Milton Friedman is Being Zen, But the Empirical Evidence Supports Him

So, now the Federal Reserve has vowed to undertake an open-ended QE.  In other words, they will continue their monetary expansion until it gets results. (They did not specify what results).  Ben Bernanke speaks in terms of lowering interests rates in order to encourage more investment.

Scott Sumner

I must say, though, that I am following this through the eyes of Scott Sumner, the economist whose blog, The Money Illusion has regularly been calling for the Fed to target a certain rate of nominal GDP growth.  Sumner has an entertaining sense of humor and a somewhat annoying one-track mind on the subject (he has himself admitted that he positively invites jokes about the man with the hammer thinking everything looks like a nail) and a much over simplified tendency to reduce all macroeconomic performance to monetary policy.  In this he copies Milton Friedman whom he greatly admires.

In particular, he is fond of pointing out that Friedman warned that low interest rates are not, in an of themselves, proof of easy monetary policy.  Quite the contrary, he likes quoting Friedman as saying that high rates are a sign that money has been too easy and low rates are a sign that it has been too tight.  Of course, people like me don't believe that everything Milton Friedman says is infallible holy writ.  To us "because Friedman said so" just doesn't cut it as proof.  The quote just sounds like Milton Friedman trying to be Zen.

Milton Friedman

So if I don't believe that Milton Friedman is infallible holy writ, what would I accept as proof.  How about empirical evidence?  And then the empirical evidence started to materialize.  Sumner said that very low interest rates are a sign of tight money, and that monetary expansion would raise them. It seemed very counter-intuitive, but a funny thing happened.  Every time the Fed announced a QE program, saying it would lower interest rates, interest rates responded by rising.  When the QE expired, interest rates fell again.  It was counter-intuitive, but it was happening.  And, once again, no sooner has Bernanke announced an open-ended policy of QE, then interest rates go up again.  Who am I to argue with empirical evidence?

Still, it wasn't enough for me to accept, "Because Milton Friedman says so, that's why."  Given that the empirical evidence was supporting a very counter-intuitive conclusion, I wanted to figure out why.  Why too-easy money would lead to high interest rates was obvious.  Too-easy money leads to inflation.  Nominal interest rates are necessarily high under conditions of high inflation just to stay ahead of it.  This was certainly born out in the 1970's when too-easy monetary policy did, indeed, lead to high inflation and high inflation led to high (nominal) interest rates.

But why are low rates a sign of too-tight monetary policy?  Well, let's start out by conceding that tight money conservatives have a point.  Interest rates these days really are pathologically low.  Their mistake, though, is in blaming our economic problems on too-low interest rates.  That confuses cause and effect.  In other words, our economy is not in bad shape because of pathologically low interests rates.  Interest rates are pathologically low because we have a depressed economy, i.e., because there is not enough borrowing.  Since I'm so fond of empirical evidence, what is the empirical evidence that interest rates are pathologically low because of a depressed economy and not because of too-easy monetary policy?  The main evidence is that every time there is a crisis of some kind, interest rates respond by falling without any action by the Federal Reserve.  Some of the things that have prompted falling interest rates have been about as counter-intuitive as you can get.

Japan, after two decades of running enormous deficits and debt, had a devastating earthquake, tsunami and nuclear power accident.  All of this will necessarily require yet more borrowing in a country with a national debt twice its GDP.  So how did markets respond?  Well, not too surprisingly, the Japanese stock market fell.  More surprisingly, the bond market did not.  In fact, investors responded to the news that Japan would have to take on huge new debts by fleeing to the safety of Japanese treasury bonds, causing interest rates to fall.

The US, by contrast, suffered a completely needles and self-inflicted wound over the debt ceiling.  The President and Congress had a long, pointless standoff with Congress threatening to force the US into a completely unnecessary default.  Moody's lowered the US credit rating on the grounds that our political system was too broken to hand even basic budgets.  So how did the markets respond?  Once again, unsurprisingly, the stock market fell.  Once again, surprisingly, the bond market did not.  The threat of default on the US debt led investors to dump their stocks and flee to the safety of US treasury bonds, causing interest rates to fall!

The various fiscal crises Europe has experienced have also led to falls in interest rates without the Fed acting, although that is not particularly surprising.  The conclusion that I would draw from this does, indeed, appear to be that our current, pathologically low interest rates are mostly the result of a depressed economy, which makes investors risk-averse, rather than too-easy monetary policy.

So Sumner, Friedman, and the empirical evidence have gotten me three-quarters of the way there, anyhow.  They have convinced me that too-easy money necessarily causes inflation and inflation necessarily causes high interest rates.  They have also convinced me that a depressed economy causes abnormally low interest rates.  So the big question is: is a depressed economy necessarily the result of too-tight monetary policy.  Or, at the very least, is our current depressed economy the result of too-tight monetary policy?  Friedman and Sumner say yes.  The empirical evidence, that interest rates go up whenever the Fed undertakes more monetary expansion, suggests that it may be true.

But somehow I can't quite be sure.  So my reaction to the Fed's announcement is one of guarded optimism. If it really does finally revive the economy, I can take it as filling in the final piece of the Friedman/Sumner puzzle and showing that the depressed economy is the result of too-tight money.  I just need a little more empirical evidence to be convinced.