"At the macroeconomic level, is the market economy self-equilibrating?"
I used to think that was the most important and fundamental question in macroeconomics.
Now I think it's a stupid question that doesn't make sense.
So when I read Paul Krugman saying:
"Think of it this way: Friedman was an avid free-market advocate, who
insisted that the market, left to itself, could solve almost any
problem. Yet he was also a macroeconomic realist, who recognized that
the market definitely did not solve the problem of recessions and
depressions. So he tried to wall off macroeconomics from everything
else, and make it as inoffensive to laissez-faire sensibilities as
possible. Yes, he in effect admitted, we do need stabilization policy —
but we can minimize the government’s role by relying only on monetary
policy, none of that nasty fiscal stuff, and then not even allowing the
monetary authority any discretion.
At a fundamental level, however, this was an inconsistent position:
if markets can go so wrong that they cause Great Depressions, how can
you be a free-market true believer on everything except macro?"
I read Paul as accusing Milton Friedman of giving an inconsistent answer to a stupid question. It's a stupid question Paul. Of course Milton would give an inconsistent answer. That's the only sort of answer you can give to a stupid question.
Why is it a stupid question? Here's why:
Let your imagination run free. Think up the worst possible monetary policy you can imagine. What precisely that would be would depend on your particular model of the economy, and on your imagination. But it would probably have something like the following feature:
MP(worst): When you see inflation rise and market activity rise, loosen monetary policy a lot; and when you see inflation fall and market activity fall, tighten monetary policy a lot.
What precisely you will mean by "loosen/tighten monetary policy a lot" will depend on your particular macroeconomic model and how you conceptualise monetary policy. I will leave that up to you. But Paul's answer would probably not be terribly different from mine; we would both think that the other's personal MP(worst) was pretty terrible.
Now ask yourself this more precise question:
"Conditional on my MP(worst) being followed: at the macroeconomic level, is the market economy self-equilibrating?"
And (at least) 99.9% of macroeconomists would answer that question: "Don't be stupid. Of course it isn't!"
What sort of economist would answer "Yes" to that question? Who's in the 0.1%?
Maybe, just maybe, an extreme RBC theorist who happened to be smoking crack and who had a very stunted imagination would answer "Yes" to that question.
"At the macroeconomic level, is the market economy self-equilibrating?" is a stupid question because it doesn't specify the monetary policy being followed.
The only person who would answer "yes" to that unconditional question is someone who can't think up a worst possible monetary policy. Which means that person thinks that all conceivable monetary policies are equally good. Which means he doesn't think that monetary policy matters.
If I had to summarise Milton Friedman's thought in three words they would be: "Monetary policy matters".
I'm old enough to remember when that was a highly controversial statement in macroeconomics. Modern macroeconomic fish don't feel the Friedmanite water they swim in.
And if there is one thing we ought to have learned from the recent recession, as we ought to have learned from the Great Depression of the 1930's, as Friedman tried to teach us, it is that monetary policy does indeed matter, and matters a lot.
The most dangerous idea in macroeconomics is that monetary policy doesn't matter. [link here (pdf) Thanks Lorenzo!. link to that recent paper please, because I left my brain back on the farm.] Or, since that was precisely Friedman's message, to say the same thing a different way: the most dangerous idea in macroeconomics is that Friedman is an unperson.
Update: and make very sure you read Frances' comment immediately below. Because my point here generalises beyond macro/money. Institutions matter. Monetary policy is one of those institutions. So are markets. So is government.
Update2: as an antidote to all this "Friedman is an unperson" stuff, read R.A.'s superb essay in the Economist.
Update3: or this good post by Scott Sumner.
Worthwhile Canadian Initiative 
Replying to Determinant (8/10, 11:54): If the mere fact that some commercial bank served as a government depository, or assisted another illiquid bank in trouble, qualifies it as a “Central Bank,” then of course we should never be allowed to speak of any past banking system as lacking such a bank. But a central bank isn’t merely a government depository bank or one that occasionally supports (or acquires) an illiquid rival (as commercial banks have always done during crises–there’s a reason, after all, why genuine central banks are called lenders of last resort!). It is a bank enjoying substantial monopoly privileges, particularly with regard to the right to issue paper notes. The Bank of Montreal was certainly not a central bank according to the usually meaning of the term.
Catching up on your recent posts, and was puzzled by this:
“Conditional on my MP(worst) being followed: at the macroeconomic level, is the market economy self-equilibrating?” And (at least) 99.9% of macroeconomists would answer that question: “Don’t be stupid. Of course it isn’t!” What sort of economist would answer “Yes” to that question? Who’s in the 0.1%?
Count me with the 0.1%. I don’t see why the market economy should not adjust to some kind of equilibrium – in the extreme, the economy could simply substitute some other monetary area’s money for nearly all purposes and get on with it. I presume you have in mind the same “efficient” equilibrium regardless of which monetary policy, no?