Brad Delong asks Paul Krugman to explain the behavior of Milton Friedman’s disciples as the crisis lingers here and gets worse in Europe:
I have been trying to understand why those who claim to be Friedman’s intellectual disciples–especially those who hold appointments at the Becker-Friedman Institute–have not been aggressively out there condemning Bush, Bernanke, and Obama for insufficient policy activism. The natural generalization of virtually all of Friedman’s work to the current situation is that the task of the government is to Stabilize the Growth Path of Nominal GDP by Any Means Necessary–which means issuing cash and buying stuff that is not a perfect substitute for cash with it until nominal GDP is on its previous growth path.
Yet the ranks of Friedman disciples appear to be limited to Scott Sumner and (perhaps) David Glasner.
And in this morning’s FT I read my guru Martin Wolf writing about how for central banks “The immediate task is to manage an exit from the interventions.” He does go on to say that “A far greater danger exists of premature retrenchment than of excessive delay…” but the initial sound bit makes me wince. And his colleague the highly-intelligent and usually reliable Gideon Rachman [Rachman's piece is here] denounces you for shrillness and warns us that “the assumption of unlimited Dutch and German creditworthiness” to support fiscal expansion “is unconvincing”.
It seems to me that we have lost not just those professional Ph.D. economists who became addicted to DSGE and RBC models and lost touch with reality, but have also lost a good many who either want to retain contact with reality or who ought to be willing to worship Milton Friedman as their guru. And I am still not sure why, or how…
There are four pieces of “policy activism” that are not like one another. The first is what might be called standard intervention by the Fed–what we once called monetary policy–the manipulation of interest rates and the creation of high-powered money. The second is non-standard monetary policy–the guaranteeing of Bear Stearns’s so-called toxic assets so that the firm could be more easily sold to JP Morgan Chase. The third is fiscal policy–the expansion of government spending using borrowed money. And the fourth is non-standard activities by the Federal government–the cash for clunkers program, the rescue of GM and AIG, the conservatorship of Fannie and Freddie.
There are a lot of people who have supported all four of these kind of interventions and whose only complaint is that they have not been aggressive or large enough. The only one that Milton Friedman would have supported in any fashion is the first one. DeLong is sort of correct about this–Friedman in 1998 implored the Central Bank of Japan to be aggressive in expanding the money supply despite low interest rates. He argued that low interest rate did not necessarily mean that monetary policy was loose. They could indicate that it had been tight. Nor did low interest rates mean that monetary policy was impotent. The central bank can purchase government bonds (or presumably other assets) thereby injecting liquidity into the banking system and increasing the money supply. Of course that is what Bernanke has done. Yet it has had little effect. Banks are maintaining large levels of reserves on the books of the Fed. Why? I assume that part of the problem is that at the same time that the Fed bought about a trillion dollars of assets from banks, they began to pay interest on reserves that banks held at the Fed. I do not understand why that is so. I do not think Milton Friedman would have thought that a good idea.
So I think Friedman would agree with DeLong that monetary policy has been poorly executed. But I don’t think he would advocate anything like DeLong would want. As for Europe, it is a political and economic mess. Friedman certainly did not believe that the euro could survive given the political incentives facing the European Union. He was right. Trying to fix that problem by printing money would seem to be an invitation to return to the Germany of the 1920′s when hyperinflation helped bring the Nazis to power. So I also don’t think Friedman would encourage the ECB in the same way he might encourage the Fed in the US.
Krugman’s explanation for the failure of Friedmanites to support more intervention, at least from the Fed, is peer pressure:
My best theory here is that it’s political and sociological: conservative-leaning economists who should know better are driven by peer pressure to suppress their better instincts.
Think about Greg Mankiw and inflation. Early on in the Lesser Depression Greg came out for inflation — fairly high inflation! — as the solution, to give us negative real interest rates. But he encountered a firestorm of criticism from his political allies — and went silent.
The point is that even among academics with tenure and established reputations, there is apparently enough leverage in the hands of the enforcers of right-wing orthodoxy that they end up bowing to the reign of error.
As for Rachman: I think this is a subtler form of peer pressure. And for what it’s worth, Ryan Avent has already written the devastating reply to Rachman I haven’t had time for because I’m on Reddit!
Mr Rachman is right that, left on its own, Spain has no choice but to react to high yields by embracing drastic austerity in order to reduce its borrowing needs. The question facing Europe is not whether this is a true dynamic—obviously it is, and it’s strange that Mr Rachman would see a need to point it out. The question is whether it should be allowed—or encouraged—to play out, given the euro zone’s deep commitment to economic integration. That’s what the anti-austerity folks are complaining about. Enforced rapid, deep austerity in places that don’t obviously need it entrenches a bizarre halfway integration that’s ultimately doomed to fail.
What, then, are the alternatives to austerity? Well, first up would be an integration that would help break the diabolical loop now gutting the periphery. Creating a euro-zone-wide safe asset and a euro-zone-wide set of institutions to stand behind damaged banks would help accomplish that…. Perhaps fiscal stimulus is out of the question, even in Germany and the Netherlands. One puzzling mistake Mr Rachman makes is in implying that the only fiscal alternative to austerity is stimulus; in fact, less austerity is also a decent option. Less austerity would be entirely appropriate in Spain, where gross debt levels remain low by rich world standards. It would be appropriate in Germany. It would be appropriate in lots of places not called Greece or Portugal….
Of course, structural reforms are necessary. If the German labour market is running too hot (maybe it is; this is increasingly in doubt), leading the ECB to conclude that more easing would merely generate rapid wage inflation, then structural reforms to boost mobility across borders would be very helpful. But structural reforms are not an inseparable part of some reform cocktail that necessarily includes austerity. On the contrary, structural reform and adequate demand are two great tastes that taste great together: without some wage inflation in Germany, efforts to boost Spanish mobility won’t succeed in generating sufficient migration.
To boil it down, the alternative to austerity in Europe is to:
Creating a euro-zone-wide safe asset and a euro-zone-wide set of institutions to stand behind damaged banks
Structural reform. [Whatever that is.]
That should be a piece of cake–create some institutions and implement some structural reform. While Europe is knocking that simple task off in an afternoon, they can follow it up by assuming they have a can opener.
What Krugman appears to like about Avent’s piece is the critique of Rachman. Krugman has a simpler alternative–Spain should leave the euro-zone.