What GOP Economists Don't Understand About Milton Friedman

Republican economists love Milton Friedman. But some of them are finding a strange way to show it. They're taking the most important conclusions from the famous conservative economist and saying the opposite. It's not just a few conservatives. It's lots of them.

For example, Bloomberg View's Amity Shlaes argues that Friedman would counsel Bernanke not to combat deflation and depression today. Actually, she goes further, claiming that Bernanke has essentially betrayed Friedman's legacy by embarking on quantitative easing. This is like saying that Paul Krugman has betrayed Keynes' legacy by advocating gobs of government spending.

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.

It's counterintuitive that falling prices can be bad. After all, nobody ever complained about stuff being cheaper. The problems, though, are twofold. First, if prices fall across the board, so too will wages -- but debts won't. Borrowers will have a harder time making their payments. More of them will default. And defaults will push down prices and wages even more. This so-called debt deflation is basically a doomsday machine for mass bankruptcy -- and it's exactly what happened in the 1930s. The other way of thinking about why deflation is so toxic is that it effectively increases interest rates just when we want to reduce them. What matters for borrowers is the real interest rate: that is, the interest rate minus inflation. But falling prices mean inflation is negative, so real interest rates go up. Again, bad for borrowers.

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 (hat tip to Marginal Revolution).

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.

There it is: Friedman championing quantitative easing to fight deflation. Of course, we don't have deflation today, but we've certainly flirted with it. Indeed, it was only when core inflation fell below 1 percent in the summer of 2010 that Bernanke unleashed the much-derided QE2. That sounds like something Friedman would support.

This isn't just an academic debate. It's critically important for policy. After the 1930s, liberals and conservatives came up with their own depression-fighting strategies. Liberals turned to Keynesian deficit-spending. Conservatives said that a central bank committed to preventing deflation could make fiscal stimulus mostly unnecessary. It was a powerful counterargument. Now, though, far too many on the right seem ready to throw away this hard-won knowledge. There are a few lonely voices -- Scott Sumner, David Beckworth and Ramesh Ponnuru come to mind -- fighting the good fight, but they're still a minority.