The Dangers of Misunderstanding "Helicopter Money" and Higher Inflation Targets

Ashwin Parameswaran has a fantastic post today explaining why Helicopter Money Is Not Dangerous, All Macroeconomic Policy Is Dangerous “in the sense that irresponsible implementation can lead to macroeconomic chaos.” Before jumping into the main attraction of the post, I want to briefly clarify a general discrepancy regarding what helicopter money actually entails.

More than forty years ago, Milton Friedman famously quipped that price deflation can be fought by "dropping money out of a helicopter."[37] Friedman was referring to central bank policy and, to this day, a “helicopter drop” is typically associated with monetary policies, such as quantitative easing (QE). This is an unfortunate interpretation of monetary policy since most central banks, including the Federal Reserve, are as equally unable to actually implement a “helicopter drop” today as they were back in 1969. Willem Buiter clarifies how the policy could realistically be implemented in a paper on “Helicopter Money” (equations omitted):

Technically, if the Central Bank could make transfer payments to the private sector, the entire (real-time) Friedmanian helicopter money drop could be implemented by the Central Bank without Treasury assistance.

…

The legality of such an implementation of the helicopter drop of money by the Central Bank on its own would be doubtful in most countries with clearly drawn boundaries between the Central Bank and the Treasury.  The Central Bank would be undertaking an overtly fiscal act, something which is normally the exclusive province of the Treasury.47

An economically equivalent (albeit less entertaining) implementation of the helicopter drop of money would be a tax cut (or a transfer payment) implemented by the Treasury, financed through the sale of Treasury debt to the Central Bank, which would then monetise the transaction. If the direct sale of Treasury debt to the Central Bank (or direct Central Bank lending to the Treasury) is prohibited (as it is for the countries that belong to the Euro area), the monetisation of the tax cut could be accomplished by the Treasury financing the tax through the sale of Treasury debt to the domestic private sector (or overseas), with the Central Bank purchasing that same amount of non-monetary interest bearing debt in the secondary market, thus expanding the base money supply. (2004: p. 59-60)

One might inquire whether changing to a “permanent floor” monetary policy regime alters the necessity of monetisation. Apparently prepared for such a future outcome, Buiter says:

This difference between the effects of monetising a government deficit and financing it by issuing non-monetary debt persists even if the interest rates on base money and on non-monetary debt are the same (say zero), now and in the future.  When both money and bonds bear a zero nominal interest rate, there remains a key difference between them: the principal of the bonds is redeemable, the principal of base money is not. (2004: p. 10)

Although monetisation may be necessary to achieve the full effect of “helicopter money,” this practice does not alter the dangers associated with the Treasury’s actions. As Ashwin points out:

Whether they are monetised or not, excessive fiscal deficits are inflationary.

On the topic of inflation, I have recently been engaging in a debate with Mike Sax (see here and here) about the potential benefits of targeting a higher inflation rate. This policy has garnered support from both sides of the political and economic aisle (New Keynesians and Monetarists), yet I think its potential benefits are being extremely oversold. My two basic arguments against such a policy are the following:
1) Higher inflation does not necessarily entail higher nominal wages (which many people clearly assume). 

Aside from the top quintile of households, real income has been declining for nearly 15 years. The only way higher inflation helps reduce real debt burdens is if nominal wages increase faster than nominal interest rates on debt. If instead higher inflation stems primarily from higher costs-of living (nominal food and energy prices), than most Americans may find themselves in the precarious position of requiring even more debt to maintain current living standards.

2) Higher inflation alters saving, investment and consumption decisions which can lead to a misallocation of capital. On this second point is where Ashwin’s post really hits home:

During most significant hyperinflations throughout history, the catastrophic phase where money loses all value has been triggered by the central bank’s enforcement of highly negative real interest rates which encourages the rich and the well-connected to borrow at negative real rates and invest in real assets. The most famous example was the Weimar hyperinflation in Germany in the 1920s during which the central bank allowed banks and industrialists to borrow from it at as low an interest rate of 5% when inflation was well above 100%. The same phenomenon repeated itself during the hyperinflation in Zimbabwe during the last decade (For details on both, see my post ‘Hyperinflation, Deficits and Real Interest Rates’).

This also highlights the danger in simply enforcing a higher inflation target without taking the level of real interest rates into account. For example, if the Bank of England decided to target an inflation rate of 6% with the bank rates remaining at 0.50%, the risk of an inflationary spiral will increase dramatically as more and more private actors are tempted to borrow at a negative real rate and invest in real assets. Large negative real rates rarely incentivise those with access to cheap borrowing to invest in businesses. After all, why bother with building a business when borrowing and buying a house can make you rich? Moreover, just as was the case during the Weimar hyperinflation, it is only the rich and the well-connected crony capitalists and banks who benefit during such an episode. If the “danger” from macroeconomic policy is defined as the possibility of a rapid and spiralling loss of value in money, then negative real rates are far more dangerous than helicopter money.

These pernicious traits of higher inflation and especially negative real interest rates are entirely compatible with recent experience. Households and businesses “with access to cheap borrowing” have been pouring money into stock, bond, housing and commodity markets rather than investing in tangible capital. The remarkable rise in asset prices has unfortunately not funneled down to households in the bottom four quintiles of income and wealth, only furthering the inequality gap. Recognition of these effects is precisely why a Federal Reserve fearing bubbles, not inflation, would be a significant step in the right direction.

To be clear, similar to Ashwin, I am in favor of “helicopter money” and believe higher wages for the bottom 80 percent are key to ending the balance sheet recession as well as ensuring more sustainable growth and unemployment going forward. Targeting higher inflation and larger negative real interest rates is the wrong approach to achieve these goals and may actually work in the opposite direction. Yes, all macroeconomic policy is dangerous. But even more dangerous is misunderstood and misrepresented macroeconomic policy.
 

Bibliography
Buiter, Willem H., Helicopter Money: Irredeemable Fiat Money and the Liquidity Trap (December 2003). NBER Working Paper No. w10163. Available at SSRN: http://ssrn.com/abstract=478673

The Current State of Macroeconomics

1) Against Friedman: Why Assumptions Matter by Unlearningecon @ Unlearning Economics

In my opinion, Friedman’s essay is incoherent even on its own terms. He does not define the word ‘assumption,’ and nor does he define the word ‘prediction.’ The incoherence of the essay can be seen in Friedman’s own examples of marginalist theories of the firm. Friedman uses his new found, supposedly evidence-driven methodology as grounds for rejecting early evidence against these theories. He is able to do this because he has not defined ‘prediction,’ and so can use it in whatever way suits his preordained conclusions. But Friedman does not even offer any testable predictions for marginalist theories of the firm. In fact, he doesn’t offer any testable predictions at all.

Friedman’s essay has economists occupying a strange methodological purgatory, where they seem unreceptive to both internal critiques of their theories, and their testable predictions. This follows directly from Friedman’s ambiguous position. My position, on the other hand, is that the use and abuse of assumptions is always something of a judgment call. Part of learning how to develop, inform and reject theories is having an eye for when your model, or another’s, has done the scientific equivalent of jumping the shark. Obviously, I believe this is the case with large areas of economics, but discussing that is beyond the scope of this post. Ultimately, economists have to change their stance on assumptions if heterodox schools have any chance of persuading them.

Woj’s Thoughts - This essay by Friedman, “The Methodology of Positive Economics,” marked the beginning of my PhD program and helped shape my views about mainstream economics. Despite our (Unlearning Econ and mine) very different backgrounds, as usual, I came to a very similar conclusion:

Friedman sets out on the difficult task of developing a positive economics with normative implications. While his efforts to prove that a hypothesis must not be judged solely by the realistic nature of its assumptions were valiant, this strength of his paper has been largely overlooked. Instead, Friedman’s normative views regarding determination of a theory’s validity, choosing among competing valid hypotheses and application to specific circumstances have indoctrinated economists with a means to defend orthodox, mainstream economics from all criticism.

2) The State of the Economic Union by Dan Kervick @ New Economic Perspectives

The Most Urgent Problems We Face

2. Working People and Capital Moving in Opposite Directions

• Corporate profits are up 36% since January 2008, and up 200% since January 2001.
• The share of national income going to working people has fallen 6.2% since January 2008, and 11.2 % since January 2001.
• For the bottom fifth of wage earners, the number of annual hours worked increased by 22% between 1979 and 2007, but real hourly wages increased by only 7.7%.  For the period between 2000 and 2007, real wages in this group actually fell by 3.2%

3. An Unstable Financial Economy

• Although household debt has declined since the peak of the recession, it remains very high by historic standards.  Total household credit market liabilities as a share of GDP are now over 81%.  This compares to 43% in 1970, 49% in 1980, 60% in 1990, and 67% in 2000.
• The financial sector remains dangerously large, and growing, with an 8.4% share of GDP – bigger than it was just before the recession.  The US financial industry now accounts for 30% of all domestic corporate profits.
• The total outstanding debt of the domestic financial sector is over 87%, down from 107% at the beginning of 2007, but still much higher than in January 2000 (80%), January 1990 (44%) and January 1980 (19%).

4. Socioeconomic Inequality

• The after tax income of the top 1% of households, adjusted for inflation, has risen by about 130% since 1967.  The income of the next 20% has risen by 28%.  The incomes of all other income groups have fallen.
• The richest 1% of Americans control 34.6% of Americans’ net worth.  The bottom 90% control 26.9% of net worth.

Woj’s Thoughts - Dan lays out seven different problems that currently plague America, of which three are listed above. These specific selections were chosen because I personally found them most compelling, as presented, not to imply they’re the most important. Dan also presents five immediate actions the federal government could take to address these issues. I don’t necessarily support all of the proposals but they represent a good starting point for debating how to best turn the economy around.

Lachmann on Valuing Realistic Assumptions

While outlining Milton Friedman’s “The Methodology of Positive Economics” a few days back, I criticized his method of choosing between “valid” hypotheses on the basis that:

“logical completeness and consistency” [are] criteria which “are relevant but play a subsidiary role. (p. 5)”

Mainstream economists have clearly sided with Friedman on this debate, preferring “simplicity” to realism. However, as someone interested in Austrian tradition, I found comfort in the following from Ludwig Lachmann’s paper on “The Significance Of The Austrian School Of Economics In The History Of Ideas”:

Since we lack successful prediction as a means of evidence, we must of course devote special care to the validity of our theoretical assumptions.

Although I’ve just begun to read Lachmann’s work, he is quickly moving up the ranks of my favorite economists.

The Positive Limits and Normative Implications of Milton Friedman's Methodology

In 1953, Milton Friedman set out to establish “The Methodology of Positive Economics” to improve economics’ contribution to determining policy. He believed that “differences about economic policy among disinterested citizens derive predominant from different predictions about the economic consequences of taking action...rather than from fundamental differences in basic values. (p. 2-3)” While the goal was worthy of the task, it becomes clear quite quickly that Friedman’s normative views will shape the discussion.  

Friedman begins by explaining that “The ultimate goal of a positive science is the development of theory” or “hypothesis” that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed. (p. 3-4)” While few would probably disagree with that statement, a divergence of opinion tends to arise when assumptions upon which a hypothesis rests are unrealistic. However, once one understands the “canons of formal logic (p. 4)” it becomes readily apparent that a hypothesis cannot be rejected solely on these grounds. A basic proposition of formal logic is that x implicates y (x → y) is always true, unless x is true and y is false. Therefore a hypothesis is valid if the predicted outcome (y) occurs, regardless of whether the assumptions (x) are realistic. Although Friedman was only restating the principles of formal logic, arguments of this kind remain prevalent today, hence the importance of his point cannot be understated.

After dispelling the notion that a theory can be rejected based solely on its unrealistic assumptions, Friedman ventures on to the far more difficult task of applying positive economics to policy determination. At this juncture the discussion takes a distinctly normative turn, which Friedman acknowledges but downplays at the same time. The troubles with making this application are primarily three-fold:
1) How does one determine if a theory is valid?
2) How does one choose among hypotheses that are consistent with available evidence?
3) How does one decide the circumstances for a which a theory holds?
 
Regarding question one, Friedman points out the inherent difficulty (near impossibility) of conducting “controlled experiments” in the social sciences “foster[ed] a retreat into pretty formal or tautological analysis.9 (p. 6)” This path is clearly not suitable if economic theory “is to be able to predict and not merely describe the consequences of action. (p.7)” Empirical evidence seemingly offers the greatest potential for validating theories, but leads to the normative question of “whether [a theory] yields sufficiently accurate predictions. (p. 9)”

Moving beyond questions of validity, Friedman accepts that “The choice among alternative hypotheses equally consistent with the available evidence must to some extent be arbitrary, (p. 5)” but believes “there is general agreement that relevant considerations are suggested by the criteria “simplicity” and “fruitfulness”. (p. 5)” Friedman also mentions “logical completeness and consistency” as criteria which “are relevant but play a subsidiary role. (p. 5)” Establishing the relative weights of these criteria, let alone the relative value of different hypotheses on each scale, clearly extends into normative economics. On the whole I find Friedman’s support for his normative views unconvincing and suggest reordering the criteria as follows: fruitfulness, consistency, logical completeness, and simplicity.

Assuming agreement on a specific, valid hypothesis, one must still decide how “to specify the circumstances under which the formula works. (p. 11)” Friedman argues that “the assumptions [cannot] be used to determine the circumstances for which a theory holds. (p. 11)” Instead, the validity of the hypothesis tells us whether the theory holds for given circumstances. Unfortunately this statement is no more than a tautology and offers little guidance for applying policy to different circumstances in advance of known outcomes. Here we find the importance of a hypothesis’ logical completeness and consistency. Without knowing in advance if, and to what degree, a hypothesis will prove correct, the assumptions (regardless of how unrealistic) become a necessary guide to determining applicable circumstances.

Friedman sets out on the difficult task of developing a positive economics with normative implications. While his efforts to prove that a hypothesis must not be judged solely by the realistic nature of its assumptions were valiant, this strength of his paper has been largely overlooked. Instead, Friedman’s normative views regarding determination of a theory’s validity, choosing among competing valid hypotheses and application to specific circumstances have indoctrinated economists with a means to defend orthodox, mainstream economics from all criticism.

These departures from the “positive”, though not explicitly or (maybe) even implicitly intended by Friedman, have led to the frequent practice of three pitfalls in straight thinking:
1) Fallacies of composition - Ex. Households face a budget constraint based on income and ability to borrow, therefore governments must face similar constraints.
2) Fallacies of analogy - Ex. Greece’s sovereign debt rates are high because of its large public debt-to-GDP and Japan has higher public debt-to-GDP, therefore Japan’s sovereign debt rates should be soaring.
3) Post hoc ergo procter hoc (i.e. "after this, therefore because of this") - Ex. Lehman Brothers went bankrupt right before the financial crisis happened, therefore the failure of Lehman Brothers caused the financial crisis.  

The failure of mainstream economics to predict the housing bubble, financial crisis, recession, and weak recovery, has not materially weakened the acceptance of previously held theories. This should not be surprising given Friedman’s claim that “the continued use and acceptance of [a hypothesis] over a long period, and the failure of any coherent, self-consistent alternative to be developed and be widely accepted, is strong indirect testimony to its worth. (p. 14)” Contrary to this view, advances in modeling network systems implies that suboptimal outcomes can actually be self-sustaining.

“The Methodology of Positive Economics” is ultimately both a positive and normative method for discerning real implications of economic hypotheses, although the line has become blurred over time. If economics is to regain its grandeur, it must recognize the strict limits of positive economics before readdressing the normative decisions posed by Friedman. In this manner, economics may come to study and accept a much broader range of hypotheses that are not only more fruitful, but also more logically complete and consistent.

Update - Credit should be given to Ernest Nagel’s paper, “Assumptions in Economic Theory”, for inspiring a number of my thoughts in this post.

Steve Keen's Proposal for "Sub-Euros" and "an SDR of Europe"

Markets around the globe rallied following Mario Draghi’s statement that he would “do ‘whatever it takes’ to protect the euro zone from collapse.” Unfortunately, for market/Europe optimists, this statement was not accompanied by any specific forthcoming policy action or timeline for action. While open-mouth operations continue to scare the shorts and offer a short-term boost, the spike in optimism will once again be short-lived as growth concerns soon return to the fore.

Over the past couple years, I’ve remained pessimistic about the potential for a United States of Europe. Instead, I continue to believe that the EMU will eventually break-up but remain hopeful that free trade and labor mobility will persist. During this time, I’ve tried to highlight various proposals for solutions to the crisis that appeared both reasonable and feasible. Drawing from the work of Keynes, Friedman and Godley, Steve Keen offers a new proposal that re-institutes national currencies while maintaining the Euro as an SDR of Europe:

Some see the way out of today’s catastrophe as creating what does not exist—the United States of Europe. But if that were ever a possibility, it is far less one after the damage done by Maastricht, and the Franco-German insistence on austerity for the periphery in this crisis. However what is a possibility—and which has echoes in some of the contributions here (such as “Nau” proposal from Gerald Holtham)—is to move the Euro closer to a continental version of Special Drawing Rights.

The Euro could be the currency of inter-European and international trade, while “sub-Euros” created by each of the nations of Europe could be used for domestic trade and, importantly, domestic financial arrangements. The disciplinary aspects of Maastricht—which are currently inappropriately directed at government deficits and are amplifying the downturn—would then be redirected at trade deficits within Europe instead (and matched by pressures to minimize intra-European trade surpluses as well).

The Euro-Drachma, Euro-Peso and Euro-Mark could be introduced at one-to-one parity with the Euro, and all financial assets and liabilities would be denominated in these national currencies rather than the Euro. These national currencies would then float freely for a period (say one year), after which they would be fixed in proportion to the Euro.

The obvious devaluation that would occur for the Euro-Drachma and Euro-Peseta would reduce their foreign debts—and force the nations whose banks over-lent to them to deal with the consequences. It would also end the currency flight that is currently occurring: a Euro-drachma would still be a Euro-Drachma, whether it resided in a Greek or German bank account.

The introduction of such a system could provide a rapid resolution to the current crisis. It could not be pain free, but it would be difficult to imagine that it would impose more pain than is currently being felt by Greece and Spain, or is about to be felt by other countries once the contagion passes on to them.

This system would also introduce what is otherwise impossible in the Euro: exchange-rate flexibility. Economists as widely apart ideologically as Wynne Godley and Milton Friedman observed long before the Euro began that it would fail (a) because it imagined that a market economy would reach a harmonious equilibrium on its own without government intervention—which Godley correctly characterized as a deluded neoclassical fantasy; and (b) because it pushed together widely disparate nations which Friedman noted were utterly unsuited to a currency union.

A step backwards by Europe from dystopian fantastical object of a single currency, to a mini-version of what Bretton Woods should have been, could thus be a workable way out of this crisis and towards the political dream of a non-fractious Europe.

Don Boudreaux - Vouching for Freedom

if in our attempts to win a little more liberty and efficiency today we pragmatically choose not to man the barricades for ultimate ideals, do we not risk being labeled (however unjustly) as unprincipled compromisers?  And worse: do we not delay, perhaps forever, the prospects of achieving our ultimate ideals?  If at every moment we pragmatically reach only for what is currently achievable rather than for what is in principle most desirable and good, then won’t we lose sight of our ultimate aims?  Won’t our reach become so inadequate and so lazy that we’ll become incapable of ever grasping for genuine, significant change? (emphasis mine)

Read it at The Library of Law and Liberty
Vouching for Freedom - Friedman’s Principled Pragmatism in Liberating Education from State Administration
By Don Boudreaux


Boudreaux offers one of several articles on the site celebrating the 50th anniversary of Milton and Rose Friedman’s Capitalism and Freedom. Growing up in a very liberal (Democratic) household, I went through college with an uninformed, negative view of Milton Friedman’s political biases. When I read this book a few years ago it greatly changed my views on Friedman and the role of the state. Still pursuing my own answers about the correct role of government, these questions frequently cross my mind.

The bold question, in my opinion, is especially important regardless of one’s political orientation. Policy discussions often turn to political constraints and trying to effect change at the margin. I often worry that our political system places too much emphasis on effecting change at the margin and too little weight on whether those changes move policy in a direction that aligns with our “ultimate aims.” I agree that answers to these questions remain elusive, if even possible, yet still hold that thinking through these questions is an extremely worthwhile exercise.

What are your thoughts on the matter?

Quote of the Week

...is from page 5 of Milton and Rose Friedman’s classic book, Free to Choose: A Personal Statement:

In the government sphere, as in the market, there seems to be an invisible hand, but it operates in precisely the opposite direction from Adam Smith's: an individual who intends only to serve the public interest by fostering government intervention is "led by an invisible hand to promote" private interests, "which was no part of his intention."

News headlines over the past few weeks have been rife with examples of the invisible hand in reverse that the Friedman’s highlight. The Jumpstart Our Business Startups (JOBS) Act that was signed into law this week exempts small, newly public companies (those with less than $1 billion in revenues...seriously?!) for 5 years from disclosing executive compensation, having “an auditor attest to their internal financial controls” and “comply[ing] with all the accounting rules required of public companies today.” Further, “banks underwriting their IPOs may be able to issue research reports on the stocks ahead of the offerings, a practice prohibited a decade ago after analysts pumped dot-com stocks their firms were helping take public.” While this bill may encourage more companies to become public, it also promotes several types of fraud that have cost investors dearly over the years.

Apart from the JOBS Act, the current debate over the individual mandate is in part due to the stranglehold on Congress held by private health insurance companies. Instead of creating a single-payer health care system, the current bill protects and improves the position of health insurance companies by mandating the entire population by their products.

These are just two recent examples but there are countless others that include special tax breaks for oil companies, bailouts of automotive companies and lax capital requirements for banks. This is not to suggest that individuals’ in government purposefully seek to promote the interests of a few over the many, but rather that the structure of the institutions and personal desire for re-election lead to this outcome.

From an economic perspective, I agree with many individuals on the left that large budget deficits currently continue to play an essential role in reducing unemployment and promoting economic growth. However, in light of this view, it is important to remember that big government increases the returns to and proliferation of crony capitalism. Weighing the benefits and costs of these options is rarely easy, but the wonderful aspect is that we remain “free to choose.”

Deflationary Monetary Policy

“The first requirement is that the monetary authority should guide it-self by magnitudes that it can control, not by ones that it cannot control. If, as the authority has often done, it takes interest rates or the current unemployment percentage as the immediate criterion of policy, it will be like a space vehicle that has taken a fix on the wrong star. No matter how sensitive and sophisticated its guiding apparatus, the space vehicle will go astray. And so will the monetary authority.”

-The Role of Monetary Policy by Milton Friedman

On Sunday I outlined a game plan for the week with expectations of increasing volatility. Needless to say the first two days have far exceeded my imagination. While most investors watched in disbelief on Monday as markets sank over 6 percent, yesterday’s nearly 9 percent reversal from overnight lows was even more remarkable. For those unaware, after China reported higher than expected inflation, S&P futures tumbled from 1111 to 1077. By the market open, futures had roared back to 1138. After stumbling near flat, the market surged another 30-plus points. Following the Federal Reserve’s statement, trading ranges expanded dramatically with the market initially selling off nearly 50 points before rallying back 75 to ultimately close almost 5 percent higher. Volatility certainly appeared heightened by the Fed meeting and their semi-policy change is worth further consideration.

Over the past several days, an increasing number of investors and economists have been calling for the Fed to enact QE3. When the Fed initially decided to apply quantitative easing (QE), market liquidity had dried up and financial institutions were witnessing modern day bank runs. QE was an effective means for exchanging liquid assets (Federal Reserve notes) in return for illiquid (generally devalued) securities. Responding to a liquidity crisis, QE was well directed and ultimately successful.

Last summer the economic recovery showed deterioration and stock markets sold off substantially. Renewed Fed intervention involved another round of quantitative easing aimed at reducing interest rates and increasing asset values. If successful, these measures would generate increasing consumption and debt while lowering savings. This policy was ill-advised as the economy no longer suffered from a liquidity crisis, but rather a balance sheet recession in which excessive private debt decreases aggregate demand.

Beyond being misguided, QE2 was also poorly understood by much of the general public. Common conception is that quantitative easing is inflationary money printing. However, as noted earlier, quantitative easing (as practiced) is strictly an asset swap between the Federal Reserve and banks. Operationally, QE2 simply involved the Fed exchanging interest-bearing Federal Reserve notes for treasury notes. Net financial assets were not actually increased during this process. Quantitative easing therefore involves no money printing, simply swapping assets.

Misunderstanding the Fed’s policy as inflationary, markets sold dollars and bid up asset prices. Unfortunately for the Fed, markets viciously bid up prices of real assets including food and energy. With many households still over-burdened by debt and high unemployment restraining income growth, these increasing costs actually reduced demand for other goods. This recognition is likely why the Fed correctly believes higher inflation will be temporary. Reviewing recent GDP and unemployment data, it’s patently false that QE2 had a significant, if any, positive economic impact.

An obvious follow up question, why are people demanding QE3? One argument claims that dollar devaluation increases exports and as a byproduct, economic growth. Ludwig von Mises and Frédéric Bastiat (among others) clearly disproved this notion decades ago, but I’ll save that topic for another day. Others hold out hope that wealth effects create far larger multipliers than most economic research shows. Another group believes simply doing something is better than nothing. In spite of requests, the Fed thankfully did not proceed with QE3 (at least not yet).

So what did the Fed do? Well, in some ways nothing and in some ways everything. From their statement:

“The committee currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013”

Although not explicitly stating interest rates will remain “exceptionally” low through mid-2013, markets reacted as such. In Treasury Yields Low for Good Reason, I noted that “interest rates are a function of the expected rates over that time period.” Hence shifting expectations for 0 percent rates through 2013 sent treasury yields plunging, with 10-year notes briefly touching an all-time low of nearly 2 percent. Longer-term inflation expectations also moved higher, devaluing the dollar and creating a surge in equity markets. Impressively, without committing to actual policy change, the Fed effectively generated the impact of QE (at least for a day) with some wisely chosen words.

This post began with equally wise words from Milton Friedman, chosen specifically from his paper, The Role of Monetary Policy, which outlines my greatest fear of the new Fed policy. Friedman posits that monetary policy is unable to control real interest rates, apart from short periods, which remain relatively stable over longer time horizons. Since economic capital is only produced if expected returns are positive, real interest rates must be positive in the long-run. Monetary policy, as determined by the Fed, sets nominal interest rates. Friedman’s theory implies that long-term nominal interest rates are equivalent to long-run real interest rates plus inflation. Therefore a “monetary authority could assure low nominal rates of interest--but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy.”

In 1996 the Bank of Japan (BOJ) lowered benchmark interest rates to 0.5 percent, attempting to jump start economic growth stunted by debt deleveraging. Over 15 years later the benchmark interest rate sits at 0 percent, having never exceeded 0.5 percent during that span. Given Friedman’s framework, if long-run real interest rates are around 1 percent, then maintaining an effectively 0 percent nominal interest rate requires Japan to experience small, consistent deflation. Japan’s economic record the past decade displays confirming evidence of this assumption.

During the financial crises of 2008, the Fed lowered its benchmark interest rate practically to 0. Although initially expected to be temporary, yesterday’s projection portends retaining a lower bound rate policy for at least 5 years. If structural changes are not made, a weak economy could keep Fed rate hikes on hold far longer. As Friedman theorized and Japan bore witness, maintaining low nominal interest rates is ultimately deflationary.

What I find most discouraging is that the names of Keynes, Hayek and Friedman are highly revered today, yet much of their work and philosophy appears to have been lost in translation. Monetary policy today focuses on both fronts Friedman argued would lead the “space vehicle...astray.” Avoiding an outcome similar to Japan requires policy makers to recall the great economic minds of the 20th century. As the philosopher George Santayana said, "those who cannot remember the past are condemned to fulfill it."