selections for cycle initial, peak and terminal points.  Note, both the graphs and the table are recreations of the Friedman displays used in his final November 17, 2006 article, published in the Wall Street Journal.

Importantly, qualifying factors in the Friedman analysis are complied with in all three cases, i.e., (1) the U.S. represents a major world economy over all time periods of interest, and (2) all three business cycles are characterized by technology-led growth periods leading up to the cycle peak.  On point 2, for instance, the booming market for financial innovation products blossomed over this time period, as evidenced in the widespread adoption of mortgage-backed securitization instruments and credit-default swaps contracts. 

Organizations like the British Bankers Association and the Bank for International Settlements have monitored the rise in popularity of these products over the 2000s period.  And the Financial Times has catalogued the scale of this market in relation to other popular money markets (see Figure 4).

In graphics 1, 2 and 3, you can see a clear depiction of monetary policy at work compared from cycle to cycle.  Figure 1, regarding the money stock, evidences a Federal Reserve policy undertaken today that very similarly resembles the prescription undertaken by the central bank in the 2001:Q1 cycle.  That is, money supply rising steadily going into the peak in 2007:Q4 and escalating aggressively afterward, culminating in July of this year.

Figures 2 and 3 are frightening depictions of just how severe were these downturns from peak to trough.  Some paper columnists are already noting the eerie resemblance of the stock market downturn of the 1930s to that having occurred from 2007 to March of 2009.  Ron Zweig, writing in the Wall Street Journal, has noted the fall and threatened recovery in the Dow Jones index that has tended to coalesce around 1½ years after peak.  Others at Econbrowser have noted similarity between the current recession and that of the 1930s by spotlighting multiple stock indices’ performances.  

My estimates document a 51% drop in the S&P index from peak to trough spanning September 1929 to December 1930, and an identical 51% drop spanning October 2007 to March 2009.  Over the next 3-month period beginning December 1930, the S&P recovered 13% moving into 1931, only to plummet another 41% by bottoming out eventually in June 1932.  In contrast, the current recovery having begun March 2009 evidences a 25% recovery through July 2009. 

Anxiously, Wall Street economists and paper journalists are hoping that stocks may be reaching a new “permanently high plateau,” as Fisher once proclaimed.  For instance, Goldman Sachs and others are hoping that the next technology-led period will be ushered in by bundling and securitizing life-insurance policies, as reported by the New York Times

That speculation aside, other economists seem to be weighing in daily.  Bernanke, for instance, speaking yesterday at the Brookings Institution, remarked that the recession is “very likely over” right now.  John Taylor, an American economist associated with Stanford University, writing in Bloomberg, is estimating the Taylor Rule warranted being held at a zero fed funds rate target.  And at least one consensus of economists, including 41 of 51 surveyed in a recent Wall Street Journal poll, is proclaiming the recession has ended and recovery has begun. 

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