David Wessel says Friedman would support QE2

Channeling Milton Friedman

By DAVID WESSEL Wall Street Journal OCTOBER 28, 2010

Enough about John Maynard Keynes. We can be sure the 20th century British economic giant would advise more government spending to spur U.S. economic growth with consumers and businesses so hesitant and short-term interest rates at zero.

What would Milton Friedman, the University of Chicago champion of monetary discipline, do now? What would he say—reversing the charges when he returned a reporter's call, as he always did—if asked about Federal Reserve Chairman Ben Bernanke's imminent move to print hundreds of billions of dollars to buy more U.S. Treasury bonds to put more money into the economy?

We can't ask him. He died in 2006. "Friedman," says one of his eminent students, Robert Lucas of the University of Chicago, "was such an original thinker that one could never guess how he would react to a new question." Nevertheless, this seems a ripe moment to contemplate Friedman's views and those of his disciples—though they don't agree among themselves. Friedman believed in the power of money: the more money, the more income and, eventually, the more inflation. He didn't think the Fed could deliver full employment. He regarded interest rates as a misleading measure of whether the Fed was loose or tight. He favored flexible exchange rates, and would have lectured China against pegging its yuan to the dollar.

He didn't trust central bankers. He blamed the Bank of Japan for the deflation of the 1990s and the Fed for the Great Depression of the 1930s and the Great Inflation of the 1970s. He would, if his sharp-tongued co-author Anna Schwartz is any clue, have condemned the bank bailouts of recent years. "They should not be recapitalizing firms that should be shut down," she told the Journal in October 2008.

Friedman would have scoffed at the notion that the Fed is out of ammunition. He believed in the potency of "quantitative easing," or QE—printing money to buy bonds.

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But how would he decide if the Fed should buy bonds now?

He would look at the growth of the money supply, though he and his followers always had trouble identifying which measure was the right one. The Fed pumped up the monetary base (currency plus bank reserves), but broader measures are growing slowly. That bolsters the QE case. Still, the money supply is growing, not shrinking, Mr. Lucas notes. "If we had something like the Japanese deflation I'm sure Milton would say: Pour more money into the system. But we're not in that situation." POINT: Uncertain on QE.

He would warn, as he often did, about "erratic swings" in the money supply. For much of his career he said the Fed should let the money supply grow at a fixed rate. "Friedman did not believe in big discretionary changes in the money supply," says John Taylor, a Stanford University economist. "He would argue that we need to keep money growth stable, and if it slows, pick it up." But he wouldn't back massive bond-buying, Mr. Taylor insists. POINT: Against QE.

He would look at velocity, the number of times a dollar turns over in a given year, to gauge demand for money. "To keep prices stable, the Fed must see to it that the quantity of money changes in such a way to offset movements in velocity and output," he wrote in this newspaper in 2003.

When velocity is stable, the Fed should keep money growth steady. When velocity swings widely, the Fed shouldn't be passive. Velocity rose sharply from 1990 to 1997 and then plummeted; the Fed offset that and kept inflation stable, he said with praise. Velocity has been falling—which means each dollar the Fed prints has less oomph. POINT: For QE.

He would look at growth in income. "He considered stable nominal [unadjusted for inflation] income growth desirable because sudden swings in it (and thus in spending) cause huge macroeconomic disturbances when wages and prices fail to adjust quickly," says economist David Beckworth of Texas State University. Income is growing well below historical norms. POINT: For QE.

He would look at bond-market inflation expectations. In his 1992 "Money Mischief," Mr. Friedman said Treasury bonds with an interest rate tied to inflation would produce "a market measure of expected inflation" that would give the Fed "information to guide its course that it now lacks" and a way to "hold it accountable." It could even lead Congress to legislate an inflation target, he said with approval.

Today, we have inflation-tied bonds and what amounts to a Fed inflation target. Markets anticipated low and falling inflation—until Mr. Bernanke began talking about QE2 in late August, a sign that markets believe Fed's bond-buying will boost inflation, as the Fed desires. POINT: For QE.

Milton Friedman held unswervingly to his principles, but was more pragmatic than some of his modern-day followers. He was supremely self-confident, but, as Mr. Lucas puts it: "One of the many lessons I learned in Friedman's class was to work out my own views on questions, using economic logic as well as I can, and not to trust authority—even his."

The Friedman logic, though, makes the case for QE2.