Monday, November 29, 2010

Case Closed: Milton Friedman Would Have Supported QE2

The debate over what Milton Friedman would say about QE2 can now be closed.  Below is a Q&A with Milton Friedman following a speech he delivered in 2000.  In this excerpted exchange with David Laidler, we learn that Friedman's prescription for Japan at that time is almost identical to what the Fed is doing now with QE2: (my bold below)
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.

The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.
So Milton Friedman said in 2000 that the Bank of Japan should do what the Federal Reserve would be doing 10 years later!  In fact, if names, dates, and places were changed in the above excerpt one could get a 2010 Ben Bernanke Q&A. Friedman's belief that a zero policy interest rate could be contratctionary and thus required the central bank to buy long-term securities shows that he understood unconventional monetary policy long before it was vogue.  He truly was a great economist.

Note, though, that his emphasis is still on expanding the monetary base as much as needed to start and maintain an economic expansion.  This implies he saw an excess money demand problem in Japan, just as there is one today in the United States.  He understood, though, the need to expand the monetary base through purchases of long-term securities rather than short-term ones.  This is because short-term securities are close to a perfect substitute for the monetary base at a zero percent policy rate. Swapping perfect substitutes does not change anything in one's portfolio of assets and therefore has no effect on spending.  Thus, Friedman saw the need for purchasing long-term securities, which are not perfect substitutes with the monetary base.

Although Milton Friedman probably would have preferred a rule-based approach to QE2, this excerpt is the smoking gun that ends all debate on whether he would have supported QE2. The case is closed.

Thanks to Doug Irwin for locating this gem.


  1. That "Case Closed" is going to annoy some people, but I suppose you know that already.

  2. Lee,

    I am not trying to annoy them, but I am dying to see how they handle this gem. Of course, if they couldn't accept the evidence we previously showed them I am not sure anything will change their minds.

  3. "Swapping perfect substitutes does not change anything in one's portfolio of assets and therefore has no effect on spending."

    Do you have a source that spells this issue out in detail?

    Great blog by the way.

  4. Well, we do not have deflation. We are nowhere near deflation. Unlike the situation in Japan, real interest rates are significantly negative.

    We are in a stagflation situation with a modest rate of inflation. There is no reason to think QE2 will increase real output if it succeeds in accelerating inflation.

    Now Friedman indeed made the case in 2000 that the fed can stimulate further when fed funds are at 0% by buying bonds. It does not follow that Friedman would believe that this is the case in 2010. And there are good reasons to think that the growth in shadow banking has fundamentally altered the potential of monetary policy to fine tune the economy through open market operations of any kind.

  5. Stagflation, Charles? Good grief. Can't you have the decency to wait until NGDP growth hits 6% (at the very least) before talking about stagflation?

    Stagflation is so.... 70's. You know, 8,9,10,14% NGDP and not so much RGDP.

    Last I checked, NGDP wasn't even up to 5% yet. Whatever that sucker is, it ain't stagflation.

  6. Wouldn't it depend on whether Friedman agreed that we were currently in deflation? From December 1999 to December 2000 the Japanese CPI fell from 102.5 to 102 ( From October 2009 to October 2010 the US CPI rose from 216.177 to 218.711 ( So we're not as obviously in deflation as Japan was when Friedman gave this speech and Q&A. Certainly those who say Friedman would NEVER have countenanced QE are wrong (though that's scarcely news). But I think "case closed" is a bit strong.

  7. Agree with last Anon, "case closed" is a bit strong word.

    Situation in US is really a bit different than it was in Japan back then.