THIS week's Free exchange column takes a look at whether economist Milton Friedman, who would have turned 100 on July 31st had he lived, would be urging the Federal Reserve to do more or less to help the economy. Quite plausibly, the piece concludes, he would have recommended doing more:

Today, critics of Fed easing point to Friedman’s preference for stable money-supply growth, to help establish central-bank discipline. John Taylor notes that money growth was quite rapid during the recent recession. Hawks also cite Friedman’s anti-inflation crusade. To Allan Meltzer, “The Fed’s plan to increase inflation [through QE]…is a large step away from the policy that Milton Friedman favoured.” It is more like old Keynesianism, which held that faster inflation could buy a permanent drop in joblessness. Friedman rejected this. He contributed to the “natural rate hypothesis”, that efforts to push employment above an economy’s limits simply bid up wages, raising inflation. Yet Friedman also considered variables other than prices. A characteristic of both the contraction of the 1930s and the Japanese stagnation of the 1990s, he noted, was the drag of tight money on nominal GDP. Reversing this would “have the same effect as always,” he said: “output will grow, and after another delay, inflation will increase moderately.” He grew flexible, as well, concerning money-supply rules. In 1984 he wrote that slow, steady monetary growth was “not a necessary implication of monetarist theory”. And when an economic crash in 1990s Japan gave way to a feeble recovery and deflation, Friedman recommended a monetary “kiss of life” in the form of QE.

Unfortunately, we can't know how he would have reacted. It falls to today's monetary practitioners to decide what to do.

I gave a talk today on precisely that subject: what the Fed should do and why. The why, I conclude is rooted in a rethinking of the meaning of the past century's great monetary inflection points. It's a bit long, but have a look if you care to:

The title of my talk today is “Ben Bernanke’s economy: Can the Fed deliver morning in America?” It’s fairly remarkable, when you think about it, that we find ourselves asking such questions today. Much of my first exposure to economics, and life, came in the 1990s. It is remarkable to think back on the prevailing attitude toward stabilization policy at the time, which was something like omnipotence on the part of the Fed. Inflation was a slain beast. Financial turmoil was nothing the committee to save the world couldn’t handle. And unemployment, in Paul Krugman’s phrase, was sure to be what Alan Greenspan wanted it to be, plus or minus a random error reflecting the fact that he is not quite god. Krugman wrote that in 1997, in a column for Slate entitled “Vulgar Keynesians”. I recommend Googling and reading it; doing so is a perfect way to capture the upside-down nature of today’s macroeconomics.

What happened after 1997 to turn the world upside down we will come to shortly. But I think it’s best to start by recapping the events that took us to that moment in the late 1990s, starting with the formative macroeconomic experience: the Great Depression. Indeed, if you want a simple way to think about the history of macroeconomics it’s this: economics was shocked by the calamities of the interwar years, it spent 30 years debating what that experience meant, and then spent 30 years seeing if it had arrived at the right answer. And at the end of that 30 year test, I think we can say that it got one important thing right, and one important thing wrong.

To an economic historian, the Depression inspires a kind of morbid fascination, like contemplating the campaigns of Genghis Khan or the spread of the Black Plague. The details are astounding. In America, net national income fell in half. Equity prices dropped 90%. The price level fell by a third. It was an unbelievable disaster, made all the more painfully poignant by the economic revelation that it was largely a preventable catastrophe. The Depression was manmade.

That it was manmade became the economic consensus relatively quickly. British economist John Maynard Keynes decisively carried several of the arguments of the day. The Depression, it was widely agreed, was a problem of demand. It was a colossal market failure. And it was susceptible to stabilization policy by the government. On the basis of these insights, Keynesians came to dominate the early postwar economic order. They built complex economic models with substantial roles for government management. They focused on fiscal policy as an engine of stabilization, and they largely relegated the central bank to a secondary policy role.

But the postwar debate over the meaning of the Depression quickly intensified. Where many prominent Keynesians held that central banks were relatively helpless during the Depression, because interest rates fell to very low levels, others, most notably Milton Friedman, suggested that nothing could be further from the truth. On the contrary, he said, interest rates were low because the Fed had pursued a too-tight monetary policy. It raised interest rates to prick the stock bubble of the late 1920s and to defend gold reserves, and when higher rates squeezed banks into trouble, it failed to step in to save them or to offset the fall in the money supply when they closed en masse. The Fed was anything but helpless when interest rates hit zero, he argued. On the contrary, open-market securities purchases, what we might now call quantitative easing, would raise the money supply, halt deflation, and arrest the economy’s downward spiral.

In fact, what the Depression showed, Friedman argued, was that monetary policy was extremely powerful, that the central bank had an important influence over money supply, and that in the short run this could have a significant impact on the real economy. Keynesians disagreed. They disagreed that the price level was entirely within the central bank’s control. They believed that there was a “demand” in the economy not intimately bound up with monetary policy. And they thought that you could use fiscal and monetary policy to boost the economy on an ongoing basis without creating inflation, so long as you controlled the supply-side causes of rising prices, like high union wage demands or price increases by opportunistic businessmen.

This argument came to a head in the 1970s, when inflation began to spiral out of hand. Keynesians suggested that “incomes policies” or wage and price controls, could fix the problem, while Friedman’s monetarists argued that only the Fed could bring inflation to heel. Friedman won the rhetorical battle, largely because wage and price controls were all but useless in stopping inflation. And then, when Paul Volcker became chairman of the Fed, raised interest rates dramatically, and brought inflation crashing down to tolerable levels, Friedman won the intellectual battle.

That was the critical moment. That was the point at which the postwar arguments over the meaning of the Depression were settled. And in the calm created by Friedman and Volcker a New Keynesian consensus emerged, rooted firmly in monetarism.

That consensus consisted of a few key tenets. Money matters. The central bank controls inflation. The central bank, by controlling inflation, can dramatically reduce the volatility of business cycles. And the optimal way to control inflation was to keep it low, stable, and predictable. The pain of the Depression was down to deflation, in this view, and the pain of the 1970s to accelerating inflation. But at last, central banks knew what to do. And so began the 30-year test.

In the early going, things could scarcely have gone better. The Volcker disinflation ushered in what many of us call the Great Moderation. Business cycle expansions became decade-long affairs, recessions were rare, short, and relatively shallow, and inflation went from mild, to subdued, to entirely domesticated.

Toward the latter end of the second great expansion of this era, we catch back up to Paul Krugman, singing Greenspan’s praises. It wasn’t long thereafter, however, that cracks began to appear in the facade. Japan’s powerful economy, which inspired fear in America in the 1980s, lost its footing in the early 1990s and was driven into a nasty recession by the Asian financial crisis of the late 1990s. But while emerging Asia quickly recovered from the crisis, Japan sank into stagnation. Growth seemed to stall out, and deflation became a concern. America’s economists, including Ben Bernanke, gazed from their perch in America, where central bankers were kings, and concluded that weakness prevented the Bank of Japan from doing what was necessary to restore healthy growth. Milton Friedman surveyed the scene and called for quantitative easing. Bernanke said the Bank of Japan was constrained by “self-induced paralysis”, and could restore prosperity if it wanted to, through QE, or devaluation, or other aggressive monetary action.

Japan, in other words, suffered from peculiarly Japanese weaknesses. Macroeconomics was not to blame. At Milton Friedman’s 90th birthday, in 2002, Bernanke, then a new Fed governor, mused on the damage of the Depression and told Friedman, “You’re right. We did it. We’re very sorry. But thanks to you we won’t do it again.”

Meanwhile, in Japan, here’s what happened. The Bank of Japan initially promised to keep rates at zero “until deflationary concerns subside”. Finding this ineffectual, it shifted to QE, aggressively buying assets between 2001 and 2006. By 2006, inflation had stabilized at low but positive rates. Seemingly satisfied, the Bank of Japan halted QE, drew down the level of bank reserves and raised its benchmark interest rate. Growth and inflation plodded along in low but positive territory until 2008, when the economy lapsed back into contraction and deflation. Which has once again triggered BoJ intervention to move prices back into positive territory.

There is no overstating Japan’s economic disaster. Its real income per capita rose to 90% of America’s in the early 1990s, but has since fallen back to 70% of the current American level. This failure has inspired many idiosyncratic explanations: demography, a zombie banking system, a corrupt political class, and so on. But idiosyncratic explanations look much less compelling now, with the rich world’s large economies following on Japan’s heels.

When the crisis of 2008 shrunk, central banks responded by following Milton Friedman’s playbook. They stepped in to prevent cascading failures in the banking system. They deployed QE to fend off deflation. And they succeeded in bringing inflation back to rates close to target, typically around 2%. When inflation has threatened to fall back toward zero, they’ve deployed new rounds of QE. The commitment to low and stable inflation is flawless.

And yet the rich world looks ever more like Japan. The Fed has drawn a line at 2% inflation rather than 0% inflation, but the impact seems not to have mattered much. As in Japan, American output has come in consistently at or below trend, and virtually none of the output gap that opened up during the recession has been closed. As in Japan, the rise in unemployment that accompanied the economic slowdown has retreated a bit, but has come nowhere close to pre-crisis levels. And as in Japan, long-run interest rates have collapsed despite rising debt loads, seemingly signalling expectations of a long, long period of extremely disappointing growth.

Now, it’s possible that this is coincidence. It’s possible that structural economic factors in Japan have been replicated, a decade later, across the rest of the rich world—that a technological slowdown, for instance, hit Japan in the 1990s and only later settled on America and Europe. But this seems very unlikely. It looks very much like the fault lies with the macroeconomic policy regime.

So what is the fault? By now the pattern in America’s recovery is unmistakable; I think we’ve actually come to expect it. Growth and employment gain momentum, then some headwind strikes. Growth slips back toward zero, hiring falls below levels sufficient to reduce the unemployment rate, and inflation expectations slowly sink. When the outlook for inflation is weak enough to get the Fed worried about deflation it intervenes. Inflation expectations then rise, employment and hiring recover, and things look promising again. Hopes that the Fed might sustain its intervention then disappear. And then some headwind strikes.

At no point is there anything resembling growth fast enough to make up some of the ground lost, relative to trend, during the recession. By some variables, we’re falling further behind.

The key number in this dance is 2%. That’s the threshold. The Fed targets a 2% rate of inflation. It says 2% is a symmetrical target but in practice it functions more like a ceiling. The Fed’s preferred measure of inflation has risen above 2% in only a handful of months since the crisis of 2008. Economic troubles in Britain and Europe are qualitatively different, but they also suffer from this cap. The 2% inflation target exerts a strong constraining force on monetary policy.

This is perverse. If you ask Ben Bernanke, he’ll tell you, quite forthrightly, that the Fed could do more to boost growth and employment, but that it doesn’t want to risk confidence in the 2% target. And when one thinks on the power of that 2% number, one begins to reexamine the lessons of the Depression and of the 1970s.

Read Friedman again and you can see the possibility of a different interpretation of economic history. He says monetary policy can influence nominal output—total spending in the economy, unadjusted for inflation. In the short run, he says, this can influence real variables like real GDP growth and employment. In the long run, however, it can only affect inflation.

But the total amount of spending in the economy is nothing more and nothing less than aggregate demand. If demand were higher, people would have spent more. If it were lower, less. Monetary policy, at all times, controls demand. In the short run, higher demand will generate an uncertain mix of changes in the economy—some price and wage increases but also some real output increases—so that higher inflation is, at all times, likely to accompany higher demand. There is no pure, sterile stimulus that the Fed can deliver that will bring higher real growth without higher prices, as Bernanke now claims he would like to do.

But these higher prices signal accelerating inflation—the scourge of the 1970s—only to the extent that they become embedded into wage increases. And when there is broad slack in the economy, that is very unlikely to happen. In the long run, higher demand raises inflation only to the extent that the economy faces supply constraints. Only if it’s operating at potential.

So now let’s rerun the crises of the past century. The key fact of the Depression was not deflation; it was plunging demand; deflation was the symptom. A central bank commitment to fight deflation therefore leaves some monetary fruit unplucked. The recent crisis was much less severe than the Depression because central banks thought deflation prevention was critical; in fighting deflation they couldn’t help but prevent a big demand collapse. But having beaten deflation they were at a loss what to do next. The answer was simple: create more demand! But that was beyond the consideration of inflation-obsessed central bankers.

Take the 1970s. The dynamic there was no more and no less than the fact that demand was running beyond the economy’s capacity to produce. Higher demand had nowhere to go but into higher prices. And as higher prices became built into expectations, wage demands rose, and accelerating inflation resulted. Central banks then resolved to rein in inflation. It took a recession to re-establish low inflation because Volcker needed to convince people that the Fed could control inflation and would control inflation, in order to reset expectations. But once that was established, control over inflation was simply a side effect of demand, constrained at or below the supply capacity of the economy.

Bernanke now argues as though it would take another Volcker recession to defeat high inflation. But the public no longer needs to be convinced that the central bank has the ability to control inflation—that is well established. It just needs to be told under what conditions it will do that. And that’s fairly straightforward: when inflation dynamics begin to signal that supply constraints are beginning to bind.

What would that mean in practice? Central banks should focus their efforts on measures of demand—nominal GDP, nominal income, nominal spending—rather than measures of inflation. If nominal GDP is at a level that’s inconsistent with full employment, demand is too low and the central bank should do more. That might take inflation above some arbitrary level, and that’s totally fine. It won’t stay above that arbitrary level and accelerate unless the central bank keeps raising demand indefinitely. This is not to say that there are no costs to having 4% inflation for a year rather than 2%. There are surely some efficiency costs to changes in relative prices. But if the alternative is a trillion dollar output gap and 6m unnecessarily unemployed workers, that’s probably a pretty good trade-off to make.

We learned a hugely important lesson from the Depression—that central banks could influence the economy and prevent demand-side macroeconomic disasters. But we took a wrong turn in thinking that the way they did this was by moderating inflation. It was as if we discovered a magical sword in the woods and then went about confronting enemies by whacking them with the sheath.

We can move past this intellectual limitation. Monetary policy can influence demand, plain and simple. This economy could plainly use more of it; millions of unemployed workers are a testament to that. Not to do more to get them to work is to leave the sword at one’s side during a battle, because it looks prettier there. And the Fed should be careful. If it doesn’t use it, someone might try to take it away.