Tuesday, August 17, 2010

From Keynes to Friedman, and Back Again!

As many undergraduates are prone to do, I took the words of one of my economics professors without any grain of salt whatsoever, and felt comfortable with the assumption that Milton Friedman was an idiot. However, if you really pushed me at the time, I probably couldn't have told you what it was exactly that made him this way. And, as you might have guessed, in time I noticed that this did not exactly mesh so well with my goal of examining primary sources in economic theory. This discomfort prompted me to purchase The Great Contraction (at an outrages price I might add). This "book" is actually a section from Friedman and Schwartz's Monetary History of the United States. I'm sure I'll get to it all in due time, but for now, I've only read the most famous chunk. Part of me thinks it is
inappropriate to discuss this work before I've covered The General Theory by John Maynard Keynes. But, "The Great Contraction" is a simpler work, and a kind of commentary within Keynesian theory. This is why, before I touch on the major points of the work, I'd like to skip a bit through time and tell you how I felt after reading both Keynes and Friedman.

I began to read "The Great Contraction" with a determination to throw away all my presuppositions about Milton Friedman. When I finished it, my mind had been changed. He is a talented historian, a relatively thorough economic theorist, and he makes convincing arguments. However, after reading Keynes, I found his work to possess a degree of genius far superior to Friedman. And, in fact, Friedman's contributions are largely indebted to the superior intellect of Keynes. Thus, my esteem for both economists increased absolutely, but I still feel that Keynes comes out on top.

As for "The Great Contraction"

1. The argument that Friedman and Schwartz make is that the severity of the Great Depression (1929-1933) can to a great extent be explained by FED policy that allowed the Money Supply to collapse. This happened both by allowing banks to fail, and using discount rate in conjunction with open market operations in contractionary ways. This froze credit markets and destroyed the already weak incentive to invest, and might have been the catalyst for turning the recession into a depression.

2. They make this argument by referring to several historical "episodes". Their goal is to use these episodes to extract a causal relationship between FED policy, the money supply, and the overall direction of the economy. The episodes are:

*The Stock Market Crash (October 1929): This event is known to most. The crash, and the great economic uncertainty that arose thereafter, gave individuals the incentive to hold cash. Thus, not only was a great deal of wealth wiped out by the crash, but the desire to hold cash meant less money for banks to lend out. Thus, the money supply contracted. The recession begins.

*First Banking Panic (October 1930): Runs on banks, prompted by fears about their solvency, actually cause major banks to fail. The FED largely chooses a policy of inaction, thinking it is proper to punish bad banks. The Money Supply shrinks further. The recession deepens.

*Second Banking Panic (March 1931): Continued uncertainty about the soundness of banks sparks a more violent run. Banks try to dump assets on the market to satisfy their depositors, these assets promptly plummet in value. More banks fail, and the Money supply shrinks further. The recession deepens.

*Britain Leaves the Gold Standard (September 1931): The UK severs its ties to Gold, because it feels it can no longer follow the deflationary spiral that seems to be in place. Fears that the US will follow prompt speculators to attack the dollar. The FED raises the discount rate (a contractionary measure) to restore confidence in the Gold Standard. The depression deepens.

*FED begins Expansionary Policy (April 1932): After years of inaction or contractionary policy, a faction in the FED raises enough support to experiment with expansionary Open Market Operations. The Money Supply expands. The depression eases!

*FED Expansionary Policy Terminated. Third Banking Panic Ensues. Glass-Steagall is Passed. Banking Holiday is Declared (1933): Factions against Expansionary policy regain control and terminate Open Market Operations. Another Banking Panic arises, and President Roosevelt responds by declaring a Banking Holiday. Glass-Steagall expands the powers of the FED. Money Supply shrinks. The depression returns.

3. Apart from this historical evidence, Friedman and Schwartz attempt to explain the seemingly odd behavior of the FED during this time. They assert that, following the death of a man named Benjamin Strong (a powerful influence in the FED), the collection of central banks lost their center of leadership and essentially suffered from gridlock. Friedman, a staunch Libertarian, might be expected to approve of this--but he doesn't!. This is because the FED was designed specifically for the purpose of keeping an eye on the economy through the money supply. Banks that suffered from a run counted on their help--and they did not get it.

4. True to his Libertarian roots, though, Friedman does point out that the banking system prior to the FED had a policy of acting together to restrict the ability of depositors to take out their funds. Thus, they had an internal mechanism for halting runs on banks. The FED dismantled this tool, and then essentially left them bleeding on the field when the next panic hit.

5. Friedman and Schwartz make the case for the preventative measures that should have been taken. Namely, that the FED should have taken action to maintain the money supply. The reasons for doing so can best be expressed by Friedman and Schwartz:

"Because no great strength would be required to hold back the rock that starts a landslide, it does not follow that the landslide will not be of major proportions."
--Friedman and Schwartz (pg 207).

Too Long To Read Summary: I assumed Milton Friedman was an idiot, and I was wrong. Still, I find Keynes to be the better economist. Friedman and Schwartz make a convincing argument that, in allowing the money supply to contract too far (and thus depressing credit and investment), the FED worsened the Great Depression. This happened due to a failure of leadership in a centralized organization that was designed to lead. The FED should either do this job, or return their powers to the banks. And, finally, just because something is easily preventable, doesn't mean it isn't serous.


  1. You're reading it all wrong. Monetarists' best arguments are in 1933 (exiting gold standard causes recovery), 1937 (monetary tightening via doubling reserve requirements causes double dip), and international comparisons (countries that quit gold standard earlier invariably recover a lot faster).

    Focusing only on States 1929-1932 really misses the point.

  2. I think you have misunderstood the intention of my post. My point was to offer my interpretation of Friedman and Schwartz's "The Great Contraction". In this work, the authors say little about the US Gold Policy in 1933, and it does not cover 1937. While I am inclined to agree with your points, I think it is important that you recognize that I am commenting on Friedman's case for Monetarism, and not making my own case. That will have to wait!