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.

Although I am not really a monetarist, I do like their basic approach, especially the way they distinguish between money and credit.  Changes in the price level are determined by changes in the supply and demand for the medium of account, i.e. money.  Unfortunately, the Fed seems to have forgotten that, and increasingly seems to focus on credit.  Here is Dave Altig of the Atlanta Fed:

Is the 25 basis point return paid by the central bank creating a significant incentive for banks to sit on reserves rather than lend them out to consumers or businesses? At least some observers are skeptical:

“Barclays Capital’s Joseph Abate…noted much of the money that constitutes this giant pile of reserves is ‘precautionary liquidity.’ If banks didn’t get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn’t see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum.”

This is one of those situations where I don’t know whether I should be criticizing Abate, for what he said, or Altig, for seeming to approve of it.  But whoever is to blame, this quotation seems to get things exactly backward, and does so by focusing on credit, rather than money.

Let’s suppose banks reacted to a cut in the interest rate on reserves (IOR), by switching over to some sort of short term debt.  Where would the reserves go?  There is only one place unwanted bank reserves can go, out into circulation.  That means a nearly instantaneous $1 trillion increase in currency in circulation, with banks instead holding more short term assets like T-bills.

[As an aside, I do understand that this probably wouldn’t happen, I’m just trying to work through Abate’s worst case.  In practice, yields on T-bills might fall to zero, or even a few basis points below zero.  Of course if there was a negative interest rate on ERs (including vault cash), then it really would happen.]

So what would this mean for the economy?  First, it would be equivalent to a trillion dollars in quantitative easing (QE), which is quite a bit.  But you might ask; “Why would an extra trillion in QE help, didn’t the last round of QE have relatively little effect?”  One answer is that at least it had some effect, it was better than nothing.  But more importantly, the previous QE had little effect because most of the new base money went into ERs.  If the banks got rid of reserves and replaced them with short term debt, then all the extra base money would go into circulation.  It would be like a trillion in QE, with 100% of the new base money becoming currency in circulation. Not just QE, but super-charged QE.  Indeed this is the nightmare scenario that led to the IOR program in the first place.  The Fed was doubling the monetary base in late 2008, and feared what would happen if all that extra cash went out into circulation.  What Abate defines as failure, to me seems like a dream come true.

Of course a super-pessimist like Paul Krugman might talk about how sales of safes boomed in Japan once rate hits zero.  And technically it is possible that even this super QE would have no effect—it might all be hoarded.  But a trillion dollars is a lot of cash, and I think it more likely that the “hot potato” process would take over—people would try to spend some of the extra money, driving up AD.

The “hot potato” process is the central concept of monetary economics.  If you put more cash into circulation than people want to hold, they’ll try to get rid of it.  Individually they can, but collectively they cannot.  The attempt to get rid of the cash will drive up AD.  I think everyone understands this (excluding post-Keynesians of course) but many economists forget what monetary policy is all about; the supply and demand for money.  Lowering the IOR will lower the demand for money, and tend to raise prices and NGDP.  The effect may be small or large, it mostly depends what else the Fed does.  But with the economy this weak it is certainly worth trying.

HT:  Mark Thoma, JKH, JimP

Tyler Cowen links to this post from Mark Thoma:

As for Tyler’s (and others’) call for monetary policy instead of fiscal policy, here’s the problem. It relies upon changing expectations of future inflation (which changes the real interest rate). You have to get people to believe that the Fed will actually be willing to create inflation in the future when it comes time to do so. However, it’s unlikely that it will be optimal for the Fed to cause inflation when the time comes. Because of that, the best policy is to promise that you’ll create inflation, then renege on the promise when it comes time to follow through. Since people know that, and expect the Fed will not actually carry through, it’s hard to get them to change their expectations now. All that credibility the Fed has built up and protected concerning their inflation fighting credentials works against them here.

Paul Krugman developed the idea of an expectations trap as a way of explaining the dilemma faced by the Bank of Japan.  Except there is just one problem.  Almost everyone agrees that Japan does not face an expectations trap.  They can devalue the yen whenever they wish, as much as they wish.  Some claim they would not be able to do this because there would be too much resistance from their trading partners.  There are two problems with this argument.  First, even if true, why would they have recently allowed the yen to rise from 115 to the dollar to 90 to the dollar in the midst of deflation?  Surely if they had simply kept it at 115, they would not have attracted much attention.  But even if I am wrong, the expectations trap argument is still wrong.  If the problem was foreign pressure; that would have also precluded BOJ attempts to spur the economy through open market purchases.  After all, if Japan truly can’t depreciate its currency, then logically it could not do any policy action that would cause its currency to depreciate.  And of course any credible and effective policy of open market purchases will cause a currency to depreciate.  So even in that case, it wouldn’t be an expectations trap, it would be a case where the big bad Westerners are forcing Japan into a policy of deflation.  It would be a “bully trap.”

But here’s the bigger flaw with the whole expectations trap argument.  People think it applies to monetary policy, but they forget it applies equally to fiscal policy.  (Indeed I never realized this until today.)  Here’s why.  Krugman’s model relies on rational expectations, indeed you can’t get the expectations trap without ratex.  But if you have ratex in your model, then no policy can work unless it is expected to work.  That’s why ratex should actually be called “consistent expectations.”  What you are really assuming is not that that people are “rational” (which is pretty much a meaningless term anyway), but rather that their expectations are consistent with the predictions of the model.  So if monetary policy is aimed at boosting nominal spending by 10%; it will only “work” in a ratex model if it is expected to boost nominal spending by 10%.  But that’s equally true of a fiscal policy aimed at boosting nominal spending by 10%.  It won’t work unless it is expected to work.

So why do people think this applies to monetary policy but not fiscal policy?  Because they visualize the transmission mechanisms in vastly different ways.  Most Keynesians (wrongly) think monetary policy is all about getting lower real interest rates.  In fact, it’s been shown that a highly effective monetary policy might lead to such bullish real growth expectations that real interest rates rise.  The real problem is linking current and future aggregate demand.  Woodford showed that it’s hard to boost current AD unless expected future AD also rises.  Think of this in terms of a price level target.  It’s hard to get current prices to rise unless future expected prices also rise.  But that will only occur if future expected monetary policy becomes more expansionary.

[If this is confusing think of a micro analogy.  If the government decides to pump up copper prices by buying massive quantities of copper, the policy will be almost totally ineffective if the government is expected to give up on the policy and sell off its copper hoards in 6 weeks.  Why would buyers stock up on copper today at $5 a pound, if they expected copper to sell for $3 a pound in 6 weeks?]

For some reason people don’t worry about this problem with fiscal policy; and the reason is very odd.  Perhaps without knowing it, people tend to assume that future monetary policymakers would be expected to sabotage current monetary policymakers, but would not be expected to sabotage current fiscal policymakers.  This is a rather odd assumption, as you’d expect that future monetary policymakers have more respect for current monetary policymakers than they do for the bozos in Congress.  After all, given the very long terms served by Greenspan (and now apparently Bernanke) the future and current monetary policymakers are often the very same person.  Is future Mr. Bernanke expected to differ from current Mr. Bernanke, by more than future Mr. Bernanke differs from the current Congress?

Here’s one way to think about this issue.  The future Fed is considered the last mover in this game.  The current Fed can do QE, and the future Fed can undo QE.  Or the future Fed can raise rates sooner than expected, or by more than expected.  But that’s also true of fiscal policy.  The Congress can pass a bill to spend more money, and the Fed can raise rates right afterward if they think inflation is going to exceed their target.  I’m not saying that’s likely, but I also don’t think it’s likely that the future Mr. Bernanke would try to sabotage the current Mr. Bernanke if the current Bernanke publicly announced “We need to get core inflation back up to the trend line of 2% extending out from September 2008, and will do whatever it takes.”  Why would the future Mr. Bernanke try to sabotage the current Mr. Bernanke, if he made that promise publicly and explicitly?   After all, if he did so he would make both Bernankes look like fools in the history books.

So please don’t take this post the wrong way.  When I say that the expectations trap is equally applicable to fiscal policy, I’m not saying that I think the Fed is likely to go out of its way to sabotage fiscal policy.  But it is even less likely to sabotage monetary policy, indeed the latter hypothesis seems much more far-fetched to me.

Over in the comment section for an intriguing post in Nick Rowe’s blog I asked: When in the entire history of the universe has a central bank explicitly tried to create inflation and failed?  Until someone can answer that question, I’ll keep assuming that it’s really easy to get inflation.  And also that the reason monetary policy seems to have so much trouble generating inflation at the zero rate is because monetary policymakers don’t want inflation, and go out of their way to say they are opposed to inflation.  Indeed they are even opposed to inflation that merely would bring us back to the implicit target trend line for the core CPI (which we have fallen below.)

PS.  A couple quick comments on the Tyler Cowen post I linked to.  I completely agree that real interest rates are less important than many people believe.  I look forward to his future post on this.  As far as uncertainty, I think we might be looking at the same concept from a different angle.  Suppose Walmart is thinking about building 75 new stores in America next year.  And suppose NGDP is currently $20 trillion and expected to be $21 trillion next year.  If Walmart is certain it will be $21 trillion, they are more likely to make irreversible investments than if there is a 50% chance it will be $20 trillion and a 50% chance it will be $22 trillion.  I understand that businessmen don’t use terms like “NGDP,” but when they are considering “how business will be next year” they are implicitly thinking about some sort of aggregate for total spending.   So I agree that uncertainty hurts investment.  Where I suspect we disagree is that I think an enormous amount of this aggregate uncertainty comes from not having a clue as to where NGDP is going over time.  From 1984 to 2007 we could be pretty confident that aggregate “business” next year would 5% more than business this year, plus or minus a couple percent.  Starting in 2008 things got vastly more uncertain.  I blame the Fed.

This is a sort of response to a recent Nick Rowe post.

Good monetarism uses the excess cash balance mechanism.  It relies on the thought experiment that if you double the supply of base money in the economy, and the demand for base money is unchanged, then nominal expenditure levels must also double in order for money supply and demand to reach equilibrium. And that in the long run monetary shocks don’t have real effects, so any change in NGDP is attributable to prices, not output.

Bad monetarism is focused on the banking system.  Like hydraulic Keynesianism it is obsessed with all sorts of mechanical transmission mechanisms.  Bad monetarism sees monetary policy affecting the economy by first impacting the monetary aggregates through a “multiplier process.”  In fact, the aggregates respond endogenously to the overall macro environment, which is determined by expectations of future changes in the supply and demand for base money, and hence NGDP. 
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