Economic Crisis 2008-9: Ignore Friedman's Lessons at Your Peril

I can’t count the number of times I’ve heard that the financial/economic crisis has discredited Milton Friedman and Chicago School economics. This argument was raised repeatedly during the shrill debate over the creation of the Milton Friedman Center at UC, but it has been made repeatedly in other contexts as well.

I say let’s look at the record. First consider Friedman’s scholarly work. Note that one of his most important contributions, with Anna Schwartz in A Monetary History of the United States, was to demonstrate the salient role of the Federal Reserve in causing economic contractions–including the Great Depression. He subsequently argued quite presciently that Fed policy during the 1960s and 1970s would cause inflation, and were the cause of the inflation that in fact occurred.

If anything, the monetary policy of the 2000s, which played a central role in the 2008-2009 crisis, provides a ringing confirmation of Friedman’s fundamental point about how a discretionary, fine-tuning monetary policy is ultimately highly disruptive and likely to end in economic misery. The crisis of 2008-2009 would therefore be fertile ground for another chapter-or four–in an updated version of Friedman’s history. Thus, a compelling argument can be made that the crisis is actually a testament to Friedman’s prescience in warning of the dangers of bad monetary policy.

It should also be noted that in setting monetary policy during the crisis, Bernanke was consciously striving to avoid the Fed’s mistakes of the 1930s–mistakes that Friedman pointed out long ago. Note too that Bernanke’s own research on monetary policies and depressions owes a great debt to Friedman’s (and Schwartz’s) pioneering scholarship.

One of Friedman’s other seminal contributions–the theory of the consumption function/permanent income hypothesis–has also stood up extremely well. The temporary tax cut in 2008 was about as close to a controlled experiment of an economic theory as you can get, and the permanent income hypothesis came through with flying colors. (The effects of the stimulus are much more difficult to test, given that the stimulus occurred simultaneously with a massive monetary policy intervention.) Also, the sharp decline in personal consumption resulting from the large decline in personal wealth due to the fall in housing prices is just what one would have predicted based on Friedman’s permanent income hypothesis.

Now consider Friedman’s more polemical advocacy of capitalism. The current crisis is commonly considered to be a resounding failure of capitalism requiring government correction. But note well: The Great Depression was also widely considered a failure of capitalism, but scholarship emanating from Chicago, much of it done by Friedman, eventually largely refuted that verdict. As Friedman notes in his joint memoir with his wife Rose, Two Lucky People (p. 41), at Chicago

teachers widely regarded the depression as largely the product of misguided policy–or at least greatly intensified by such policies. . . . During that period, the small minority of economists who did not succumb [what a choice of verbs!] to the Keynesian Revolution consisted disproportionately of Chicago-trained economists.

Friedman’s above-mentioned scholarship on monetary policy during the Depression was instrumental in overturning the conventional wisdom, and convincing most economists that perverse monetary policy and perverse banking legislation was the primary culprit for the onset of the Depression, and its persistence. Moreover, Friedman was also an outspoken proponent of the view that government policy during the Depression, most notably the NRA and the Wagner Act, by cartelizing the product and labor markets, also undermined normal recovery. This view has recently received considerable support from the research of Cole and Ohanian. This goes to show that early, facile judgments that economic crises demonstrate the inevitable failures of capitalism do not necessarily stand the test of time.

It’s not sporting to pick on the dead; or put differently, the silent dead can’t resist the efforts of the living to discredit them. I daresay that if Friedman were alive today, and in his form of the 1960s and 1970s, those who state with such assurance that the current situation is evidence of the inevitable instability of a capitalist system that requires a firm government hand to fix would have quite a fight on their hands. And I’d put my money on Friedman. The thought of him slicing Krugman or Stiglitz to ribbons is too delicious for words. Alas, it is not to be. (Not to mention the fact that Friedman had so much more class than those two.)

Friedman’s absence does not mean that the facile snap judgments are going unanswered. There are many scholars active today that have a decidedly Friedmanesque take on the current crisis, arguing that in fact the events of 2007-2009 (and the years leading up to the explosion of the crisis) are traceable in large part to egregious government failures. Some of these are monetary policy failures, but others relate to the perverse regulation of the supposedly unregulated banking and financial systems. And no, I’m not talking about the repeal of Glass-Steagall, or the CFMA.

For a very clear explanation of this view, I strongly recommend this interview (by former colleague and fellow Chicago guy Russell Roberts) with Charles Calomaris. Charles deftly destroys most of the shibboleths that dominate today’s discourse on the crisis, and makes a very persuasive case that myriad government policies were necessary conditions for the crisis. These policies (some of the most egregious traceable directly to Barney Frank) created a perverse incentive system that made it rational for banks to do what they did. All I can say is, listen to this and you’ll realize that the Beltway conventional wisdom is 99.99 percent unadulterated BS. (His disquisition on Glass-Steagall is particularly choice, making it clear that people as various as Paul Volcker and Mara Liasson–whom I heard blame the financial crisis on G-S repeal last week–have no clue. None. Zero. Zip.)

The Calomaris interview is long, but worth it. If for nothing else, it is worth it to hear him tell, with considerable relish, the story of how Joe Stiglitz and Peter Orszag (now Obama’s head of OMB, who presumes to tell us the best way to reorganize the entire health care system) wrote a paper for Fannie Mae (FNM) in which they confidently stated that the probability that Fannie or Freddie Mac (FRE) would ever cost the taxpayers a penny “was essentially zero.” Calomaris says that they were right! It didn’t cost a penny! It cost $350 billion.

Keep that in mind the next time you hear Stiglitz bloviate on the crisis, or regulation, or the financial system, or capitalism. Or whether the sun rises in the east.

Even though Russ Roberts is sympathetic to Calomaris’s arguments, he is a good interviewer, and challenges him repeatedly. Another reason for listening.

As I’ve said over and over, the great lesson of the Great Depression was that people learned the wrong lessons from the Great Depression. Milton Friedman was instrumental in helping us unlearn the wrong lessons, and grope for the truth. There are many parallels between the thirties and the noughties, and I think that two of the most important ones are the rush to heap responsibility on the market system and the related drive to swell the power of government. Some of the blame the market-laud the government sentiment is intellectual error; some (probably more) is an opportunistic power grab.

Those who are so anxious to dance on Milton Friedman’s grave today should remember that the easy verdicts of lazy minds about the Depression did not withstand the power of his scholarship. They should take this as a lesson, and consider the very real possibility that their easy, lazy verdicts about the implications of the recent crisis are similarly vulnerable.

Comments

[BulSprig:]

Excellent, and well orchestrated article. Too bad more publicity regarding Barney Frank's and Chris Dodd's implicit involvement in providing the various catalysts which did indeed lead to the financial meltdown of 2008. The abrogation of Glass Steghall by Graham,Leihey, and Bailey in 1999 was likely the straw that broke the financial systems back. Too bad the demgogs like Frank and Dodd will never have to face up to their responsibilities. As for Greenspan's role, lax policies were contributors. However, without Frank, Dodd, and the GS act being tossed in 99 Greenspan's contributions to the meltdown were likely small potatoes, i believe.

Oct 28 07:32 AM

[chap08:]

Moon, your comment seems confused to me. You say "It's nice to hear someone come in defense of Friedman". Then you go on to criticize Bernanke for his recent actions.

Bernanke summarized his thoughts on the Great Depression when he turned to Friedman and Schwartz and said "you were right, we [the Fed] did it". His actions in this crisis have reflected the lesson from Friedman. Friedman summarized the lesson in this way:

"The recession was an ordinary business cycle. We had repeated recessions over hundreds of years, but what converted [this one] into a major depression was bad monetary policy.

The Federal Reserve System had been established to prevent what actually happened. It was set up to avoid a situation in which you would have to close down banks, in which you would have a banking crisis. And yet, under the Federal Reserve System, you had the worst banking crisis in the history of the United States. There's no other example I can think of, of a government measure which produced so clearly the opposite of the results that were intended.

And what happened is that [the Federal Reserve] followed policies which led to a decline in the quantity of money by a third. For every $100 in paper money, in deposits, in cash, in currency, in existence in 1929, by the time you got to 1933 there was only about $65, $66 left. And that extraordinary collapse in the banking system, with about a third of the banks failing from beginning to end, with millions of people having their savings essentially washed out, that decline was utterly unnecessary.

At all times, the Federal Reserve had the power and the knowledge to have stopped that. And there were people at the time who were all the time urging them to do that. So it was, in my opinion, clearly a mistake of policy that led to the Great Depression."

If you want to criticize Bernanke for these actions, then you have to repudiate Friedman.

On Oct 28 05:12 AM Moon Kil Woong wrote:

> It's nice to hear someone come in defense of Friedman and other non-Keynsians
> these days. Just like the Great Depression the US is traveling down
> a laid out path to financial ruin through government and Federal
> Reserve fiascoes not a lack thereof.
>
> It starts with a perversion of the market through strange but completely
> innoculous programs like Fannie Mae and Freddie Mac, allowing derivatives
> to go unregulated, and not monitoring banks properly for over a decade.
> Culminates with the government spending all their money preventing
> what should never have happened and dragging out the decline transforming
> a quick collapse into a steep slope with permanent wage losses. And
> is completed when government spending is shown to be unsustainable
> (of course) and the market is so damaged by socialist stimulus programs
> no one can be sure what real demand or the real market wants or needs
> anymore.
>
> Of course the Great Depression could have been dragged on longer
> if the government just spent even more of the GDP they couldn't afford
> and the Fed dropped rates to 0% and started printing via QE. But
> would it have prevented it? Most likely not. In fact, if they did
> what Barnake is doing today the US might have gone into the gutter
> even longer and most certainly America probably would have been too
> broke to even enter the World War considering we would need overseas
> funding just to stay afloat.
>
> Bernake needs to revisit his thesis asumptions before they land us
> in something much more nasty than a recession that has already been
> made worse and prolonged by Greenspan, Paulson, Geithner, and Bernake.

Oct 28 08:19 AM

[locksmith:]

Friedman will go down in history as another deluded flat-earth economist ignoring biophysical limits.

"Milton Friedman: "The world can, in effect, get along without natural resources ... at some finite cost, production can be freed of dependence on exhaustible resources altogether... [ Milton Friedman 1974 lecture to the American Economic Association cited in p. 117, STEADY-STATE ECONOMICS, H. E. Daly editor)

Oct 28 08:40 AM

[a fat panda:]

"His actions in this crisis have reflected the lesson from Friedman. Friedman summarized the lesson in this way:"

I can see the lessons from Friedman in what Bernanke hasn't done. He hasn't repeated the mistakes of the Great Depression. He has made mistakes of his own that Friedman wouldn't have endorsed. I never heard Friedman suggest that dropping cash from a helicopter was a wise idea. The lessons Bernanke learned seem to be what not to do, rather than what to do.


On Oct 28 08:19 AM chap08 wrote:

> Moon, your comment seems confused to me. You say "It's nice to hear
> someone come in defense of Friedman". Then you go on to criticize
> Bernanke for his recent actions.
>
> Bernanke summarized his thoughts on the Great Depression when he
> turned to Friedman and Schwartz and said "you were right, we [the
> Fed] did it". His actions in this crisis have reflected the lesson
> from Friedman. Friedman summarized the lesson in this way:
>
> "The recession was an ordinary business cycle. We had repeated recessions
> over hundreds of years, but what converted [this one] into a major
> depression was bad monetary policy.
>
> The Federal Reserve System had been established to prevent what actually
> happened. It was set up to avoid a situation in which you would have
> to close down banks, in which you would have a banking crisis. And
> yet, under the Federal Reserve System, you had the worst banking
> crisis in the history of the United States. There's no other example
> I can think of, of a government measure which produced so clearly
> the opposite of the results that were intended.
>
> And what happened is that [the Federal Reserve] followed policies
> which led to a decline in the quantity of money by a third. For every
> $100 in paper money, in deposits, in cash, in currency, in existence
> in 1929, by the time you got to 1933 there was only about $65, $66
> left. And that extraordinary collapse in the banking system, with
> about a third of the banks failing from beginning to end, with millions
> of people having their savings essentially washed out, that decline
> was utterly unnecessary.
>
> At all times, the Federal Reserve had the power and the knowledge
> to have stopped that. And there were people at the time who were
> all the time urging them to do that. So it was, in my opinion, clearly
> a mistake of policy that led to the Great Depression."
>
> If you want to criticize Bernanke for these actions, then you have
> to repudiate Friedman.
>
> On Oct 28 05:12 AM Moon Kil Woong wrote:

Oct 28 09:15 AM

[RiskAverseA...:]

Monetarism is the tool of a dying imperialist current whose living adherents apparently would rather perish in the rage of its desperate victims than consider the error of their worldview in the framework of the simple, single-sentence preamble to the U.S. Constitution whose stated principles have been persistently ill-served by fantasy-filled formulations separating financial processes from physical processes, such as the Chicago School has become quite adept at developing. Y'all might better call yourselves "Greenspan" because although you might talk brilliantly, deep down your sense of history is as dull (and wrong) as Bernanke...

Oct 28 09:59 AM

[The Geoffster:]

Governments intervene in economies to assuage favored constituencies. Politics and economics don't mix well because the result is malinvestment. The public has come to depend on government intervention under the belief that capitalism needs constraints. The left leaning mainstream media rarely questions these constraints because they often masquerade as fairness.

Oct 28 10:01 AM

[cyclingscholar:]

Or to put it succintly....this crisis was caused by keeping interest rates TOO LOW for TOO LONG....and the Anointed One thinks the solution is....to keep interest rates low.

Oct 28 10:26 AM

[ech:]

You expose your analysis as not so much economics as partisan politics when you claim the most egregious policies can be traced directly to Barney Frank. Your script was written by Rush and Hannity, and you probably don

Oct 28 10:27 AM

[Alphameister:]

Excellent article. Friedman is one of my heros. Capitalism is cyclical, as is everything else in life. Efforts by foolish utopians to "perfect" capitalism (and human existence more generally) inevitably lead to big government and the mischief government can do. The road to hell is paved with good intentions, and there's not a politician alive able to foresee even a small fraction of the unintended consequences of his various economic manipulations.

Oct 28 10:53 AM

[chap08:]

fat panda, Friedman's criticism of the Fed in 29-32 was that they:

- allowed real interest rates to rise
- allowed broad money supply to collapse
- failed to prevent a widespread collapse of the banking system

Which of Bernanke's actions do you see as being inconsistent with "helicopter" Milton's agenda?


On Oct 28 09:15 AM a fat panda wrote:

> "His actions in this crisis have reflected the lesson from Friedman.
> Friedman summarized the lesson in this way:"
>
> I can see the lessons from Friedman in what Bernanke hasn't done.
> He hasn't repeated the mistakes of the Great Depression. He has
> made mistakes of his own that Friedman wouldn't have endorsed. I
> never heard Friedman suggest that dropping cash from a helicopter
> was a wise idea. The lessons Bernanke learned seem to be what not
> to do, rather than what to do.

Oct 28 11:11 AM

[ctjaeger:]

True statements. I would pick one bone though. When you say "The public has come to depend on government intervention under the belief that capitalism needs constraints" I sense that you believe in completely unfettered capitalism, correct. There is a role that government serves in a capitalistic society. IMHO, that role is policeman.

Over the years, Fed policies created an environment in which many of the credit abuses we have seen could flourish. Maintaining higher interest rates over time - rather than the fairly loose policy over the past decade or so - would have tamped down the economic incentive for consumers to overextend via credit. If the Fed actively dampened wage growth, the consumer offset flat wage growth with use of credit. From a macro-economic standpoint, higher wage growth across the spender/saver curve would have reduced reliance on credit growth and lessened the impact of the current economic downturn.

Stronger wage growth would have, theoretically, put upward pressure on consumer prices as a disproportionate amount of wage is paid in the lower socio-economic tiers. However, the devastating effect of excessive debt in an economic downturn would have been largely avoided had wages grown at a rate that diminished the perceived "need" to use credit to fund a given lifestyle.

Imprudent use of credit puts a damper on economic growth. It would be wiser - from a legislative and monetary standpoint - to strengthen wage growth and lessen growth of debt. From a foundational standpoint excessive debt will always eventually bring down the house. Excessive debt also hampers growth in generational wealth reducing opportunity for upward mobility on a generational basis.

On Oct 28 10:01 AM The Geoffster wrote:

> Governments intervene in economies to assuage favored constituencies.
> Politics and economics don't mix well because the result is malinvestment.
> The public has come to depend on government intervention under the
> belief that capitalism needs constraints. The left leaning mainstream
> media rarely questions these constraints because they often masquerade
> as fairness.

Oct 28 11:18 AM

[Pat C:]

Unbelievable waste of time.

Oct 28 11:37 AM

[BRUCE E. W.:]

The documentation of this legacy of a "Golden Liberty" and cold war ideological economic distortions can be followed through its courses of real time kickbacks and blowbacks in Naomi Klein's comprehensive critique of the rise of disaster capitalism in her NY Times Best Seller SHOCK DOCTRINE.

The ugly truth is that it has finally crashed our own system. The most common counterattack and denial from your agency is never a comprehensive assessment or a systems model of proof; not even a games theory analysis to demonstrate potentials and projections. It has always been the same in every crisis it follows from region to economic region around the world. More of the same...harder and more rigorous is necessary. It is never capable of admitting fatal and viscious cycles of destruction. It always claims in the face of direct destruction that it wasn't applied more strenuously or sufficiently to gain results. It is reminiscent of when Doctors would bleed a patient for a cure. The lack of results lent itself to more bleeding consecutively until the patient was dead. Of course it was simply "incurable" and the bloodletting was applied too late...etc.. Your perennial assault on empirical realities with assertions of self fulfilling prophesies of doom are truly fictions of an eternal return. Even Paul Samulson (Nobel Prize 1970) and Simon Kuznets (NP:1971) turned away from such one dimensional projections.
For those market equilibrium proponents consider this: Essential equilibrium models that developed in the 20th century were modeled on thermodynamics which sort a balance of costs as much as centering price. Friedman's models are supply side capture and are entirely deranged around price and floating currency capture.
see: homepage.newschool.edu...
and:
www.britannica.com/EBc...
and you decide if Friedman should be this cult of personality that you present here as some redeemer savior. In my opinion he resembles Freddie from Friday the 13th: doesn't die and just keeps coming back to create more destruction and exploit the fear.

Oct 28 11:49 AM

[Living4Divi...:]

Isnt Freidman's criticisms of the Fed handling the aftermath to the Great Depression similar to Bernanke's criticisms?


On Oct 28 11:11 AM chap08 wrote:

> fat panda, Friedman's criticism of the Fed in 29-32 was that they:
>
>
> - allowed real interest rates to rise
> - allowed broad money supply to collapse
> - failed to prevent a widespread collapse of the banking system<br/>
>
> Which of Bernanke's actions do you see as being inconsistent with
> "helicopter" Milton's agenda?

Oct 28 11:58 AM

[BRUCE E. W.:]

I can't help wondering how it is that Fannie Mae and Freddie Mae keep showing up in discussions with such accusational condemnation. This same critique of derivitives fades to the background despite the monumental center it holds for the crisis and collapse of our economic stability in finance. The hot money, however, has never been comfortable without using every opportunity to invade this market and scavenge it into its liquidation process of recycling. This is the heart of a Friedman strategy of capture and so called deregulated equilibrium.

As early as 1990 the American Enterprise Inst. was calling for the liquidation of FNM & FRE (GSEs: Government Supported Enterprise) as part of the deregulatory and privitizing process they were pushing. At that time the idea was initiated that a "downpayment" support would replace the extended mortgage servicing and after the initial downpayment the mortgages would be shifted into a National Mortgage Market. In Sept 2008 the SHADOW FINANCE REGULATORY COMMITTEE which is essentially a working team created by the AEI made a direct recomendation with Paulson that they should take "the opportunity" of the crisis to initiate that liquidation process. Now we stand today discussing a "new" initiative to utilize a "downpayment" support which sounds suspiciously like the first step of the American Enterprise schema to invade and capture that market.
Much like a baloon payment might destroy investments among first time home buyers (often criticized for its inclination towards planned collapse),
such a policy would certainly assure a rate of secondary failures among inexperienced home seekers who can step...and then step right out of their American Dream. To Friedman this would simply be written off as free market corrections...but then he always tended to be paid by the survivors. Check the endowments and contributions to The Department of Economics at the University of Chicago and see what massive amounts have gone into pumping out Friedman's political economic version of "MAXWELL'S DEMON" www.eoht.info/page/Max...

Oct 28 12:13 PM

[chap08:]

Exactly, they are the same. In discussing the Great Depression, Bernanke has referenced Friedman extensively and favorably. He specifically endorsed Friedman's conclusions.

A key point to note though, is that they were/are not talking about handling the aftermath, they are talking about the CAUSES i.e. what makes the difference between a recession and a depression


On Oct 28 11:58 AM Living4Dividends wrote:

> Isnt Freidman's criticisms of the Fed handling the aftermath to the
> Great Depression similar to Bernanke's criticisms?

Oct 28 01:01 PM

[Gary A:]

You Friedman worshippers obviously think that Bernanke's reflation has worked. You don't really know that it has worked because the game isn't over. Pimco's Gross says assets are inflated by 15 trillion dollars.

As this bubble gets farther and farther from earth what do you suppose could happen?

Oct 28 03:12 PM

[bob adamson:]

OK Mr. Pirrong, as of today, what should the US Government and the US Fed do to address the current economic malaise? By ‘do’ I include simply withdrawing, if this would be your recommendation, from the interventions that you deem misguided and counterproductive.

If your recommendation is simply that, for the US Fed, the goal should be that interest rates be kept low and money supply growth modulated in light of growth patterns for the economy generated solely by the free market and, for Government, spending and taxes should be dramatically cut and the budget balanced, then do you honestly think a deep depression can and should be avoided?

Oct 28 03:35 PM

[a fat panda:]

Chap, To some extent you have demonstrated my point. Bernanke listened to Friedman about the problems that you listed. But we are discussing his solutions which do not show me that he listens at all. We are not making the mistakes of the Great Depression. We are making brand new ones.

Here is the gist of our difference. You see that Bernanke's approach as the sole solution to avoiding these problems :

" - allowed real interest rates to rise
- allowed broad money supply to collapse
- failed to prevent a widespread collapse of the banking "

Where as I think that there are many (and much better) solutions to avoid these problems.


On Oct 28 11:11 AM chap08 wrote:

> fat panda, Friedman's criticism of the Fed in 29-32 was that they:
>
>
> - allowed real interest rates to rise
> - allowed broad money supply to collapse
> - failed to prevent a widespread collapse of the banking system<br/>
>
> Which of Bernanke's actions do you see as being inconsistent with
> "helicopter" Milton's agenda?

Oct 28 05:01 PM

[Socialism c...:]

Hardly innocuous! You acknowledge that yourself by stating that F&F pervert the markets. Socialist interference in housing was at the core of this economic meltdown, and F&F were key players in that socialist agenda.

> It starts with a perversion of the market through strange but completely
> innoculous programs like Fannie Mae and Freddie Mac

Oct 28 05:06 PM