Paul Krugman Versus Milton Friedman

by: Shareholders Unite

One of the mildly pleasant consequences of 'living in interesting times' (as the Chinese proverb goes), for empirical macro-economists like ourselves, is that suddenly the world has become something like an economics lab. Different situations and different policy reactions provide raw data by which one can gauge the success or failure of certain approaches and the assumptions of the underlying economic models.

For instance, we know that during 'normal' times, monetary policy is quite effective. Raising interest rates by the Fed (and other central banks) has snuffed out many periods in which the economy was overheating and inflation accelerating, and the subsequent reduction of interest rates-- after having sufficiently squeezed demand and reduced inflation-- invariably got the economy going again. We're all Friedmanites (or at least, most of us), at least during 'normal' times. However, these are not 'normal' times.

We also know with near certainty that the reaction to the financial crisis, through the Bush-Obama bailouts and stimuli, was a lot better than the initial policy reaction to the 1930s depression. The financial shocks were comparable, the vertiginous fall in economic variables was even bigger this time around, but then suddenly that fall was arrested and even (mildly) reversed.

We also know that Japan, which suffered the biggest financial shock of them all in 1990, hasn't really experienced lost decades when you take into account that the Japanese population is shrinking and concentrate on GDP per person. The latter, as it happens, grew faster than either the U.S. or Europe. Some lost decade. But was there a role for monetary policy in preventing a depression from materializing in Japan?

Milton Friedman and the Great Depression

Another interesting area of contention to look at is to assess the effectiveness of monetary policy. We basically have two camps. We have monetarists like Milton Friedman, who argues it is effective especially in a crisis:

They are inspired by interwar economists Ralph Hawtrey and Sweden’s Gustav Cassel, as well as monetarist guru Milton Friedman. “Anybody who has studied the Great Depression should find recent European events surreal. Day-by-day history repeats itself. It is tragic,” said Lars Christensen from Danske Bank, author of a book on Friedman. [The Telegraph]

The 'they' mentioned at the beginning of this quote refers to proponents of 'nominal-GDP' (NGDP) targeting. And here:

Milton Friedman said yes, arguing that it was the Fed’s failure in 1930 to pursue “open market operations” on the scale needed that deepened the slump. [FT]

Indeed. Friedman and Anna Schwartz wrote a rather famous book (A Monetary History of the United States) arguing just that. And look who agreed:

In 2002 Ben Bernanke (then a Federal Reserve governor, today the chairman of the Board of Governors) made this startling admission in a speech given in honor of Friedman’s 90th birthday: “I would like to say to Milton and Anna: Regarding the Great Depression, you’re right. We did it. We’re very sorry.” [Freemanonline]

It's somewhat funny to realize that Hayek, the other big pillar of free-market economics, was actually diametrically opposed to these views:

Hayek arrived in London in January 1931, just as the world slump was deepening. He gave four lectures, arguing, as he had before, that an increase in the money supply would further distort the structure of production and prolong the slump. [Economicprincipals]

Perhaps that explains why people who one would normally expect to align with free-marketeer Friedman (the likes of Ron Paul and Perry) are arguing that monetary policy is not only ineffective, but positively dangerous.

There was a letter from conservative economist, and even a rather unprecedented one from Republican politicians) warning the Fed against further interventions:

It is not clear that the recent round of quantitative easing undertaken by the Federal Reserve has facilitated economic growth or reduced the unemployment rate. [McConnell, Boehner, Kyl, Cantor]

And indeed, they do have a point. It is certainly not clear that the large scale bond buying program or 'quantitative easing' (QE)-- while it probably did play a significant role in stabilizing the economy in 2008 through the provision of emergency credit that has kept the banking system from keeling over-- has much further traction in delivering higher growth or lower unemployment. Why not?

Enter Paul Krugman and Richard Koo

Keynesians like Krugman argue that the economy is in a liquidity trap where monetary policy loses much traction. In a liquidity trap, there is still an excess of savings over investment even at very low interest rates, which basically bump against the zero bound so they cannot be lower.

Monetary policy has lost much of its effectiveness and it's basically akin to Keynes' famous dictum that it would be like 'pushing on a string.' (If you're interested in this concept there is an excellent entry from the multi-volume Palgrave dictionary of economics). Increasing the money supply further has no effect on interest rates, and according to Keynes, it was interest rates which provide the leverage on the real economy from monetary policy.

In a liquidity trap, the demand for money becomes basically infinite (in the economics 101 textbook model, the LM curve becomes horizontal, something that also nicely explains the lack of rise in interest rates, even at very high public deficits). While modern Keynesians like Krugman still see a role for monetary policy (basically by managing expectations), Richard Koo is rather more categorical.

Koo argues that during 'normal' times, monetary policy has traction. Once again, these are not normal times. According to Koo, we're experiencing a balance sheet recession, which is a recession following the implosion of a financial bubble which leaves private balance sheets impaired as asset prices underpinning them have fallen below debt values.

During a balance sheet recession the private sector becomes obsessed with paying down debt, so there is little room for credit expansion, even in the face of record low interest rates, so monetary policy has no effect.

The evidence from the U.S.

Well, it's interesting to look at what happened to all that QE money. Here is the U.S.:

As you see, base money (that is, the most important part of it-- bank reserves) ballooned, but it's just sitting there, as excess bank reserves. The central bank can pump them up even more, but isn't this exactly what Keynes meant by 'pushing on a string?' It's very difficult to make a convincing argument that it led to much (if any) effect in the real economy. Credit creation to household is down, for instance:

And it's not such a big surprise why that is. Households are deleveraging, paying down debt and saving more in order to repair balance sheets.

The evidence from Japan

In Japan, the Bank of Japan ((BoJ)) embarked on quantitative easing in 2002. According to Koo, this hasn't really gained much traction either:

Click to enlarge

You'll notice that private sector credit is actually declining quite substantially during the Japanese QE. Pushing on a string indeed!

So on balance, the argument that massive money creation will have a substantial effect on real economic variables like output and employment is rather weak under present conditions (which can be described as either a liquidity trap or a balance sheet recession, they're by no means mutually exclusive).


Another thing one has to realize is that while QE hasn't led to a notable uptick in real variables like output and employment, it hasn't led to any accelerating inflation either. Japan still experiences mild deflation, while in the U.S. some very mild inflationary pressure comes from the energy market, but this is largely the result of rising energy demand from emerging economies meeting inelastic energy supply.

At this stage one might wonder why we bother with QE in the first place if it doesn't do any good, but doesn't do any harm either. Some, like Krugman, argue that we basically have to throw everything and the kitchen sink at the economy, and we -- as empirical macro economists-- marvel at that (as it provides more data and experiments to draw more conclusions from).

A more sophisticated version of Krugman has couched the debate in terms of central banks managing expectations (you'll be able to read about that in the link we provided above to the Palgrave dictionary entry on the liquidity trap), arriving at a rather bizarre conclusion that the central bank has to be able to credibly commit to be irresponsible (or something along those lines).

That might be the topic for another article some day, but we cannot close this one without mentioning Europe. It's hair pulling that exactly there-- where a central bank can have the most effect through some QE policy, it's most reluctant to do so. Why? Because unlike the U.S. or Japan, in the eurozone, the central bank (the ECB, European Central Bank) can actually easily influence expectations.

As we have argued in numerous articles, the European Central Bank could credibly commit to draw a line in the sand keeping bond yields on Spanish, Italian (French, Belgium, etc.) debt below some figure and preventing self-reinforcing panic from materializing. Rates there are high, but these have less to do with the state of public finances (which, apart from Greece, are no worse compared to the U.S., Britain, or Japan, quite the contrary) but these countries effectively lend in a foreign currency, one they do not control.

The Swiss central bank did something similar to keep the Swiss franc from rising, and a mere announcement is likely to be much more effective than the half hearted intervention the ECB is practicing at present. Yes, we know, it creates a bit of a moral hazard problem, but there are other ways to deal with that than let the whole euro system be blown up.


Monetary policy is effective during normal times, but much less so during the present economic circumstances in which the private sector is paying off debt (that is, during a balance sheet recession or liquidity trap). However, it can still be effective in the eurozone, as the ECB could easily manage expectations.

Nevertheless, as we will argue in a follow up article, QE, even where it doesn't seem to be very effective, might still have a trick up the proverbial sleeve.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.