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Attempt to bury monetarist garners no praise

by Caroline Baum

Bloomberg

It’s good that Milton Friedman is dead, because for the past week Paul Krugman has been trying to kill him off and discredit his monetarist theories.

According to an Aug. 8 post on Krugman’s blog at The New York Times, Friedman — whom he designates an “unperson” — has “virtually vanished from the policy discourse.”

John Maynard Keynes is back (he never really left), as is Friedrich Hayek, but a few decades from now, historians will regard Friedman as “little more than an economic footnote,” the Princeton University economist writes.

Somehow, I doubt it. If by “policy discourse” Krugman is referring to academic studies on the effectiveness of the Federal Reserve’s large-scale asset purchases, or daily screeds by policy wonks on Janet Yellen’s and Larry Summers’ differing views on quantitative easing, then Friedman’s virtual vanishing is in the eye of the beholder.

I come to praise Friedman, to counter Krugman’s claim that the post-2008 period demonstrates that monetary policy is ineffective when interest rates are close to zero and that fiscal policy saved the day.

The evidence suggests just the opposite. Despite federal fiscal policy that was “more expansionary than in any downturn since the Great Depression,” the results were pretty lousy, according to researchers at the Federal Reserve Bank of San Francisco. The Fed is mostly to blame.

Fiscal policy gets its bang from monetary policy, and monetary policy was still tight — the Fed funds rate was at 4.5 percent — when the economy slipped into recession in December 2007. Government spending, without expansionary monetary policy, is just a transfer of resources from one party to the next.

The federal deficit started to shrink in mid-2010 and is falling fast now. Krugman posted a chart to either herald the good news or taunt the deficit scolds (take your pick). This time, the Fed was proactive, offsetting the effect with asset purchases. Forecasts of dire consequences from automatic spending cuts have failed to materialize. Continued growth in the U.S. economy, albeit at a subpar pace, in the face of contractionary fiscal policy is “one big piece of evidence that monetary policy is effective at the zero bound,” says David Beckworth, assistant professor of economics at Western Kentucky University.

M2, the broad monetary aggregate, never collapsed during or after the recent recession, as it did in the early years of the Great Depression. So what looked like a liquidity trap to Keynesians such as Krugman was actually a sieve through which money seeped into the economy — even with the funds rate close to zero.

Krugman likes to point to Japan’s two lost decades as proof positive that monetary policy is impotent at the zero bound. Fine, except that until now, the Bank of Japan never committed to a permanent increase of the monetary base.

Previously the BOJ would take baby steps to increase bank reserves before sabotaging its efforts by capping excess reserves or draining what it had added.

Friedman told Japanese policymakers what they needed to do back in 2000 in a keynote address at the Bank of Canada. He said the BOJ should buy long-term government bonds and keep buying them until the high-powered money made it into the economy.

It took a long time, and a lot of personnel changes, but the BOJ is finally following Friedman’s advice and is committed to doubling the monetary base.

Europe’s tepid recovery from the 2008-2009 recession and fallback into a 1½-year recession provide additional fodder for the idea that money matters. Why, in the face of contractionary fiscal policy, is the U.S. outperforming Europe?

“Unconventional monetary policy,” Beckworth says, referring to various rounds of Fed asset purchases.

One week after declaring Friedman an “unperson,” Krugman honed his critique and got to the point. Friedman’s free-market ideology seems to be in conflict with his support for a central bank as a lender of last resort and overseer of the money supply. (Krugman’s real point, as always, is that the far right whackos have no room for someone like Friedman. But let’s stick to our storyline.)

“Friedman was a pragmatist,” says Michael Bordo, a former Friedman student at the University of Chicago who is now director of the Center for Monetary and Financial History at Rutgers University in New Brunswick, New Jersey. “He believed we needed an authority to set the nominal anchor for the dollar and act as a lender of last resort.”

It would be a mistake to interpret Friedman’s criticism of what the Fed did during the Great Depression — allowing the money supply to contract by a third — as a criticism of the concept of a central bank.

Friedman believed there was a role for government in creating a monetary standard because it provided a degree of certainty. He thought deposit insurance was key to preventing the type of bank runs the U.S. experienced in the 1930s.

He was “more inclined to talk about capital ratios after the savings-and-loan crisis,” says Robert Hetzel, another Friedman student and a senior economist and research adviser at the Federal Reserve Bank of Richmond. He later talked about “100 percent reserve requirements as an extreme ideal case, but basically he was a free-market guy for the nonfinancial sector and not a free-banking guy.”

That shouldn’t be too hard for a Nobel laureate like Krugman to understand. And if it is, I’d be willing to wager that he, not Friedman, will end up as the footnote in economic history.

Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. E-mail: cabaum@bloomberg.net.