Thanks to Milton Friedman’s brilliance, charisma, and diplomacy he became an ardent spokesman for many free-market reforms in this country. And now Ivan Pongracic, Jr. (“The Great Depression According to Milton Friedman,” September 2007) gives him credit for accomplishing what seems miraculous—convincing Fed officials that the Fed itself was responsible for precipitating the crash and the 1929–1933 monetary contractions that followed. But the contractions were only the spark that brought the boom to an end. Contrary to both Keynes and Friedman, the seeds of the depression were sown in the preceding boom. In fact, the seeds were inherent in the very principles on which the Fed was founded.

The Fed was established in 1913 in the hope of avoiding the banking crises that had periodically occurred because of a shortage of funds. The Fed was to create a “flexible” money supply to satisfy the “needs of business” and to serve as the lender of last resort to banks in crisis. Thus its very purpose was inflationary. It fostered “easy money” by making loans available at relatively low interest rates. The new “easy money” lured businessmen to undertake enterprises they would not have considered profitable at market interest rates. Thus business boomed. The stock market flourished. If there had been no boom, there would have been no monetary contraction. Thus the Fed’s responsibility for the depression extends to the preceding boom.

Ludwig von Mises laid the groundwork for this Austrian theory of the business cycle in his first book, The Theory of Money and Credit, in 1912. He showed that because under inflation prices would rise sharply without apparent end (threatening runaway inflation), a crisis is inevitable.

As far as I know, Friedman gave no indication that he realized that the choice between runaway inflation and depression was inherent in the very principle on which the Fed was based. But then he was an inflationist; he believed that only by constantly and steadily increasing the money supply, to keep abreast of increases in production and population size, can an economy prosper.

—Bettina Bien Greaves

by e-mail

Ivan Pongracic, Jr., replies:

Thanks to Mrs. Greaves for these interesting and important points regarding the long-running Monetarist-versus-Austrian debate over the business-cycle theory. This topic was outside the confines of my piece, but it certainly bears closer attention.

The cause of the speculative bubble that led to the stock market crash is an unresolved and somewhat controversial topic. Whereas Milton Friedman and Anna Schwartz accepted that the bubble was caused by investors, seemingly endorsing—at least partly—the Keynesian “animal spirits” explanation, Austrian economists have argued otherwise, beginning with Ludwig von Mises, F. A. Hayek, and Lionel Robbins in the 1930s.

Following in the Austrian tradition, Murray Rothbard in his 1963 book America’s Great Depression collected his own monetary data showing that the Fed engaged in a highly expansionary policy in the 1920s, contradicting Friedman and Schwartz, who claim that the Fed engaged in a basically stable monetary policy during that period.

In the Austrian account, the Fed’s expansionary policy created an unsustainable boom, with the over-expansion of credit distorting interest rates and making it impossible for investors to correctly judge the validity of different business projects, thus leading to the mistakes that manifested themselves in the stock-market crash of 1929.  (Note that the Austrian explanation was not at odds with the rest of Friedman and Schwartz’s story—in fact they are quite complementary. The Austrians argue that poor Fed policy led to the bust of 1929, while Friedman and Schwartz explain how the Fed went on to magnify that bust many times over.) Friedman and Schwartz relied on conventional measures of the money supply to come to the conclusion that the pre-crash period was not inflationary, whereas Rothbard used an unconventionally broad measure to come to the opposite conclusion.

This issue has not been conclusively settled one way or another. The Freeman in fact ran an exchange several years ago between Richard Timberlake and Joe Salerno arguing over this very point, with Timberlake arguing pro-Friedman and Salerno arguing pro-Rothbard (April, May, June, and October 1999 and September 2000, all online at www.fee.org). See also Richard Ebeling’s “From the President” column in the December 2006 Freeman, where he claims that Friedman’s failure to fully grasp the causes of the crash were due to his “aggregate” analysis, which prevented him from seeing the distortions created by the Fed on the microeconomic level. More work is necessary on this debate, though I remain sympathetic to the Austrian argument.

I will take issue with Mrs. Greaves’s letter over one point:  I think it is highly uncharitable—and ultimately inaccurate—to refer to Friedman as an “inflationist.” For most of his life he believed that the benefits of a commodity money (which he recognized as providing a greater check on inflation than fiat money) were outweighed by its costs (digging the metal out of the ground as well as removing it from industrial and ornamental use).  He proposed his constant money-growth rule exactly to check the Fed’s inflationary power, which came with control over fiat money.  But he eventually realized that that power is highly unlikely to be checked by such a rule and therefore changed his mind on this issue.  Friedman was an honest intellectual, willing to admit when he was wrong. We do him—and ourselves—a disservice when we apply labels to him that question his dedication to liberty.