Originally posted: Sep 11 2009

The referenced article is a talk given at the Chicago Fed. It discusses the Monetarist vs. “Output-gappers” views on inflation and deflation.

Monetarists are probably represented best by the late Milton Friedman. Output-gappers are best represented by Keynesians such as Paul Krugman.I favor Friedman as opposed to the output-gap position.

Implied in the output-gap position is the “incorrect” definition of of inflation/deflation as rising or declining prices. The Friedman position tends to fail empirically in recent years because of technological improvements and financial innovations. That is, the very definitions of money are blurred and changing. Does one include the “shadow-banking” system or not? Does one adjust for sweep accounts that effectively reduce reserve requirements in the banking system? These are merely two of the examples that muddy the empirics and destroy what had been long- standing correlations.

Neither position has an adequate theory of the business cycle. Output-gappers tend to be entirely ad hoc, usually pointing to some external event such as a supply shock. Monetarists always blame recessions on a slowdown in the rate of money creation. The Fed’s dual mandates of sound money and high levels of employment have placed them in a role as a Central Planning Authority. These mandates, although not necessarily conflicting, become so in a politicized democracy.

Every “blip” in the data becomes important and pressures the Fed to do something. It is impossible for them to admit that they have limited control, don’t know when policy actions will affect the economy or how much of an effect they will have. Monetarists such as Friedman argued that these unknowns resulted in Fed remedial actions greatly exacerbating the conditions they intended to solve.

The same commentary can be offered regarding fiscal policy. It too is burdened with unknown lags and effectiveness. Because it is directly a part of the political process, it has enormous front-end lags while the program is endlessly debated, pork inserted, etc. The emergency stimulus bill is a good example. While it passed quickly, only a small amount of the money has been spent. It is estimated that it will not all be spent until the end of 2010 or beyond.

Regardless of which position one favors, the process of trying to manage the economy is akin to driving while only looking in the rear-view mirror. http://www.chicagofed.org/news_room/speeches/2009_09_09_CFRNY_speech.cfm