What Would Milton Friedman Think of Ben Bernanke?

Gavyn Davies Financial Times November 9, 2010

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If he were still alive today, what would Milton Friedman think of his disciple, Ben Bernanke? This is a matter of some concern to the Fed chairman, who is reported as saying to colleagues on Saturday: “I grasp the mantle of Milton Friedman…I think we are doing everything (he) would have us do.” With libertarian economists tending to be among those most critical of QE2, Mr Bernanke is relying on Friedman’s halo effect to enhance the legitimacy of the Fed’s recent actions. Friedman’s friends say that his opinions were unpredictable, which is what made them interesting. But some some free market economists, like Allan Meltzer, claim that Friedman would have strongly disapproved of QE2. Are they right?

Mr Bernanke’s admiration for Milton Friedman goes a long way back. In this famous speech, made in honour of Friedman’s 90th birthday in 2002, Mr Bernanke described his hero in simple but glowing language:

“Among economic scholars, Friedman has no peer.”

This was mainly because of Friedman’s work on the causes of the Great Depression. A reverential Mr Bernanke said that the “special genius” of Friedman was to identify exogenous events which changed the money stock independently of the economy from 1928-1933, and then to identify the impact which these shocks had on the behaviour of output and prices. By doing this, he established that the collapse in the money supply independently “caused” the collapse in gross domestic product, and not the other way around. The crucial implication was that the Fed could have prevented the Great Depression by ensuring that monetary growth remained positive at key moments during the crisis.

Chairman Bernanke took this lesson to heart when Lehman Brothers collapsed in 2008. The emergency injection of liquidity into the financial system was taken, without much deviation, from the Friedman analysis of the Fed’s errors in the early 1930s. The fact that it worked can be claimed as a triumph for Friedman’s work and his enduring influence on the macro-economic profession - a profession which had not wholly distinguished itself in the years before the credit crunch. If there were any libertarian economists critical of the Fed’s emergency action, they remained fairly silent at the time. And it strains credulity to suggest that Friedman would have disapproved of QE1.

QE2 is a different kettle of fish. While Keynesians generally criticise QE2 as being insufficient or ineffective, libertarian economists worry that it is inflationist and (sometimes) interventionist. The free marketeers are gradually building a critique against QE2, and it would be awkward for them if the doyen of the Chicago school of economics, Milton Friedman, could be credibly placed on the other side.

In discussing this, I will rely on two key sources from Friedman himself - his presidential address to the American Economic Association in 1968, when he best summarised his theoretical view on the role of monetary policy; and his Hoover Institute piece on the Japanese predicament in 1997, which very closely resembled the dilemma facing the US today.

The presidential address argues that, in the long term, the level of unemployment and the level of real interest rates is invariant to the stance of monetary policy. However, monetary policy - meaning the rate of growth of “nominal” aggregates like the money supply - does have a critical role in determining the path for output and employment over shorter periods. In fact, all major contractionary episodes in the US are attributed by him to prior periods in which monetary growth independently slowed down.

The crucial question is whether the Fed should seek to use monetary policy to smooth out these shorter term contractions (which Friedman envisages as lasting for several years at a time). Here, it seems to be all a matter of degree. Friedman warns that the Fed often forgets that monetary policy works with long lags, so he does not normally like “fine tuning”, arguing instead that the Fed should try to stick to a constant growth rate of 3 to 5 per cent in their preferred measure of broad money. But he does allow himself a loophole:

“Experience suggests that the path of wisdom is to use monetary policy explicitly to offset other disturbances only when they offer a “clear and present danger.”

It is obvious that the Fed chairman believes that the circumstances of 2010 constitute a “clear and present danger”. But what would Friedman have thought? This is where we need to turn to his piece on Japan. When he wrote this piece, Japan was not experiencing outright deflation. Friedman explicitly pointed to a five year period in which Japanese inflation was marginally positive, when output was growing at 1 per cent a year, and when the broad money supply was growing at 2 per cent. He described this economic condition - which is not at all far from the condition of the US today - as “sick”, and recommended that the Bank of Japan should immediately increase money growth to around 8 per cent. And how should it do this?

The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases.

What is this other than QE2? Paul Krugman points out here that this policy prescription was subsequently tried in Japan, and did not work because the expansion in high powered money failed to trigger the desired growth in M2. But Milton Friedman never conceded that monetary policy would be ineffective. I conclude that he would probably have voted for QE2 if he had been a member of the FOMC last Wednesday.

What Would Milton Friedman Think of Ben Bernanke?

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