Friday’s U.S. employment report came in strong, showing nearly 300,000 new jobs created during the month of April. The unemployment rate declined to 6.3 percent, a level not seen since September 2008. And while falling labor force participation, which I have written about previously, remains a concern, overall the announcement helps assuage concerns that the economic recovery is stalling out.
What fundamental factors underlie the continuing improvement in the U.S. economy? Some clues about where to look can be found in work that Milton Friedman and Anna Schwartz published more than half a century ago, in their 1963 article “Money and Business Cycles” from the Review of Economics and Statistics. In that classic paper, Friedman and Schwartz presented evidence showing how movements in the U.S. money supply exhibit a noticeable lead over subsequent movements in economic activity so that, for example, a sharp decline in money growth almost always presages a recession.
In much of his other writing, Friedman used the evidence he assembled with Anna Schwartz to argue against the view—as popular in his time as it has become today—that there is an inherent instability that plagues all capitalist economies and that policymakers must constantly work to fix. Friedman explained, instead, how the lead of money over output is consistent with the much different view that activist policymaking leads consistently to mistakes that are, themselves, a source of macroeconomic instability. According to Friedman, monetary and fiscal policies work much better when they are conducted according to simple rules that all workers, consumers, and business owners can follow and understand. Under those conditions, the government removes itself as a source of distortions and shocks and allows private agents, operating in free and fair markets, to create stable growth in spending, income—and jobs.
Although much about the U.S. economy has changed since Friedman and Schwartz did their work, the relationship between money growth and economy activity that they detected long ago still appears, even in the most recent data. The graph below shows this, by plotting year-over-year growth rates of the Divisia M1 and M2 money supply measures constructed by William Barnett and his associations at the Center for Financial Stability in New York. Notice how, in the picture, declining money growth occurs in the years leading up to the last two recessions in 2001 and 2008-09. Notice, too, that after accelerating during the early stages of recovery in 2009, U.S. money growth declined quite sharply again. This last observation suggests that the Federal Reserve pulled back too soon from its initial attempts to stabilize money growth in the aftermath of the financial crisis, allowing insufficiently accommodative monetary policy to generate the sluggish growth and slow inflation that we have seen more recently.
The money supply rebounded in 2011, however, and has continued to growth at healthy rates since then. Those who organize their thoughts about the economy using the intellectual framework developed by Friedman and Schwartz, therefore, have not been surprised to see the economy regain its strength. Indeed, all the signs point to continued improvement ahead.
Federal Reserve policy remains far from perfect. By expanding the scope of its open market purchases to include mortgage-backed securities in addition to U.S. Treasury bonds, the Federal Open Market Committee has misdirected its efforts towards the allocation of credit to a particular sector of the economy. This ignores evidence that borrowing and lending occurs much more efficiently when decisions are made by private agents who have their own money to lose from their mistakes. And by paying interest on bank reserves at the same time it has been conducting its large-scale asset purchases, the Fed has been using one policy tool to work against the other, perversely limiting the impact that the massive expansion in its balance sheet has had on the broader measures of money shown in the graph.
Still, unlike their counterparts at the European Central Bank, which I have focused on before, Federal Reserve officials deserve credit for not sitting idly by while money growth stagnates and deflationary pressures build. Now, by continuing to scale back its interventions in the economy, while making sure that broader measures of the money supply continue to grow at stable rates, the Fed is doing everything it can to support an accelerating economic recovery.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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