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.
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.