I know I'm right in saying that Milton Friedman's thermostat is an important idea that all economists ought to be aware of. And I'm pretty sure I'm right in asserting that almost all economists are unaware of this important idea. Am I wrong? Are you aware of this idea? Maybe under some other name??
Google seems to tell me I'm right. I'm the first link, which is really pathetic for such an important idea; the second is Friedman himself (pdf); and most of the rest on the first page are other bloggers, mostly Market Monetarists. But this idea has got nothing (in particular) to do with Monetarism. Compare that to what Google comes up with for another of Milton Friedman's important ideas. Scholarly articles, and its own Wikipedia page.
And every few days I come across an economist saying something that he would not have said if he were aware of Milton Friedman's thermostat. Today it was Casey Mulligan, but the class "economists who seem to be unaware of Milton Friedman's thermostat because they say something they would not say if they were aware of it" seems to me to cover lots of very different economists.
This really bugs me.
Milton Friedman's thermostat has got nothing to do with Monetarism, or even macroeconomics. Or rather, Milton Friedman's thermostat is an idea that has very broad application, and has nothing in particular to do with Monetarism or even macroeconomics. Or even economics.
If I had to categorise where this idea belongs, I would say it is an idea that belongs to applied econometrics. But, as far as I can see, I would say that applied econometricians are as unaware of this idea as any other economists, even though they have the greatest need to be aware of this idea.
And it's not even original to Milton Friedman. The first economics article I can find laying out the basic idea was by an Old Keynesian, Maurice Peston (gated), who applied it to fiscal policy, not monetary policy. Like most important ideas, it has probably been independently invented several times, by someone who realised they needed to invent it. (I invented it myself, and only after I had invented it did I learn that other people had previously invented it too). But calling it "Milton Friedman's thermostat" is a good name for the idea, because it's a good metaphor, and Friedman is the one who came up with that metaphor.
And it's not even a very complicated idea. You can explain the gist of it using words and simple examples.
But it's a really really important idea. Both theoretically important, and practically important.
So why does such an important idea need to keep on being reinvented? Why are (almost all) economists unaware of this idea?
It's not as though Milton Friedman were some no-name economist that everybody ignored. Every economist is very aware of lots of Milton Friedman's other ideas. Those other ideas are taught to all economics students. Why not this idea?
Here's the idea:
Everybody knows that if you press down on the gas pedal the car goes faster, other things equal, right? And everybody knows that if a car is going uphill the car goes slower, other things equal, right?
But suppose you were someone who didn't know those two things. And you were a passenger in a car watching the driver trying to keep a constant speed on a hilly road. You would see the gas pedal going up and down. You would see the car going downhill and uphill. But if the driver were skilled, and the car powerful enough, you would see the speed stay constant.
So, if you were simply looking at this particular "data generating process", you could easily conclude: "Look! The position of the gas pedal has no effect on the speed!"; and "Look! Whether the car is going uphill or downhill has no effect on the speed!"; and "All you guys who think that gas pedals and hills affect speed are wrong!"
And no, you can not get around this problem by doing a multivariate regression of speed on gas pedal and hill. That's because gas pedal and hill will be perfectly colinear. And no, you do not get around this problem simply by observing an unskilled driver who is unable to keep the speed perfectly constant. That's because what you are really estimating is the driver's forecast errors of the relationship between speed gas and hill, and not the true structural relationship between speed gas and hill. And it really bugs me that people who know a lot more econometrics than I do think that you can get around the problem this way, when you can't. And it bugs me even more that econometricians spend their time doing loads of really fancy stuff that I can't understand when so many of them don't seem to understand Milton Friedman's thermostat. Which they really need to understand.
If the driver is doing his job right, and correctly adjusting the gas pedal to the hills, you should find zero correlation between gas pedal and speed, and zero correlation between hills and speed. Any fluctuations in speed should be uncorrelated with anything the driver can see. They are the driver's forecast errors, because he can't see gusts of headwinds coming. And if you do find a correlation between gas pedal and speed, that correlation could go either way. A driver who over-estimates the power of his engine, or who under-estimates the effects of hills, will create a correlation between gas pedal and speed with the "wrong" sign. He presses the gas pedal down going uphill, but not enough, and the speed drops.
How could the passenger figure out if the gas pedal affected the speed of the car? Here's a couple of ideas:
1. Watch what happens on a really steep uphill bit of road. Watch what happens when the driver puts the pedal to the metal, and holds it there. Does the car slow down? If so, ironically, that confirms the theory that pressing down on the gas pedal causes the car to speed up! Because it means the driver knows he needs to press it down further to prevent the speed dropping, but can't. It's the exception that proves the rule. (Just in case it isn't obvious, that's a metaphor for the zero lower bound on nominal interest rates.)
2. Ask the driver. If the driver says that pressing the gas pedal down makes the car go faster, and if the driver says he wants to go at a constant 100kms/hr, and if you see the car going a roughly constant 100kms/hr, then you figure the driver is probably right. Even more so if you ask him to slow the car to 80kms/hr, and he says "OK", and then the car does slow to a roughly constant 80kms/hr. If the driver were wrong about the relation between gas pedal and speed, he wouldn't be able to do that, and it wouldn't happen, except by sheer fluke. (Just in case it isn't obvious, that's a metaphor for inflation targeting.)
3. Find a total idiot driver, who doesn't understand the relation between gas pedals and speed, and who makes random jabs at the gas pedal that you know for certain are uncorrelated to hills or anything else that might affect the car's speed, and then do a multivariate regression of speed on gas and hills. But you had better be damned sure you know those jabs at the gas pedal really are random, and uncorrelated with hills and stuff. Which means this can only work if you are certain that you know more about what is and is not a hill than the driver does. Or you are certain he's pressing the gas pedal according to the music playing on the radio. Or something that definitely isn't a hill. Are you really really sure your instrument isn't a hill, or correlated with hills? And if so, why doesn't the driver know this, and why does he jab at the gas pedal in time with that instrument? You had better have a very good answer to those questions. And no, Granger-Sims causality does not answer those questions, or even try to.
Why is this idea so important for economists to be aware of? Because economists look at correlations in the data. And a lot of correlations in the data are created by someone looking at some first thing, and adjusting some second thing in response to the first thing, in order to control some third thing. That someone could be a government, or a central bank, or a firm, or a person. And the first, second, and third things could be almost anything. And if you are unaware of what Milton Friedman's thermostat tells you about the correlation between those three things, you will misunderstand the correlations between those three things. And you will make some bad mistakes about lots of things.
Milton Friedman's thermostat is an idea that is both important and right. Why are (almost all) economists unaware of this idea?
Here are some of my old posts, where I either explain the idea, or use it to explain why economists who are unaware of this idea are making mistakes, or use it to explain how to do it properly:
An application to critique econometric methods for identifying monetary shocks.
An application to critique tests of core inflation as an indicator. [Update, a much clearer version.]
An application to properly test core inflation as an indicator. And again, more simply.
I've probably missed some.
Worthwhile Canadian Initiative 
Right now, I have other battles to fight. The bottom line, Greg, is you’ve tried to mount a classic Austrian argument, you tried to get Nick involved (yet again) and if I’ve cut this tangent short, I’ve won, that’s what I wanted. It’s the same sort of tangent the MMT’ers do and which makes my eyes roll.
Nice ad hominems, though. Also a decent Denying the Antecedent fallacy there. (If I really knew Hayek, I’d agree with you).
You need to seriously reflect on what I’ve just said.
No. Honestly, I’m not going to think about it at all. Maybe chuckle to myself, but that’s it.
You are deluded, “Determinant”.
And still a sock puppet .. which is telling.
A Sock puppet is a second name registered on the same board where you don’t admit to the second login. You can literally carry on a conversation with yourself, which is why the better boards ban the practice.
I am merely a poster on this board who uses a nickname, as do half the posters here, many of long standing.
An ad-hominem and one that doesn’t even use the correct terminology? Wow, that was a damp squib of a retort, Greg.
Well, sorry for putting my free thinking two cents in. You experts enjoy yourselves.
Oh, and I forgot to thank you for the insults.
By the way, I logged in with an account, the site gave me the “Determinant” moniker.
“Determinant” — I don’t trust blog commenters who won’t use their own name. That’s a product of long experience, nothing personal.
Here are some facts:
1. Austrians use aggregates. You’re claims about Austrians are prima facie false.
2. Your claims about complex phenomena, et al, and their relation to statistics not true and don’t seem to be well informed. You haven’t even tried to establish otherwise.
3. You haven’t show any grasp of the Austrian case against Keynes’ use of aggregates.
4. You haven’t explained by you don’t open an Blogger account and make you case in a forum which will allow you to make the case you wish to make.
Greg and Determinant. Let’s not continue this.
And I am now somewhat upset at several econometrics professors.
Mostly because it’s a better example of endogeneity than gun crime and gun legislation.
Determinant,
I’m not so sure that control theory hasn’t been applied in some fashion to economics.
Here’s a book about it:
http://mitpress.mit.edu/catalog/item/default.asp?ttype=2&tid=12731
Andy Haldane of the Bank of England presents one dimension of my point:
“a rather restricted and blinkered view of the dynamics of social and economic systems got carried across into how public policy was thought about and executed.
Again, I have an evolutionary story as to why economics ended up in this place. I don’t think it’s because people were taking pay-checks from consultants or countries to cook the answers. I don’t think for a minute that was the core of it. It was driven by the quest for certainty, and mathematisation of economics was a means of achieving that certainty. It was the desire to have the laws of economics as well-defined as seemingly were the laws of physics or other natural sciences, as a basis for policy experimentation. They were all good reasons for wanting to make the discipline rigorous and robust.
I think one of the great errors we as economists made in pursuing that was that we started believing the assumptions of economics, and saying things that made no intellectual sense. The hope was that, by basing models on mathematics and particular assumptions about ‘optimising’ behaviour, they would become immune to changes in policy. But we forgot the key part, which is that the models are only true if the assumptions that underpin those models are also true. And we started to believe that what were assumptions were actually a description of reality, and therefore that the models were a description of reality, and therefore were dependable for policy analysis.
With hindsight, that was a pretty significant error.”
So, Nick, this is an argument that is out there, made by the Executive Director of Financial Stability at the Bank of England, Andy Haldane.
Do you not see that the picture of economics being countered by Haldane is the picture built into your car example, ie a simple physical system following the most simple, linear physical laws, ie one or two variable math formulae?
As has been mentioned, the flaw of this concept is that feedback control systems (like a thermostat) are perfectly well understood. If you gave me a time series with the outside temperature and inside temperature I could calculate the transfer function of your thermostat/furnace in two minutes… and I would have a statistic called coherence (like an R-squared) to determine how well this model fit. Even if we exclude the possibility of choosing a better model (frequency vs. time domain) to fit to the data, we’re left with outside temperature correlating with the furnace (or the pedal with hills) which, while imperfect, is not erroneous.
Thanks for an interesting blog post!
I do not want to go into the quibbles of Austrians vs. Keynesians, but I must say a couple of things in defence of modern empirical economists. First, the the concept of permanent income hypothesis, is developed in several widely cited scholarly articles whereas the concept of the thermostat is developed in an op-ed column published in wall street journal. This is a natural reason why the first concept is much more widely known among economists than the second.
Second, even though the friedman’s thermostat may not ring many bells, the ideas underlying it are hardly unknown to people doing empirical economic research. As someone already pointed out, even undergrads know of endogeneity. Moreover, the concept of cointegration was defined already in the seventies (in your example speed, gas and hills seem to be cointegrated) and there is tons of research taking advantage of different kinds of natural experiments/instrumental variables to estimate causal effects (your example number three also points to this direction).
Of course, being a trained economist, you must already be aware of this.
Hi Nick,
Obviously a bit late to the party, but to defend the applied econometric folks (God help me), but it may jus be an issue of lingo. The thermostat concept is alive and well (although when I was taught on the subject Mr. Friedman was not given credit) and is generally discussed under state space modeling and feed back errors (http://en.wikipedia.org/wiki/State_space_representation#Feedback). You may find the Google search reveals a bit more with this terminology.
And of course, if I’ve misinterpreted your post, my apologies.
Cheers,
Finn
Finn: (Never too late!), and o.k. too:
Dunno. Sure, econometricians talk about endogeneity. And maybe they talk about feedback errors too. But I’m going to repeat the response I’ve made to Dave above (though minus my rudeness to Dave, because you two have been nice to me):
Dave: “This post is a bit of an embarrassment, most economists/econometricians are fully aware of this problem, it it known as the “problem of endogeneity.””
That’s a bit like saying: “most economists/econometricians are fully aware of this problem, it is known as “the problem that sometimes stuff goes wrong in empirical work”.”
Let’s see how embarrassing it is for you to answer these questions:
Suppose you are Governor of the Bank of Canada. Your mandate for the last 20 years is to target 2% headline inflation at a 2 year forecast horizon. Suppose you have the overnight rate exactly where you want it to be. Then Statistics Canada releases its latest inflation data. Headline inflation is above where you expected it to be, and core inflation is below where you expected it to be. You want to know whether to adjust the overnight rate up or down.
1. What regressions would you estimate to help you decide what action to take? (A rough answer would suffice).
2. Suppose your econometrician told you that neither headline nor core inflation, either singly or jointly, had any ability to forecast future headline inflation at a 2 year horizon, over the last 20 years’ data.
Would you be surprised by that result? How would you interpret that result? What action would you take if you believed that result?
(Hint: “leave the overnight rate unchanged” is the wrong answer.)
3. My guess is that there are a hundred or so empirical studies that try to answer the question of whether inflation-targeting central banks should respond to core, or headline, or both, as indicators of future inflationary pressure.
In my links above I cite 3 such studies that do it wrong (one from the Atlanta Fed, one from the St Louis Fed, and one from the ECB).
Are you able to find a single study that does it right?
(I explain how I would do it right in my last two links above.)
Over to you, Dave.
Finn and o.k. : what do you think? Maybe I just got a dud sample of applied econometric studies of whether inflation targeting central banks should look at core or headline inflation? (That’s not a rhetorical question, because maybe I did get an unlucky sample.)