What was true in Adam Smith’s day is still essentially true in market economies, despite great growth in the size of government and business organizations. Nor is it any less miraculous today than in Smith’s day that, with very little central economic planning or control over the decisions of individual producers and consumers, millions and millions of different goods and services are produced and delivered in the quantities desired, in the qualities and types wanted, at the right places, and at the right time. This is, if anything, more remarkable today than in Smith’s day because of the complexity of the modern industrial process with the long lead-times involved in planning production, the highly specialized nature of industrial production, and the masses of people involved in producing even the seemingly most simple objects.
To get a sense of the remarkable complexity of determining in a modern industrial economy what to produce, how to make it, for whom, and how much in total, consider some object of our society, such as this. Think what was involved in producing it: the building and running of the printing press; the manufacture of the steel that went into the press; the assembly of the iron ore, coke, steel scrap out of old automobiles and so on; the metal alloys that were needed to make the steel equipment, the printing press, the structures in which all this activity was housed; the mills in which the paper for the book was made; the chemicals that went into the paper-making process; the inks; the textiles for the book’s hard cover; the thread for its binding; and so on. Consider the diversity of human labor involved in making and marketing. The steel workers, printers, farmers, engineers, chemists, railroad engineers, fork truck operators, book salesmen, publishing executives, truck drivers, secretaries, and even authors – authors who needed typewriters, typewriter ribbons, paper, other books, calculators, pencils, pens, desks, and offices. Think of the transportation system by which this manuscript was carried between the authors in different cities.
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Resting on the pillars of private property, freedom of enterprise, the profit motive, and competition, the primary economic institution of the essentially free, decentralized economic systems is the market. A market is a place where buyer and seller transact business. But it is not necessarily, or even usually, a single physical location. Indeed, the distinguished British economist Alfred Marshall stated that, “A market is an area within which buyers and sellers are in such close communication with each other that price tends to be the same throughout the area.” One could in fact, take this approach to the meaning of the term even further and simply say that the market is a method or system permitting buyers and sellers to deal with each other, either directly or through intermediaries. In a market economy every good or service can be regarded as having a market, in which certain quantities of the good are bought and sold. In a market economy private persons and businesses, freely exchanging goods and services chiefly through the medium of money, largely determine by their actions what goods are produced by the nation, how those goods are produced, who gets them, and how much will be produced in total – both now and in the future. However, the governments of all market economies in the real world regulate, modify, and supplement the workings of markets in order to achieve particular social objectives, such as the military defense of the nation, the preservation of natural resources, the provision of common facilities such as highways and schools. But the marketplace remains the primary economic institution of a free, decentralized economy.
One of the major discoveries made by early economists, including Adam Smith, the noted eighteenth-century British economist,was the way that markets work in a free enterprise economy to allocate resources efficiently and spur national production and the growth of income. Adam Smith was so impressed by the way free markets worked to solve human problems that he said it was as though the economy were guided by an “invisible hand.”
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The third of three episodes in a major natural experiment in monetary policy that started more than 80 years ago is just now coming to an end. The experiment consists in observing the effect on the economy and the stock market of the monetary policies followed during, and after, three very similar periods of rapid economic growth in response to rapid technological change: to wit, the booms of the 1920s in the U.S., the ’80s in Japan, and the ’90s in the U.S.
The prosperous ’20s in the U.S. were followed by the most severe economic contraction in its history. In our “Monetary History” (1963), Anna Schwartz and I attributed the severity of the contraction to a monetary policy that permitted the quantity of money to decline by one-third from 1929 to 1933. Since 1963, two episodes have occurred that are almost mirror images of the U.S. economy in the ’20s: the ’80s in Japan, and the ’90s in the U.S. All three episodes were marked by a long period of rapid economic growth, sparked by rapid technological change and the emergence of new industries, and accompanied by a stock market boom that terminated in a crash. Monetary policy played a role in these booms, but only a supporting role. Technological change appears to have been the major player.
These three episodes provide the equivalent of a controlled experiment to test our hypothesis about what we termed the Great Contraction. In this experiment, the quantity of money is the counterpart of the experimenter’s input. The performance of the economy and the level of the stock market are the counterpart of the experimenter’s output, i.e., the variables whose relation to input the experimenter is seeking to determine. The three boom episodes all occurred in developed private enterprise market economies, involved in international finance and trade, and with similar monetary systems, including a central bank with power to control the quantity of money. This is the counterpart of the controlled conditions of the experimenter’s laboratory.
The Money Supply: In addition, history has provided a close counterpart to the kind of variation in input that our hypothetical experimenter might have deliberately chosen. As Fig. 1 shows, monetary policy, as measured by the behavior of the quantity of money, was very similar in the three boom periods, and very different in the three post boom periods, with settings that might be described as low, medium, high.
To measure the quantity of money, I use M2 in the U.S. and the conceptually equivalent M2 plus certificates of deposit in Japan. To express the data for the two countries and the widely separated periods in comparable units, I use as an index of the money stock the ratio of the quantity of money to its average value for the six years prior to the cycle peak. The peak quarter of the relevant business cycle is the third quarter of 1929 (29.3) for the earlier U.S. episode; the first quarter of 1992 (92.1) for Japan; and the first quarter of 2001 (01.1) for the second U.S. episode (see Table 1). Finally, the data are plotted to align the dates at the cycle peak.
Fig. 1 shows a striking contrast between the period before the cycle peak and the period after the cycle peak. There are some differences before the peak — money growth is slowest on the average for the earlier U.S. episode, fastest for Japan — but the differences are small and there is reasonably steady money growth in all three episodes. The contrast with the period after the cycle peak could hardly be greater. Money supply declines sharply after the cycle peak in the first episode, goes from stable to rising mildly in the second, and rises steadily and sharply in the third. Our hypothetical experimenter planned his experiment well.
The GDP:The results of the third episode of this natural experiment are now all in. Fig. 2 shows how GDP in nominal terms (dollars or yen in current prices) behaved during the boom and post boom periods. I use nominal GDP rather than real GDP because M2 is also a nominal magnitude. How changes in nominal GDP are divided between prices and output is an important question but one that is not directly relevant to this experiment. One further preliminary comment: I believe the erratic behavior of nominal GNP during the ’20s and ’30s is largely a statistical artifact. The data for that period are scarce and of poor quality.
As in Fig. 1, there is a striking contrast between the boom and the post-boom periods: roughly similar growth during the booms, widely variable growth during the post-boom. Both before and after the cycle peak, nominal GDP growth paralleled monetary growth. During the boom, money and nominal GDP grew most rapidly in Japan, most slowly in the first U.S. episode, and at an intermediate rate in the second U.S. episode. Table 2 shows the ratio of the money stock at the cycle peak to its value six years earlier (the initial date in the figures) and the corresponding ratio for GDP. In the first two rows of the table, the ratios are highest for Japan, lowest for the U.S. 1920s.
After the cycle peak, money fell sharply in the first episode and so did nominal GDP; money growth stagnated in the second episode and so did GDP; money grew at a rapid rate in the third episode and, after a brief lag (corresponding to the mild 2001 recession) so did GDP. Table 3 shows the ratio of the money stock at the terminal date plotted to its value at the cyclical peak and the corresponding ratio for GDP. Both ratios are decidedly lowest for the U.S. 1920s, and decidedly highest for the U.S. 1990s.
The Stock Market: The peak of the stock market, as measured by S&P’s index, coincided with the cycle peak in the first episode, both occurring in the third quarter of 1929 (29.3). However, that was not the case in the later episodes. In Japan, stock prices as measured by the Nikkei peaked in the fourth quarter of 1989 (89.4), nine quarters before the cycle peak. In the second U.S. episode, stock prices as measured by S&P 500 peaked in the third quarter of 2000 (00.3), two quarters prior to the cycle peak. Accordingly, Fig. 3 plots the data to align the series at the stock market peak.
The near identity of the three stock market series during the boom is truly remarkable. Yet even the minor deviations that exist reflect to some extent the differences in monetary growth, as Table 2 makes clear. Money growth was highest in Japan, and the Nikkei shows the largest rise in the stock market. The other two do not conform: Money rose more in the ’90s than in the ’20s, while stock prices rose slightly less, as shown by the ratio of peak to initial value in Table 2.
Of more interest for our purpose is what happened after the peak. For a year after, the three stock-price series fell in tandem, responding to the inner dynamics of a collapsing bubble. Then, the differences in monetary policy began to have an effect. Beginning in late 1930, the S&P index started falling away from the others under the influence of a collapsing money stock. For another year and a half, the other two indexes move in tandem. Then the much more expansive policy of the Fed in the ’90s than of the Bank of Japan in the ’80s takes effect and pulls the S&P 500 away from the Nikkei, which stabilizes in response to the passive monetary policy of the Bank of Japan (as shown by Table 3).
The results of this natural experiment are clear, at least for major ups and downs: What happens to the quantity of money has a determinative effect on what happens to national income and to stock prices. The results strongly support Anna Schwartz’s and my 1963 conjecture about the role of monetary policy in the Great Contraction. They also support the view that monetary policy deserves much credit for the mildness of the recession that followed the collapse of the U.S. boom in late 2000.
Mr. Friedman, who died yesterday, was the 1976 Nobel Laureate in economics. He was a senior research fellow at the Hoover Institution and professor emeritus at the University of Chicago.
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