Milton Friedman's free market credentials are beyond question, so it is somewhat curious that the voice of this towering figure isn't invoked nearly as much as this other towering figure of 20 century macro-economics, John Maynard Keynes.
It is remarkable because Friedman was, together with Hayek, the main intellectual driver for the revival of free market economics. He was an adviser to Ronald Reagan and a brand of monetarism was implemented under Thatcher in the UK (with rather mixed results).
Apart from numerous academic contributions (on the consumption function or the methodology of economics, for instance) Friedman is probably best known for:
- His book Free to Choose, a popular expose about free market economics for a wider audience (and made into a TV series)
- His theory of the natural rate of unemployment, and (together with Edmund Phelps), the busting of the stable Phillips curve (depicting a trade-off between unemployment and inflation), a theoretical advancement that won both the Nobel price as it preceded events in the 1970s (stagflation)
- His book (together with Anna Schwartz) "A Monetary History of the United States" in which it is argued (new and controversial, at the time) that monetary policy mistakes by the Fed caused (and worsened) the 1930s depression
- That book, and other publications led to a revival and restatement of monetarism, the economic framework in which the supply of money plays a determining role in economic activity and prices.
It's a little weird perhaps that we feel we have to introduce Friedman, but it's even weirder that he seems almost completely gone from the debate.
How would Friedman have solved the economic crisis?
The policy mistakes that Friedman blamed the crash and the depression on where all perpetrated by the Fed. Monetary policy was too tight, this shrunk the money supply, causing a contraction in both output and prices.
Rate rises in 1928 led to a recession and the stock market crash in 1929, rate rises in 1931 and 1932 to defend the dollar worsened the depression, and the Fed was negligent with respect to banks (there were widespread bank failures).
Famously, on Friedman's 90th birthday, Fed president Ben Bernanke promised not to repeat these mistakes, and by and large, they haven't. The Fed was quick of its feet propping up the financial system, providing ample liquidity, and slashing rates. Banks were subjected to stringent stress tests and forced to recapitalize themselves on the markets.
It's a little bit of a mystery, then, why so many on the right rail against Bernanke's monetary policy. There was even an open letter to the Fed, predicting all sorts of mayhem, the kind we associate with the Austrian school. But there is more.
Japan experienced a similar asset bubble crash as the US did in the 1930s and 2008 (although the Japanese asset crash was three times the relative size). Whilst a depression was prevented by expansionary fiscal policy (despite asset prices like land and stocks crashing 80-90% and banks turned into zombie banks because of mountains of bad debt).
Monetary policy was slow to react, but eventually rates were cut to zero, but this had little effect. Here is an interview with Milton Friedman, verbatim, about the Japanese situation. David Laidler is a well known English monetarist.
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.
Laidler's conclusion is also noteworthy:
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.
Since it's rather obvious that little of that high-powered money is getting the economy in an expansion, now you know why Bernanke is still hitting the gas pedal. One could make a strong case that Friedman would do the same.
Friedman is famous for arguing that inflation is always and everywhere a monetary phenomenon, and many people take that as a clue to point to the great dangers of "money printing" by the central banks. This will inevitably lead to accelerating inflation many have argued for years.
It's worthwhile to keep in mind that:
Milton Friedman himself, doyen of postwar monetary economists, argued that the quantity of money alone matters. Measures of broad money have stagnated since the crisis began, despite ultra-low interest rates and rapid growth in the balance sheets of central banks.
Data on "divisia money" (a well-known way of aggregating the components of broad money), computed by the Center for Financial Stability in New York, show that broad money (M4) was 17 per cent below its 1967-2008 trend in December 2012. The US has suffered from famine, not surfeit. [Martin Wolf, FT]
Why this has been the case isn't a mystery at all. By lending, banks create deposits, which is the main part of the money supply. Credit demand is tepid as the private sector (and banks themselves) are deleveraging, so money creation has been weak.
Of course, whether a policy is effective or whether it is supported by Friedman are not necessarily the same thing. The excellent Martin Wolf sums it up:
Expanding banking reserves is an ineffective way to increase lending, not a dangerous one.
Keynes, of course, compared it to "pulling on a string." Most current academic research also shows that the effectiveness of QE is modest, at best. Most of the "printed" money just sits as bank reserves (way in excess of what they need), without hitting the veins of the economy.
So we are in the rather awkward situation that for QE to work, banks must convert at least part of these reserves into lending, but that is also the route by which inflation worries become more manifest (at least a little). Isn't there something better?
But Friedman even had some sort of solution for that. Drawing upon an earlier Chicago tradition, he suggested a more direct injection of money into the economy. This can be either to the government (monetary finance), or to the public (akin to a one-off tax cut). Others have suggested this as well:
- The Chicago plan
- Willem Buiter in 2003
- Ben Bernanke proposed it for Japan in 2003
- Adair Turner
- Martin Wolf (FT)
- Ambrose Evans-Pritchard
These are no left-wing big government spenders by any means. Bernanke and Evans-Pritchard are conservatives and the latter is a monetarist as well, Wolf is FT's premiere columnist. Adair Turner used to be the UK's regulator for the financial markets (FSA), and before that, he was head of the British employers organization (CBI). Martin Wolf argues:
Cancer sufferers have to undergo dangerous treatments. Yet the result can still be a cure. As Lord Turner notes, "Japan should have done some outright monetary financing over the last 20 years, and if it had done so would now have a higher nominal gross domestic product, some combination of a higher price level and a higher real output level, and a lower debt to gross domestic product ratio". The conventional policy turned out to be dangerous.
Indeed. But these views are exceptions left of center. Monetarism and Friedman have nearly disappeared from the debate, whilst Hayek and the Austrians dominate, especially in the US.
It is noteworthy that Friedman would, in all probability, be in favor of QE and perhaps even of the more radical 'helicopter money' solution, whilst he has always been dead set against fixed exchange rate regimes like the gold standard. This is exactly the opposite of the Austrians today. No wonder Friedman is hardly ever mentioned.