Cant and Recant

More than any other individual, Milton Friedman was the intellectual inspiration of the conservative counterrevolution against activist government as an engine of economic efficiency and social justice. In his scholarly work contending that government intervention invariably makes things worse, and in his popular polemics equating capitalism with human freedom, Friedman inspired conservative academic economists and movement activists alike. He is the high priest of the ideology that can be reduced to a bumper sticker: Markets work; government doesn't. More narrowly, Friedman is famous for the economic theory known as monetarism and the corollary view that the Federal Reserve System works best when it is essentially passive, contenting itself with maintaining stable prices.

Now in his 94th year, Friedman has just published new research with implications that are curiously double-edged. On one level, his study, in the latest issue of the Journal of Economic Perspectives, confirms his early scholarly work demonstrating that wrongheaded policy by the Fed drastically deepened the Great Depression. Friedman wrote, in his 1963 history of U.S. monetary policy with Anna Schwartz, that the Fed's error was to let the money supply shrink while the real economy was imploding. This conclusion is now accepted by scholars of all stripes, though Friedman gives the Fed's role far more weight than most. But on another level, Friedman's new work can be read as inviting a most un-Friedmanlike inference -- that competent, creative, and vigorously interventionist government, in this case by central bankers, matters immensely. Friedman, of course, recoils from this conclusion. Yet the implications of his own research, read against the Fed's actual history, drive a stake in his anti-government ideology.

In his new work, Friedman compares three great bull markets, three ensuing stock-market crashes, and the recovery path after each: the Great Crash of October 1929, the Japanese slow collapse of the late 1980s and early 1990s, and the U.S. market meltdown of 2000-2001. He then looks at the money supply in each case and treats the results as a natural experiment. After 1929 in the United States, money supply plummeted and so did the economy. In the late 1980s in Japan, the money supply and the economy were fairly stagnant. But in the United States after 2001, money supply and economic growth, after a brief pause, resumed growing.

Friedman rightly credits Alan Greenspan's Fed for avoiding the mistakes of its 1929 predecessor. (Given the immense dependence of the United States on foreign borrowing, it remains to be seen whether Greenspan's successor, Ben Bernanke, can do as well.) For Friedman, what Greenspan did right was to keep the money supply and price level on a steady course. However, Friedman entirely glosses over what Greenspan actually did. For Friedman, the moral of the story is his usual one: The money supply is paramount, and the central bankers can do no better than to target price stability in their conduct of monetary policy. Monetary policy, his paper concludes, deserves much credit for the mildness of the recession that followed the collapse of the U.S. boom in late 2000.
But the Fed of the Greenspan era did far more than keep prices stable. It was the most interventionist Fed ever.

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When financial markets implode, inflation is the least of a central banker's problems. In percentage terms, the stock market collapse of October 19, 1987, was nearly double the one-day crash of October 29, 1929. In the 1987 collapse, the market lost 22.6 percent of its value in a single day, compared to only 11.7 percent in the worst day of 1929. More shareholder equity was wiped out, relative to the gross domestic product, in the dot-com bust of 2000-2001 than in the Great Crash of 1929-1930.

In both the crashes of 1987 and 2000-2001, the Greenspan Fed prevented the crash from triggering a depression by flooding money markets with liquidity, jawboning bankers to keep lending, and all but commandeering Wall Street to continue credit flowing. It distorts history to contend, as Friedman does, that the Federal Reserve in the 1980s and 1990s was mainly in the business of maintaining stable prices.

On at least six occasions, Greenspan persuaded his colleagues to intervene very actively, stretching the limits of the law, to keep markets from destroying themselves. When the stock market collapsed in October 1987, just weeks into Greenspan's tenure, the new chairman -- working closely with Gerry Corrigan, thenpresident of the New York Fed -- importuned banks to keep lending to brokerages that were technically under water. The Fed would keep them whole.

The entire credit system was on the verge of seizing up, as panicky brokers resisted paying short-term debts to other brokers. The Fed, with a deep knowledge of history, basically guaranteed payment. The Paul Volcker Fed had done much the same when it bent the regulatory rules in the early 1980s, after Third World loan losses left every major money-center bank technically insolvent.

In 1990, Greenspan personally intervened to bail out Citibank, which had taken a big bath on Third World loans, by arranging an infusion of Saudi money. He helped orchestrate the mopping up of the $200 billion savings-and-loan meltdown. The Greenspan Fed intervened mightily during the Mexican crisis of 1994, lobbying Congress for a most un-marketlike $40 billion bailout. Again, in the Asian currency panic of the late 1990s, Greenspan intervened aggressively to make sure that financial institutions following their own narrow self-interests did not trigger a credit crunch. Some critics contend that the Fed's policy of very low interest rates in the late 1990s, partly necessitated to keep money flowing to Asia, helped supercharge the stock market bubble. And after the stock market collapse of 2000-2001, Greenspan led the Fed to cut interest rates 12 times in a year, reducing the short-term interest rate effectively to zero.

Greenspan opened the monetary floodgates, even as George W. Bush was acting to pursue a very expansionary fiscal policy with immense tax cuts that were also blessed by Greenspan. (Liberals can properly take issue with the form of Bush's 2001 tax cut, which was far too heavily tilted to the wealthiest five percent of Americans. The same deficit spending built on public outlays and tax breaks for working people would have delivered even more stimulus, dollar for dollar.) In short, despite Friedman's obsession with money supply, it took a very loose monetary policy by the Fed coupled with major interventions in the banking system plus a very stimulative budget (helped along by the willingness of foreign central banks to continue lending America money) to keep the post-crash economy from sinking into deflation and deep recession. Whatever Greenspan did, he neither put the money supply on automatic pilot nor passively targeted price stability.

* * *

Interestingly, the deflation dilemma was the subject of a 1999 book written on the eve of the dot-com crash by Paul Krugman, The Return of Depression Economics. Reflecting on the Asian financial crisis, the austerity policies of the International Monetary Fund, the depressed purchasing power in the Third World, and the persistent stagnation of the Japanese economy, Krugman warned that deflation and failure of aggregate demand, phenomena supposedly banished by activist government after the 1930s, could return. Foreign creditors were imposing harsh deflationary measures on vulnerable emergent economies. Japanese consumers were acting out a scenario described by John Maynard Keynes. The more fearful they became, the more money they saved. In this Keynesian liquidity trap, said Krugman, anxious consumers refused to spend; rational behavior by individuals was irrational for the economy as a whole. Central bankers could only do so much, since interest rates can't be reduced below zero. Even massive public works spending and wide-open monetary policy by the Japanese government were just barely enough to keep the economy from imploding.

Much more than money supply was involved. If Japanese authorities were targeting anything, it was the health of Japanese exports, not Friedman's price stability. Indeed, given Japan's palpable liquidity trap, that nation's financial leaders would have welcomed a little inflation. Though Americans had no aversion to borrowing to maintain consumption, the world economy as a whole, including the United States, could find itself in this dilemma, Krugman warned. The conventional wisdom, he contended, was to worry about inflation, when the real concern was deflation. And contrary to Friedman, Krugman viewed deflation as a phenomenon that included institutional components such as the banking system, as well as demand-side factors, not just the money supply. Judging by his policy behavior, Greenspan, though a fellow conservative, was reading Krugman more than Friedman.

As Bernanke succeeds Greenspan as Fed chairman, he could face an even tougher challenge. With the dollar overvalued in world markets because of America's reliance on foreign borrowing, many economists believe the dollar is holding its value only because other central bankers continue propping it up so that American consumers will keep buying their exports. No less a figure than Volcker contends that this co-dependence is unsustainable, and that a dollar crash followed by a deep recession is only a matter of time.

These are uncharted waters for the Fed. Bernanke, who embraced the idea of inflation-targeting earlier in his career, has spent the last several weeks distancing himself from the concept. If, for example, the U.S. currency tumbled in world financial markets, the Fed would be torn between a policy of tight money to stem the dollar's fall and loose money to keep the domestic economy out of severe recession. Mainly, it would be imploring central bankers to keep lending. Targeting price stability, a la Friedman, would be of no use.

Friedman insists that markets always correct currency misalignments. Of course there are periods when the exchange rate gets out of line, he told me. [But] the market will adjust faster than the government would. Why is this true? Because it is true by definition. Governments always screw things up.

* * *

I conducted an extensive interview with Friedman on the implications of his new study and on his views in general (see page 37; the entire transcript can be read online at Friedman, despite his praise for the Greenspan Fed (and stunning understatement of what it did), is unrepentant in his views of government and the economy. He is a man of great charm and accomplishment, in remarkably full control of his scholarly faculties. He still displays the intellectual trademarks that have characterized his career: prodigious research, inventive use of evidence, and a redefinition of terms when unfolding facts fail to match his hypotheses.

While he has good reason to be satisfied that American politics has taken the turn away from activist government that Friedman has long commended, events have not been kind to his most cherished theories. For instance, Friedman and fellow monetarists have urged a strict monetary rule. The Fed and other central banks should avoid the temptation to intervene proactively in the economy to even out its peaks and valleys in service of steady growth and full employment, and should instead keep their eyes on the lodestar of stable prices. Friedman insists that this is what central banks since the 1980s have in fact done. But what good is zero inflation when the economy is sinking into deflation, as the Japanese economy was in the late 1980s and early 1990s, and the U.S. economy nearly was after the dot-com bust?

Another favorite Friedman idea was a natural rate of unemployment -- the rate of joblessness that would keep prices roughly stable, supposedly around 6 percent. If governments or central bankers tried to reduce unemployment below this ostensibly natural rate, inflation would result, because workers in tight labor markets could bargain for wage increases in excess of their actual productivity.

However, the rate of unemployment that is consistent with stable prices turns out not to be a constant or knowable number, hence not a reliable target for monetary policy. As James K. Galbraith has demonstrated in these pages and elsewhere, the supposedly natural rate of unemployment moves around, as rates of productivity growth change, and as institutional factors, such as price competition and the strength of unions, shift. There is no reliable correlation between unemployment and inflation. Since the early 1990s, a lower and lower unemployment rate has been consistent with stable prices, because of increased productivity and competition.

Greenspan, against the advice of many of his colleagues, became a convert to this viewpoint. During the boom of the late 1990s, the Greenspan Fed allowed unemployment to fall to 4 percent, well below the level that would supposedly trigger inflation. For critics like Galbraith, this history is a good reason to junk the entire natural rate theory. But Friedman insisted in our conversation that the theory still holds. The natural rate does move, he acknowledged: It just means whatever rate of unemployment is generated by the labor market with its friction, without producing inflation. But with that concession, the theory is just a tautology.

For Friedman, whatever government does makes things worse, by definition. Our conversation ranged across a wide variety of subjects where some role for government is seemingly necessary, from health care to schools to regulation of securities markets and the environment. When free markets do not provide a good or service that society needs at prices people can afford to pay, economists call that a positive externality. The whole concept makes Friedman uncomfortable. When pressed, he concedes that government ought to provide catastrophic health insurance for people who can't afford to buy it, but as a humanitarian act of charity and not as an act of economic efficiency. He blames the rising cost of health care not on the advances of medical technology but on government.

Friedman makes similar arguments about schooling. In his ideal world, government would cease providing, or even financing, schools entirely. My ideal school system, he told me, would be one in which parents are responsible for supporting [the education of] their children, as they are responsible for feeding and clothing them. He added, If government has any role at all, it is solely on a humanitarian basis, for those cases of indigent families who simply cannot afford to school their child. Friedman contends, in an inventive use of statistics, that in Britain, in the 1870s and 1880s, before there was compulsory education, something like 90 percent of the kids were going to school and that educational performance did not go up after government got involved. In fact, in Britain, compulsory schooling beyond age 10 was not even a national requirement until 1880, and the vast majority of teenagers did not attend secondary school.

A signature Friedman debating technique is to disclaim knowledge when conversation moves into an area where the facts are at odds with his theories. For example, self-regulation obviously failed investors in the multiple insider-trading, self-dealing, and stock promotion scandals of the late 1990s that in turn led to the stock-market bubble. Insiders ripped off investors by cooking corporate books, misallocating trillions of dollars of investment capital. The misrepresentations went on for a decade. But as Friedman sees things, it was the market that ultimately brought down Enron and the rest, not Eliot Spitzer or the sec. And what of the industry lobbying that led the Republican Congress, as part of the Contract with America, to weaken the laws that allowed defrauded investors to sue and virtually invited abuses? I don't know what those amendments were. You've got me out of my depth, he said modestly.

So, in the end, is Milton Friedman pleased that the Federal Reserve, in the more than 75 years since the 1929 cataclysm, has learned how to prevent a stock market crash from turning into a general depression? Doesn't this suggest that at least some government agencies are capable of institutional learning, and that interventionist government is often necessary to save the market from itself? Friedman is unmoved.

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