Friday, January 9, 2009
Austrians and Keynesians Agree: Milton Was Wrong About the Depression
I don't usually find much of value in Paul Krugman's articles, but in this piece he relates something very important:
Don't let Krugman's smarmy tone fool you: He is right. According to the monetarists, the Fed behaved just fine during the 1920s. After all, output was booming, and consumer price inflation was virtually nonexistent. (In my forthcoming book I will have quotes from people like Irving Fisher saying how the Fed had done a great job achieving the much ballyhooed "price stability" during the period.)
If the Fed behaved OK during the 1920s, then if you're a fan of the free market, you have to blame the Great Depression on either the Smoot-Hawley tariff and/or Fed behavior in the early 1930s. And, as Krugman says, that's just what Milton Friedman and other supply-siders have done. I myself adopted this view when I was younger, since it fit so neatly into my anti-government worldview: "Ha! You think it was laissez-faire that caused the Great Depression? Nonsense! The Fed let the money supply fall by a third. What do you expect to happen when the authorities are such nincompoops?"
Well now the proponents of "scientific" economics have their chance. As my favorite chart below reminds us, the Fed certainly hasn't allowed the money supply to drop. Yet I think we are in store for the worst depression since the Great one.
If nothing else, this episode will discredit the monetarist interpretation of the 1920s and 1930s. (Poor Alex Tabarrok! Look at what he was reduced to in trying to defend the Friedman position. He actually argued that the Fed hasn't been injecting liquidity into the system; it's all a statistical illusion.) That will leave us with the Austrian theory, versus those (such as the Keynesian and Marxist) that blame the Depression on the inherent instability of capitalism. Proponents of free markets, take your pick.
(Incidentally, for a refutation of Friedman's theory that it was government "intervention" to not inflate the money supply amidst the bank runs of the early 1930s, see Matt Machaj's great article.)
For many years most economists believed that preventing another Great Depression would be easy. In 2003, Robert Lucas of the University of Chicago, in his presidential address to the American Economic Association, declared that the “central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.”
Milton Friedman, in particular, persuaded many economists that the Federal Reserve could have stopped the Depression in its tracks simply by providing banks with more liquidity, which would have prevented a sharp fall in the money supply. Ben Bernanke, the Federal Reserve chairman, famously apologized to Friedman on his institution’s behalf: “You’re right. We did it. We’re very sorry. But thanks to you, we won’t do it again.”
It turns out, however, that preventing depressions isn’t that easy after all. Under Mr. Bernanke’s leadership, the Fed has been supplying liquidity like an engine crew trying to put out a five-alarm fire, and the money supply has been rising rapidly. Yet credit remains scarce, and the economy is still in free fall.
Don't let Krugman's smarmy tone fool you: He is right. According to the monetarists, the Fed behaved just fine during the 1920s. After all, output was booming, and consumer price inflation was virtually nonexistent. (In my forthcoming book I will have quotes from people like Irving Fisher saying how the Fed had done a great job achieving the much ballyhooed "price stability" during the period.)
If the Fed behaved OK during the 1920s, then if you're a fan of the free market, you have to blame the Great Depression on either the Smoot-Hawley tariff and/or Fed behavior in the early 1930s. And, as Krugman says, that's just what Milton Friedman and other supply-siders have done. I myself adopted this view when I was younger, since it fit so neatly into my anti-government worldview: "Ha! You think it was laissez-faire that caused the Great Depression? Nonsense! The Fed let the money supply fall by a third. What do you expect to happen when the authorities are such nincompoops?"
Well now the proponents of "scientific" economics have their chance. As my favorite chart below reminds us, the Fed certainly hasn't allowed the money supply to drop. Yet I think we are in store for the worst depression since the Great one.
If nothing else, this episode will discredit the monetarist interpretation of the 1920s and 1930s. (Poor Alex Tabarrok! Look at what he was reduced to in trying to defend the Friedman position. He actually argued that the Fed hasn't been injecting liquidity into the system; it's all a statistical illusion.) That will leave us with the Austrian theory, versus those (such as the Keynesian and Marxist) that blame the Depression on the inherent instability of capitalism. Proponents of free markets, take your pick.
(Incidentally, for a refutation of Friedman's theory that it was government "intervention" to not inflate the money supply amidst the bank runs of the early 1930s, see Matt Machaj's great article.)
Comments:
You can still argue that the recession would be much more deeper, were the Fed not pumping liquidity into the system.
And remember the myriad of interventions which postpone the necessary market correction and make things worse.
Btw, Machaj´s piece is terrible. See Larry White´s take:
http://divisionoflabour.com/archives/003603.php
"... we need to spell out Friedman’s institutional counter-factual. That is, what did Friedman think would have happened without a central bank? Friedman understood something that Krugman never mentions, namely that before the Federal Reserve Act financial panics in the US were mitigated by the actions of private commercial bank clearinghouses. (The key article here is “The Central Banking Role of Clearinghouse Associations," JMCB Feb. 1984, by Richard H. Timberlake, a Friedman student. JSTOR pdf here.) Friedman and Schwartz’s view of the 1930s was that the Fed, having nationalized the roles of the clearinghouse associations, 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 Fed’s nationalization of the clearinghouse roles for granted, the Fed was guilty of not doing its job. Given that proviso, Krugman is right that Friedman’s account indicates that the Fed should have been more active. But because we can consider a world where the proviso doesn't hold, Krugman is wrong to think that Friedman’s account can’t honestly support the view that government should have stayed out."
And remember the myriad of interventions which postpone the necessary market correction and make things worse.
Btw, Machaj´s piece is terrible. See Larry White´s take:
http://divisionoflabour.com/archives/003603.php
"... we need to spell out Friedman’s institutional counter-factual. That is, what did Friedman think would have happened without a central bank? Friedman understood something that Krugman never mentions, namely that before the Federal Reserve Act financial panics in the US were mitigated by the actions of private commercial bank clearinghouses. (The key article here is “The Central Banking Role of Clearinghouse Associations," JMCB Feb. 1984, by Richard H. Timberlake, a Friedman student. JSTOR pdf here.) Friedman and Schwartz’s view of the 1930s was that the Fed, having nationalized the roles of the clearinghouse associations, 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 Fed’s nationalization of the clearinghouse roles for granted, the Fed was guilty of not doing its job. Given that proviso, Krugman is right that Friedman’s account indicates that the Fed should have been more active. But because we can consider a world where the proviso doesn't hold, Krugman is wrong to think that Friedman’s account can’t honestly support the view that government should have stayed out."
Did Friedman argue that there would have been no depression/recession had the Fed intervened in the 1930s? If so, that would lend credence to your belief that the monetarist view of the 1930s has been exploded. But if Friedman did not argue this - if he argued instead that the Fed could have thwarted a complete meltdown but not a mild recession -then I'm not sure you are correct. Perhaps Matej is right - the Fed has thwarted something much more severe than what we are actually in for.
Also, I'm not clear if you see a severe monetary contraction as a problem or significant exacerbating factor of the GD, if not the sole cause? Do you believe prices would have adjusted without Fed intervention?
Iwaaks, a price that "adjusts" as the result of intervention is not a price at all - it's a mandate.
As for monetary contraction being the sole cause, although hyperinflation might completely undermine the monetary and economic system, it's difficult to see how monetary contraction, on its own, could do the same. For example, in the absence of legal tender laws, if gold became too scarce to be an appropriate money then people would switch to silver or copper... so legal tender laws must also come into play. In the absence of minimum wage laws, labor rates could come down to adjust to the new quantity of money in supply, so labor laws must also come into play. Deflation, in and of itself, did not cause the depression. It is the government and central banks reaction to that deflation which must be inspected more carefully if you want to find the root causes (and I doubt very much that there is any "single" cause).
As for monetary contraction being the sole cause, although hyperinflation might completely undermine the monetary and economic system, it's difficult to see how monetary contraction, on its own, could do the same. For example, in the absence of legal tender laws, if gold became too scarce to be an appropriate money then people would switch to silver or copper... so legal tender laws must also come into play. In the absence of minimum wage laws, labor rates could come down to adjust to the new quantity of money in supply, so labor laws must also come into play. Deflation, in and of itself, did not cause the depression. It is the government and central banks reaction to that deflation which must be inspected more carefully if you want to find the root causes (and I doubt very much that there is any "single" cause).
# posted by 
: January 9, 2009 at 9:36 AM
: January 9, 2009 at 9:36 AM
What are you guys talking about? At the very least, can you agree that Bernanke--assuming Krugman didn't invent that quote--thinks that Friedman thinks that the Fed singlehandledly could have prevented the Great Depression?
Actually, no. What Milton Friedman said was that the Fed policy turned what otherwise might have been a quite mild recession into a deep downturn.
Sorry for my broken English, I am not a native speaker.
Sorry for my broken English, I am not a native speaker.
The argument is not what poison will kill us,the problem is we as a country have to produce a product that the world or others want this will provide the capital that is needed in our economy,only then will we get out of the mess all of these so called economist have created.It does not take a very smart person to know that something from nothing leaves nothing.
# posted by : January 9, 2009 at 1:35 PM
: January 9, 2009 at 1:35 PM
I confess to being ignorant here. So I will just ask questions. Why is it unreasonable to argue that the Fed could have prevented the GD by avoiding a monetary contraction of 1/3rd? That's not the same thing as saying a recession would not have occurred, is it? As for price adjustments in the face of a severe and rapid price deflation, is not the "who goes first" issue a real problem (as discussed in S. Horwitz' book _Macroeconomics and Microfoundations_)?
The Blackadder Says:
Friedman's view, as I understand it, is that the Depression was caused by a significant contraction in the money supply. If what happens now is that we have a significant expansion of the monetary supply, followed by a depression, this wouldn't refute Friedman, as his argument was that a contraction is a sufficient cause of a depression, not that it is a necessary one.
In fact, I'm pretty sure that the monetarist view is that a big contraction and a big expansion in the money supply are bad and can lead to serious economic trouble. The way Friedman would be refuted is if there was a huge contraction in the money supply, and nothing bad happened. I take it that this is not likely to happen.
Friedman's view, as I understand it, is that the Depression was caused by a significant contraction in the money supply. If what happens now is that we have a significant expansion of the monetary supply, followed by a depression, this wouldn't refute Friedman, as his argument was that a contraction is a sufficient cause of a depression, not that it is a necessary one.
In fact, I'm pretty sure that the monetarist view is that a big contraction and a big expansion in the money supply are bad and can lead to serious economic trouble. The way Friedman would be refuted is if there was a huge contraction in the money supply, and nothing bad happened. I take it that this is not likely to happen.
# posted by : January 9, 2009 at 6:09 PM
: January 9, 2009 at 6:09 PM
Bob, why "Milton Was Wrong..." and not "Friedman Was Wrong...?" Using his first name is rather unconventional.
# posted by : January 10, 2009 at 2:58 PM
: January 10, 2009 at 2:58 PM
I really enjoy your commentary. This is an excellent piece. What Friedman missed was the fact that the monetary expansion in the '20s caused the depression, not the subsequent contraction. You can't inflate forever (without worse consequences).
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