A tribute to Milton Friedman

On 13 September, the Federal Reserve, under the chairmanship of Ben Bernanke, unveiled a fresh round of quantitative easing (QE3)—which many have termed unlimited easing—where the US central bank has promised to buy mortgage-backed securities worth $40 billion per month without a termination date. This is in addition to the ongoing programme of buying long-term maturity bonds till the end of this year. The idea, it seems, is to bring down the interest rate to such a low level that economic agents are forced to “return to productive risk-taking". The Federal Reserve also took the unprecedented step of linking the action on monetary policy to the outcome in the real economy and improvement in the job market. The Federal Open Market Committee (FOMC) of the Federal Reserve underlined that if the condition in the labour market does not improve, it will continue to buy mortgage-backed securities and will go for additional asset purchase and also use other tools till desired improvement is achieved. All this, however, as stated, will be in the context of price stability.

With the latest announcement, it appears, Federal Reserve is willing to do whatever it takes to keep the promise its boss made to Milton Friedman, a Nobel laureate and possibly one of the most powerful and influential thinkers of the last century, on his 90th birthday in 2002. Bernanke, then governor at the Federal Reserve board, said: “I would like to say to Milton and Anna (Schwartz): Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again." Friedman and Schwartz in their much celebrated work—A Monetary History of the United States, 1867-1960—had argued that had Federal Reserve taken appropriate monetary action, the Great Depression could have been averted.

Bernanke, a scholar of Great Depression himself, after taking the chair at the Federal Reserve and being confronted with the worst financial crisis after the Great Depression, took the “unconventional" route to save the banking system and the financial world. The medicine worked. The financial system did not collapse and the world avoided another depression.

But this still leaves us with too many larger questions. Can the medicine of “unconventional" measures boost output, growth and create jobs even at this stage? Can the US economy skip the pain of repairing household balance sheets? Can the economy live beyond its means, forever? Is the Federal Reserve not throwing too much money to solve a problem which originated, as many argue, because of the accommodative stance of monetary policy?

It is argued that Federal Reserve, under the legendary Alan Greenspan, kept interest rates too low for too long in the aftermath of the dotcom bubble burst in early 2000s. This created a bubble in the property market in the US, which was exported world over through complex financial derivatives with underlying assets in the US property market.

Therefore, in a world of easy money where printing presses at central banks are beginning to compensate for loss of factory output, it is only natural to ask: Are we heading towards another bubble of some sort, which is not visible even to the best of minds at the moment—like it was the case in 2000s? There are no easy answers; in fact, there was never one. It is just that complex policy choice, at times, despite the best of understanding of the context, results in damaging consequences. This time, too, liquidity may find an asset to create a bubble and no amount of regulation may be able to prevent it.

For the second time since the current financial and economic crisis started in 2008, the monetary policy in the US, which has global consequences, has ventured into completely uncharted territory, where gauging risks and rewards have become intensely complicated. In his remarks made at Jackson Hole on 31 August, Bernanke, while highlighting the potential cost and benefit of the unconventional means, acknowledged: “Both the benefits and costs of non-traditional monetary policies are uncertain; in all likelihood, they will also vary over time, depending on factors such as the state of the economy and financial markets and the extent of prior Federal Reserve asset purchases."

However, irrespective of the consequence, at a theoretical level, this decision will be one of the most important that any large central bank has ever taken and will be studied and discussed for years to come.

For those in the global financial markets celebrating the blank cheque of liquidity by the Federal Reserve and once again willing “to dance till the music stops" must remember that “there’s no such thing as a free lunch", a phrase much popularized by Milton Friedman himself.