Economics Books

The best books on Monetary Policy

recommended by Lars Christensen

Milton Friedman by Lars Christensen

(in Danish)

Milton Friedman
by Lars Christensen


Monetary policy isn't just about setting interest rates and if we think about it in those terms, we'll never really understand it, says Danish economist Lars Christensen. Here, he recommends books to better understand monetary policy, and explains why reading about the past is so important for avoiding mistakes in the future.

Interview by Benedict King

Milton Friedman by Lars Christensen

(in Danish)

Milton Friedman
by Lars Christensen


Before we get on to the books, could you explain briefly what monetary policy is?

It’s a good question and makes me reach for one of the books actually, because Milton Friedman, in Money Mischief, has a good discussion of this—not what monetary policy is, but what monetary theory is. He says, “monetary theory is like a Japanese garden. It has aesthetic unity born of variety and a simplicity that conceals a sophisticated reality, a surface view that dissolves in ever deeper perspective. Both can be fully appreciated only if examined from many different angles, only if studied laterally but in depth. Both have elements that can be enjoyed independently of the whole, yet attain their full realisation only as part of the whole.”

I think that’s pretty lyrical about monetary theory. The point is that monetary policy is much more complicated than we make it out to be. There is a tendency to try and understand monetary policy through the very, very simple lens of just looking at interest rates. Monetary policy, in reality, is very little about interest rates. Interest rates are part of how monetary policy is implemented. But if we only see monetary policy in terms of interest rates, we won’t really understand it.

I think what the five books I’ve chosen have in common is that they try to understand monetary policy in a way that goes beyond just interest rates. Often we can understand monetary policy better if we try, at first, to ignore interest rates.

Of course monetary policy as it’s taught in universities is often about ‘r’, which is the interest rate. And there’s only one ‘r’ and this is set by a central bank. And then, later on, some students will learn about monetary theory, but actually in the macroeconomic models they learn about ‘r’ so that becomes monetary policy. And it fits into our simple macroeconomic models. Many economists don’t learn the rest of it. They don’t learn about the Japanese garden. And that carries over into our public policy debates about monetary policy. We read in the media that the Federal Reserve has hiked interest rates, but what have they actually done? What is the mechanism by which they ‘hiked’ interest rates?

I spend quite a lot of my time as an advisor on monetary policy to central banks and investors and as a public intellectual, trying to explain what monetary policy really is. One of the reasons that I thought it would be interesting to do this interview is that I think we can learn a lot from studying monetary history and monetary history is a common denominator in four of the five books I’ve chosen.

When the crisis hit in 2008, it seemed like economists and central bankers had forgotten about the crisis of the 1930s. They remembered the crisis of the 1970s and were reluctant to respond because they were worried about inflation. Now, it actually seems like the crisis of 2000-2001 and all central bankers can remember is 2008 and they’ve forgotten the 1970s. So while everybody was afraid of inflation in 2008, now everybody’s afraid of deflation. And it seems like there’s this tremendous lack of understanding of monetary history in the analysis of monetary policy and the conduct of monetary policy. And that makes them re-make some of the mistakes of the past. The idea about studying history is to avoid those mistakes. I hope the insights from these books help with that.

You mentioned that looking at interest rates didn’t help you understand monetary policy. If you take interest rates out of the picture entirely, what is it that you’re left with to look at?

For me, the way to understand monetary policy is to try to think about a world without money. In the world of Robinson Crusoe you have Friday and Crusoe. They can barter with each other. Friday can trade some coconuts for some tools. And there is a relative price between those, like two coconuts for one hammer, or whatever. But there is also a trade in time. So Crusoe can borrow three coconuts or four coconuts from Friday and repay them a week later, by giving back one more coconut—an interest rate over time. So we can see that interest rates can exist in a world without money. Essentially, interest rates are not a monetary phenomenon.

“We can learn a lot from studying monetary history”

What is a monetary phenomenon is a rising price level because, once we introduce money, these coconuts will not be coconuts versus hammers, but $1 or 1 Euro  or Krona, or whatever it is, against a coconut, or against a hammer. And so at the core is the price level, which determines what we can buy for money. And so, really, what is interesting is the demand and the supply of that money. How much money do we print, and how much money do we, for whatever reason, demand. The supply and demand of money determines the price of money. This is essentially the inverse of the price level—what you can buy for that money. So, understanding the demand and supply of money is at the core of understanding monetary policy. One of the books, The Fluttering Veil by Leland Yeager, really sets this out.

If we understand this, much more complicated matters become much clearer. And we don’t stay at that very simplistic description of ‘r’ in our economic models which, essentially, is something that would exist even if there was no monetary policy.

The Fluttering Veil by Leland Yeager is the first of your monetary policy books. Tell us a bit more about the story this book tells.

This is a book that that had a tremendous influence on my thinking about monetary theory. Leland Yeager is a very overlooked economist; he is not well known. This particular book consists of a number of his essays and articles, collected by my friend, George Selgin, now at the Cato Institute. The essays essentially describe a framework for understanding monetary policy. At the core of that is the price level, or rather nominal demand in the economy. (Nominal demand is the number of goods times the price of those goods, which is also the money circulating in the economy.) This is often described by the equation of exchange MV=PY times, which says the quantity of money (M) times the velocity of money (V)—a measure of the circulation of money in the economy—equals prices (P) times GDP/production (Y).

This central to what we call monetarist thinking today. But what Leland Yeager does in his book is to lay out a framework for a theoretical understanding of money. Central to this is an understanding that money is not only about the printing of money, but also about the demand for money. He tells us that if the demand for money increases, we need to increase the supply of money to match it, otherwise we get deflation. A failure to increase the supply of money is essentially what happened in 2008. I would argue that the crisis of 2008 had very little to do with a housing market bubble or excesses prior to 2008, but was rather related to the demand for money increasing sharply and the Federal Reserve and the ECB and all central banks, initially, failing to respond appropriately in terms of increasing the supply of money, the money base.

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What Yeager does in his book is describe what happens where there is that disequilibrium between the demand and supply of money. We either get inflation or deflation, both being harmful. And he argues that what we need to do when we think about money is to create a monetary system where, by some automatic rule, for example through the private issuance of money, which Leland Yeager actually advocated, or through monetary policy rules that adjust so the demand and the supply of money meets to ensure either a stable price level, or stable monetary demand in the economy, or stable nominal demand in the economy.

That’s Yeager’s project for understanding monetary theory. And I think it’s a very, very overlooked book. I read it early on when I was a young economist, but later rediscovered it after 2008 and really learned to appreciate it. It first came out in 1997. It was very much in line with what I read in Milton Friedman. But Yeager continually argues that the focus needs to be on both the supply of, and the demand for, money and that there can be a disequilibrium. In a world without money, where there is never a recession, the price of coconuts and the price of hammers will always find an equilibrium for trade between Crusoe and Friday. But, in a monetary world, if a central bank fails to print enough money when money demand goes up, as happened in the 1930s and in 2008, there will be disequilibrium in the money market, which spills over to the real world, leading to unemployment and low capacity utilisation in the economy in general. It’s only when prices then adjust or monetary policy adjusts that we re-establish equilibrium in the real world and unemployment comes down again. I think these are the very important insights. This book helps us to understand what happened in 2008, even though, of course, these articles were written way before that.

Your next monetary policy book is Milton Friedman’s Money Mischief: Episodes in Monetary History.  What does this one tell us?

This is another book that influenced my thinking, and is also the easiest read of the five. Again, it’s a collection of articles. Milton Friedman retired as a professor from the University of Chicago in 1977. And this book came out in 1992.

I read Milton Friedman for the first time when I was 16 years old, and that was what made me want to become an economist and gave me a keen interest in monetary policy. Money Mischief is a wonderful book. It goes through episodes of monetary mistakes in history and, to a monetary policy nerd, it reads like beautiful literature.

Obviously, Milton Friedman was a master of communication. He could take these complicated matters and set them out in a simple way. I have myself written a book on Milton Friedman. Unfortunately for non-Danish-speaking audiences, it’s in Danish. In that book I called Milton Friedman a pragmatic revolutionary. What Milton Friedman did, both in his academic work on economic theory and history, monetary policy and so forth, and as a policy advocate deeply engaged in policy debates, was to take things and make them very, very easy to understand. And he was able to convince people of his argument by making those arguments very logically.

In Money Mischief, you learn about all the thinking that went on behind Milton Friedman’s academic and policy work. A view that for example was presented in his famous speech to the American Economic Association in 1968, when he was its president. That speech essentially argued that we cannot reduce unemployment permanently below what he called the ‘natural level’—the NAIRU [non-accelerating inflation rate of unemployment]—without creating inflation. In that speech, he forecast what then happened in the coming years of rising US and global inflation, starting around that time.

If you want to understand his work starting in the 1950s and 1960s at the University of Chicago, the Money and Banking Workshop which he set up there, all of that work is summed up beautifully in Money Mischief in a very accessible fashion. It’s something that an economics student can read fairly easily and learn a lot from.

There are also a range of odd examples. He discusses fixed exchange rate policies and looks at two examples, Chile and Israel. Chile had a period of being linked to the dollar, which ended in economic disaster. Israel had a period of being linked to the dollar that helped bring down very high inflation. And he discusses why these two similar policies lead to two different outcomes. He says ‘never underestimate the importance of luck for nations’. I often remember that phrase, because I think it’s so telling in a lot of the things in politics and economics.

Another takeaway from the book that has influenced me is that monetary rules are extremely important. He discusses bi-metalism, which nobody remembers, when some countries used to be linked to gold and others to silver and some to a combination of gold and silver. It’s not that he’s advocating that system, but by taking these historical economic examples, he teaches us about the mechanisms of monetary policy.

We’re staying with Milton Friedman for our next book, which is A Monetary History of the United States.

I got goose bumps when I picked up this book to do this interview, which is really odd given that I have picked it up many, many times before. It’s co-authored with Anna Schwartz, who was Milton Friedman’s long-time collaborator and who was associated with the National Bureau of Economic Research for many years. Unlike Money Mischief it’s a very, very hard read. If you’re looking for something to read on a vacation, you have to be a really committed monetary nerd to go for this book.

Why did they write it and what were they trying to achieve?

The first edition came out in 1971—it’s 50th anniversary is this year.  It reflects the problems of 50 years ago.

It’s best known for its discussion of the Great Depression, that the Great Depression was a result of monetary policy failure, a result of the Federal Reserve failing to respond to a sharp increase in money demand. It’s also known for collecting a lot of data on the money supply. They did great work in that area. These days we take it for granted that economic data is something we just get off the computer. We have the economic data of any country in the world. Sometimes you wonder why a data series doesn’t go back beyond, say, 1973. And the reason is because the data wasn’t collected. What Milton Friedman and Anna Schwartz did was actually construct the numbers. They didn’t make up the numbers, they collected the data for the money supply in the US. In that way they also showed that the monetary contraction of the 1930s played a major role in the Great Depression.

I have now come to appreciate, after reading and studying and doing the analysis, that there is a deeper monetary story that connects the international monetary regime to the one told by Friedman and Schwartz in this book. One of the problems with many US-based economists is that they are so US-centric, they fail to understand the world in a wider context and often fail to learn the lessons from other countries. Because a lot of the economic theory that has been developed over the years is US-centric, we teach economics students about a large, closed economy. But my country, Denmark, is a small, open economy, with no monetary policy of its own. We have a fixed exchange rate with the Euro, which means monetary policy in Denmark is determined in Frankfurt. And most of the cash flows in and out of the country are a result of that. So starting out with a closed economy model actually teaches no Dane anything about his economy.

“Milton Friedman was a master of communication”

Studying the monetary history of the United States of America on its own is tremendously interesting. But I would also say—and Friedman and Schwartz accepted this later on—that they fail to account for what happened with respect to the gold standard and, in particular, what central banks outside of the US were doing in terms of monetary policy. For instance, the fact that the Bank of France was hoarding gold and, by doing that, creating upward pressure on gold prices, which helped create these deflationary pressures, both in the US and in the global economy. The US only decoupled from that when Roosevelt devalued the dollar against gold in 1933, giving a monetary injection into the US.

In the Monetary History Friedman and Schwartz describe this, but from a very US-centric perspective. We can see what happens to the money supply and that analysis is right, but it doesn’t tell the story about that global phenomenon.

Another thing that we learn from Friedman and Schwartz is that money supply numbers are important. To understand what happens to inflation, to nominal demand, we need to start in the money supply. But, as Leland Yeager told us, we need to understand the balance between the money supply and the demand for money. That’s really the important thing. Friedman and Schwartz, of course, understand this and discuss it. They discuss monetary policy in the US right back in the 19th century, after the Civil War. It’s something that’s rarely talked about, but we need to understand that.

What’s the full historical scope of the book?

It’s from 1867 to 1960. You need to be able to step away from the book, and not get lost in the detail. The bigger picture here is that when monetary policy works, when the monetary machine functions well, we don’t see monetary policy. So, in modern times, from the mid-1990s, after inflation had been brought down in Europe and the US, and up to 2008, monetary policy essentially disappeared. It was a period where economists started to write books about sports, Freakonomics, these kinds of things—which I love, by the way. But that was because there was monetary stability, the rules were well functioning and it’s really uninteresting to write monetary history about periods when things are fine. Monetary history becomes interesting when there are monetary policy mistakes. Monetary history is a long description of one monetary policy failure after another.

I think what you can also learn from it is that monetary policy really isn’t made to be optimal. It’s always a gradual process. You have a system that works in a period and then it gets out of whack for some reason. The government behaves in an irresponsible way. There is a war, or the central bank asks the government to print money and suddenly you have inflation. And then a new regime is created that can provide that monetary stability, whether it’s bi-mentalism or the gold standard, or Bretton Woods after the Second World War, or inflation targeting. What they have in common is that none really works perfectly and at some point they all fail.

That’s a lesson you get from reading A Monetary History. There have been these continuous failures. The question for historians is whether today we have a monetary institutional setup that is better than the pre-First World War gold standard. I’m no big fan of the gold standard, but I can’t forcefully argue that what we have today is better than what we had in that golden period of tremendous global trade, global capital flows, and increases in global incomes and prosperity, starting in the 1880s and which broke down with the First World War.

A Monetary History provides the story of the struggle, over successive monetary regimes, to get the monetary system right. It doesn’t get to the last part of the story, but it gets a lot of the story, at least from a US perspective. And what you don’t get in Monetary History, you get in The Midas Paradox.

…which is the next monetary policy book you’ve recommended. Tell us about The Midas Paradox by Scott Sumner.

Scott Sumner was a much overlooked monetary thinker until 2008. This goes back to my student days, when Scott was a young professor. He wrote some very interesting work on monetary policy rules. Scott’s personal history as an academic is interesting in relation to the history of monetary policy, particularly in the US, because Scott and Robert Hetzel, who we’ll come to in the final book, both did some work that was very similar. I read both of them when I was in university in the early 1990s. I’m very happy to call both of them very good friends today.

They both wrote on monetary policy rules and how we could have better rules that could stabilise either nominal demand in the economy or the price level. What happened in the early 1990s was that those kinds of policies were, in a broad sense, adopted. The monetary machine was working fine and nobody was interested in monetary policy. What Sumner had been writing about in his career as a young professor was solved quite fast. But then he started to teach monetary history and was writing on it, and worked on this book, the Midas Paradox, for many years.

Up until the crisis, he had not been a public person. He was just an economics professor. But, when 2008 happened, he said, ‘Well, this is a monetary crisis.’ And Robert Hetzel, who was an economist at the Federal Reserve, said the same thing. And I was sitting in Copenhagen saying, ‘Well, this is a monetary crisis.’

Sumner and Hetzel were both graduates and PhDs from Chicago, where Friedman had taught. I see myself as a Chicagoan, even though I was educated at the University of Copenhagen, because all I read was Milton Friedman. We all came to the same kinds of conclusions in 2008-9. What we all realised was that when we went back to Milton Friedman and looked at the money supply numbers, something was missing because, just looking at the money base, you could see that it was going up. That led a lot of people to conclude that we would have very strong inflation.

But the markets were telling us a different story. Commodity prices and the stock market were plummeting, the dollar was strengthening. In the Treasury bond market inflation-indexed government bonds suggested the market was expecting inflation to fall from around 2% to negative inflation. The markets were telling us that we were not easing monetary policy, but actually going through a period of monetary contraction.

Sumner was the one who, in 2008, pointed out most forcefully what was happening on his blog The Money Illusion. The thinking that came out of this was that monetary stability, and hence economic stability, is about the supply and demand for money and we can observe that in financial markets. They tell us something about it. It’s one thing to observe the money base, but it’s harder to observe money demand and the relation between the two things. If commodity prices and wages are sticky, monetary disequilibrium will not show up there immediately. But it will show up in financial markets. That is the insight of my two last books, Scott Sumner’s book and Robert Hetzel’s. They both argue that we have a way to understand monetary policy or to read monetary policy by observing financial markets.

2008 interrupted Scott Summer’s work on the book he had been working for many years. The book had been rejected by numerous publishers—nobody found Scott’s stories about the Great Depression interesting. 2008 changed that. The story Scott tells is really a contribution to how to conduct monetary research and economic history research. It’s a wonderful book, not only in the way that it describes what happened during the Great Depression, but because it also teaches us a new method of understanding the world.

That method is ‘market monetarism’, a term I coined in a working paper in 2011 or 2010, but which Scott has embraced wholeheartedly. At the core of market monetarism is the old-style monetarism of Milton Friedman and Anna Schwartz, combined with the insight of Leland Yeager, that the demand and the supply of money is important; and that by reading what the markets are telling us we can understand that better than by purely looking at money supply numbers.

“Because a lot of the economic theory that has been developed over the years is US-centric, we teach economics students about a large, closed economy”

Milton Friedman used to say that monetary policy works with long and variable lags, that we do something today and then economic variables change later on. And the way things change depends on the economic regime, price rigidity, wage rigidity, what kind of institutional frameworks we have, expectations and so forth. But Scott Sumner says that monetary policy works with long and variable leads. What does he mean by that? Obviously that isn’t completely right. Monetary policy does not work before it’s been implemented. But the question is, how is it implemented? When do we implement it?

You can explain what he means as follows. If today, as Federal Reserve Chairman, I announce that in three months I’m going to triple the money base, when will that have an impact on the monetary economy? If we take Schwartz and Milton Friedman’s work on monetary history, we wouldn’t see anything in the money supply numbers before we actually triple the money supply three months later. But financial markets move immediately. So the real macroeconomic impact of that announcement would happen immediately. Even before we start printing the dollars, there is an impact. That is a great insight—one, of course, that Milton Friedman understood. But that insight is regime-dependent, because the regime in which we operate shapes all of the economic agents’ actions.

This book came out in 2015 and was many years in the making. Scott wanted to get it perfectly right. He created this method by which a monetary policy action is many things. His primary source was the New York Times, which has a wonderful archive of news articles going back to the Great Depression years. He said that monetary actions would be revealed in market movements. He looked at what happened to commodity prices, to the price of gold and to the stock market.

Textbooks say that if we tighten monetary policy—meaning we contract the money supply relative to the demand for money—then stock prices and commodity prices will go down and the yield curve will flatten—that is the longer term, longer horizon, longer maturity yields will drop relative to shorter maturity yields, and so forth. Sumner asked what this news archive would have to say about major movements in the markets. What did the Federal Reserve or the US Treasury Department say at various points (the Treasury Department was a monetary actor because they were determining the exchange rate policy)? So, both the Roosevelt administration and the Federal Reserve could conduct monetary policy. The introduction of new reserve requirements was the kind of thing you could read in newspaper articles.

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Another thing Sumner did was to say that there are three phases of the Great Depression. There’s the period from 1929 to 1933, a deflationary depression with a monetary contraction. Roosevelt is elected US president in November of 1932. And then there is the devaluation of the dollar in April of 1933. He’s not very far into his presidency when he eases monetary policy tremendously. The second phase is essentially all of the Roosevelt administration’s horrendous policy mistakes. Those policy mistakes were particularly related to the fact that Roosevelt’s economic advisors believed that labour unions were too weak, that deflationary pressures were essentially a result of this crisis of capitalism, and that you needed to strengthen labour unions. So they passed the National Industrial Recovery Act, which was essentially a move for the cartelisation and unionisation of the US economy. One could say that this was not very unlike the kind of economic thinking of the Mussolini government in Italy, essentially corporatist—some would say a fascist—economic policy, where you have strong unions and strong big business coordinating their actions with a strong government to set prices. This maintained private enterprise, but in a way that was a break from what you had seen up to then in the US. It meant that salaries were pushed above levels of productivity. If you look at the stock market in the US at this point, it stalls. You have the initial impact of the monetary easing, but then the US economy is whacked by the National Industrial Recovery Act. Then, in 1935, the National Industrial Recovery Act is overruled by the US Supreme Court as unconstitutional. And you can see the reaction in the financial markets. The stock market shoots up and immediately after that the US economy continues on its path of recovery. Only later on does it run into trouble again, when the Roosevelt administration in 1937 starts to fear inflation. Scott Sumner has a good discussion of that, the so-called recession in the depression that happens in 1937-38. I think there’s great agreement among economists that the Federal Reserve and the Roosevelt administration moved too fast to tighten monetary policy because of those overblown inflation fears.

There’s been lots of discussion about what caused this. What Scott Sumner shows is that dollar policy was quite important and that monetary policy in that exact period works with long and variable leads. The Roosevelt administration’s continued voicing of concerns about inflation was telling financial markets that they would tighten monetary policy soon. And if you know that the dollar will be revalued, what will you do? You will start to hoard dollars. And as you do that the demand for money goes up relative to the supply of money. And then that creates the recession in the depression of ’37. And Scott Sumner shows that in a beautiful way, discussing and going through those New York Times articles, telling us exactly what the administration was saying. Before they took actual actions, by speaking, by voicing their concerns about inflation, they were actually implementing monetary policy. Sometimes policy works before it is actually implemented, or even announced. Obviously, central bankers know this very well today. But that was less the case in the 1930s.

I also think Sumner shows us something that’s missing. When we look at macroeconomic research, and also macroeconomic historical research, we build econometric models where we look at macroeconomic data, and estimate what happens to consumption through the money supply, and to interest rates, and how that all fits together. That’s one kind of model. Then we have simulations, we simulate something, there’s a shock, and we can incorporate rational expectations and forward looking behaviour.

What economist haven’t taken much time over is the empirical study of expectations, those we can read directly from financial markets. That kind of thinking, I learned from Scott Sumner. It would be wrong to say that I learned it from reading The Midas Paradox, because I read Scott early on in the 1990s, and have known him for many years now. But it combines that thinking about money with the really deep economic and historical thinking. That’s the beauty of the book.

Let’s move on to your final monetary policy book, The Great Recession: Market Failure or Policy Failure? by Robert Hetzel.

Bob had a very distinguished career at the Federal Reserve System. He joined the Federal Reserve System in 1974, at the Federal Reserve Bank of Richmond, and was an advisor to four or five different presidents of the Richmond Fed. In that capacity, he participated in a significant number of Federal Open Market Committee meetings, going back to the 1970s. He retired a couple of years ago.

This means that Bob is probably the Federal Reserve official who has been closest to monetary policy for the longest in the US. His own insights are, of course, shaped by being a Federal Reserve insider for many, many years. But he’s also maintained a very strong, independent and academic strand of thinking.

Hetzel wrote his PhD with Milton Friedman as his primary advisor. And you can see Milton Friedman’s influence on Hetzel. The Great Recession: Market Failure or Policy Failure is very much written in the great tradition of the Monetary History by Friedman and Schwartz. It’s just a tremendous work. You have to remember this book was written while Bob was still a policymaker/researcher within the Federal Reserve System. It’s a really scathing critique of the conduct of monetary policy in the run-up to 2008 and the aftermath. The Federal Reserve System deserves a lot of praise for allowing that. It would never have happened in Europe.

This book actually discusses two things, but at the core of it is a working paper that came out in 2010. The argument in that paper is the same argument that Scott Sumner was making and that I was making at the time, that the cause of what happened in 2008 was not a property market bubble. It was not over-easy monetary policy ahead of that, it wasn’t that interest rates were too low, although they might have been. The main cause was the Fed’s failure to respond aggressively enough, in a rules-based way, to the increase in the demand for money. And that brings us back to Leland Yeager.

You have this hoarding of dollars, not by the French central bank, as in the 1920s, but by private investors. When Lehman Brothers collapsed, there was a hoarding of dollars, and the Fed responded to that only gradually and not aggressively enough. That’s really at the core, this monetary disequilibrium as a result of the Fed’s failure to respond. That brings us back to this question about interest rates. If you see interest rates as your measure of monetary policy, you would see that they had cut interest rates to nearly zero. Monetary policy is very easy.

Friedman used to say that interest rates are low when monetary policy has been tight. And why is that? Well, if monetary policy has been tight, inflation and inflation expectations are low. As Irving Fisher said, interest rates have two components, a real component and an inflation expectations component—the so-called Fisher equation. And so, when inflation expectations drop because monetary policy is tightened, interest rates are low. There is also what we call a liquidity effect, that if you flood the money market or the bond market with money, you can push up the price of bonds, and thereby push down interest rates.

“Monetary history becomes interesting when there are monetary policy mistakes”

What Hetzel and Sumner realized in 2008 was that monetary policy was becoming very, very tight. And we can see it from those market indicators. The Fed, for a very long time, thought that monetary policy was becoming too easy because it was expanding the money base and interest rates were low. But Hetzel is looking at many more different measures of the money supply. For instance, if you have all your money in money market funds, what do you do when the world is collapsing? You put money into the bank. In terms of pure monetary statistics this will increase the money supply as it is measured, since bank deposits are part of the money supply, but money market funds are not. That was what was happening in 2008.

One of the things that Robert Hetzel is really, really good at is understanding that kind of factor and disentangling these things to say, ‘Well, that is happening, but you should study this and this and this, as well.’

If you look at the so-called TIPS market, the inflation-linked Treasury bonds in the US, the difference between the yield on regular nominal government bonds and inflation-linked government bonds is the inflation expectation for a given period. That difference declined very steeply in the summer and autumn of 2008 and was telling us that monetary policy was tight.

If we go back to Money Mischief, Milton Friedman said that the money supply should grow by a fixed rule, or fixed percentage every year, 4% or 5%. That would ensure nominal stability and hence low and stable inflation. But, in doing that, we ignore the fact that demand for money can change, as happened in 2008. That was the thing that Leland Yeager would have told us. But Friedman knew when he wrote Money Mischief that that rule maybe wasn’t the best rule and that Robert Hetzel had actually come up with a better rule.

Friedman wrote in 1997: “Recently, Robert Hetzel has made an ingenious proposal that may be more feasible politically than my own earlier proposal for structural change, yet that promises to be highly effective in restraining the inflationary bias that infects government. He proposes that ‘the Treasury be required through legislation to divide its issue of bonds at each maturity into a standard bond and an indexed bond. Interest and principal payments on the indexed bonds would be linked to a price index. The Treasury would be required to issue the two forms of bonds in equal amounts. The market yield on the standard bond, which makes payments in current dollars, is the sum of a real (inflation-adjusted) yield, and the rate of inflation expected by investors. The market yield on indexed bond, which pays interest in dollars of constant purchasing power, in contrast, would simply be a real yield. The difference in yield on the two kinds of bonds would measure the inflation investors expect over the life of the bonds.'”

This is what Hetzel had written in an op-ed in the Wall Street Journal in 1991. He had written that op-ed at Milton Friedman’s suggestion. Friedman also suggested to the opinion editor at the Wall Street Journal that they should print it. And Friedman also suggested to the then Treasury Secretary, Larry Summers, that the Treasury should actually issue inflation-linked bonds, which they did in 1997. And, since then, we have had a measure of market inflation expectations.

Interestingly enough, that market in 2008 told Robert Hetzel, who had been behind its creation, that monetary policy had become too tight. I think that’s a beautiful story.

If we look at the rhetoric today of monetary policymakers at the Federal Reserve, the Fed refers to market inflation expectations to an extent that they never did before. Now he’s retired from the Federal Reserve System, Robert Hetzel, in his commentary on the Fed’s actions over the past 14 months, has been increasingly voicing concerns about monetary policy becoming inflationary—concerns I largely agree on. But both Bob and I have a problem. One of our favourite measures of inflation—namely, market inflation expectations—is telling us not to be too worried. But what we learned from Milton Friedman was that we should be worried when the money supply goes up by 27%.

One of the things that permeates all of Robert Hetzel’s writing is that monetary regimes are important, that we cannot analyse monetary policy independently of the monetary regime. The monetary supply going up means one thing if you have a fixed exchange rate policy, but it means another thing if you have no policy at all.  It means something else if you have an inflation target. So, what we learn from reading Hetzel and Sumner on top of Friedman, is the importance of these institutions.

Another thing that Hetzel discusses in the book is ‘too big to fail’. Just because Hetzel is not saying there was a bubble in 2008 doesn’t mean that he didn’t say there was a problem. He strongly believes in, and spelled out in the book, that financial regulation and different subsidies within the US housing system—ownership guarantees, both implicit and explicit—created a lot of problems in the US banking system in the run-up to 2008. He has a good discussion of ‘too big to fail’ and moral hazard issues in the book. It’s an important discussion of what happens financially in the run-up to 2008, but he doesn’t suggest it’s the main cause. He sets it all out wonderfully in this book.

Interview by Benedict King

August 11, 2021

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Lars Christensen

Lars Christensen

Lars Christensen is a Research Associate at Stellenbosch University as well as a Senior Lecturer at the Copenhagen Business School. He is a member of the advisory board of Life + Liberty Indexes and the owner and founder of Markets and Money Advisory. He has worked as an economist for the Danish government and for Danske Bank. He is the author of  Milton Friedman – en pragmatisk revolutionær (Milton Friedman – a pragmatic revolutionary).

Lars Christensen

Lars Christensen

Lars Christensen is a Research Associate at Stellenbosch University as well as a Senior Lecturer at the Copenhagen Business School. He is a member of the advisory board of Life + Liberty Indexes and the owner and founder of Markets and Money Advisory. He has worked as an economist for the Danish government and for Danske Bank. He is the author of  Milton Friedman – en pragmatisk revolutionær (Milton Friedman – a pragmatic revolutionary).