Defending Milton Friedman’s Monetary Policy Prescriptions (Again)

Paul Krugman notes that Amity Shlaes has misinterpreted Milton Friedman’s legacy on monetary matters, as I did earlier this month. But then he loses me when he claims “that this time the Fed did all that Friedman denounced it for not doing in the 1930s. The fact that this wasn’t enough amounts to a refutation of Friedman’s claim that adequate Fed action could have prevented the Depression.” Huh?

The Princeton professor’s critique is confusing for several reasons, starting with the fact that we just heard the exact opposite from Berkeley economics professor Christina Romer, a fellow Keynesian and former chair of the Council of Economic Advisers in the Obama administration. Earlier this week, Romer again criticized the Fed for not doing more, calling the central bank’s reluctance to act more forcefully as a “missed opportunity.” Romer, in fact, has been chastising the central bank for some time. For example, in a widely quoted speech in May 2011 she said:

I give the Federal Reserve a lot of credit for preventing the financial crisis from spiraling out of control. They took a number of incredibly creative and aggressive actions to unfreeze financial markets and keep credit flowing in the fall of 2008. In early 2009, they did a round of quantitative easing that helped to reduce mortgage rates and stabilize the housing market.

My main criticism is that they took their eye off the ball in late 2009 and 2010. They started to think more about exit than about the fact that the economy was still operating far below capacity. The second round of quantitative easing, which started last November has been helpful, but it came about a year too late.

Krugman suggests that the Fed did all it could, but Romer begs to differ, even though the Fed’s target interest rate is virtually zero. In fact, you don’t have to look very hard to find other economists who agree with Romer. Market monetarist Scott Sumner, for instance, tells us:

Romer is a very strong advocate of the position that monetary policy does not run out of ammunition at the zero bound. Indeed Romer has recently been calling for NGDP [nominal gross domestic product] targeting, level targeting. Bernanke said the BOJ could definitely increase prices if they wanted to, and called on them to show “Rooseveltian resolve.” He clearly thought the lessons of 1933 had relevance for today. Bernanke has repeatedly said the Fed is not out of ammunition.

It’s understandable that even Nobel-prize winning economists can misinterpret zero interest rates as an easy monetary policy that’s at its limits, but Sumner sets us straight on this confusion, largely by drawing on the insights laid out by Milton Friedman:

America and Japan have dramatically enlarged their monetary bases; they’ve cut interest rates to almost zero. If even that wasn’t enough, just imagine how much monetary stimulus it would take to get a meaningful recovery!

I hear this all the time, and I have to respond to this over and over again in the comment sections. And also to the question of what the Fed should buy, and will those purchases cause major distortions in the economy?

Unfortunately, the worriers have it exactly backwards. They aren’t looking at robust monetary stimulus that failed; they are seeing what ultra-conservative monetary policy looks like, policy which drives NGDP growth to very low levels. The fruits of ultra-tight money just happen to look like what most people (wrongly) think ultra-easy money looks like: near zero rates and a huge monetary base (as a share of GDP.)

Sumner also asserts:

In late 2008 the markets were telling us that the Fed was making a tragic mistake by allowing NGDP expectations to plunge. But the economics profession didn’t listen, as they view stock investors as being irrational. Economists were obsessed with the notion that the real problem was banking distress, and that fixing banking would fix the problem. No, the real problem wasn’t banking, the real problem was nominal.

One of the arguments for why the Fed isn’t doing enough is that it’s worried about raising inflation expectations. But if the macro problems are truly nominal these days, as Sumner and others argue, then raising nominal GDP equates with raising inflation. Why’s that important? Because we’re still in a period that I like to call the new abnormal, or a time when growth and inflation expectations are positively correlated. A deeper explanation for what’s going on here comes from economist David Glasner, who writes:

As I showed in this paper there is no theoretical basis for a close empirical correlation between inflation expectations and stock prices under normal conditions. The empirical relationship emerged only in the spring of 2008 when the economy was already starting the downturn that culminated in the financial panic of September and October 2008. That the powerful relationship between inflation expectations and stock prices remains so strikingly evident suggests that further increases in expected inflation would help, not hurt, the economy. Don’t stop now.

One of the lessons in all of this is that expectations matter, a lot. As David Beckworth, an economics professor at Texas State University, recently observed: “…the Fed could pack more of punch if it did a better job managing expectations about future nominal spending (and by implication inflation) via a nominal GDP level target.”
This is an idea that stretches back through economic history. To take the most compelling example, it was an attitude adjustment that pulled us out of the deep dive of the Great Depression all those decades ago. The recovery was squandered by a premature monetary tightening in the mid-30s, but that’s another story. As for the first phase of the rebound in the second half of 1933, the record is clear. Gauti Eggertsson wrote a valuable study for the New York Fed a few years ago that explained how

…the U.S. economy’s recovery from the Great Depression was driven by a shift in expectations brought about by the policy actions of President Franklin Delano Roosevelt. On the monetary policy side, Roosevelt abolished the gold standard and—even more important—announced the policy objective of inflating the price level to pre-depression levels.

As for arguing that the Fed over the last several years has embraced Milton Friedman’s advice at full throttle, the empirical evidence looks weak. Marcus Nunes has been making this point for a long time by letting graphics tell the story. For example, the relatively weak rebound in job growth since the Great Recession formally ended in mid-2009 can be explained by the ongoing slump in NGDP growth relative to the trend. “The Fed dug a ‘deep hole’ and shoved employment inside,” the hole, he explains. “Four years later it still refuses to ‘shine the light'” by engineering an appropriate monetary policy that addresses the problem.
Casual observation may suggest that the Fed has done all it can do, but a fair reading of the evidence suggests that Milton Friedman’s advice hasn’t been fully implemented. Krugman argues otherwise, although one might wonder why he’s willing to give the apparent failure of fiscal stimulus a pass but offers no leeway for interpreting monetary policy? Indeed, Krugman has opined that the Obama administration’s efforts with fiscal stimulus were too small if not missing entirely, and so Keynesian economics can’t be blamed for the weak recovery. In evaluating the effectiveness of monetary policy, on the other hand, he’s subjectively holding it to a higher standard.