Milton Friedman’s Letter: I Do Believe There is Gold in Them There Hills

I came across this letter today while digging in my desk for something else, and decided I should make a digital copy since it was starting to show its age. Having done so, I decided to post it here (after thinking about whether it would seem to self-serving, or whatever, which it probably does).

This is why I will always have a soft spot for Milton Friedman. I was a relatively new assistant professor when I received this in response to a paper I sent to him. The paper was based on his Plucking Model, but I never expected a reply, and given the demands on his time, I'm still amazed he responded at all. Some parts, such as this, relate at least tangentially to debates we are having today:

In a frictionless world in which money was completely neutral, the impact of monetary growth would always be solely on inflation. In the real world, given the lags that I have described and taking for granted that positive money growth is not reflected in inflation for a considerable period, it must be reflected somewhere. The obvious candidates are output, interest rates, and buffer money stocks. When the economy is operating below capacity, it is easy for part of the impact to be taken up by real output and a lesser part by interest rates or by buffer stocks. But when the economy is operating at full capacity, it cannot be taken up by output. It will therefore have to have a stronger influence on the two other components.

Milton Friedman was my dissertation advisor's dissertaion advisor, so I guess he's my intellectual grandpa. Here's the letter (at this time, monetary aggregates were used to measure policy, and the debate over the use of M1 versus M2 in empirical work was not yet fully resolved) (pdf):

Stanford, California 94305-60I0
June 24, 1991
Professor Mark Thoma
Department of Economics
University of Oregon
Eugene, Oregon 97403-1285

Dear Mark Thoma:
I was delighted to receive your paper "Asymmetries and the Effects of Money." Needless to say, I am pleased that my paper stimulated you to do further work along these lines. I do believe there is gold in them there hills.
I am not competent to judge the details of your statistical analysis. I have not kept up with recent statistical developments, particularly those associated with the VARS. Hence, my comments will be on a much more general level; I assume that you have done the details correctly.
On the series employed, I believe that M2 is preferable to M1 in most such analyses. It has had a stabler meaning over time and a more consistent relationship with other economic magnitudes. Interestingly enough the first two articles in the May issue of the Journal of Money, Credit, and Banking, which has just come my way, reach the same conclusion.
It would be highly desirable to extend your analysis to a longer period. Monthly data are available on M2 for as far back as on Ml, both to 1907. The current M2 series can be regarded as a continuation of the M3, or for a trivial improvement, the M4, series in Table 1 of Anna Schwartz's and my Monetary Statistics of the United States. Linking those data with the current Federal Reserve Board M2 series gives a reasonably homogeneous and continuous series. Similarly, linking our Ml series with the Federal Reserve's does the same. Interest rate series are of course available way back. Monthly industrial production indexes are available back at least to 1919 and perhaps earlier. In short, the same analysis carried back to encompass the whole period from about 1907 on should be entirely feasible and would give a much sounder base for any conclusions.
Returning to the period you considered from 1959 on, I suspect deflated personal income would be a more useful monthly measure of real output than the industrial production index, which is rather limited in its coverage and does not always track total output very well.
One further point re the interest rate data that you used. The appropriate variable is not the Treasury bill rate or the commercial paper rate by itself, but the difference between the Treasury bill rate and the interest paid on money. In our Monetary Trends, we used an approximation computed by assuming that implicit interest was paid on demand deposits. Bob Hetzel

Professor Mark Thoma
June 24, 1991
Page 2
at the Federal Reserve Bank of Richmond has constructed a better series of the interest paid on M2 as well as a series on the differential interest, that is, the excess of the interest earned on outside assets over the interest earned on money. I do not recall whether his series are monthly; they may be quarterly. However, the interest paid on money is a rather slow-moving series with high serial correlation, so it should not be difficult to interpolate it. In any event, you might want to get from Bob his series.
Turning to your mathematization of the idea, I am struck that it is extremely ingenious and I have no comments to make on that. In re the conclusions, I am not greatly disturbed that positive money growth shocks do not have a large impact on inflation when the economy is operating at maximum level. We have consistently found that changes in money lead changes in inflation by about two years, and there is no reason why that lag should not be just as operative at upper turning points as elsewhere. You include, as I understand it, a lag of at most six months. True, the impulse response functions implicitly extend the lag, but I suspect that is not the same as allowing for a very much longer lag. Changes in money tend to affect output after something like about six to nine months, and inflation only after another 18 months, by which time the effect on output is negative rather than positive. Hence, it is not surprising that the short-term reaction is on interest rates rather than on inflation. In a frictionless world in which money was completely neutral, the impact of monetary growth would always be solely on inflation. In the real world, given the lags that I have described and taking for granted that positive money growth is not reflected in inflation for a considerable period, it must be reflected somewhere. The obvious candidates are output, interest rates, and buffer money stocks. When the economy is operating below capacity, it is easy for part of the impact to be taken up by real output and a lesser part by interest rates or by buffer stocks. But when the economy is operating at full capacity, it cannot be taken up by output. It will therefore have to have a stronger influence on the two other components. A measure of buffer stocks conceivably could be obtained from velocity figures, but this is rather questionable since empirically velocity tends to be positively related to the cycle, implying that buffer stocks are less at the peaks. However, this conclusion is for measured velocity which is not necessarily the appropriate variable. What you would really like is the difference between actual and desired money stocks; that would depend on long-term variables such as permanent income rather than current nominal income. Perhaps some of the people who have done research on buffer stocks have constructed estimates of their size. David Laidler would probably know. If there were a convenient series available, it would be interesting to introduce it as an additional nominal variable.
The disturbing finding is that negative money growth shocks have a negligible impact on real activity when the economy is at its maximum level. I did not expect that and so any explanation I suggest will be a rationalization. The

Professor Mark Thoma
June 24, 1991
Page 3
rationalization that appeals to me most is very much along the line of the distinction between permanent and transitory components of consumption. The counterpart is the following. You have divided your dates into three batches: corresponding to maximum output, average output, low output. Money is by no means the only factor that accounts for the economy being at the stage it is. Of the many other factors at any point in time, some are likely to be favorable, some are likely to be unfavorable. Consider the group of dates corresponding to maximum output. The method of selection of those dates assures that favorable factors dominate. Conversely, at dates corresponding to low output. At dates where other factors are disproportionately favorable, negative money growth shocks might simply be offsetting other unduly favorable factors, while at the bottom they would be reinforcing disproportionately unfavorable factors. A way to get around this regression bias would be to classify dates by the level of the money series as opposed to the level of the output series. One could then see whether the influence of downward plucks in money was different at high levels of the money series, which means that the money series was relatively favorable to the level of output than they are when the money series was average or low.
I am not sure what to expect from this experiment. It would not surprise me if the downward plucks had roughly the same effect at all three money levels. I have stated this suggestion in my statistical language not yours, but I trust that you can translate it.
These are off-the-cuff comments on a paper that I clearly found interesting. Keep it up.

Sincerely yours,
Milton Friedman
Senior Research Fellow

CIT saved, but troubles still brewing in the CP market

David Rosenberg of GluskinSheff draws attention to the continuing contraction of the US commercial paper market, one of the main portals of funding for medium-sized enterprises in the country. In his latest report he writes (our emphasis): We continue to hear from strategists and economists that the credit clouds have parted,...

“A More Pleasant Society will then Evolve”

Do egalitarian societies cause egalitarian beliefs?:

How to upgrade human values, by Andrew Leonard: "As Karl Marx would have said," writes Yale economist John Roemer in the newest edition of the Economist's Voice, "under feudal rules we get serfs who desire only to subsist; under capitalism, we get capitalists who desire to maximize their wealth. Each mode of production (set of rules) determines to a large extent the values and the social ethos of the people who live within it."
But most economists, says Roemer, don't see people's values as contingent on modes of production; so when they think about ways to tinker with the "system" so that global economic meltdowns are less likely to clobber us, their premise is "that we must accept people as they are and design new rules that will prevent bad results from occurring."
Roemer believes that in a capitalist society individuals will always figure out ways to break or twist the rules. So he proposes what he calls "a less ambitious aim": Changing people. "If we follow a path leading to a society whose individuals are more solidaristic, then I believe it is much easier to design rules that will guarantee good outcomes."
So how does one go about this? Basically, Roemer suggests that if you build a more egalitarian system, people will change to reflect more egalitarian beliefs. He uses the oh-so-topical issue of healthcare as an example.
There is of course no social engineer who can command either that people change their preferences, or who can impose a new set of rules. Because we value democracy, rules must ultimately be approved by the voters. Nevertheless, history may produce a path that would engender the desired change in preferences and rules. Suppose, for example, that America succeeds in implementing universal health insurance; that is, that voters in their majority demand it. A more pleasant society will then evolve: people will be under less from the fear of losing their health insurance when unemployed, or because they contract a major disease; emergency rooms will be less clogged with poor, uninsured persons; insurers will have incentives to urge people to undertake more healthy life styles (to keep costs down), and so on. There is a good chance that citizens generally will like these changes -- not only because of their own increased financial security, but because civility will increase, and poverty will be, at least along one dimension, less glaring. Citizens may come to value equality of condition more than they previously did. This change in preferences may well render politically feasible other insurance innovations and increased financing of public goods -- more support for the unemployed with job training, perhaps more direct income support for the unemployed, and more support for intensive education for the disadvantaged.
Well, one can dream, can't one? ...


Where, oh, where do we place the Bloomberg news agency on this "visual thesaurus," an interactive tool from Thinkmap that allows us to "discover the connections between words in a visually captivating display?"  Words like GULLIBLE. We ask because of the latest reporting howler, whereby Bloomberg -- through its automatic republishing of external news sources -- managed to distribute a seemingly fake takeover story involving Harman International,...

The modifier on innovation

There has been a fair amount of discussion recently about financial innovation. Willem Buiter has suggested that new financial products should have a licensing regime akin to drugs, and Felix Salmon has written provocatively on the link (or lack thereof) betweeen innovation and economic growth. This should be read in the context of David Warsh's work on Knowledge and the Wealth of Nations, a work that this post from Science Blogs reminded me of.

So, what do we know? First that certain infrastructures help innovations generate wealth. The ability to profit from a good idea helps, as does the ability to finance development. Hence patents and joint stock companies. Education is necessary, and law which gives certainty of ownership is also helpful.

Next, we know that most innovation does not produce growth. A lot of it isn't harmful, but there are many, many dead ends. Markets are sometimes (but not always) good at sorting out which ideas are useful.

Now to specifically financial innovation. The point of financial innovation is to produce products which meet specific needs better (more cheaply, more accurately), and thus often to lower the cost of finance. Some innovations have worked out: a good example would be the convertible bond, which allows companies to monetise the volatility in their stock price. Others have been more or less useless but benign. Credit spread options are a good example here: in the early days of credit derivatives, these were a competitor with CDS as standard credit risk transfer products. CDS turned out to work rather better, and so credit spread options faded into illiquidity without doing anyone any harm.

Are there genuinely harmful wholesale financial products? I am still not sure that there are. I certainly can't think of one. If firms are required to keep enough capital against the risk of a product; to value it properly; and to document it carefully, then why should trading be constrained? Isn't product licensing just a route to a less efficient economy?

links for 2009-07-21

Bernanke in the Wall Street Journal on Exit Strategies

Chairman Bernanke (in an unusual move ) discusses exit strategies from the Fed’s current policy stance. I thought it was unusual as the piece is in the Wall Street Journal on the day that the Chairman will testify before Congress on the economic outlook and monetary policy.

The article is rather pedestrian and does divulge any novel approaches. It is pretty standard stuff with reliance on paying higher rates of interest on reserve accounts or employing traditional matched sales.

I would also be remiss if I failed to note that at both the beginning and the end of the article that the Chairman noted that funds would remain low for an extended period of   time and economic conditions did not warrant shrinkage of the Fed balance sheet at the present time.

Metals in China Rise; HK Lehman Bonds Settlment

Mining and metals stocks surge in Shanghai. Retail investors have driven the demand for resource stocks in the last three months on the hopes of economic recovery. China Minsheng surge an approval to sell shares in Hong Kong. HK banks will pay sixty percent of principal of Lehman minibonds.

Bulls Win Today; Watson’s Example is Timeless

Good Evening: U.S. stocks stretched their recent winning streak to six straight today, as some good economic news and some potential help for CIT combined to lift share prices. With more investors becoming convinced the worst is over for our economy, the major averages all tacked on gains of 1% or more. The S&P 500 posted its highest close of 2009 on Monday, and though we haven’t exactly seen a buying panic yet, those who are either short or underinvested are getting increasingly uncomfortable. The swelling ardor for equities should remind bulls and bears alike of the need to be patient and flexible in this unprecedented environment, but I wonder if we would even be in this fix if financial professionals at all levels were more like Tom Watson.

Stock markets overseas were on the firm side overnight, as were our stock index futures this morning. Much of the credit for this early rise went to a pending capital infusion by CIT’s current bondholders (see below). This privately financed rescue package would be a costly one for CIT (indications are LIBOR +1000 bps), but it’s good news in that 1) hundreds of small and medium sized businesses will see less disruption to their operations, and 2) the U.S. government is not involved. With $2 billion out of a total of $3 billion already committed, a CIT rescue is not exactly a done deal, but word that Seth Klarman’s Baupost Group is on board will probably give other bondholders the comfort (and cover) they need to participate.

Adding to the warm and fuzzy feelings before the bell was a stronger than expected print for the leading economic indicators. Up 0.7% versus consensus estimates of 0.5%, the leading indicators figures have now been strongly positive for three straight months — a streak usually associated with the end of recessions in the post WWII period. This post-bubble recession may be a different animal than ones populating econometric models, but the strength in the LEI was enough to cause BAC-MER to once again opine that the worst is most assuredly over for the U.S. economy (see report at bottom). Other firms offered similar sentiments, and stocks wasted little time in rallying 1% once trading commenced in New York.

When the S&P was unable to surmount the 950 level, a quick bout of profit taking took the major averages back toward unchanged. That was it for the downside, though, and equities spent the balance of the session marching higher. By day’s end the S&P did manage to close above 950, and the rest of the averages closed with gains ranging from 1.1% (S&P, Dow) to 2.1% (Dow Transports). Treasurys for once didn’t suffer at the hands of a strong equity tape, and yields fell between 2 and 5 basis points. Dollar holders had their pockets picked by approximately 1%, while commodities continued their confident run to the upside. Recently acting more like a tech-laden ETF than a basket of tradable goods, the CRB index levitated a further 1.2% today.

It was nerves, pure and simple. I refer not to yesterday’s British Open, but to the time 13 years ago when I stood on the first tee of the 445 yard first hole at Cog Hill Golf Club. Through a series of fortunate events, I had the honor of playing in the Pro-Am of the Western Open, one of the PGA tour’s oldest tournaments. Before I could even swing my driver on that opening hole, I had warmed up on the range with household names; I had my photo taken with a future member of golf’s Hall of Fame; and my brother/caddie was sporting a bib with my name on it. Greg Norman’s group had just teed off ahead of us, and the group including Tiger Woods, then an amateur, was set to tee off in the group behind us. The fairways were lined with people on both sides, the loudspeaker had called my name, and I suddenly realized this was a very big deal.

I barely made contact, and the ball skittered just far enough along the ground for me to escape the indignity of not getting past the ladies’ tee box. As my group headed toward the fairway, I asked our pro for advice. “Tom, how can I deal with nerves on the golf course?” The legendary Tom Watson turned to me and smiled, saying, “just take a deep breath, finish your backswing, and then fire. You’ll be fine”. And he was right; it worked.

Though he was trying to prepare for the tournament that would start the next day, Tom Watson spent the entire afternoon engaging everyone in our group. Want golf advice? He gave it. Prefer to figure it out for yourself? Tom let you play. Ask him a question, and he’d look you in the eye before giving you a straight answer. He told golf stories, a couple of jokes, and was not above playing a practical joke on one of his playing partners. Coming off the 18th green, our whole group agreed that Watson was a consummate gentleman from the old school, the type of man who understood it is the fans, volunteers, and pro-am donors who transform the game he loves into a great way to make a living. He tried very hard to make everyone — including the marshals and sign holders — feel special. He was a class act, a man of character.

I relate this vignette not because I’m a golf fanatic (though I am). Nor is it some ode to Tom Watson, though it would be fitting after watching him almost beat the world in the Open Championship this past weekend at the ripe age of 59. I write not to say how much I feel for a man who gave it his all against long odds in an attempt to make sports history. No, I write to say that I wish there were more Tom Watsons on this planet. Had the executive suites in Wall Street been populated by men with his character, and had policy makers in Washington (e.g. in the corner office of the Eccles building) possessed even a fraction of his values, then we might have avoided the worst of the financial crisis.

It’s been said, and I agree, that you learn a lot about a person during a round of golf. Honor, grace, dignity, and a penchant for doing what’s right because it’s the right thing to do — those were the things I learned about Tom Watson that day in 1996. That he couldn’t win a record sixth British Open when almost eligible for Social Security is a shame, but it’s not a tragedy. As Mr. Watson himself said in mock admonishment to the press after letting the title slip away in a playoff yesterday, “C’mon, this isn’t a funeral!” No, the tragic loss I bemoan is that there aren’t more people like him, and not just on the PGA tour. Whether in high places in Wall Street or in high office in Washington, we need more role models like Tom Watson.

– Jack McHugh

U.S. Stocks Gain, S&P 500 Jumps to Highest Level Since November
CIT Said to Get $3 Billion Rescue Financing From Bondholders
Leading Index Shows U.S. Economy Nearing Slump’s End
Tom Watson Not Ready to Mourn After British Open Loss to Cink
LEI suggest economy passed the bottom.pdf

techfile 21.07.09

  • Barnes & Noble unveiled its challenge to Amazon’s Kindle e-book service with an expanded online store selling more than 200,000 e-book titles for both laptop computers and mobile devices. The chain also said it would provide the e-book store for a wireless portable e-reader being developed by Plastic Logic that is scheduled for launch next year.
  • Texas Instruments, the second largest US chipmaker, reported a surge in demand for its products in the second quarter as it beat revenue and profit expectations. Following Intel’s positive outlook last week, TI gave another boost to the tech sector, forecasting solid growth in the current quarter.
  • The European Union is taking a closer look at how Google’s book-scanning project might affect authors’ and publishers’ copyrights. In October Google agreed to pay $125m to settle a dispute with authors and publishers in the US, and the EU is seeking comments on how that settlement might affect its 27 member nations.
  • EMC has acquired a majority stake in Data Domain following the conclusion of a bidding war with NetApp. EMC now has 83.1 per cent of Data Domain shares, and expects to complete the acquisition once it has at least 90 per cent of shares. EMC also said that Data Domain would be the centre of a new de-duplication division within the company, to be led by Data Domain chief executive Frank Slootman.

Shaking The MoneyTree: VC Investment (Still) Rises in Q2

Stop me if you’ve heard this one before: Venture capital investing increased in the second-quarter of 2009, even though investment activity was still much lower than in Q2 2008. Oh yeah, we wrote about it over the weekend (and have been twittering about it for weeks).

What’s different this time is that the data comes from MoneyTree, a joint venture of the National Venture Capital Association, PwC and Thomson Reuters. That last one just happens to publish peHUB, which means we trust these numbers a bit more, have access to the actual database and are able to display a gluttonous smorgasborg of charts (see below).

The topline number is $3.7 billion invested in 612 U.S.-based companies. This compares to $3.19 billion raised by 601 U.S.-based companies in Q1 2009, and $7.55 billion raised by 1,048 U.S.-based companies in Q2 2008. To use a semi-apt sports analogy, VCs took a baby step off the sidelines, but are nowhere near the line of scrimmage (particularly given that barely over $300 million has been invested thus far in Q3).

In terms of industy sectors, IT managed to (barely) keep its unbeaten streak alive against life sciences ($1.72b vs. $1.53b). This is different than what the earlier data from Dow Jones showed, and MoneyTree does show biotech as its fattest cash cow in a more segmented analysis.

The quarter’s largest deal was for startup Clovis Oncology, which raised $146.3 million from Domain Associates, New Enterprise Associates (NEA), Versant Ventures, Aberdare Ventures, Abingworth, Frazier Healthcare Ventures, ProQuest Investments and the Company’s management team. Click here to download the entire Top 10 Deals list, including an unannounced $40 million round for online identity management company LifeLock.

Northern California continued to dominate geographically, with its companies garnering 32.29% of all domestic VC investments. Runner-up New England grabbed just 12%, followed by a virtual three-way tie between NY Tri-State, SoCal and Rocky Mountains.

The second quarter’s busiest firm was Canaan Partners, with 18 transactions. It was followed Innovation Works (17), Kleiner Perkins (16), New Enterprise Associates (16), Polaris Venture Partners (13), DAG Ventures (11), U.S. Venture Partners (11) and First Round Capital (11). The busiest seed/early stage investor was First round (apropos), with 9 such transactions.

Tons of charts below. If there are other types of runs you think we should do, just let me know in the comments section. And, remember, the amount of investment only reflects what has gone out. The far more important number, at least from a VC sustainability point-of-view, is what is returned:


FSA warns banks over long-term bonuses

Banks that have agreed to pay their executives a guaranteed bonus for more than a year risk heavy penalties, the head of the FSA warned in a letter sent to more than 40 chief executives within the financial services industry. Hector Sants said using long-term guarantees to lure star investment bankers could put them in breach of the authority's new remuneration code....

Deutsche Bank caught by ‘spying’ probe

Deutsche Bank is involved in a probe into possible criminal wrongdoing after it hired detectives to carry out surveillance of board members in the latest in a series of "spying" scandals at top German companies. Data protection authorities in the bank's home state of Hesse have asked prosecutors to establish whether to open a criminal inquiry,...

Friends rejects Resolution’s sweetened offer

Friends Provident on Monday rebuffed a fresh takeover proposal from Clive Cowdery's Resolution after a frosty meeting that left the two sides at odds over the structure of a merged group, the FT said. Mr Cowdery said his Guernsey-based company would not make an offer for Friends that compromised Resolution's status as a separate vehicle designed to pursue various consolidation projects....

Drug groups to reap swine-flu billions

Some of the world's leading pharmaceutical companies are reaping billions of dollars in extra revenue amid global concern about the spread of swine flu. Analysts expect to see a boost in sales from GlaxoSmithKline, Roche and Sanofi-Aventis when the companies report first-half earnings lifted by government contracts for flu vaccines and antiviral medicines,...

Tarp exposes US to $23,700bn risk, watchdog says

Neil Barofsky, special inspector-general for the troubled asset relief programme, said that the various US schemes to shore up banks and restart lending exposed federal agencies to a risk of $23,700bn - a vast estimate that was immediately dismissed by the Treasury, the FT said. The Treasury said the estimate for total liabilities was "inflated"...