Cowen on Friedman and the Depression

Money/macro is the area where I am the least in agreement with Tyler Cowen. However I strongly agree with this excellent post on monetarism and the Great Depression.  Let me try to quickly summarize the findings of my research on the Great Depression, as contained in my forthcoming book (don’t ask).

1.  Would monetarism (M2 targeting) have prevented the Depression, if the US had continued to adhere to the gold standard and had been willing to use some “emergency” gold reserves to do so?

I’d say there is a good chance it might have, but there’s also a decent chance it would not have.  Even Friedman admitted (much later) that he and Anna Schwartz should have focused more on the constraints of the international gold standard.

2.  Would full blown monetarism circa 1963 have prevented the Great Depression? I.e. a policy of M2 targeting combined with a floating exchange rate.

Very, very likely.  Or at least greatly moderated the Depression.  And this is the counterfactual to consider when evaluating the usefulness of Friedman’s 1960s monetarism for modern policymaking, where there is no gold constraint.

3.  Would the policy favored by Friedman later in his life (inflation targeting) have prevented the Great Depression?

Almost certainly.  Prices started rising immediately after FDR devalued the dollar. And by immediately I don’t me “that year,” I mean THAT DAY. Of course the collapse of 1929-33 was a deflationary demand shock.



17 Responses to “Cowen on Friedman and the Depression”

  1. Gravatar of Bill Woolsey Bill Woolsey
    11. August 2013 at 08:33

    Cowen’s focus appears to be “bailing out the banks.” Friedman argued that the Fed should have served as lender of last resort. This would have prevented the failure of large number of banks. (Or that seems to be Cowen’s view.)

  2. Gravatar of ssumner ssumner
    11. August 2013 at 09:05

    Bill, That’s a tough question. If the Fed was more expansionary in 1930 then fewer banks would have failed, but more for “macro” reasons than “bailout” reasons.

  3. Gravatar of Edward Edward
    11. August 2013 at 10:39

    Hi Scott,

    here’s a link to a post where Krugman actually mentions us market monetarists!

  4. Gravatar of TallDave TallDave
    11. August 2013 at 12:29

    p6 from the essay: A fourth effect, when and if it becomes operative, will go even farther, and definitely mean that a higher rate of monetary expansion will correspond to a higher, not lower, level of interest rates than would otherwise have prevailed. Let the higher rate of monetary growth produce rising prices, and let the public come to expect that prices will continue to rise. Borrowers will then be willing to pay and lenders will then demand higher interest rates-as Irving Fisher pointed out decades ago. This price expectation effect is slow to develop and also slow to disappear. Fisher estimated that it took several decades for a full adjustment and more recent work is consistent with his estimates.

  5. Gravatar of TallDave TallDave
    11. August 2013 at 12:33

    p7 Paradoxically, the monetary authority could assure low nominal rates of interest-but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy.

  6. Gravatar of Mark A. Sadowski Mark A. Sadowski
    11. August 2013 at 12:33

    The Cowen post was originally written in response to the Krugman “The Pigou Effect” post.

    “But what I did was a little different from what the MMs have done this time around: I set out to prove my instincts right with a little model, a minimal thing that included actual intertemporal decisions instead of using the quasi-static IS-LM framework. [If you have no idea what I’m talking about, you have only yourself to blame — I warned you in the headline]. And to my considerable surprise, the model told me the opposite of my preconception: there was no Pigou effect. Consumption was tied down in the current period by the Euler equation, so if you couldn’t move the real interest rate, nothing happened.

    One way to say this “” which Waldmann sort of says “” is that even a helicopter drop of money has no effect in a world of Ricardian equivalence, since you know that the government will eventually have to tax the windfall away. Of course, you can invoke various kinds of imperfection to soften this result, but in that case it depends very much who gets the windfall and who pays the taxes, and we’re basically talking about fiscal rather than monetary policy. And it remains true that monetary expansion carried out through open-market operations does nothing at all.”

    OK, I understand that Krugman’s post came with the “Double-super-special-wonkish” warning label. I also get that Krugman has a Nobel Prize, and that Robert Waldmann is a top ranked economist (even though he is super duper flakey). But I don’t follow this argument at all, and I consider myself slightly smarter than the average bear.

    What on earth does Ricardean Equivalence have to do with helicopter drops of money?!?

    Here’s my simple take on this in IS-LM terms.

    The Investment Savings (IS) Curve is a function of income, the real long interest rate, the real exchange rate and real wealth.

    To believe that monetary policy can have no effect at all on the IS Curve (and therefore is completely impotent when the IS curve intersects the LM curve on its horizontal portion) is to believe that:

    1) Monetary policy cannot affect real long interest rates and/or real long interest rates have absolutely no effect on nonresidential investment, residential investment or durable goods

    2) Monetary policy cannot affect the real exchange rate and therefore cannot affect exports

    3) Monetary policy cannot affect income expectations and/or current real wealth and therefore cannot affect investment and consumption

    Does anyone really believe all of those things? (Really?!?)

    Furthermore I’ve noticed that Krugman is getting extra super cocky in his declarations that monetarism is dead, Friedman is irrelevant and monetary policy is totally ineffective lately. And I’ve noticed an enormous pushback from on at least the first two points from people who normally are in full agreement with him.

    In my opinion when someone repeatedly declares victory in battle with such swagger it usually means that they’ve lost the war.

  7. Gravatar of Jon Jon
    11. August 2013 at 12:44


    Friedman blamed part of the M2 contraction on the Fed’s failure to fulfill its role as lender of last resort.

    Given that the bank failures lagged the start of the depression, it is also true as you say that this was not the first failure to act.

    The first failure to act was the policy of raising the gold cover ratio in fear of a future gold drain due to panic in the banking system until 1930. This was then reinforced by doing too little to negate the effect of France’s gold demand on the price-level.

  8. Gravatar of ssumner ssumner
    11. August 2013 at 12:55

    Edward, Thanks.

    TallDave, Yes, that’s like Nick Rowe’s balancing the board in your hand analogy.

    Mark, In my new post I actually agree on the “helicopter” thing, but only if you buy into his liquidity trap model. A helicopter drop won’t work if the government announces they’ll show up with guns a few weeks later to demand all their money back.

    I agree that Krugman must be responding here to pushback that he’d gone too far in criticizing Friedman.

    Jon, The first failure was not a failure to act, it was an ACT. They reduced the base and raised the gold ratio in 1929-30, especially if you look at October to October data, which is obviously seasonally adjusted.

  9. Gravatar of Saturos Saturos
    11. August 2013 at 13:11

    For the lulz:

  10. Gravatar of Mark A. Sadowski Mark A. Sadowski
    11. August 2013 at 13:55

    Scott wrote:
    “Mark, In my new post I actually agree on the “helicopter” thing, but only if you buy into his liquidity trap model. A helicopter drop won’t work if the government announces they’ll show up with guns a few weeks later to demand all their money back.”

    I guess what I was thinking by a “helicopter drop” was an increase in the monetary base without a corresponding increase in assets held by the central bank. If a helicopter drop results in the central bank acquiring assets one for one how is that any different from a fully QE funded fiscal stimulus?

  11. Gravatar of ssumner ssumner
    11. August 2013 at 14:57

    Mark, Look at the post I link to in my post replying to Krugman. If the currency injection is temporary it won’t have much effect, regardless of whether it’s an OMO or a cash drop. If it’s temporary everything gets unwound later.

  12. Gravatar of W. Peden W. Peden
    11. August 2013 at 14:59


    You mean the INSANE Bank of France.

  13. Gravatar of Geoff Geoff
    11. August 2013 at 15:48

    Would the policy favored by Friedman later in his life (inflation targeting) have prevented the Great Depression?

    Would a policy of abolishing the central bank favored by Friedman even later in his life have prevented the 1920s boom that led to a market collapse which was followed by the Great Depression?

    There is a good argument that it would have.

  14. Gravatar of benjamin cole benjamin cole
    11. August 2013 at 16:38

    Xlnt blogging.
    Yes QE is just a tool towards NGDP targeting.
    But I think worth exploring is Beckworth’s idea of the Fed depositing money into taxpayer bank accounts, or my idea of a national lottery in which there are more winners than losers…both as mechanisms to increase the effectiveness of QE.

  15. Gravatar of ssumner ssumner
    12. August 2013 at 10:11

    Ben, I don’t like those ideas, as they are too costly in the long run. If the Fed ever decides they want to deflate, they won’t have any trouble doing so with standard policies like QE.

  16. Gravatar of chris mahoney chris mahoney
    12. August 2013 at 16:10

    The Fed did not have the statutory power to go off gold; that was a Treasury matter. Given that fact, their hands were tied and Hoover wanted them tied. FDR ignored every serious economist’s advice and began to steadily raise the price of gold, using bogus statutory powers. Then, a few years later, the leading lights in the profession convinced him that an unanchored currency was bad for “confidence”, and they induced him to arrange another big deflation, which postponed the recover for another three years. We were very lucky that the gentleman farmer from Duchess County had so much self-confidence that he could defy both his advisors and the law by choosing unilaterally to reflate. And he made this decision before Fisher published his theory.

  17. Gravatar of ssumner ssumner
    13. August 2013 at 05:07

    Chris, Close, but a couple small errors. FDR was pressured into ending the dollar floating program after only 9 months. And I believe Congress did give him statutory power, it was the abrogation of the gold clause in debt contracts that was doubtful. The Supreme Court saved him in a 5 to 4 vote. And Fisher advocated the dollar depreciation plan long before FDR became president, about 1920 I believe.

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