Milton Friedman's Advice

In 1997 Milton Friedman commented on Bank of Japan policy following Japan's deflationary spiral of the early 1990s:

Defenders of the Bank of Japan will say, "How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?"

The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.

Austerity measures adopted in Europe are failing and central banks are likely to attempt Friedman's option in a number of guises. Already, as Gary Shilling points out "competitive quantitative easing by central banks is now the order of the day." The Bank of Japan last year expanded its balance sheet by 11 percent, the Federal Reserve by 19 percent, the European Central Bank by 36 percent and the Swiss National Bank by 33 percent. Even countries with relatively strong balance sheets, like Switzerland, are forced to respond to prevent appreciation of their currencies from harming exports.

Inflation will remain moderate only so long as central bank balance sheet expansion is offset by deflationary pressures from private sector deleveraging. That is the difficult task ahead: to maneuver a soft landing by balancing the two opposing forces. Failure to do so could lead to a bumpy ride.