Skip to comments.Milton Friedman and Restraint: The Fed failed as lender of last resort in the Great Depression
Posted on 08/12/2013 7:38:40 AM PDT by SeekAndFind
Lovers of Big Government and apologists for debt like Paul Krugman have tried to paint Milton Friedman as a contradiction. They say that Friedmans insight that more Fed intervention might have mitigated the Great Depression is inconsistent with his view that the Depression would have been less severe without the Fed.
Krugman can typically be discounted because his partisanship diminishes his perceptiveness. It is, however, disappointing when National Review joins the fray and publishes opinion claiming that Friedman would likely have supported a much more aggressive monetary response to our economic downturn.
Professor Ivan Pongracic of Hillsdale College explains that Friedmans insight was that the Feds inaction in the Great Depression was in the context of a banking system in which the central bank had monopolized the position of lender of last resort.
Friedman and Schwartz claimed that the depression would not have been a Great Depression if there had been no Federal Reserve in the first place: [I]f the pre-1914 banking system rather than the Federal Reserve System had been in existence in 1929, the money stock almost certainly would not have undergone a decline comparable to the one that occurred.
That point was effectively elaborated by Milton and Rose Friedman in Free to Choose:
Had the Federal Reserve System never been established, and had a similar series of runs started, there is little doubt that the same measures would have been taken as in 1907 a restriction of payments. That would have been more drastic than what actually occurred in the final months of 1930.
The existence of the Reserve System prevented the drastic therapeutic measure: directly, by reducing the concern of the stronger banks, who, mistakenly as it turned out, were confident that borrowing from the System offered them a reliable escape mechanism in case of difficulty; indirectly, by lulling the community as a whole, and the banking system in particular, into the belief that such drastic measures were no longer necessary now that the System was there to take care of such matters.<
Pongracic goes on to explain that Friedmans insight that the Fed should have acted to avert deflation in the face of bank runs is a conclusion based on the scenario of a Federal Reserve System that has monopolized the function of lender of last resort, quoting from monetary economist Lawrence H. White:
Friedman and Schwartzs view of the 1930s was that the Fed, having nationalized the roles of the clearinghouse associations [CHAs], particularly the lender-of-last-resort role, did less to mitigate the panic than the CHAs had done in earlier panics like 1907 and 1893. In that sense, the economy would have been better off if the Fed had not been created. This position is perfectly consistent with the position that, provided we take the Feds nationalization of the clearinghouse roles for granted, the Fed was guilty of not doing its job.
So, was Friedman an advocate for an aggressive Fed? I think it a mistake to label an economist famous for monetary restraint as an advocate for aggressive monetary policy. It is a stretch to try to make Friedman into some Krugman-like apologist for quantitative easing.
Donald Boudreaux of George Mason makes the point as well. Friedman, he writes, advocated Federal Reserve intervention given a Federal Reserve monopoly of lender of last resort:
Friedman understood that, without the Federal Reserve, private bankclearinghouse associations market institutions that were displaced by the Fed would likely have prevented the money supply from collapsing and, hence, might well have kept the depression from becoming great. But Friedman also understood that the Fed, having substituted its own technocratic discretion for the market adjustments of clearinghouses, then had a responsibility to manage the money supply properly. It failed to do so. Friedman (and his co-author Anna Schwartz) properly criticized the Fed for this terrible failure.
It is a disservice to Milton Friedmans memory, though, to assert that he would be a Krugman-like advocate for quantitative easing. Anna Schwartz in her lecture The Legacy of Milton Friedman writes that Friedmans position was that monetary restraint is necessary for inflation control. Friedman advocated for a constant growth rate of a monetary aggregate. Hardly sounds like the monetary expansion of quantitative easing.
No one, myself or anyone at National Review, can claim to know exactly what Friedman would say about our current debacle. But if he were alive today and given the choice of adjectives to describe his monetary policy, aggressive or restrained, I cant imagine he would not choose restrained.
Rand Paul is a Republican U.S. senator from Kentucky.
That is one tortured article to illustrate an obvious point.
Overly loose monetary policy leads to asset bubbles.
But when those asset bubbles burst, you MUST pursue loose monetary policy.
The Fed in the 1920’s was overly loose, and then insanely in the 1930’s was overly tight.
The Fed in the 2000’s was overly loose, but after the crash became appropriately loose, to prevent the crash from becoming a depression. Yes, they caused a lot of the problem in the first place, but at least did not compound it as they did in the 30s by tightening at the worst possible moment.
Bernanke: Federal Reserve caused Great Depression
There is a downturn in the economy? That can’t be because Democrats are in charge. Oh wait........
Kensian economics has failed everywhere and every time it has been tried.
Maybe Friedman is not the free market God we want him to be. It seems clear to me that he blames Fed Reserve inaction for what happened in 1929 instead of putting the blame where it belonged, on the Fed creating the conditions for the bubble to begin with.
It’s not an either/or situation. Friedman was very critical of the Fed’s inaction in the 1920s stock market bubble, AND very critical of them for tightening credit in the 1930s, which was absolutely the wrong policy at the wrong time.
I wish more people would realize is that if speculative demand causes the prices of certain things to substantially exceed the value of any uses to which they could actually be put, such a bubble is guaranteed to burst before the value of those things can be extracted; the sooner that happens, the smaller the losses that will be realized when it does. The term "market correction", properly applied, is not a euphemism. Tightening credit earlier in the 1920's would have collapsed the market sooner, but that would have been a good thing.
With regard to today's situation, I think the problem isn't that credit is too tight or too lose, but rather with that there's no confidence that those in power won't arbitrarily change the rules to the detriment of anyone who ventures forth into the marketplace without the proper political connections.
But it will work this time, with the Zero-Pelosi-Biden-Reid brain trust in charge.
Well, for one thing when people talk about Keynesian stimulus they are usually referring to fiscal policy rather than monetary policy.
For another, Keynes himself in his general theory believed that over time budgetary balance was the correct policy, but that deficit policy could be used to increase economic activity in periods of subpar growth, then surpluses could be run in periods of strong growth.
There’s really no serious economist, and that would certainly include the late Dr. Friedman, who would say that Keynes was fundamentally mistaken, but most believe that fiscal policy is a difficult instrument for policymakers to employ because the timing of budgets and taxes and spending can be difficult to gauge perfectly with the natural rises and dips in the economic cycle. There is also the problem that politicians have a very hard time cutting spending, ever, or raising taxes, ever, so when there are periods of too-strong growth Keynes prescription to tighten fiscal policy always goes unheeded.
Monetary policy on the other hand, is very flexible, and can be changed within a day if needed, so as a counter-cyclical response mechanism, monetary policy has become the preferred device. The central bank also has the fortune not to have to face elections by the idiot American public.
I strongly recommend reading Friedman’s “Free to Choose” to understand how a truly brilliant man explains the economy.
“If he thinks manipulating the money supply in the 1930s how does that make him different than a big government Keynsian?”
For one thing the majority of Keynes critics have no idea what Keynes actually wrote. He was for balanced government budgets except for the case of extreme downturns, ‘liquidity traps’, where he advocated tax cuts and deficit spending. Keynes would be to the right of many conservative economists writing today.
As for “manipulating the money supply during the 1930s”... most people have no idea that the American money supply collapsed by a full 30% over the years 1930-33. The money simply disappeared as a consequence of massive bank failures and loans going bad. We have never seen anything like that in the years since.
As American banks failed on a massive scale the Fed was confronted with its first great test but its Chairman had died on the eve of the Depression and there was no leadership. So the Fed did nothing.
The failure of the Fed to act to restore the vanished 30% of the money supply is the crux of Friedman and Schwarz’s criticism of the 1930’s Fed in their magnum opus ‘A Monetary History of the United States’.
The process by which the Fed would have restored the vanished money is through the purchase of bonds or other debt paper... which is probably not much different than Quantitative Easing, which if I understand it correctly is the Fed monetizing debt instruments.
Friedman and Schwarz wrote that the greatest reform to come out of the Depression was the FDIC, the guarantee to depositors that the money that they put into banks wouldn’t vanish as it had done in the Depression. That, and Fed learning that it had to act when confronted by a massive deflationary event, has kept us from witnessing a collapse of the money supply like what was experienced in the ‘30s. We have plenty of other problems, but not that one.
Look where Debt Monetization got us. I know that Keynes was an ivory tower liberal he loved big government. His ideas were dangerous. Credit contraction is not a problem IMHO.
Enjoyed the article.. very enlightening. Thanks for posting it. bmfl
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