MILTON FRIEDMAN MISUNDERSTOOD QUANTITATIVE EASING

It turns out that Milton Friedman was a big fan of QE.  He even recommended it for Japan.  In a 1998 paper he described exactly what he would do for the Japanese – just raise the money supply.  He said (thanks Barry Ritholtz):

“The surest road to a healthy economic recovery is to increase the rate of monetary growth, to shift from tight money to easier money, to a rate of monetary growth closer to that which prevailed in the golden 1980s but without again overdoing it. That would make much-needed financial and economic reforms far easier to achieve.

Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”

The answer is straightforward: 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. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.”  (You can read Friedman’s entire piece here.)

This is simply not correct.  Now, I know it’s blasphemy for me to claim that the great Milton Friedman doesn’t understand the modern monetary system.  Then again, this is the same man who is largely responsible for the free market ideas that helped deregulate the banking system, financialize the US economy, and convince everyone that monetary policy was the end all be all.  Of course, monetarism is now dead to the point where its followers have been forced to rebrand it.  But never mind all of that.  The systematic deconstruction of the US economy via these misguided economic theories are just a minor detail, right?   Right?

Anyhow, Friedman’s statement makes one thing very clear.  He thought the Fed could “print money” via QE.  In the words of Richard Koo, Milton believed the apple salesman just needed to add more apples to the shelves during his apple sales drought.  Of course, that’s not the cause of the apple salesman’s drought.  He doesn’t need more inventory.  He needs more customers.  The lending markets work no differently.  Besides, banks never loan reserves anyhow so Friedman’s premise is flawed from the beginning.  But this myth of the money multiplier is one that even the Fed appears to only just recently be noticing (see here for more).

More importantly though, the Fed doesn’t “print money” during QE.  Fed operations such as this one involve asset swaps that help them target interest rates by altering reserve balances.  Interestingly, in the case of QE, they’re not even succeeding in their efforts to control interest rates because the policy is implemented without any sort of specificity.  Like policy at the short end, monetary policy is always about price and not size.  But QE as is implemented, names a size and not a price as they do at the short end.  This is the primary reason why there is even debate about the real interest rate impact.

What they’ve essentially done via QE2 is swap 0.25% paper for 2% paper and call it a day.  The banks aren’t “more liquid” than they were before and since they don’t lend reserves they don’t have more firepower with which to lend.  All QE really seems to do is generate mass confusion and a portfolio rebalancing effect which appears to cause disequilibrium between markets and reality.  In addition, it’s important to remember, helicopter drops are fiscal operations, not monetary operations.  You would think that more of this would be hotly debated on a daily basis after QE2’s fantastic failure, but the myths persist.  It seems that Milton Friedman had it completely wrong.

Mr. Friedman finished the above piece with an interesting quote:

“After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

Indeed they don’t.  Expect to hear lots of chatter about “money printing“, “debt monetization” and other fallacies in the coming weeks….

 

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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