The Friedman Deflation Rule Implies a State that Ultimately Vanishes

Is deflation good or bad, a hard enough theoretical question at the best of times but made harder when you have nations, without their own currencies, with a low oil price good deflation (not an oil exporter) boosting GDP (possibly by +2% according to estimates in Spain) on top of a bad debt deflation, and at close to the zero lower bound.

In monetary theory we have a real conflict between Central Banks, who favour price stability, and the theoretical approach derived from Friedman (1969) (who borrowed from Bailey (1956), Keynes interestingly, and the Cambridge cash balance approach.)  This states that deflation is a good thing and should exactly equal the rate of growth in the economy – so the two should cancel out so the rate of interest is zero.  Interestingly then Friedman’s conclusion was the same as Keyne’s – welfare is maximised with a zero interest rate.  We should not be surprised as Friedman was operating very much within Keynesian parameters but implying different policy conclusions.

Friedman/Bailey argued that their was a real welfare loss to society from agents holding too much of their portfolios outside cash as this could not be used to spend.  Their is a welfare cost to society from inflation as agents shift their portfolios to less liquid assets.   The argument is that to maximise consumer surplus the marginal benefit to society of holding money should equal the marginal cost to society of producing money. With the simplifying assumption that the cost to society of producing money is zero, the optimal nominal interest rate is then zero – the Friedman rule.

Although Keyne’s wished to euthenise rentiers, the effect also would be to euthenise the state.

Thinking about the issue from a monetary circuit perspective if you wish to achieve deflation then you must destroy outside money (the unit of account) at a faster rate (taxation)  than you create outside money (state spending). If you do this then you have a primary surplus year in year.  If this happens and you manage to continue this policy successfully forever then eventually the national debt is wiped out, and so it the state as it shrinks in size to the limit, infinitely small.

So we can see that the Friedman rule and the political philosophy of George Osborne are perfect compliments, a small state (though I prefer the higher level generalization public spending), indeed an infinitely small state (public spending).

So far economic arguments have either automatically assumed that deflation is bad (the Krugman position I think), or counteracted, with Friedman Rule based arguments that deflation is good.  We can see this in the the wide apart positions on the issue taken by prominent economists on the issue back at a Minn Fed Workshop in 2003 (papers here) – with the likes of Lucas and Bernanke taking diametrically opposed positions.  The Swedish Riksbank is holding a similar workshop this June given the renewed global concerns on the issue.

The debates reflects I think gaps in monetary theory.  The Friedman rule assumes a single currency and general equilibrium.  Many thinkers have claimed that the optimum policy rule is none zero  in real world multiple currency conditions. (Bernake’s view, and the view I suspect of all none German or Scandinavian Central Bankers).

I think the issue though is more fundamental.  There is a failure to properly tease out the differences between the stock and flow effects of the transactional demand for money, and more fundamentally between its increase for reasons that cause increased budget constraints (i.e. increased debt costs) and those that reduce them (growth of incomes).

I also think Friedman may have been ‘off by one derivative’ to use the phrase he used of Hume, as the changes of demand for money are more important than its static state.  Growth matters, there is no point is arguing about what shape of the aggregate demand curve maximises consumer surplus if the scale of that curve in real wage units produces low incomes and low growth.  If Keynes had been around to argue with Friedman in 1969 i’m sure he would have argued from that position.  What matters is the discounted NPV of all future consumer surpluses in real wage units.

Monetary thinkers really need  to start properly addressing this position as it is critical to determining current public policy issues about what is the optimum level of public spending/taxation.  I’m wondering if their are any parallels here with the theory of optimum city size in the new economic geography (which students at one university recently complained was too tough to answer a question on) as this is already a framework which is growth centric and is focused on the benefits of Samuelson public goods.

Further Reading

Bailey, Martin J. “The Welfare Cost of Inflationary Finance,” Journal of Political Economy, vol. 64 (April 1956), pp. 93–110.

Friedman, Milton. “The Optimum Quantity of Money,” in The Optimum Quantity of Money, and Other Essays. Chicago: Aldine Publishing Company, 1969.

Wolman, Alexander L.  Zero Inflation and the Friedman Rule: A Welfare Comparison  Federal Reserve Bank of Richmond Economic Quarterly Volume 83/4 Fall 1997

One thought on “The Friedman Deflation Rule Implies a State that Ultimately Vanishes

  1. All manner of assumptions in those theories that actually aren’t accurate number one. Number two profit making systems, innovation in general and artificial intelligence, which is just getting started, all have a basic logic of efficiency regarding their costs (labor, human effort and with artificial intelligence human input at all) …so along with the enforcement of the cost accounting convention that all costs must go into price this means that macro-economically the rate of flow of total costs will always tend to exceed the rate of flow of total individual incomes…with which to liquidate those costs/prices….and then you have the above three factors further reducing aggregate demand. So how is a system like that supposed to keep the wheels on, the family fed and create a nickel or two for 95% of the working populace let alone the burgeoning populace of the unemployed…for a pony ride every six months or so???????

    Unless of course you supplement individual incomes with a gift of income and a gift of a discount on prices to consumers. All economists are nascent social crediters. Some have more to overcome than others.

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