October 22, 2010
REVISITING FRIEDMAN'S ADVICE
Economist Scott Sumner makes a good point: "For decades the Fed has steered the economy along a path of two to three percent inflation. The policy has not been controversial. Sometimes they ease, and sometimes they tighten." But the policy has become controversial these days. What's changed? Again quoting Sumner: "Recently inflation has run closer to 1%, and Bernanke has suggested pushing the rate back up to 2%." Those are fighting words in some circles.
Bernanke's policy prescription has triggered an outcry that the central bank should effectively stand back and let nature take its course. What is that course? Allow inflation to continue falling. This seems utterly misguided, but there's a growing chorus of pundits who argue for no less. And let's be clear: We're really talking about the nominal change in the economic growth. In the current climate, it's unlikely that we'll see nominal GDP rise until the inflation rate stops falling if not rises a bit.
How can we achieve that goal? The policy at issue is a second round of so-called quantitative easing (QE2), or the Fed's purchase of government bonds. Is this some radical idea cooked up by crackpots who are oblivious to economic realities? No, not at all. The challenge facing the U.S., while far from common, is hardly unprecedented. The recent experience in Japan is one example, and the Great Depression in the 1930s is another. Indeed, Milton Friedman delivered what many economists see as the definitive prescription for what a central bank should, and shouldn't, do in the face of low and falling inflation, high unemployment and forecasts of lower aggregate spending. As explained in detail in A Monetary History of the United States, 1867-1960, it's a mistake to maintain tight monetary policy under those conditions.
Ah-hah! counter the critics. Fed policy is loose, very loose these days, as indicated by the zero-to-25-basis point Fed funds target rate. Actually, that's a misreading of current conditions. Indeed, as one example, the Taylor Rule implies that Fed funds should be at negative 5% or so. The Fed's not going to engage in negative policy rates, but it still has options, namely QE2. For some background on why that's reasonable and arguably necessary, allow Milton Friedman to explain, albeit as it related to Japan in the 1990s. Analyzing the Japanese economic ills in 1998, Friedman dismissed the idea that low interest rates were a sign of easy money and that there was nothing else the Bank of Japan could do.
Although Friedman's point is misunderstood in the current climate, if not ignored entirely, some economists are attempting to set the record straight. For instance, David Beckworth and William Ruger provide a basic overview in Wednesday's op-ed "What Would Milton Friedman Say About Fed Policy Under Bernanke?
Yes, there are risks with QE2. But the risks of not engaging in QE2 appear to be substantially greater. Unless you expect a material change for the better in the economy in the near term, calling on the Fed to stand pat risks repeating the mistakes of monetary history.
Posted by jp at October 22, 2010 6:29 AM
In the Hoover Institution article to which the above article links, Friedman claims that “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.”
That is nonsense. First, the theory: commercial banks do not need reserves in order to lend. If they see a viable lending opportunity, they create the relevant money out of thin air. Second, the evidence: U.S. (and U.K.) bank reserves have risen by astronomic and unprecedented amounts over the last two years, but they are not rushing out to lend!
As for Friedman’s claim that “whether they do so or not, the money supply will increase”, that is also nonsense. A money supply increase is a total irrelevance unless someone does something with the increase (as David Hume pointed out in his essay “Of Money” over 250 years ago). If I print a million tons of $100 dollar bills and hid them down a disused coal mine, there’d be no effect, would there?
The problem the U.S. has is political. The banks have money, plus businesses are cash rich; but it’s households that are (or feel) cash constrained, i.e. they are deleveraging. Unfortunately the only way of feeding cash to households involves increasing the deficit, and the politicians on Capitol Hill won’t wear that. Those politicians should burn in Hell.
Posted by: Ralph Musgrave at October 22, 2010 8:34 AM