Monday Smackdown Watch: Paul Krugman Admonishes Me on My Making Out of Milton Friedman Not a Golden, But a Paper-Money Calf

Paul Krugman: Milton, Money, and Interest Rates: “I have a moderate disagreement with Brad DeLong…

…[who] has been arguing that demands for tight money are, in fact, contrary to the bankers’ own interests:

It was Milton Friedman who insisted, over and over again, that in any but the shortest of runs high nominal interest rates were not a sign that money was tight–that the central bank had pushed the market interest rate above the Wicksellian natural rate–but rather that money had been and probably was still loose, and that market expectations had adjusted to that.

Friedman did in fact make that claim. But… he was wrong.

Consider the Volcker disinflation. The Fed… did everything one might imagine to make it clear that there was a regime shift that would lead to disinflation…. This policy change nonetheless led to a severe recession… conclusive evidence against both the Lucas notion that only unanticipated monetary policy has real effects, and the Prescott view that business cycles reflect real shocks. But the episode also undermines the Friedman claim on interest rates…. Short rates… were sharply elevated for three years…. Long rates… rose along with short rates and stayed high for several years. So put yourself in the (very expensive) shoes of a bank CEO today…. Even if you understand the macroeconomics and know the history (which you probably don’t), this is a story about a better bottom line four or five years down the pike, by which time you will have foregone a lot of bonuses and may well be retired. As I see it, interest-rate hawkery on the part of bankers isn’t irrational, just evil.

Touché…

I confess I have been thinking that we have a choice between:

• The Federal Reserve starts its liftoff this fall, and then has to reverse course within two yours back to the ZLB, thus cementing market expectations that we will be at the ZLB for a loooong time…

• the Federal Reserve waits two years to start liftoff, and then successfully accomplishes normalization…

Paul says: It won’t be that quick. And the historical evidence is certainly on his side.

Plus: Dean Baker piles on:

Dean Baker: The Argument for Higher Interest Rates: Are the Bankers Evil or Stupid?: “I would mostly agree with Krugman, but for a slightly different reason…

…An unexpected rise in the inflation rate is clearly harmful to banks’ bottom line. This will lead to a rise in long-term interest rates and loss in the value of their outstanding debt…. While we (the three of us) can agree that such a jump in inflation is highly unlikely in the current economic situation, it is not zero. Furthermore, a stronger economy increases this risk….[Banks] are faced with a trade-off between a greater risk of something they really fear, and something to which they are largely indifferent. It shouldn’t be surprising that they want to the Fed to act to ensure the event they really fear (higher inflation) does not happen. Hence the push to raise interest rates.

I suspect also there is a strong desire to head off any idea that the government can shape the economy in important ways. There is enormous value for the rich to believe that they got where they are through their talent and hard work and that those facing difficult economic times lack these qualities. It makes for a much more troubling world view to suggest that tens of millions of people might be struggling because of bad fiscal policy from the government and inept monetary policy by the Fed.