Charles Lane has a column laying out the case that the Federal Reserve, by pursuing easy money low interest-rate policies, is accidentally easing pressure on Congress to engage in long-term fiscal consolidation. As Lane sees it, Ben Bernanke is faced with a nasty dilemma. Either he could engage in some “discipline and punish” monetary policy to whip congress into shape with all the human suffering that might entail, or else he can perpetuate a situation in which in low interest rates make it easier for members of congress to stick to their guns than to compromise on fiscal consolidation.
I think that in reality there’s a way out of this dilemma, but what it entails is easier money not tighter. But this goes back to an important conceptual disagreement about what easy money is. Typically the Federal Reserve has pursued easy money through the tool of low interest rates, which leads many to argue that low interest rates per se constitute easy money. But Milton Friedman disagreed.
Here he is talking about Japan in 2000:
As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.
During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. Monetary growth has been too low. 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.
The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy.
I think that was the right prescription for Japan at the time, and the right prescription for us today. The key to the view that Friedman and I share is that currently the growth rate of real output is rather low and the inflation rate is low and stable. In our view, the stance of monetary policy should be judged by the behavior of the variables not the interest rate. If your car is moving slowly because it’s on a steep incline, then you’re not driving fast no matter how hard you’re pressing on the accelerator. Easy money is a situation of high or rising real output and inflation, of high or accelerating nominal growth. Note that interest rates are much lower today than they were at the height of the 1970s inflation, but it would be perverse to say that money is easier today than it was back then.
So now suppose the Fed took Milton Friedman’s advice and committed to open-ended broad asset purchases until nominal accelerated. Well, interest rates would rise not fall. First they would rise because higher actual and expected inflation would cause investors to demand a higher nominal interest rate on government-issued debt. Second they would rise because higher actual and expected real output would cause investors to be more interested in alternatives to investing in government-issued debt.
That would have two consequences for the budget situation. One is that more rapid growth would lead to somewhat higher tax revenues and somewhat lower safety net expenditures and make the deficit picture a bit brighter. But second and more important, it would end Lane’s dilemma. The higher rates would create a situation where deficit reduction is more of a political winner—a viable path to reducing small business borrowing costs and cheaper mortgages—while simultaneously relieving fears that deficit reduction would hammer a weak economy.
The dilemma, in other words, is a figment of confusing low interest rates with easy money. In fact, it’s caused by tight money which creates both low interest rates (which make high deficits viable) and weak growth (which makes high deficits look desirable). Friedman diagnosed the problem in Japan more than a decade ago and the analysis applies precisely today.