Over the past few years, many writers have made the claim that Milton Friedman would roll over in his grave if he knew what Ben Bernanke was doing at the Fed. These observers claim that both the ad-hoc nature and scale of monetary policy intervention would never be sanctioned by Milton Friedman. I and others have responded many times that except for the former point, this critique is wrong. Just look at Milton Friedman’s own words to see why. Nevertheless, this “What would Milton Friedman Say?” critique against Bernanke’s Fed keeps reappearing in prominent media outlets like a never-ending whack-a-mole game.
[T]he Fed chairman is abusing his old connection to the monetary master, Friedman, as a cover for a policy that Friedman might not endorse. That policy is doing anything Bernanke feels like — dumping money in the economy, or simply scaremongering — with the defense that doing so is honoring Friedman’s desire to avoid that deflation, that recession or that Depression.
It is time to call Bernanke’s Friedman bluff… Bernanke is operating with a license Milton never gave him.
Actually, it is Shlaes who is operating without a license here, at least when it comes to writing on Milton Friedman’s views on large scale asset purchases. Her claim that Friedman would not endorse QE2 or Operation Twist overlooks some important facts.
First, Milton Friedman advocated large scale asset purchases for Japan. Here is an exchange he had with David Laidler in 2000:
David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero, monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?
Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.
During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?” It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.
Milton Friedman’s call here for purchasing long-term government bonds as a way to push the Japanese economy out of its quasi-recession is similar to the Fed’s justification for QE2 and Operation Twist. The only meaningful difference is that Friedman was advocating a continual, sustained purchase of securities until a robust recovery began. The Fed, on the other hand, has been applying a piecemeal approach (i.e. QE2, Operation Twist, long-term interest rate forecasts) that in someways creates more uncertainty. For example, will the Fed do QE3 or not? No one, even the Fed, knows for sure.
Second, not only did Friedman call for large-scale asset purchases (LSAPs) but he also provided theoretical reasons for doing so. His main argument was that LSAPs created portfolio effects that in turn affected aggregate nominal spending. Edward Nelson, probably the foremost authority on Friedman’s monetary views, has an excellent article that summarizes Friedman’s view on LSAPs and its implications for the portfolio channel. Anyone who wants to make claims about Friedman’s monetary views should read this article first.
Third, Milton Friedman was very clear that one should never look to the level of short-term interest rates as a guide to monetary policy. Shlaes does not do this, but others making the same claim as her on QE2 and Operation Twist often point to low interest rates as indicating the Fed has kept monetary policy super loose. Consequently, the LSAPs were unnecessary. Friedman called this the interest rate fallacy. In order to truly understand the implication of interest rates one needs to first know the level of the natural interest rate. Only if interest rates are lower than their natural rate level is monetary policy stimulative. Too many observers miss this point and thus fall prey to Friedman’s interest rate fallacy.
The one point where I do agree with Shlaes is that Friedman would have preferred that monetary stimulus be done in a more systematic manner. Instead of announcing successive, politically costly rounds of QE the Fed could have announced a nominal level target from the start and said asset purchases will continue until the level target was hit. There would have been no need to announce a large dollar size of the asset purchases up front that attracts so much criticism. There would also have been no need to announce successive rounds of QE that make it appear the previous rounds did not work. More importantly, it would have more firmly shaped nominal expectations in a manner conducive to economic recovery. The question is what type of systematic level target would Friedman have supported? This 2003 WSJ article indicates he might have liked a nominal GDP level target.
My hope is that in the future Amity Shlaes and others who want to critique the Fed based on Milton Friedman’s views do so appropriately. If they really are fans of Friedman, then they should come after the Fed for not doing enough in a systematic manner. Anything else falls short of the true Milton Friedman.
This post originally appeared at Macro and Other Market Musings and is posted with permission.