WSJ.com - The Fed's Thermostat
I haven't harped on the deficit, though I dislike it, because I consider it transient. The reason I consider it transient is because we have mastered the single most important component to a strong economy: price stability. Inflation has been largely beaten and appropriately demonized over the years, and with an independent Fed, it's unlikely the government will try to use "the printing press" to cover the cost of government. There'll be no inflating our way out of fiscal problems.

At some point we will have to determine how much government we are willing to pay for and the manner in which we pay. My series of proposed solutions (a transaction tax to replace the entire federal tax code, notional accounts for Social Security and personal accounts for out-of-hospital healthcare costs) could, if implemented, go a long way towards fixing the government's fiscal situation.

So again, why am I not worried about the deficit? Because we have the fundamentals down and solutions are available. We just have to implement them.

The reason we're in this situation is the man quoted below: Milton Friedman.

The basic responsibility of the Federal Reserve is to produce as close an approximation as possible to price stability. Chart 1 provides evidence on how well it has performed that function. It plots for each quarter the annual rate of inflation in a comprehensive price index -- the deflator used to calculate real GDP.

The contrast between the periods before and after the middle of the 1980s is remarkable. Before, it is like a chart of the temperature in a room without a thermostat in a location with very variable climate; after, it is like the temperature in the same room but with a reasonably good though not perfect thermostat, and one that is set to a gradually declining temperature. Sometime around 1985, the Fed appears to have acquired the thermostat that it had been seeking the whole of its life.

A convenient way to explain the Fed's problem is with a truism called the quantity equation of money: the quantity of money (M) times the velocity of circulation (V) equals the price level (P) times output (y), MV=Py.

The Fed does not control directly any of the variables in this equation. For all practical purposes, the Fed controls one thing and one thing only: the volume of its own obligations -- that is, high-powered money or the base. (The Fed controls the amount of high-powered money through open-market operations: when it buys securities, it adds to the base; when it sells securities, it subtracts from the base. In addition, the Fed can change the discount rate and, to some extent, reserve requirements. But those powers are of minor importance compared to open-market operations and serve only to obfuscate the analysis.)

Control over the base enables the Fed, if it chooses to do so, to control within narrow limits any one of a number of monetary aggregates, such as M1, M2 or M3 (corresponding to each aggregate, there is a matching velocity). Its control over these is absolute. It could make the chosen aggregate rise or fall at the annual rate of 2% or 5% or 10%, or you name it, not day by day or week to week but certainly quarter to quarter and year to year. Control over the base also enables the Fed to peg any of a number of interest rates, such as the federal-funds rate or the three-month Treasury bill rate. In practice, the Fed employs a changeable peg of the federal-funds rate as its operating instrument. It pegs the fund rate by open-market operations, in the process determining the rate of monetary growth.

To keep prices stable, the Fed must see to it that the quantity of money changes in such a way as to offset movements in velocity and output. Velocity is ordinarily very stable, fluctuating only mildly and rather randomly around a mild long-term trend from year to year. So long as that is the case, changes in prices (inflation or deflation) are dominated by what happens to the quantity of money per unit of output.

Yet it does, I believe, suggest the answer. Central banks the world over performed badly prior to the '80s not because they lacked the capacity to do better, but because they pursued the wrong goals according to a wrong theory. Keynes had taught them that the quantity of money did not matter, that what mattered was autonomous spending and the multiplier, that the role of monetary policy was to keep interest rates low to promote investment and thereby full employment. Inflation, according to this vision, was produced primarily by pressures on cost that could best be restrained by direct controls on prices and wages.

That Keynesian vision was thoroughly discredited by experience in the '70s and '80s. It has since been replaced by what has become known as New Keynesian Economics, which incorporates some key quantity theory (monetarist) propositions: that inflation is always and everywhere a monetary phenomenon; that monetary policy has important effects on real magnitudes in the short run but no important effects in the long run (the long run Phillips curve is vertical), the crucial function of a central bank is to produce price stability, interpreted as a low and relatively steady recorded rate of inflation. Once the banks adopted price stability as their primary goal, they were able to improve their performance drastically.

Admittedly, this is an oversimplification. The accumulation of empirical evidence on monetary phenomena, improved understanding of monetary theory, and many other phenomena doubtless played a role. But I believe they were nowhere near as important as the shift in the theoretical paradigm. The MV=Py key to a good thermostat was there all along.

He also manages to squeeze in his own law of economics: inflation is always and everywhere a monetary phenomenon. I love that man.