Caroline Baum of Bloomberg recently suggested that Milton Friedman would have been appalled by the many top economists arguing the Fed is out of ammunition:

Milton Friedman, Nobel Laureate in Economics, died in 2006. Monetarism, the school of thought he founded, seems to have died with him, judging from recent comments.

Academics, such as Princeton’s Alan Blinder and Harvard’s Martin Feldstein, are claiming there’s very little the Federal Reserve can do to stimulate the U.S. economy. Newspaper headlines deliver the same message: the Fed is “Low on Ammo.” The public is feted with explanations — couched in technical terms, such as the “zero-bound” and a “liquidity trap” — as to why the Fed’s hands are tied.

What planet are these people on?

They’re clearly not on planet monetarism.  On the other hand John Taylor thinks Friedman’s message still resonates, but that he would have been opposed to additional monetary stimulus:

I see neither those ideas nor their adherents going to the grave. Indeed, the experience of this crisis is proving that Milton Friedman’s ideas were right all along, and I can see them gaining favor.

Two of Friedman’s most famous ideas in the macroeconomic sphere were (1) that monetary policy should follow a simple policy rule and (2) that discretionary fiscal policy is not useful for combating recessions, and indeed could make things worse. Both ideas have been reinforced by the facts during the recent crisis.

The first idea is reinforced by the evidence that the crisis was brought on by the failure of the Fed to keep following the rules-based monetary policy that had worked well for 20 years before the crisis. Instead, it deviated from such a policy by keeping interest rates too low for too long in 2002-2005. But Caroline Baum wonders whether the Fed should now just print a lot more money and buy more mortgages or other securities. That might sound like a monetarist solution, but Friedman did not believe in big discretionary changes the money supply. Rather, he advocated a constant growth rate rule for the money supply. I doubt that he would have approved of the rapid increase in the money supply last year, in part because he would have known that it would be followed by a decline in money growth this year. He always worried about monetary policy going from one extreme to the other and thereby harming the economy. That is why the Fed should be clear and careful as it brings back down the size of its balance sheet, which exploded during the crisis.

While Taylor’s argument is defensible (and I agree with him on fiscal policy), I believe the weight of evidence supports Baum’s interpretation.  Let’s look at what Milton Friedman had to say about Japan in December 1997.  The subtitle is as follows:

Nobel laureate and Hoover fellow Milton Friedman gives the Bank of Japan step-by-step instructions for resuscitating the Japanese economy. A monetary kiss of life.

And here’s Friedman’s argument:

The surest road to a healthy economic recovery is to increase the rate of monetary growth, to shift from tight money to easier money, to a rate of monetary growth closer to that which prevailed in the golden 1980s but without again overdoing it. That would make much-needed financial and economic reforms far easier to achieve.

Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”

The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.

The Interest Rate Fallacy

Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

In the article, Friedman presents data showing Japanese monetary growth slowing sharply in the 1990s.  He also notes that RGDP growth slowed from 3.3% during what he calls the “Golden Age” of 1982-87 to only 1.0% during 1992-97.  Inflation slowed from 1.7% to 0.2%.  From this we can infer:

1.  Friedman does not seem to agree with Fed hawks who think price stability is a good thing.  After all, Japanese prices were very stable during the 5 year period when he thinks money was far too tight.  Admittedly, some at the Fed define price stability as 2% inflation, but the hawks clearly don’t agree, as inflation is 1% and falling, yet the hawks still oppose stimulus. 

2.  Friedman thinks near-zero interest rates are a sign that money has been too tight.  And he suggest that QE is the proper response.

3.  Friedman cites data showing that Japanese NGDP growth has slowed from 5% during the golden age to 1.3% in 1992-97.  Of course 5% NGDP growth is quite close to the US experience from 1992-2008, another “golden age.”  But then US NGDP fell 3% between mid-2008 and mid-2009, nearly 8% below trend.  And it continues to grow at well under trend during the “recovery.”  Friedman would have seen that as a warning sign.

4.  Friedman advocates raising money growth rates in Japan (M2) up much closer to the 8.2% of Japan’s Golden age.

5.  In the US monetarists tend to look at broader aggregates like M2 and MZM (although unfortunately we lack the ideal divisia index that monetarists like Mike Belongia say is needed.)  For what it’s worth, here are the growth rates of M2 and MZM from mid-2008 to mid-2009, and then from mid-2009 to mid-2010:

2008-09:   M2 grew 8.8%,  MZM grew 10.2%

2009-10:  M2 grew 2.1%, MZM fell 1.8%

So on average the aggregates grew around 9-10% during the financial turmoil, and then barely changed over the following 12 months.  It is difficult to know what Friedman would say about the increase in the money supply between 2008 and 2009.  Obviously the facts don’t exactly fit either my interpretation or Taylor’s.  But if we take a more expansive view of Friedman’s approach to macroeconomics, then I believe there is even more reason to believe that he would now favor monetary stimulus, just as in Japan:

1.  In the Monetary History, Friedman and Schwartz decided not to use the monetary base as their indicator of the stance of monetary policy.  In my view, this was partly because the base increased sharply between 1929 and 1933.  Friedman understood that NGDP had fallen in half during those four years, and thus monetary policy had obviously been too contractionary for the needs of the economy.  He also understood that the increase in the base reflected hoarding of cash and reserves during the banking panics.  Thus the most natural monetary indicator for a libertarian, the one directly controlled by the government, was not going to work.  Instead he and Anna Schwartz focused on broader aggregates, which declined sharply between 1929 and 1933.

2.  Now consider the 2008-09 increase in the broader aggregates.  Because we now have FDIC, people no longer hoard cash during a liquidity crisis; instead they hoard the very liquid and safe assets that make up MZM.  Friedman would have understood that the financial crisis was a special situation, and hence required economists to look past the temporary blip in MZM, just as he had overlooked the rise in the base during 1929-33.  He understood that money was actually tight during 1929-33, despite the increase in the base and the low interest rates.  (And he’d understand that the bloated base since 2008 largely reflects interest-bearing excess reserves, where yields exceed the rate on T-bills.)

3.  Friedman also understood that in uncertain times markets can provide an indication of whether money is too tight.  Recall his defense of speculators, and also floating exchange rates.  He clearly thought market signals were meaningful.  In 1992 [Money Mischief] he endorsed Robert Hetzel’s idea of having the Fed directly target expected inflation, by trying to peg the spread between nominal and indexed bonds.  Now recall that the TIPS spread briefly went negative in late 2008, and even today is only about 1% for one and two year T-bonds.  So if Friedman thought Hetzel’s proposal was a good idea, I think it unlikely he would brush off the message in the TIPS markets, as many conservatives seem to do.  The markets are clearly indicating both inflation and output will remain below the Fed’s implicit target for quite some time.  Friedman would have seen the importance of those market signals.

4.  There are some modern monetarists, such as Tim Congdon  (and this), who have made many of the same arguments that I’ve used in this post.  

To summarize:

1.  In 2009 NGDP fell at the sharpest rate since 1938.  And NGDP growth is expected to remain very weak.   If M*V is that weak, something must be wrong.

2.  Friedman argued the low rates in Japan were actually evidence of tight money.

3.  Friedman would have been concerned by the abrupt slowdown in the growth rates of the monetary aggregates since mid-2009.

4.  Some modern monetarists like Tim Congdon think money is way too tight.

The burst of M2 and MZM in 2008-09 does point slightly in John Taylor’s favor, but overall I believe the evidence supports Baum’s view.

Of course neither John Taylor nor I hold identical views to Friedman.  He supports the Taylor Rule (why not, he invented it!)  I give him a lot of credit, as the Taylor principle is the primary factor behind the Great Moderation.  However I believe a Svenssonian “targeting the forecast” approach is even better.  In September 2008 the Fed failed to cut rates below 2%, looking backward at the high rates of headline inflation during the summer of 2008.  But forward-looking real growth and inflation indicators were already slowing rapidly, indeed the TIPS spread on 5 year bonds fell to 1.23% just before the post-Lehman Fed meeting.  I think almost everyone would now agree the Fed should have moved much more aggressively in September 2008, before rates had fallen to zero.  A forward-looking approach would have allowed them to do so, but instead they relied on historical data that seemed to suggest the risks of inflation and recession were equally balanced.  They did nothing.

I suppose the fight over Friedman’s legacy is related to the fact that he is the one right-wing macroeconomist who is almost universally respected by conservative/libertarian economists.  Even though I’m not a strict monetarist, I’d like to think he would support my view of the current crisis.  I’m guessing Taylor feels the same way.

HT:  DanC, Benjamin Cole, David Pearson, Richard W.

PS:  After 16 months of leisure frantic blogging activity, school starts tomorrow.  Unfortunately, posting and comment replies will have to slow down.

OK, I’m ready to throw in the towel.  I just made the mistake of checking Drudge.  His website is frequently shameless, but you have to admit he often picks up the zeitgeist.  All the news about the economy is dreary.  Then I looked at Bloomberg and here are the latest TIPS spreads:

5 year conventional T-bonds 1.33%,  Indexed bonds 0.08%,  TIPS spread 1.25%

10 year conventional T-bonds 2.50%, Indexed bonds 1.03%, TIPS spread 1.47%

Both have been falling like a stone.  This suggests that a sharp slowdown in NGDP growth is very likely.  Until now I’ve tried to remain an optimist, disappointed in the pace of recovery, but assuming that we were at least muddling forward.  But it is now clear that we are no longer recovering.

So let’s put this fiasco into perspective.  What can we compare it to?  As far as I know, there are four great recessions/depressions with near zero rates:

1.  The 1929-33 contraction

2.  The 1937-38 contraction

3.  Japan since 1994.

4.  The US since 2008.

The real economy did grow after 1938, but mild deflation continued.  A serious recovery only began with WWII intensifying in mid-1940.  Japan never really had a satisfactory recovery, although there were some reasonably good years such as 2003-07.  And of course the recovery from 1929-33 only began when the dollar was sharply devalued.  The bottom line is that zero interest rate malaises don’t seem to end like ordinary recessions; short of some sort of dramatic shock like dollar devaluation or World War, they seem to linger.  What can we learn from that? 

Before explaining my analogy (actually Nick Rowe’s analogy) considering the following paradox:

1.  Near-zero nominal rates are always associated with economic malaise: a weak economy with deflation or disinflation.  So we don’t want near-zero rates.

2.  Lowering nominal rates below zero is impossible.

3.  Directly raising nominal rates through monetary policy is contractionary, and will make the recession/deflation worse.

So what do we do?  As you know I think there is a simple answer.  Indeed I think there are lots of simple answers (massive QE, negative IOR, explicit NGDP targeting, etc.)  But I think we need to face the fact that for some reason our monetary authorities don’t see it this way.  They view all these ideas as exceedingly risky, as exceedingly reckless, as exceedingly expansionary.

Go back and review the history.  Short of World War, the only escape from zero rate deflation was in 1933, with dollar devaluation.  Your history books never gave you any idea how controversial that was.  Think about this.  FDR basically had the Federal government take over the economy through programs like the NIRA and AAA.  They controlled almost everything.  And yet there was little objection from Wall Street.  People just went along.  But dollar devaluation was different.  It wasn’t just the conservatives who were apoplectic.  The unions were opposed.  FDR saw one top economic advisor after another resign in protest.  And these were his supporters.  The program was highly successful in raising prices (and output until the NIRA raised wages 20%), but nevertheless was the most controversial thing FDR ever did.  Even more than the Court packing.

Milton Friedman once noted that ordinary people were shocked when told that unelected Fed officials were free to simple double the money supply anytime they wished.  I think the same thing is true of changing the value of the dollar, as when FDR arbitrarily decided each dollar would be worth 60 cents (in gold terms.)  People seem OK with interest rate targeting, but anything else seems radical.  But interest rate targeting doesn’t work anymore.  So we are stuck.

Nick Rowe uses the analogy of balancing a long pole in your hand.  If you want the top to go left, you move your hand right.  By analogy, if the Fed wants inflation/growth (and long term rates) to go up, they lower the fed funds rate.  But if you bump up against a tall wall, then you may not be able to move your hand in the direction required to move the pole in the other direction.  You are stuck.  The only solution is to rely on some other method–such as directly grabbing the top of the pole.

The Fed needs to raise NGDP growth by some method other than lowering nominal rates.  It is up against the wall.  That means they need some other policy tool.  It might be the printing press (QE), negative IOR, price level or NGDP targets, dollar devaluation, etc.  But it can’t be done by manipulating the fed funds rate.  And for some reason the Fed seems paralyzed.

I guess because I have spent my whole life studying unconventional policy tools, and because I never favored interest rate targeting in the first place, these alternatives don’t seem at all scary to me.  FDR created inflation when he raised the price of gold.  And the inflation basically stopped when he stopped raising the price of gold.  Excluding WWII, no one has ever overshot toward high inflation coming out of a zero rate trap.  That’s why Krugman and I can have such serene confidence that the inflation scare-mongers will be proved wrong.  I’ve seen this movie already.  Several times.

Because deflation make rates low, and leads to cash and reserve hoarding, it makes money seem really loose when it is actually very tight.  Fed officials currently argue that money is very loose.  They are wrong, but that’s what they think.  Now we need to convince conservative central bankers, who are devoted to price stability, to take what seems like ultra-loose monetary policy, and make it far looser.  The thought makes me despair.  That’s why it is so tragic that Milton Friedman died in late 2006.  He was a voice that central bankers would listen to.  He was a respected conservative.  An inflation hawk.  Regarding the Japanese malaise, he said:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

That’s right Dr. Friedman, it’s just too counter-intuitive for people to accept.  And that’s precisely why we are fated to suffer through the Great Recession.  It’s a real pity.

PS.  Nick’s analogy is in the comment section of the link.

PPS.  Andy Harless has a post showing a Fed president stumbling over the interest rate paradox discussed above.

A commenter named Marcus Nunes just sent me one of the most chilling quotations I have ever read, and it was from the minutes of a Fed meeting.  But first a bit of background.  In October 2008 the Fed made the same mistake as in early 1937; they put into effect regulations that increased the demand for bank reserves, just at the moment we were entering a recession.   The 1937 action was actually more justifiable, because the recession was not yet visible.  In both cases many economists made a logical error.  In 1937 they assumed that higher reserve requirements wouldn’t be a problem because banks had lots of excess reserves—forgetting that they held ERs for a reason.  In 2008 most economists focused on interest rates as the indicator of monetary policy, not expectations of future policy actions.  The interest on reserves (IOR) program did not immediately raise rates, but did prevent them from immediately falling to zero.  Much worse, it made future QE much less effective, as markets understood that any future increases in the monetary base would now be held as excess reserves.  

Now the Fed is considering eliminating IOR as a way of stimulating the economy.  Of course if they do that, it will be an implicit admission that the October 2008 action was contractionary in effect, and it will go down in the history books as an even worse mistake than the 1937 RR increase.  Will the Fed be willing to “lose face” and admit its error? 

My wife tells me that the Chinese don’t like to lose face.  I assure her that we don’t have that problem here, Americans have no difficulty in admitting their mistakes and moving on.  But the quotation that Marcus sent me has caused me to re-evaluate my view of Americans.  Could the Fed really put losing face ahead of the well-being of hundreds of millions of Americans, many without jobs?  It seems unthinkable, almost unimaginably cruel, but the following excerpt suggests that it did happen in 1937.  Read it and then I’ll explain why.  By the way, the opening and closing passage are from a paper by Orphanides. 

On May 1, 1937, the final leg of the tightening was completed. With that in place, excess reserves fell back to levels as low as had not been seen since several years earlier (Figure 4). May 1937 also marked the peak of the incomplete expansion from the Great Depression of 1929-1932. The economy promptly returned to recession. Though the extent of the sharp decline in activity was not immediately evident, by Fall it became fully clear to the Committee that the economy was thrown back to a severe recession, once again. The following evaluation of the situation by Williams at the November 1937 meeting is informative, both for offering a frank admission that the FOMC apparently wished for a slowdown to occur and also for outlining the case that the recession, nonetheless, had nothing to do with the monetary tightening that preceded it. Particularly enlightening is the reasoning offered by Williams as to why a reversal of the earlier tightening action would be ill advised.

“We all know how it developed. There was a feeling last spring that things were going pretty fast … we had about six months of incipient boom conditions with rapid rise of prices, price and wage spirals and forward buying and you will recall that last spring there were dangers of a run-away situation which would bring the recovery prematurely to a close. We all felt, as a result of that, that some recession was desirable … We have had continued ease of money all through the depression. We have never had a recovery like that. It follows from that that we can’t count upon a policy of monetary ease as a major corrective. …  In response to an inquiry by Mr. Davis as to how the increase in reserve requirements has been in the picture, Mr. Williams stated that it was not the cause but rather the occasion for the change. … It is a coincidence in time. … If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn. It makes a bad record and confused thinking. I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground. There is no good reason now for a major depression and that being the case there is a good chance of a non-monetary program working out and I would rather not muddy the record with action that might be misinterpreted. (FOMC Meeting, November 29, 1937. Transcript of notes taken on the statement by Mr. Williams.)”

The Federal Reserve made every effort to build a convincing case that the cause of the 1937 downturn could be more than accounted for by factors other than the monetary tightening and that policy action by the rest of the government and not by the Federal Reserve were needed to restore prosperity.

I suppose someone will say that Williams is denying that the RR increase caused the 1937 depression.  Yes, he’s denying it, but you’d have to be even more naive than me (and that’s a pretty bad insult by the way) to believe he is sincere:

1.  He admits that the policy was intended to be contractionary, indeed intended to cause a “recession.”

2.  By November 1937 it was clear that the “recession” was becoming a depression.

3.  They are discussing lowering RRs as an expansionary device.

4.  Later on when the depression got worse (in 1938) they did lower RRs.

Let’s put him on the couch:

“We all felt, as a result of that, that some recession was desirable”

I.e., it wasn’t just my fault, we all felt that way.

If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn.

Do I even need to comment?

It makes a bad record and confused thinking.

Yes, we mustn’t let the public become “confused.”

I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground. There is no good reason now for a major depression

A depression can’t be happening now, because that would mean I was wrong. 

I would rather not muddy the record with action that might be misinterpreted

Muddy the record, or muddy my reputation?

A depression did occur, as NGDP fell roughly 5%.  To give you an idea of just how bad it was, the largest yearly decrease since then was only 1.7%.  BTW, that occurred in 2009, just after the Fed started the IOR.

Although I am generally a non-interventionist, for some strange reason I supported the Iraq War.  (Actually 6 or 7 reasons, none of which seem very good today.)  Sometimes in conversation I will mention how the Iraq War was a mistake, and people will say “But I thought you supported the war.”  And I think to myself, “Yes, and your point is . . . “  Sometimes you just have to bite the bullet, admit your mistake, and move on.

I’ve led a sheltered life.  I wasn’t in the room when Nixon conferred with his advisers after Watergate, or Kennedy met with his legal team after Chappaquiddick.  So I am pretty naive about people.  This transcript was a real eye-opener for me.

You probably think that I’m getting ready to accuse the Fed of being evil if they don’t get rid of the IOR.  I’m afraid my naivete is so deeply ingrained that within days I’ll again be assuming they are well-intentioned civil servants doing the best they can.  You guys are free to draw your own conclusions.

It’s been fascinating to see the topic of interest on reserves (IOR) all over the news.  I was watching a CNBC video sent to me by Mike Sandifer, and they discussed two interesting tidbits around the 5 minute mark.  First, that rumors the Fed would eliminate IOR triggered a big stock market rally the day before.  And second, they actually discussed the idea of negative interest rates on reserves.  I was gratified by the stock market reaction to the rumor that IOR would be eliminated (assuming the market was in fact reacting to this rumor, and I don’t know if it was) because market responses to news are the gold standard of causality.  Even if the stock market is wrong, it might nevertheless be right for the usual “Tinkerbell” reasons.  (If I think I can fly, then I can fly.)  If the stock market thinks a Fed action is very bullish, and rises sharply in response, that market reaction can trigger more investment even if based on an erroneous theory of monetary economics. 

I was also pleased to see the elimination of interest on reserves mentioned in these two excellent posts by Joe Gagnon and Bruce Bartlett.

And finally, I few days ago I mentioned how Jim Hamilton and Robert Hall had noticed the contractionary nature of IOR quite early on.  Yesterday I ran across a David Beckworth post that was one of the earliest and best posts on the subject.  Not only did David notice the contractionary impact, but he also saw the analogy to 1937, at a time (October 2008) when the vast majority of macroeconomists were still completely oblivious to what was going on. 

Monetary policy can affect either the supply or demand for money.  In the short run, monetary policy tools are generally used to change the supply of base money.  Indeed most textbooks are only able to come up with a single example of the Fed targeting the demand for base money in order to change the stance of monetary policy;  the 1936-37 decision to double reserve requirements.  Futures textbooks will almost certainly mention the October 6, 2008 IOR decision as a second, and even more foolish, example of raising the demand for base money at an inappropriate time.  Shame on the economics profession for not calling out the Fed at the time. 

I like to point out that 2009 saw the biggest drop in NGDP since 1938.  But as of October 2008, the decline was still not expected to be that large.  So David’s reference to the 1937 example proved to be not only accurate, but also prophetic.  Here’s how he modestly concluded his post:

Pardon me for being skeptical, but from what I can see this approach has only encouraged banks to hoard more excess reserves. I may be missing something here–and please let me know if I am–but it seems like we are making the same policy mistakes that were made in 1936-1937.

No David, you didn’t miss anything, but the rest of the profession sure did.

Benjamin Strong was President of the New York Fed during the 1920s, which effectively made him the Ben Bernanke of his time.  According to Liaquat Ahamed (p. 293-94), Strong favored a policy that attempted to stabilize the economy by looking at “the trend in prices and the level of business activity.”  Today we would call those variables the price level and real GDP, i.e. NGDP.  His policies were highly successful during the 1920s, as NGDP grew at a fairly low but steady rate after 1921.

A good example occurred during the very mild recession of 1927.  Contrary to the Austrian view, policy wasn’t particularly easy by modern standards.  Short term rates were cut to 3.5%, but that would be like 5.5% under our modern 2% inflation regime.  (In those days the trend rate of inflation was roughly zero.)  In any case, this policy insured that the recession was very mild, and the economy soon recovered.   

Unfortunately, Strong died on October 16, 1928, and a year later a tight money policy by the Fed began driving both RGDP and prices far lower than they had fallen in 1927.  Irving Fisher, Ralph Hawtrey, Milton Friedman and Anna Schwartz all argued that his death deprived the Fed of “Strong” leadership, and that the resulting power vacuum contributed to the Fed’s passivity during the Great Contraction.  I’d say that praise from those 4 scholars represent a pretty good testimonial!   Sometimes I think that if Strong had lived another 10 years, WWII might never have happened.  (Or maybe it would have been fought between the US and Soviets in 1959, with nukes.)

Are there any analogies to the current crisis?  Greenspan left the Fed in 2006, about a year before the sub-prime crisis blew up.  But I am not going to argue that he could have prevented the current crisis.  His recent policy statements don’t inspire much confidence on that score. 

Elsewhere I have argued that the economics profession is to blame for the recession.  We promised policymakers that we had the models and tools to stabilize nominal aggregates, and then we refused to do so when the time came for action.  The reasons are complex, but I believe that part of the problem is that all the activity at the Fed in late 2008 and early 2009 lulled many economists into thinking that the Fed had adopted a highly accommodative policy.  How many times have you read something to the effect that; “Bernanke was a student of the Depression, and was determined not to make the same mistakes.  Hence policy was very active, and prevented another Great Depression.”  If only it were true.

Of course policy was extremely contractionary during late 2008.  But why was this not recognized?  Among Keynesian economists you can point to an unhealthy fixation on nominal interest rates as an indicator of policy.  On the other hand Keynesians weren’t the main problem—they were not opposed to unconventional easing, just rather apathetic.  The real opposition came from those on the right, who were alarmed at the massive increase in the monetary base.

Milton Friedman died on November 16, 2006, one year before the sub-prime crisis.  I’d like to suggest that his death was the closest equivalent to the death of Strong in 1928.  In 1998 Friedman pointed out that the ultra low interest rates were a sign that Japanese monetary policy was very contractionary, at a time when most people characterized the policy as highly expansionary.

There is little doubt that Friedman would have recognized the low interest rates of late 2008 were a sign of economic weakness, not easy money.  But what about the big increase in the monetary base?  First of all, the base also rose by a lot in Japan, and in the US during the Great Contraction.  Second, Friedman would have clearly understood the importance of the interest on reserves policy, which was very similar in impact to the Fed’s decision to double reserve requirements in 1936-37.  And in his later years he became more open to non-traditional policy approaches, for instance he endorsed Hetzel’s 1989 proposal to target inflation expectations via the TIPS spreads.  Note that the TIPS markets showed inflation expectations actually turning negative in late 2008.

Why was Friedman so important?  I see him as having played the same role among right-wing economists that Ronald Reagan did among conservatives.  Reagan was really the only conservative that all sides respected; social conservatives, economic conservatives, and foreign policy (or neo-) conservatives.  After he left the scene, the conservative movement cracked-up.  

Friedman was respected by libertarians, monetarists, new classicals, etc.  Last year I criticized Anna Schwartz for adopting the sort of neo-Austrian view that she and Friedman had strongly criticized in their Monetary History.  If Friedman was still alive, and strongly insisting that money was actually far too tight, then I doubt very much that Schwartz would have gone off in another direction.  It would be like Brad DeLong disagreeing with Paul Krugman on macroeconomic policy.  Once in a blue moon.

Today there is no real leadership among right wing economists.  They are all over the map.  There are new classical types focusing on the role of labor market imperfections.  Well-known monetarists like Schwartz and Meltzer insist that the real danger is easy money, not tight money.  It is true that a few monetarists such as Robert Hetzel, Mike Belongia and Tim Congdon have spoken out against the view that low interest rates imply money is easy, but they aren’t as influential as Friedman.  Austrians are split, with the loudest voices on the internet often drowning out the more thoughtful Austrians who recognize the dangers of a “secondary deflation.”  Inflation hawks at the Fed seem to think this is a good time to get inflation down closer to 0%, where it should have been all along in their view.  When a conservative like John Makin does speak out, it is treated as a sort of freak occurrence. 

If only Milton Friedman had lived a few more years, and made the sort of bold clear statement he made in 1998 about the situation in Japan:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

Indeed.

I can’t say every conservative would have accepted his view.  But they couldn’t ignore it the way they ignore me and Earl Thompson and David Beckworth and David Glasner and Robert Hetzel and Bill Woolsey and Tim Congdon.  Milton Friedman was an intellectual giant, and his voice is dearly missed.

PS.  In January Allan Meltzer had this to say about recent Fed policy:

Mr. Volcker publicly and privately discarded the Phillips Curve in favor of bringing inflation down by high interest rates and better control of the money supply. The result: about 15 years of low inflation and low unemployment. But the Fed abandoned its success by keeping interest rates too low after 2003. And now the Phillips Curve is back in fashion, with strong support from the Fed Board of Governors.

Interestingly, since the Fed abandoned its “success” in 2003, inflation has been considerably lower than in the 15 year golden age ushered in by Volcker in 1982.  And that is precisely the problem—too little inflation.  Low interest rates usually mean low inflation; Friedman understood that.

HT:  Mike Belongia, David Glasner