A while back some commenters asked me to respond to this claim by Brad DeLong:

Back then, the Friedmans made three powerful factual claims about how the world works – claims that seemed true or maybe true or at least arguably true at the time, but that now seem to be pretty clearly false. Their case for small-government libertarianism rested largely on those claims, and has now largely crumbled, because the world, it turned out, disagreed with them about how it works.

The first claim was that macroeconomic distress is caused by the government, not by the unstable private market, or, rather, that the form of macroeconomic regulation required to produce economic stability is straightforward and easily achieved.

The Friedmans almost always made the claim in its first form: they said that the government had “caused” the Great Depression. But when you dug into their argument, it turned out that what they really meant was the second: whenever private-market instability threatened to cause a depression, the government could avert it or produce a rapid recovery simply by purchasing enough bonds for cash to flood the economy with liquidity.

In other words, the strategic government intervention needed to ensure macroeconomic stability was not only straightforward, but also minimal: the authorities need only manage a steady rate of money-supply growth. The aggressive and comprehensive intervention that Keynesians claimed was needed to manage aggregate demand, and that Minskyites claimed was needed to manage financial risk, was entirely unwarranted.

DeLong makes a plausible case for all three of his assertions.  However in the end I still believe it’s reasonable to blame the government for both the Great Depression and our more recent Little Depression.  To keep the post from being overly long, I’ll skip over policies that delayed recovery, such as the NIRA, and focus on the Great Contraction.

There are an almost infinite number of ways of looking at Fed policy, i.e. what the Fed is “really doing.”  This leads to lots of fruitless debates over errors of omission and commission.  In 1913 the Fed was set up with the goal of preventing bank panics and providing an elastic currency.  They clearly failed at this task in the early 1930s.  The real question is whether the sort of failure that occurred provides ammunition for the libertarian worldview.  If the Fed would have needed to be much more active than it actually was, that would seem to undercut Milton Friedman’s laissez-faire ideology.

Let’s see how many ways we can blame the Fed:

1.  The US was part of an international gold standard regime.  Between October 1929 and October 1930 the world’s central banks sharply raised the world gold reserve ratio.  The Fed was responsible for nearly 1/2 of that increase.  A higher gold ratio is an activist policy (which violates the “rules of the game”), and is highly contractionary.   After October 1930 the Fed lowered their gold ratio, but other central banks (in the gold bloc) kept raising them.  By this metric the world’s central banks played a huge role in the Great Contraction, but the Fed’s role was mostly limited to the first year.

2.  The Fed reduced the monetary base by about 7% between October 1929 and October 1930.  That contributed to the initial slump.  But after October 1930 the base rose sharply, as the Fed partly (but not fully) accommodated increased currency and reserve demand associated with the banking panics.  The decision to not fully accommodate the increased demand for base money is often viewed as an error of omission, and seems to be the major reason why people like DeLong and Krugman argue that Friedman was being disingenuous in arguing the Fed “caused” the Great Depression.  Indeed Krugman has doubts as to whether any base increase would have been sufficient.

3.  I seem to recall that Friedman also blamed the Fed for mishandling the failure of the Bank of the United States in December 1930.  He argued that support systems available in the pre-Fed era might have prevented the banking panic from spreading.  Thus the government took the function of banking stabilization away from the private sector and gave it to the Fed.  The Fed botched its job, and that fact supports the libertarian worldview.  On the other hand there were plenty of banking crises before 1913, so libertarians can’t really argue that the banking panics would not have occurred if the Fed hadn’t been created.

4.  I think the strongest argument against the government is based on the instability of policy.  Austrians point out that the Fed propped up the economy in the 1920s, with an activist monetary policy under the leadership of Governor Strong.  In fact, monetary policy wasn’t particularly expansionary during the 1920s, using any reasonable metric.  But they are right that Strong “fine-tuned” the economy.  He argued that the Fed should try to smooth out fluctuations in output in prices—in other words he was a proto-market monetarist.  The private sector made all sorts of decisions based on the expectation that Strong’s approach would continue on into the 1930s.  But fine-tuning was abandoned in 1929, as the Fed shifted its focus to the stock market bubble.  This sudden policy switch triggered the Great Contraction.

In the end, we don’t really know what a laissez-faire monetary regime would look like in a modern economy, so it’s fruitless to debate that counter-factual.  The Fed has been given the duty of managing monetary policy, and the question we should be examining is how much of the instability in RGDP is due to flawed Fed policy.  In my view the answer is “most of it.”  The overwhelming majority of the business cycle is due to demand shocks, fluctuations in NGDP.  (I’d guess that DeLong and Krugman would agree with me there.)  I’d also argue that the Fed can and should eliminate most of that NGDP instability.  It’s failure to do so makes it mostly responsible for the Great Depression and the Little Depression.  But this view doesn’t necessarily provide aid and comfort to libertarians, as it’s quite possible that the business cycle can only be smoothed by putting the best and the brightest into a government-run institution, and then instructing them to steer the nominal economy.  That sounds pretty interventionist.

Because I’m a pragmatic libertarian I don’t worry about these sorts of distinctions.  In my view the ideal government would be small relative to existing real world governments, but large relative to the laissez-faire ideal visualized by the more dogmatic libertarians.  By ‘dogmatic’ I mean those who believe libertarianism provides answers to questions.  People who believe you start any analysis with the presumption that the libertarian position is right, and then look for arguments to buttress your case.

In contrast, I believe economic analysis provides answers, and it just so happens that many of those answers line up with the small government agenda.  For instance I favor having the Fed stabilize the price of NGDP futures because it would make NGDP more stable than under a discretionary regime.  It would also take the Fed out of the business of determining interest rates and/or the money supply, but that’s an implication of the policy, not an argument for the policy.

Prior to Friedman and Schwartz the conventional view was that you needed big government to prevent a repeat of the Great Depression.  Friedman convinced the profession that small government plus an effective Fed could do the job.  That opened the door to the neoliberal policy revolution, which began in the late 1970s.  A little bit of ground has been lost in the current recession, but Friedman’s basic argument still stands.

I stole the title of this post from a PowerPoint slide that Lars Christensen sent me.  Perhaps there’s a bit of hyperbole there, but it reminded me of my research on the Great Depression.  During 1931 all the Very Serious People were obsessed with the debt crisis.  In some mysterious way they believed this was a major cause of the Depression itself.  I’m not sure why, I think it had something to do with “confidence.”  Interestingly, the debt crisis never really got resolved.  Instead it just gradually faded away as an issue, as by late 1932 it was becoming increasingly clear that intergovernmental debts were not going to be repaid.  And as the debt crisis receded, people discovered that the Great Depression was still there.

Of course you all know the rest of the story.  One by one countries discovered that the real problem was monetary, and recovery didn’t start in a country until it had abandoned the gold peg and started boosting NGDP rapidly.

Some argue that the ECB cannot inflate, that it must keep targeting inflation at 2%, or else lose credibility.  But they aren’t even doing a very good job in targeting inflation.  You’d think that a central bank would be interested in the overall rate of inflation, not just those goods in the CPI.  After all, no matter how dumb central bankers may seem, they certainly don’t believe that low and stable inflation is good because it holds down the cost of living to consumers.  They actually do know about the circular flow of income/expenditure.  The standard view among economists is that low and stable inflation reduces menu costs and helps stabilize output.  Of course in both cases you’d do better with a price index that covered all goods, not just those in the CPI.   And as Lars showed in this new post, they aren’t even coming close to hitting their 2% target for inflation, if we define inflation to include all goods.  Indeed since September 2008 they aren’t even hitting a 1% inflation target.

Some might argue that the ECB is targeting a different index, and that they must stick with this failed policy in order to avoid losing credibility.  It reminds me of how in the Vietnam War the US military would sometimes claim that they had to destroy a village in order to save it.  The ECB will destroy much of the eurozone economy in order to save it.  And in the end they’ll lose anyway, as politics always gets the last word.

PS.  Just to be clear, there are debt problems in Europe.  But Wall Street isn’t falling on Greek news because of the debt issue, rather it reflects a lack of confidence in the Fed’s willingness to keep NGDP growing at a healthy rate.

The Telegraph has a couple great pieces today.  Here’s Roger Bootle:

The big danger for the rest of the eurozone is not that Greece makes a complete horlicks of monetary independence but rather that it makes a comparative success of it. For this to happen, life in the proximity of Syntagma Square does not have to become a cakewalk; it just needs to be better than the current situation of economic collapse without prospect of relief.

Suppose that within a year or so of exit, it looks as though the Greek economy is starting to recover. How then would the governments of Portugal, Spain, Ireland and Italy persuade their electorates that there is no alternative to austerity stretching out until the crack of doom? The game would be up.

What’s more, the markets would know it. Bank deposits would flee from these countries and end up with German banks which, through the Bundesbank, would recycle them to beleaguered banks in the periphery. In the process, Germany and the other northern countries could end up taking on the risk of the whole banking system of peripheral Europe.

I reckon that well before that stage, either the ECB or the Germans would say “enough”. At that point, staring a banking collapse in the face, the peripheral countries would have no choice but to fund their banks by issuing their own money – i.e. leaving the eurozone.

“Why are you so gloomy about the eurozone; can’t you be more bullish?” people often ask me. They don’t understand. What I have sketched out is the bullish scenario! The bearish scenario is that the current system staggers on, with the peripheral countries locked into depression and deflation for decades to come. I am sufficiently bullish to believe that, somehow, this is not going to happen.

Wall Street investors must have read the latest from Ambrose Evans-Pritchard, who is a sort of poet of demand shocks:

“China is in deflation,” says Charles Dumas from Lombard Street Research. Yes, consumer price inflation is 3.4pc – though falling – but consumption is a third of GDP. Fixed investment is 46pc, and here prices have dropped 3.5pc in six months. Export prices have dropped 6.6pc.

The authorities have belatedly responded, cutting the reserve ratio by 50 points to 20pc over the weekend. It is thin gruel. Are we to conclude that the People’s Bank is bent on breaking excess capacity in a cathartic Schumpeterian purge, or that leadership battles have paralysed the Party? Hard to tell.

All the BRICs need watching. India’s industrial output fell 3.5pc in March. The country seems caught in a 1970s stagflation vice. Brazil has softened too, with car sales down 15pc and industrial production contracting in March. The bad loans of the banks have reached 10.3pc, higher than post-Lehman.

The bubble has probably popped already, but hoteliers in Rio are hanging on. The European Parliament has pulled out of the UN’s Rio forum on sustainable development in June because the rooms are exorbitant. “We are short the vastly over-vaunted and over-owned BRICs,” says hedge fund contrarian Hugh Hendry.

My fear has always been that the credit cycle in the Rising World would blow itself out before the Old World has safely recovered, or reached “escape velocity” to use the term in vogue.

Europe will slide further into 1930s self-destruction until it equips itself with a lender of last resort and takes all risk of EMU sovereign default off the table, though that may come too late. The US has functioning institutions at least but growth is barely above stall speed. Ben Bernanke’s “massive fiscal cliff” looms this autumn. The Economic Cycle Research Institute (ECRI) has not yet withdrawn its US recession call.

The BRICS helped save us in 2008-2009. If we now face a global crisis on all fronts – and such an outcome can still be avoided – it will test the mettle of world leaders. Interest rates in the G10 are mostly zero already, and budgets are frighteningly stretched.

Sensing what is coming, Citigroup’s chief economist Willem Buiter says global central banks have not yet exhausted their arsenal. They can “and should” crank up quantitative easing (QE), buy everything under the sun, and do “helicopter money drops”.

I would go even further. Sovereign central banks have the means to defeat any depression thrown at them by launching mass purchases of assets outside the banking system, working through the classic Hawtrey-Cassel quantity of money mechanism until nominal GDP is restored to its trend line.

The problem is not scientific. A world slump is preventable if leaders act with enough panache. The hindrance is that the Euro Tower still haunted by Hayekians, and most G10 citizens – and Telegraph readers from my painful experience – view such notions as Weimar debauchery, or plain Devil worship. Economists cannot command a democratic consent for monetary stimulus any more easily today than in 1932.

One can only pray that helicopter drops do not become necessary in the chilly winter of 2012-2013.

It’s surreal how much this is like 1931.  The only difference is that they couldn’t print gold and we can print dollars, yen, and euros.  That makes this error even more unforgivable.

HT:  Lars Christensen and Anthony J. Evans.

The relentless march of market monetarism toward world domination continues:

The Bundesbank and political leaders in Berlin, amid mounting anti-German sentiment in the eurozone, conceded what was once unthinkable, allowing Europe’s biggest economy to risk inflation in order to pull the rest of the contracting continent back from the brink.

I guess when all the other alternatives (fiscal union, eurozone breakup, etc) are completely unthinkable, then the “highly undesirable” starts to look pretty good.  Trichet bragged upon leaving office that the ECB’s “stellar counter-inflation record” was “far better than that achieved by the Bundesbank.”  Perhaps the leaders of the Bundesbank have realized that going back to the levels of inflation that they tolerated in the 1990s is not quite as bad as “eurogeddon.”

I suppose Kantoos would know how to spell market monetarism in German.  He has a new post pointing out that the “inflation rate” being targeted by the ECB is just as much of a statistical absurdity as our CPI, indeed even more so.  Read it and weep—the world economy’s fate is being determined by fools.

PS.  For the first year or two of the Great Depression, Austrian economics was quite popular—Hayek was a rival to Keynes.  After all, it looked like a morality tale where speculative excesses in the late 1920s had led to the inevitable hangover in the 1930s.  But as the Depression worsened people lost interest in both austerity and Austrian economics, and looked for pragmatic solutions to the suffering of millions of unemployed workers.  One of those solutions was monetary stimulus.  It looks like the austerity backlash is arriving right on schedule.  It doesn’t take a rocket scientist to understand that one doesn’t solve debt problems by pushing 25% of the workforce into ranks of the jobless.

Here’s Ben Bernanke in 1999:

The important question, of course, is whether a determined Bank of Japan would be able to depreciate the yen. I am not aware of any previous historical episode, including the periods of very low interest rates of the 1930s, in which a central bank has been unable to devalue its currency. Be that as it may, there are those who claim that the BOJ is impotent to affect the exchange rate, arguing along the following lines: Since (it is claimed) domestic monetary expansion has been made impossible by the liquidity trap, BOJ intervention in foreign exchange markets would amount, for all practical purposes, to a sterilized intervention. Empirical studies have often found that sterilized interventions cannot create sustained appreciations or depreciations. Therefore the BOJ cannot affect the value of the yen, except perhaps modestly and temporarily.

To rebut this view, one can apply a reductio ad absurdum argument, based on my earlier observation that money issuance must affect prices, else printing money will create infinite purchasing power. Suppose the Bank of Japan prints yen and uses them to acquire foreign assets. If the yen did not depreciate as a result, and if there were no reciprocal demand for Japanese goods or assets (which would drive up domestic prices), what in principle would prevent the BOJ from acquiring infinite quantities of foreign assets, leaving foreigners nothing to hold but idle yen balances? Obviously this will not happen in equilibrium.

Liquidity trap?  Don’t make me laugh.

And here’s Bernanke today:

“If no action were to be taken by the fiscal authorities, the size of the fiscal cliff is” so large that there’s “absolutely no chance that the Federal Reserve would have any ability whatsoever to offset that effect on the economy,” Bernanke said.

Theories?

1.  Brainwashed by the FedBorg?

2.  He’s actually saying; “Of course if I were monetary dictator I could keep core inflation at 2%, but there’s no way in hell my colleagues at the Fed will let me do what it takes.”  Thus a white lie.

3.  He’s actually saying “We’d rather you guys take the heat for stimulus, but we’ll do it if we have to.”

4.  A bit of all of the above.

And what are the odds that someone in the Congress would ask him the obvious question?  After all, isn’t the Congress full of Republicans who think Bernanke’s pursuing an inflationary policy?  Do they become born-again post-Keynesians the minute Bernanke walks into the room?  Does the GOP now believe in liquidity traps?  Or is this sort of exercise as silly as trying to decipher what an orangutan is “really thinking” when playing with an iPad?

HT:  Daniel

PS. I have a post at the New York Times!