What Would Milton Say?

Power Line reader Justin Hohn offered a very thoughtful comment on my post yesterday on the role of dollar weakness in both rising oil prices and the housing bubble:

It’s not the dollar. Yes, base money has been cranked up from ~$800B to about $2.8T. But the velocity has crashed so hard (and with it, the multiplier) that M2 hasn’t really shown a hiccup at all.

If the rest of the world wasn’t such a mess, there would be high inflation. But the demand for dollars is hugely strong– not because dollars are great, but because everything else is so lame. No one wants to hold RMB/Yuan because they know that inevitable appreciation in the currency is coming, which would give you a loss for holding it. Eurozone disasters are very well publicized. Yen is weak after Japan has suffered the tsunami/fukishima mess.

If the Fed is trying to create inflation, it is failing terribly. Interest rates this low CANNOT persist in an inflationary environment. Bernanke’s recent projections of low interest rates until 2014 mean that the Fed will be throttling the money supply at least that long. Look at the TIPS markets which show no signs of inflation at all.

There’s more, and it’s worth reading the whole thing. I actually agree with most of this analysis—sometimes I post analysis here to provoke the Power Line community in just this kind of interesting way.  (May I say again what smart readers this site has?)  I’ve made a point of what economists once called “the velocity puzzle” for a long time.  But I also think that Hohn and Domitrovic might both be right, i.e., that a weak dollar, disguised somewhat by what some have called the simultaneous competitive devaluation of all major currencies these days, may have been central to the housing bubble, though I think the classic Austrian school thesis of credit market distortions and capital misallocation is a better culprit.

This brings me to Ben Bernanke, and the successive rounds of quantitative easing.  I’ve never been able to make up my mind about this entire business.  I haven’t been able to resist the quip that Bernanke’s QE II could be regarded as the Titanic easing, since it risks sinking the dollar on the iceberg of cold consumer confidence.  But some people whose opinions I respects—John Makin, Ramesh Ponnuru—argue that Bernanke is doing exactly the right thing to stave off deflation.  Above all I’ve asked, “What would Milton Friedman say about this?”

Over on The Atlantic’s website, Matthew O’Brien makes a very persuasive case that Milton would have wholeheartedly approved Bernanke’s approach:

Friedman hated deflation. Among his many, many contributions to economics, Friedman revolutionized our understanding of the Great Depression by pointing out that the worst of the slump could have been averted if only the Federal Reserve had stopped the banking panics of the era that caused prices to go tumbling down. Capitalism hadn’t failed. Just the Fed. . .

Does any of this mean Friedman would have endorsed Bernanke’s quantitative easing? If only Friedman had said something about this. Or, at the very least, something about Japan’s similar lost decade in the 1990s. Oh, that’s right, he did. . .

O’Brien then offers two comments from Friedman on Japan’s monetary policy in the 1990s (Japan’s great “lost decade”):

Yet [the Bank of Japan's] zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity….

Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?” It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.

Responses