Posted on 06/27/2013 3:43:19 PM PDT by BfloGuy
At the end of the day, Friedman jettisoned the gold standard for a remarkable statist reason. Just as Keynes had been, he was afflicted with the economist’s ambition to prescribe the route to higher national income and prosperity and the intervention tools and recipes that would deliver it. The only difference was that Keynes was originally and primarily a fiscalist, whereas Friedman had seized upon open market operations by the central bank as the route to optimum aggregate demand and national income.
There were massive and multiple ironies in that stance. It put the central bank in the proactive and morally sanctioned business of buying the government’s debt in the conduct of its open market operations. Friedman said, of course, that the FOMC should buy bonds and bills at a rate no greater than 3 percent per annum, but that limit was a thin reed.
Indeed, it cannot be gainsaid that it was Professor Friedman, the scourge of Big Government, who showed the way for Republican central bankers to foster that very thing. Under their auspices, the Fed was soon gorging on the Treasury’s debt emissions, thereby alleviating the inconvenience of funding more government with more taxes.
Friedman also said democracy would thrive better under a régime of free markets, and he was entirely correct. Yet his preferred tool of prosperity promotion, Fed management of the money supply, was far more anti-democratic than Keynes’s methods. Fiscal policy activism was at least subject to the deliberations of the legislature and, in some vague sense, electoral review by the citizenry.
By contrast, the twelve-member FOMC is about as close to an unelected politburo as is obtainable under American governance. When in the fullness of time, the FOMC lined up squarely on the side of debtors, real estate owners, and leveraged financial speculators—and against savers, wage earners, and equity financed businessmen—the latter had no recourse from its policy actions.
The greatest untoward consequence of the closet statism implicit in Friedman’s monetary theories, however, is that it put him squarely in opposition to the vision of the Fed’s founders. As has been seen, Carter Glass and Professor Willis assigned to the Federal Reserve System the humble mission of passively liquefying the good collateral of commercial banks when they presented it.
Consequently, the difference between a “banker’s bank” running a discount window service and a central bank engaged in continuous open market operations was fundamental and monumental, not merely a question of technique. By facilitating a better alignment of liquidity between the asset and liability side of the balance sheets of fractional reserve deposit banks, the original “reserve banks” of the 1913 act would, arguably, improve banking efficiency, stability, and utilization of systemwide reserves.
Yet any impact of these discount window operations on the systemwide banking aggregates of money and credit, especially if the borrowing rate were properly set at a penalty spread above the free market interest rate, would have been purely incidental and derivative, not an object of policy. Obviously, such a discount window-based system could have no pretensions at all as to managing the macroeconomic aggregates such as production, spending, and employment.
In short, under the original discount window model, national employment, production prices, and GDP were a bottoms-up outcome on the free market, not an artifact of state policy. By contrast, open market operations inherently lead to national economic planning and targeting of GDP and other macroeconomic aggregates. The truth is, there is no other reason to control M1 than to steer demand, production, and employment from Washington.
Why did the libertarian professor, who was so hostile to all of the projects and works of government, wish to empower what even he could have recognized as an incipient monetary politburo with such vast powers to plan and manage the national economy, even if by means of the remote and seemingly unobtrusive steering gear of M1? There is but one answer: Friedman thoroughly misunderstood the Great Depression and concluded erroneously that undue regard for the gold standard rules by the Fed during 1929–1933 had resulted in its failure to conduct aggressive open market purchases of government debt, and hence to prevent the deep slide of M1 during the forty-five months after the crash.
Yet the historical evidence is unambiguous; there was no liquidity shortage and no failure by the Fed to do its job as a banker’s bank. Indeed, the six thousand member banks of the Federal Reserve System did not make heavy use of the discount window during this period and none who presented good collateral were denied access to borrowed reserves. Consequently, commercial banks were not constrained at all in their ability to make loans or generate demand deposits (M1).
But from the lofty perch of his library at the University of Chicago three decades later, Professor Friedman determined that the banking system should have been flooded with new reserves, anyway. And this post facto academician’s edict went straight to the heart of the open market operations issue.
The discount window was the mechanism by which real world bankers voluntarily drew new reserves into the system in order to accommodate an expansion of loans and deposits. By contrast, open market bond purchases were the mechanism by which the incipient central planners at the Fed forced reserves into the banking system, whether sought by member banks or not.
Friedman thus sided with the central planners, contending that the market of the day was wrong and that thousands of banks that already had excess reserves should have been doused with more and still more reserves, until they started lending and creating deposits in accordance with the dictates of the monetarist gospel. Needless to say, the historic data show this proposition to be essentially farcical, and that the real-world exercise in exactly this kind of bank reserve flooding maneuver conducted by the Bernanke Fed forty years later has been a total failure—a monumental case of “pushing on a string.”
The historical truth is that the Fed’s core mission of that era, to rediscount bank loan paper, had been carried out consistently, effectively, and fully by the twelve Federal Reserve banks during the crucial forty-five months between the October 1929 stock market crash and FDR’s inauguration in March 1933. And the documented lack of member bank demand for discount window borrowings was not because the Fed had charged a punishingly high interest rate. In fact, the Fed’s discount rate had been progressively lowered from 6 percent before the crash to 2.5 percent by early 1933.
More crucially, the “excess reserves” in the banking system grew dramatically during this forty-five-month period, implying just the opposite of monetary stringency. Prior to the stock market crash in September 1929, excess reserves in the banking system stood at $35 million, but then rose to $100 million by January 1931 and ultimately to $525 million by January 1933.
In short, the tenfold expansion of excess (i.e., idle) reserves in the banking system was dramatic proof that the banking system had not been parched for liquidity but was actually awash in it. The only mission the Fed failed to perform is one that Professor Friedman assigned to it thirty years after the fact; that is, to maintain an arbitrary level of M1 by forcing reserves into the banking system by means of open market purchases of Uncle Sam’s debt.
As it happened, the money supply (M1) did drop by about 23 percent during the same forty-five-month period in which excess reserves soared tenfold. As a technical matter, this meant that the money multiplier had crashed. As has been seen, however, the big drop in checking account deposits (the bulk of M1) did not represent a squeeze on money. It was merely the arithmetic result of the nearly 50 percent shrinkage of the commercial loan book during that period.
As previously detailed, this extensive liquidation of bad debt was an unavoidable and healthy correction of the previous debt bubble. Bank loans outstanding, in fact, had grown at manic rates during the previous fifteen years, nearly tripling from $14 billion to $42 billion. As in most credit-fueled booms, the vast expansion of lending during the Great War and the Roaring Twenties left banks stuffed with bad loans that could no longer be rolled over when the music stopped in October 1929.
Consequently, during the aftermath of the crash upward of $20 billion of bank loans were liquidated, including billions of write-offs due to business failures and foreclosures. As previously explained, nearly half of the loan contraction was attributable to the $9 billion of stock market margin loans which were called in when the stock market bubble collapsed in 1929.
Likewise, loan balances for working capital borrowings also fell sharply in the face of falling production. Again, this was the passive consequence of the bursting industrial and export sector bubble, not something caused by the Fed’s failure to supply sufficient bank reserves. In short, the liquidation of bank loans was almost exclusively the result of bubbles being punctured in the real economy, not stinginess at the central bank.
In fact, there has never been any wide-scale evidence that bank loans outstanding declined during 1930–1933 on account of banks calling performing loans or denying credit to solvent potential borrowers. Yet unless those things happened, there is simply no case that monetary stringency caused the Great Depression.
Friedman and his followers, including Bernanke, came up with an academic canard to explain away these obvious facts. Since the wholesale price level had fallen sharply during the forty-five months after the crash, they claimed that “real” interest rates were inordinately high after adjusting for deflation.
Yet this is academic pettifoggery. Real-world businessmen confronted with plummeting order books would have eschewed new borrowing for the obvious reason that they had no need for funds, not because they deemed the “deflation-adjusted” interest rate too high.
At the end of the day, Friedman’s monetary treatise offers no evidence whatsoever and simply asserts false causation; namely, that the passive decline of the money supply was the active cause of the drop in output and spending. The true causation went the other way: the nation’s stock of money fell sharply during the post-crash period because bank loans are the mother’s milk of bank deposits. So, as bloated loan books were cut down to sustainable size, the stock of deposit money (M1) fell on a parallel basis.
Given this credit collapse and the associated crash of the money multiplier, there was only one way for the Fed to even attempt to reflate the money supply. It would have been required to purchase and monetize nearly every single dime of the $16 billion of US Treasury debt then outstanding.
Today’s incorrigible money printers undoubtedly would say, “No problem.” Yet there is no doubt whatsoever that, given the universal antipathy to monetary inflation at the time, such a move would have triggered sheer panic and bedlam in what remained of the financial markets. Needless to say, Friedman never explained how the Fed was supposed to reignite the drooping money multiplier or, failing that, explain to the financial markets why it was buying up all of the public debt.
Beyond that, Friedman could not prove at the time of his writing A Monetary History of the United States in 1965 that the creation out of thin air of a huge new quantity of bank reserves would have caused the banking system to convert such reserves into an upwelling of new loans and deposits. Indeed, Friedman did not attempt to prove that proposition, either. According to the quantity theory of money, it was an a priori truth.
In actual fact, by the bottom of the depression in 1932, interest rates proved the opposite. Rates on T-bills and commercial paper were one-half percent and 1 percent, respectively, meaning that there was virtually no unsatisfied loan demand from creditworthy borrowers. The dwindling business at the discount windows of the twelve Federal Reserve banks further proved the point. In September 1929 member banks borrowed nearly $1 billion at the discount windows, but by January 1933 this declined to only $280 million. In sum, banks were not lending because they were short of reserves; they weren’t lending because they were short of solvent borrowers and real credit demand.
In any event, Friedman’s entire theory of the Great Depression was thoroughly demolished by Ben S. Bernanke, his most famous disciple, in a real-world experiment after September 2008. The Bernanke Fed undertook massive open market operations in response to the financial crisis, purchasing and monetizing more than $2 trillion of treasury and agency debt.
As is by now transparently evident, the result was a monumental wheel-spinning exercise. The fact that there is now $1.7 trillion of “excess reserves” parked at the Fed (compared to a mere $40 billion before the crisis) meant that nearly all of the new bank reserves resulting from the Fed’s bond-buying sprees have been stillborn.
By staying on deposit at the central bank, they have fueled no growth at all of Main Street bank loans or money supply. There is no reason whatsoever, therefore, to believe that the outcome would have been any different in 1930–1932.
The great irony, then, is that the nation’s most famous modern conservative economist became the father of Big Government, chronic deficits, and national fiscal bankruptcy. It was Friedman who first urged the removal of the Bretton Woods gold standard restraints on central bank money printing, and then added insult to injury by giving conservative sanction to perpetual open market purchases of government debt by the Fed. Friedman’s monetarism thereby institutionalized a régime which allowed politicians to chronically spend without taxing.
Likewise, it was the free market professor of the Chicago school who also blessed the fundamental Keynesian proposition that Washington must continuously manage and stimulate the national economy. To be sure, Friedman’s “freshwater” proposition, in Paul Krugman’s famous paradigm, was far more modest than the vast “fine-tuning” pretensions of his “saltwater” rivals. The saltwater Keynesians of the 1960s proposed to stimulate the economy until the last billion dollars of potential GDP was realized; that is, they would achieve prosperity by causing the state to do anything that was needed through a multiplicity of fiscal interventions.
By contrast, the freshwater Keynesian, Milton Friedman, thought that capitalism could take care of itself as long as it had precisely the right quantity of money at all times; that is, Friedman would attain prosperity by causing the state to do the one thing that was needed through the single spigot of M1 growth.
But the common predicate is undeniable. As has been seen, Friedman thought that member banks of the Federal Reserve System could not be trusted to keep the economy adequately stocked with money by voluntarily coming to the discount window when they needed reserves to accommodate business activity. Instead, the central bank had to target and deliver a precise quantity of M1 so that the GDP would reflect what economic wise men thought possible, not merely the natural level resulting from the interaction of consumers, producers, and investors on the free market.
For all practical purposes, then, it was Friedman who shifted the foundation of the nation’s money from gold to T-bills. Indeed, in Friedman’s scheme of things central bank purchase of Treasury bonds and bills was the monetary manufacturing process by which prosperity could be managed and delivered.
What Friedman failed to see was that one wise man’s quantity rule for M1 could be supplanted by another wise man’s quantity rule for M2 (a broader measure of money supply that included savings deposits) or still another quantity target for aggregate demand (nominal GDP targeting) or even the quantity of jobs created, such as the target of 200,000 per month recently enunciated by Fed governor Charles Evans. It could even be the quantity of change in the Russell 2000 index of stock prices, as Bernanke has advocated.
Yet it is hard to imagine a world in which any of these alternative “quantities” would not fall short of the “target” level deemed essential to the nation’s economic well-being by their proponents. In short, the committee of twelve wise men and women unshackled by Friedman’s plan for floating paper dollars would always find reasons to buy government debt, thereby laying the foundation for fiscal deficits without tears.
Copyright © 2013 David Stockman. Used with the author's permission.
David Stockman was director of the Office of Management and Budget under President Ronald Reagan, serving from 1981 until August 1985. He was the youngest cabinet member in the 20th century. See David Stockman's article archives.
Though he defended capitalism, he believed that the government must control the supply of money available to capitalists. Ben Bernanke formed his monetary theories on Friedman's writings about the Great Depression.
But Friedman's analysis of the causes of the Depression were wrong and that is proved by the failure of Bernanke's policies to end the current economic mess.
If you want to back your money with gold, fine, do so. If you want to back it with platinum, be my guest. If people TRUST your money because of any reason and are willing to take it, they should be allowed to. (Especially so since all the paper currency in the US comprises about 7% of all "money" and there is only enough gold at normal ratios to cover a tiny, tiny fraction of that 7%).
I used as my evidence the period from 1840-1860, when we had no central bank and banks competed freely by issuing their own money. Now, it is true that then all of them used a gold backing---but one of the strongest of the banks from Atlanta, whose notes circulated AT PAR in Chicago---couldn't possibly have converted its Chicago notes into gold because it didn't have a branch there. In essence, people took it on trust.
But the point is, in a true free market, anyone should be able to use anything for money if someone else will take it.
If there were any honesty left in the Federal government today... they would call what we are and have been in since the dims took over in 2007... a depression. They change the criteria of measurement as needed. They add a bogus 3.5% in Federal stimulus and Hollywood’s future receipts to the GDP and call it a correction. Unemployment figures are massaged and distorted by propagandists and keynesian theory... IOW... BS to the power of ten.
LLS
Wow. I’ve been a great fan of Friedman for years and have also listened and enjoyed all the YouTube videos of his debates and talks.
In no way am I an economist but I like Friedman so much I was prepared to dismiss Stockman our of hand. But what he says seems to make sense though much of it is over my head.
Forget "aggregate demand." Nobody ever bought an aggregate. The idea is nothing but a hydraulic metaphor, that by filling the tank, everything will be lifted up equally. That's not the way an economy works.
The Austrians believe that the only proper analysis of economics is through the actions of the individual and I agree.
Now, the famous "aggregates" are, indeed, the sum of the economic decisions made by individuals. But same aggregates cannot predict what those same individuals will do in the future.
Human action cannot be quantified. It can be described, but not turned into a formula. This is where the dominant schools of economics have gone wrong.
Could you list some specific errors he made?
His error was believing that money is to the economy as grease is to a machine. More of it will ease business transactions -- too little of it will cause the thing to seize up -- and that the government can determine the proper amount.
His analysis of the cause of the Great Depression was that, as the economy spiraled down, the Federal Reserve did not provide enough money [liquidity in modern parlance] for business to dig itself out of the hole. FDR agreed and ended the ability of Americans to trade their paper dollar s for gold. To complete the circle, he declared it illegal for Americans to own gold and forced them to sell it all back to the government.
All of this in an effort to eliminate the limits on the issuance of paper dollars imposed on the government by the gold standard. It didn't work, of course, we were still in the Depression at the outbreak of the war in 1940.
It isn't working today, either. We are still caught in the same slow-growth stagnation in 2013 we were in 1938.
Though money is certainly necessary to the operation of well-functioning economy, it is not like grease that can be added or drained from a machine as needed by a wise mechanic. Any amount of money can serve as long as prices are allowed to rise or fall according to the needs of consumers [i.e., the market].
Mr. Friedman, in his younger years, though certainly more free market than today's mainstream economists, was enamored of big-government solutions to economic issues. As we all know, he famously designed the tax withholding system during WWII [which he later admitted to regret] and believed the Federal Reserve should increase the money supply by 2% or 3% a year to promote growth -- numbers, by the way which he picked out of thin air to match his opinions of sensible growth.
Do not misunderstand me. In his later years, Milton Friedman proved himself a very capable and important advocate of free markets. But we should not ignore his myopia on what money is and his early efforts to put government in charge of it.
Too little isn't an issue?
and that the government can determine the proper amount.
Yeah, that didn't work so well.
His analysis of the cause of the Great Depression was that, as the economy spiraled down, the Federal Reserve did not provide enough money [liquidity in modern parlance] for business to dig itself out of the hole.
Didn't the money supply shrink by a third? Wasn't that a problem?
FDR agreed and ended the ability of Americans to trade their paper dollar s for gold. To complete the circle, he declared it illegal for Americans to own gold and forced them to sell it all back to the government. All of this in an effort to eliminate the limits on the issuance of paper dollars imposed on the government by the gold standard. It didn't work, of course,
What happened to the money supply after FDR repriced gold?
It isn't working today, either. We are still caught in the same slow-growth stagnation in 2013 we were in 1938.
Imagine where we'd be if money supply had shrunk by a third after 2008.
Any amount of money can serve as long as prices are allowed to rise or fall according to the needs of consumers [i.e., the market].
Massive deflation is a-ok with you?
The magnitude of the debt indicates that any deflation will be a short lived prelude to the certain inflation
No, it isn't. Prices adjust to the quantity of money available. Currently, they are adjusting upwards to accommodate a higher money supply; without government interference or long-term labor contracts, prices will adjust downward if the money supply is stable or is reduced.
Yeah, that didn't work so well.
Phew. At least we agree on that.
Didn't the money supply shrink by a third? Wasn't that a problem?
Well, yes. But only because the money supply had been artificially bloated by the Fed during the boom. When the economy collapsed, loans went bad and that part of the money supply disappeared.
What happened to the money supply after FDR repriced gold?
It increased. It increased by Fed action.
Imagine where we'd be if money supply had shrunk by a third after 2008.
Under our current system, it is the government under the direction of the Federal Reserve that pumps up the money supply and then tamps it down [see Volcker, 1982]. That is why I would like to see a return to private money -- a gold standard is my preference.
Massive deflation is a-ok with you?
No. But only government can create a "massive" deflation. It always comes just after government has created a massive inflation and then decides the economy has "overheated" which it usually has.
Under the gold system [when it was still being observed], there was a modest deflation of something like 1%/year. That reflected a stable money supply and took into account productivity improvements. That is benign deflation -- not the wrenching deflation that only a government can cause.
We have all grown up and lived under a system where the government allows the central bank to attempt to plan our economy by manipulating interest rates and the supply of money. It seems perfectly natural to us and it's difficult to envision anything else.
But government is no more competent at regulating the economic activities of 310 million individuals than it is in defending the border or deciding what health insurance we should have.
That Friedman didn't think of himself as an "Austrian" (top-down, rationalistic, a priori, as opposed to empirical, evidence-based) economist was to his credit.
David Stockman isn't necessarily your friend. It's any port in a storm for him.
I met with and had conversations with Milton Friedman. He was decidedly a free market economist. I would have to read Stockman’s book to know if indeed he was a Keynesian when it comes to manipulating money supply.
Friedman didn't believe in a gold standard; he thought a government-managed fiat money system would be best. It doesn't matter whether it was going to happen or not.
That Friedman didn't think of himself as an "Austrian" (top-down, rationalistic, a priori, as opposed to empirical, evidence-based) economist was to his credit.
Heh. Empirical economics is an oxymoron and it shows in the results we've gotten since the empiricists started running the show back in the thirties. The Austrians are the only school with a logical, consistent, and proven theory. Unfortunately, it took me a while to realize that, though.
David Stockman isn't necessarily your friend. It's any port in a storm for him.
Never considered him a friend. I probably wouldn't even like him. The book's analysis is spot-on, though. IMHO.
He had what you might call a "nuanced" view:
Friedman believed that if the money supply was to be centrally controlled (as by the Federal Reserve) that the preferable way to do it would be with a mechanical system that would keep the quantity of money increasing at a steady rate. However, instead of government involvement at all, he was open to a "real," non-government, gold standard where money is produced by the private market: "A real gold standard is thoroughly consistent with [classical] liberal principles and I, for one, am entirely in favor of measures promoting its development." He did however add this caveat, "Let me emphasize that this note is not a plea for a return to a gold standard.... I regard a return to a gold standard as neither desirable nor feasible—with the one exception that it might become feasible if the doomsday predictions of hyperinflation under our present system should prove correct." He said the reason that it was not feasible was because "there is essentially no government in the world that is willing to surrender control over its domestic monetary policy." However, it could be done if "you could re-establish a world in which government's budget accounted for 10 percent of the national income, in which laissez-faire reigned, in which governments did not interfere with economic activities and in which full employment policies had been relegated to the dustbin..." Wikipedia
Given the world as it was, Friedman didn't think a gold standard would work. You could say, he didn't want one. But he thought that if the world were different a gold standard could work. Given that those conditions weren't likely to be achieved, he thought a gold standard would have serious problems.
Empirical economics is an oxymoron and it shows in the results we've gotten since the empiricists started running the show back in the thirties. The Austrians are the only school with a logical, consistent, and proven theory.
Sure, all the theories that have actually been seriously tried have their failings, and the unproven theory that's never put into effect is perfect.
Friedman was the man.
LLS
What have been, in your opinion, the failings of Austrian theory?
I'm an empiricist, though. I don't trust big deductive theories that try to explain things without reference to the pesky details.
I was once an empiricist [it's how we're trained in America]. I thought the Austrians were cranks. Once I realized the difference between deductive theory and inductive theory, I began to take a closer look at the Austrians and am now firmly in their camp.
I hope you'll take a closer look at them.
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