Wednesday, March 7, 2012

The "What Would Milton Friedman Say?" Whack-A-Mole Game

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.

The most recent contribution comes from Amity Shlaes (ht James Picerno).  Writing for the Bloomberg View, she takes Ben Bernanke to task for not living up to Milton Friedman's counsel:
[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.


  1. Shlaes is just following Taylor.

    Obviously, he has convinced some old monetarists.

    If you think about it, they were overly persuaded that M2 velocity was sufficiently stable so that money supply rule would result in stable prices and output.

    By the way, isn't it possible that supply side policies could be used to manipulate the natural intersest rate (and heck, the relations between the natural interest rate_s_) so that the Taylor rule works? How is that for a Keynesian hyper interventionism?

    Why did they think that? Empirical evidency.

    And now, we have Taylor saying that a simple rule relating the Federeal Funds rate to inflation and the output gap will stablize inflation and output. (Oh, and get this, when it doesn't it is all about failure to follow the rule in the past. Just like actual fluctuations in M2 velocity were explained by failures to keep M2 growing on a stable path.)

    The nothing that the interbank lending rate is adquate for some permanent rule is pretty much an embarrassment. Fortunately, Friedman leaves little room to rationalize interest rate targets.

    On the other hand, Friedman did do a good bit of modeling of the Phillips curve where it was unstable inflation causing unstable output. Seems to me that there we are on shakier ground. Though, there is plenty about the point being stable nominal spending on output.

    Of course, you can always twist that into what was probably an important emphasis--that stability of real output is not the goal.

  2. Hard to believe Amity Shaes is making baseless claims with no proof, leading to unsubstantiated conclusions derived from unwarranted assumptions.

    At what point in an English literature concentration do they teach economics anyway?

  3. David, excellent post! It is shocking how Friedman is being misread by so many right-wing commentators and even by prominent economists.

    I believe your reading of Milton Friedman is perfectly correct. In fact I a couple a months ago made the same argument based on the same WSJ article:’s-thermostat-and-why-he-obviously-would-support-a-ngdp-target/

  4. And Bill, I totally agree...the craziness about the Taylor rule is incredible. Taylor never ever before AFTER the collapsed argued that bubbles were created if his rule was not followed. I did not hear Taylor join the crowd with Peter Schiff and Nouriel Roubini etc. prior to 2008. Disclaimer: I was quite negative myself prior to 2008 I was of the view monetary policy was too loose in the US.

  5. Bill and Lars,

    One can construct a Taylor Rule that shows both monetary policy being too loose during the housing boom and now being too tight. The Taylor Rule, after all, does have the natural interest rate in it. One just needs to let it vary to get reasonable results.

  6. David, I never really liked the concept of a natural interest rate. Was monetary policy in the US too easy prior to 2008? Maybe, but I still think that is was mostly unimportant in terms of explaining the crisis.

  7. Debitores CaveatisMarch 17, 2012 at 1:38 PM

    purchasing long-term government bonds as a way to push the Japanese economy out of its quasi-recession

    A q-recession emanating directly from a political attempt to resurect dead home mortgages just long enough to make whole the ineffectual bankers publicly exposed as loosers? A timely revisit to the *emaculate deflation etude* could have taught our asian cousins that full employment with full economic output could have been retained by lower prices on all things, including Japanese Government paper, not the higher bond prices from buying up bonds as price support. During Japanese deflation their government should have been auctioning lot of bonds to push prices lower. Higher interest rates would have siphoned investor resources out of real estate but into bargain bonds.

    After confirmation of bargain real prices the Japanese Public Policy could have then stopped the extra auction of long bonds to allow land prices to slowly rise. Rising real prices would have generated panic buying thus enough housing bubble to prevent extended recession. Does this illustrate that libertarian approach is always superior but seldom considered? Seldom because it does not serve the immediate needs of myopic banksters? Think about it!

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