A Milton Friedman Revival

Bloomberg columnist Caroline Baum laments that monetarists have “followed Milton Friedman the grave.” Monetarist, of course, is a term used to identify those who agree with the ideas of the great free-market economist who died in 2006. But I see neither those ideas nor their adherents going to the grave. Indeed, the experience of this crisis is proving that Milton Friedman’s ideas were right all along, and I can see them gaining favor.

Two of Friedman’s most famous ideas in the macroeconomic sphere were (1) that monetary policy should follow a simple policy rule and (2) that discretionary fiscal policy is not useful for combating recessions, and indeed could make things worse. Both ideas have been reinforced by the facts during the recent crisis.

The first idea is reinforced by the evidence that the crisis was brought on by the failure of the Fed to keep following the rules-based monetary policy that had worked well for 20 years before the crisis. Instead, it deviated from such a policy by keeping interest rates too low for too long in 2002-2005. But Caroline Baum wonders whether the Fed should now just print a lot more money and buy more mortgages or other securities. That might sound like a monetarist solution, but Friedman did not believe in big discretionary changes the money supply. Rather, he advocated a constant growth rate rule for the money supply. I doubt that he would have approved of the rapid increase in the money supply last year, in part because he would have known that it would be followed by a decline in money growth this year. He always worried about monetary policy going from one extreme to the other and thereby harming the economy. That is why the Fed should be clear and careful as it brings back down the size of its balance sheet, which exploded during the crisis.

Friedman’s idea about the ineffectiveness of fiscal policy is being reinforced by the growing recognition that the discretionary fiscal stimulus packages did little good. Forty years ago, in a famous debate with Keynesian economist Walter Heller, Friedman said “The fascinating thing to me is that the widespread faith in the potency of fiscal policy… rests on no evidence whatsoever. It’s based on pure assumption. It’s based on a priori reasoning.” It was bad news that policy makers in Washington did not heed those words in the past few years as they embarked on massive fiscal stimulus packages. But it’s good news that many more are heeding those words now.