The Great Depression According to Milton Friedman
The Great Depression Could Have Been Avoided if the Fed Had Not So Badly Botched Its Monetary Policy
The author extends special thanks to Lawrence H. White and Ivan Pongracic, Sr., for their helpful comments.
Few events in U.S. history can rival the Great Depression for its impact. The period from 1929 to 1941 saw fundamental changes in the landscape of American politics and economics, including such monumental events as America ‘s going off the gold standard and the founding of Social Security. It was a watershed for the growth of the federal government.
The Great Depression created a widespread misconception that market economies are inherently unstable and must be managed by the government to avoid large macreconomic fluctuations, that is, business cycles. This view persists to this day despite the more than 40 years since Milton Friedman and Anna Jacobson Schwartz showed convincingly that the Federal Reserve’s monetary policies were largely to blame for the severity of the Great Depression. In 2002 Ben Bernanke (then a Federal Reserve governor, today the chairman of the Board of Governors) made this startling admission in a speech given in honor of Friedman’s 90th birthday: “I would like to say to Milton and Anna: Regarding the Great Depression, you’re right. We did it. We’re very sorry.”
Friedman, the great free-market champion of the last 50 years and one of the most influential economists of the last 200 years, died in November 2006 at 94. He left us an immense intellectual legacy, including his explanation of the Great Depression, which, while persuading a majority of the economics profession, has yet to fully trickle down to the public. It is truly a great mystery why Friedman’s explanation has not been more widely recognized and accepted, especially given its influence among economists. Maybe the reason is that it does not lend itself to quick sound bites by politicians eager to justify more power. Or maybe it is usually presented in a way that makes it too difficult for the layperson to understand. Or maybe it is just that people find it easier to blame the “capitalists” rather than the hallowed Federal Reserve. Whatever the case, it would be beneficial to revisit Friedman’s argument.
The standard explanation of the Great Depression, found in most American high-school history texts, is that it was created by the wild and irrational stock-market speculation that ultimately led to the Great Crash of October 1929. Investor speculations were so excessive—so the story goes—that once the bubble popped, it triggered the most severe decline in economic activity in U.S. history. The key point of this story is that the crash and the subsequent depression were due to factors that are innate to the capitalist system, unchecked under the supposedly laissez-faire policies of Herbert Hoover. It was only once Franklin Delano Roosevelt came into office that the government jump-started the recovery. It is thus claimed that FDR’s policies were responsible not only for the recovery, but in fact for “saving capitalism from itself” when many Americans were willing to consider adopting full-blown socialism in the 1930s as a way to deal with the downturn.
Most people do not realize how much of this explanation had been shaped by Keynesian economics, the dominant economic paradigm from the 1940s to the 1970s. Keynesian economics got its start with the publication of John Maynard Keynes’s General Theory of Employment, Interest, and Money in 1936. There Keynes proposed a view of the Great Depression that was at odds with the rest of the economics profession at the time. Most economists of the era tended to agree that market economies are “self-adjusting” and that they cannot get stuck in a recession for very long. However, this view seemed to be at odds with the ugly reality of the time: persistent unemployment rates of 20 percent and more, even as high as 25 percent in 1933—with no end in sight.
Keynes seemed to be the right man for the time as he was reflecting the increasingly common view that blamed the capitalists themselves for the situation. In the General Theory Keynes rejected the view that the boom-bust cycle was due to over-expansive government monetary policy and that the stubbornness of the Depression was due to government interference with market mechanisms. He labeled all economists who believed such views as “classical”—in other words, hopelessly out of touch with reality. Instead, Keynes proposed a “general theory” that he thought capable of explaining not only the good times but also the bad.
According to Keynes, what drives the economy is aggregate demand or aggregate expenditures. Aggregate demand can be broken down into three main components: personal consumption (C), private investment (I), and government expenditures (G). The relationship can be summed up with this formula: AD = C + I + G. If Aggregate Demand is strong, the economy will be strong. However, if Aggregate Demand falters, businesses will end up with large unsold inventories and will cut back on production to avoid surpluses in the future. As they cut back they will of course need fewer inputs—including labor—and high unemployment will result.
The culprit in this story, the element that throws the entire system out of whack, is private investment. Private investment consists of business expenditures on machines, buildings, factories, and so on. In other words, investment is capital formation. Keynes claimed that private investment is inherently unstable due to what he called the “animal spirits” of businessmen/capitalists. He believed that businessmen are ultimately irrational and prone to herd-like behavior. Like sheep that blindly follow other sheep in the herd, it is easy for businessmen to become “irrationally exuberant”—as well as irrationally lethargic. Investment lethargy would trigger a large decrease in private investment, thus decreasing aggregate expenditures and triggering an economic downturn.
From Downturn to Depression
How do we go from this downturn to a full-blown recession or even a depression? As the economy slows down, unemployment rises and leads to a loss of consumer confidence. Consumer pessimism will lead to more saving and less spending, thus decreasing the personal-consumption component of aggregate demand, exacerbating the downturn. Notice that both I and C are therefore driven by the expectations of private individuals (irrational in the case of business investors): if both investors and consumers become pessimistic and expect a recession, they will cut back on their expenditures and thus cause the aggregate demand to be too low to bring about full employment of available resources. According to Keynes, a recession is, in a nutshell, a self-fulfilling prophecy.
The Great Depression was therefore a long stubborn period of dismally low aggregate expenditures, and according to Keynes, there were no economic forces working to pull the economy out of this situation automatically. In other words, he thought there is no self-corrective mechanism (or invisible hand) in a free-market economy. Instead, irrational changes in expectations would regularly lead to wide and destructive fluctuations in the macroeconomy. So we see that the business cycle is the natural and expected consequence of the unfettered operation of a market economy. Therefore if an unfettered market economy results in depressions, it is clearly undesirable. It also should be obvious now that the standard high-school history-book explanation is basically just a simplified version of this Keynesian story.
What is required to avoid a recession, then, is for the government to insure that the aggregate expenditures are enough to achieve full employment. The government can do that through either fiscal policy (taxation and government spending) or monetary policy (control of the money supply). Keynes favored fiscal policy and recommended that the government engage in massive deficit spending. Deficit spending would allow for an increase in government spending without an offsetting increase in the tax burden on private individuals and businesses. Thus increased government spending could neutralize any decreased expenditures in the private sector, preserving employment and incomes and ultimately reversing the pessimistic expectations that led to the downturn in the first place. Keynesian “demand management” clearly prescribed an important role for the government.
Keynes’s explanation, in addition to creating a new way of analyzing the economy as a whole, heavily influenced policymakers and ordinary people around the world. It was soon accepted that the government must engage in a countercyclical policy of demand management to stabilize the market economy. Both FDR and Keynes were proclaimed the “saviors of capitalism”!
Friedman Follows the Facts
In the 1950s, Friedman and Anna Schwartz began compiling historical data on monetary variables without any particular agenda or intention of overturning the dominant explanation of the Great Depression. But it became obvious that the data were at odds with the standard Keynesian explanation. So in their 1963 book, A Monetary History of the United States, 1867–1960, they presented the empirical evidence that led them to a completely different explanation.
As a result of examining more closely the key years between 1929 and 1933, Friedman and Schwartz first concluded that the Great Depression was not the necessary and direct result of the stock-market crash of October 1929, which they attribute to a speculative investment bubble. (The popping of the “bubble” may have been instigated by the Federal Reserve’s raising of the discount rate—the interest rate the Fed charges on loans to commercial banks—in August 1929. The cause of the speculative bubble that led to the crash is a somewhat controversial topic. Whereas Friedman and Schwartz accepted that the bubble was caused by investors, seemingly endorsing—at least partly—the Keynesian “animal spirits” explanation, Austrian economists have argued otherwise.) In fact, they believed that the economy could have recovered rather rapidly if only the Fed—the central bank of the United States —had not engaged in a series of disastrous policies in the aftermath of the crash.
The Fed had only been in existence for 15 years at the time of the crash, having opened its doors in 1914. The United States had two central banks before the Fed (the Bank of United States, 1792–1812; and the Second Bank of the United States, 1816–1836), but had been without a central bank of any sort for over 75 years until the creation of the Fed. It was created primarily to act as a “lender of last resort” from which private banks could borrow money in times of crisis. The need for a lender of last resort in the U.S. banking system was due to a systemic weakness caused unintentionally by state and federal banking regulations. (Canada, with a freer banking system, had no such systemic weakness and no need for a lender of last resort.) Weak banks are subject to crisis when their depositors are no longer confident that their bank holds sufficient reserves to satisfy all withdrawal demands at a certain time. This can trigger a “bank run,” where depositors attempt to get to the bank before the other depositors in order to withdraw their money before the bank’s limited reserves run out. A run on a bank can easily generate other bank runs as depositors become worried about the financial health of their own similarly weak banks.
The problem with bank runs is that when depositors withdraw money and stuff it under their mattresses rather than trust it to other banks, the money supply shrinks. To understand this phenomenon, we have to explain how we measure the money supply. The simplest measures include not only currency but also checking deposits, since they are commonly used to make payments. What complicates things is that fractional-reserve banking leads to a multiple expansion of deposits. When someone puts money in a bank his checking account reflects the deposit, but the bank does not keep all the money on hand—it’s not a warehouse. Instead, it keeps only a fraction as “reserves” and lends the rest to a borrower, who in turn buys goods or services. The seller then deposits her new income in a bank, where she gets a checking account. The money supply increases by the amount of the new deposit. This process will continue, though in ever-decreasing amounts since banks have to keep some part of the new deposits as reserves. Yet each cycle will increase the money supply by increasing the overall amount of deposits held at banks.
This process works in reverse too. When banks lose reserves due to bank runs, the economy experiences a multiple contraction of deposits. The deposits that are removed from the economy greatly exceed the additional currency that the public now holds, so the money supply decreases.
The stock-market crash of October 1929 made it more difficult for many businesses to repay their loans to the banks, and many banks found their balance sheets impaired as a result. But the most important cause of the bank runs that began in October 1930 was bad times in the farm belt, where the banks were especially weak and poorly diversified. The number of bank runs increased exponentially in December 1930—in that single month 352 banks failed. Most of the failing banks were in the Midwest , their failures caused by farmers who defaulted on their loans because they were hit hard by the economic downturn. No sooner did the first wave of bank runs subside than another got underway in the spring of 1931, creating what Friedman and Schwartz described as a “contagion of fear” among bank depositors. Bank crises continued to come in waves until the spring of 1933.
Roosevelt Comes In
FDR was inaugurated on March 4, 1933, and two days later he declared a “bank holiday,” allowing banks legally to refuse withdrawals by depositors; it lasted ten days. With his famous phrase, “The only thing we have to fear is fear itself,” he intended to dissuade depositors from running on their banks, but by then it was far too late. In 1929 there were a total of 25,000 banks in the United States. As the bank holiday ended, only 12,000 banks were operating (though another 3,000 were to reopen eventually). The effect on the money supply was equally dramatic. From 1929 to 1933 it fell by 27 percent—for every $3 in circulation in 1929 (whether in currency or deposits), only $2 was left in 1933. Such a drastic fall in the money supply inevitably led to a massive decrease in aggregate demand. People’s savings were wiped out so their natural response was to save more to compensate, leading to plummeting consumption spending. Naturally, total economic output also fell dramatically: GDP was 29 percent lower in 1933 than in 1929. And the unemployment rate hit its historic high of 25 percent in 1933.
Friedman and Schwartz argued that all this was due to the Fed’s failure to carry out its assigned role as the lender of last resort. Rather than providing liquidity through loans, the Fed just watched as banks dropped like flies, seemingly oblivious to the effect this would have on the money supply. The Fed could have offset the decrease created by bank failures by engaging in bond purchases, but it did not. As Milton and Rose Friedman wrote in Free to Choose:
The [Federal Reserve] System could have provided a far better solution by engaging in large-scale open market purchases of government bonds. That would have provided banks with additional cash to meet the demands of their depositors. That would have ended—or at least sharply reduced—the stream of bank failures and have prevented the public’s attempted conversion of deposits into currency from reducing the quantity of money. Unfortunately, the Fed’s actions were hesitant and small. In the main, it stood idly by and let the crisis take its course—a pattern of behavior that was to be repeated again and again during the next two years.
According to Friedman and Schwartz, this was a complete abdication of the Fed’s core responsibilities—responsibilities it had taken away from the commercial bank clearinghouses that had acted to mitigate panics before 1914—and was the primary cause of the Great Depression.
The obvious question is: Why didn’t the Fed act? We don’t know for sure, but Friedman and Schwartz proposed several possible explanations: 1) the Fed officials did not fully understand the disastrous consequences of letting so many banks go under. Friedman and Schwartz wrote that Fed officials may have “tended to regard bank failures as regrettable consequences of bank management or bad banking practices, or as inevitable reactions to prior speculative excesses, or as a consequence but hardly a cause of the financial and economic collapse in process”; 2) Fed officials may have been acting out of their own self-interest since many of them were affiliated with large Northeastern banks. Bank failures, at least in the early stages, “were concentrated among smaller banks and since the most influential figures in the system were big-city bankers who deplored the existence of smaller banks, their disappearance may have been viewed with complacency”; 3) The inactivity may have been caused by political infighting between the Federal Reserve Board in Washington, D.C., and regional Fed banks, in particular the New York district bank, which was the most important part of the system at that time. But we may never know the real reason.
Dangers of Centralized Power
There is an important lesson to be learned from this episode: When we centralize great responsibility and power in one institution, its failure will have far-reaching and terrible consequences. The Fed was instituted to act decisively in the exact circumstances that occurred in 1930–33. Friedman and Schwartz pointed out that the Fed’s failure was all the more serious and difficult to understand given how easily it could have been avoided:
At all times throughout the 1929–1933 contraction, alternative policies were available to the system by which it could have kept the stock of money from falling, and indeed could have increased it at almost any desired rate. Those policies did not involve radical innovations. They involved measures of a kind the system had taken in earlier years, of a kind explicitly contemplated by the founders of the system to meet precisely the kind of banking crisis that developed in late 1930 and persisted thereafter. They involved measures that were actually proposed and very likely would have been adopted under a slightly different bureaucratic structure or distribution of power, or even if the men in power had had somewhat different personalities.
This is the most worrisome fact. The institution failed because of the people within it. And given the immense power and influence it had over the economy, its failure was disastrous. It is important to understand that the Great Depression could have been avoided if the Fed had not so badly botched its monetary policy. In fact, Friedman and Schwartz claimed that the depression would not have been a Great Depression if there had been no Federal Reserve in the first place: “[I]f the pre-1914 banking system rather than the Federal Reserve System had been in existence in 1929, the money stock almost certainly would not have undergone a decline comparable to the one that occurred.”
That point was effectively elaborated by Milton and Rose Friedman in Free to Choose:
Had the Federal Reserve System never been established, and had a similar series of runs started, there is little doubt that the same measures would have been taken as in 1907—a restriction of payments. That would have been more drastic than what actually occurred in the final months of 1930. However, by preventing the draining of reserves from good banks, restriction would almost certainly have prevented the subsequent series of bank failures in 1931, 1932, and 1933, just as restriction in 1907 quickly ended bank failures then. . . . The panic over, confidence restored, economic recovery would very likely have begun in early 1931, just as it had in early 1908.
The existence of the Reserve System prevented the drastic therapeutic measure: directly, by reducing the concern of the stronger banks, who, mistakenly as it turned out, were confident that borrowing from the System offered them a reliable escape mechanism in case of difficulty; indirectly, by lulling the community as a whole, and the banking system in particular, into the belief that such drastic measures were no longer necessary now that the System was there to take care of such matters.
In the February 15, 2007, New York Review of Books economist and columnist Paul Krugman charged Friedman with “intellectual dishonesty” because Friedman repeatedly called for a significant reduction of the Fed’s power or even its outright abolition as a result of his work on the Great Depression. Krugman, however, concluded that the real lesson to be learned from Friedman’s explanation is that government institutions should be more active, not less. Krugman believes his conclusion to be so obvious that he is convinced that Friedman’s contrary recommendation must be driven by an ideological agenda and thus is an example of intellectual dishonesty. However, Krugman is clearly missing the point.
Friedman’s conclusion was perfectly logical given his belief that had the Fed not been created, the downturn of 1929 would not have become a major depression. Friedman claims in the paragraph above that without the Fed “the same measures would have been taken [in 1930] as in 1907—a restriction of payments,” which he believes would have prevented the crisis from spreading to “stronger banks,” those not guilty of overextending themselves through over-risky loans. Monetary economist Lawrence H. White of the University of Missouri-St. Louis filled in the blanks in Friedman’s “institutional counter-factual” on the Division of Labour blog (March 12, 2007):
Friedman understood . . . that before the Federal Reserve Act financial panics in the US were mitigated by the actions of private commercial bank clearinghouses. Friedman and Schwartz’s view of the 1930′s was that the Fed, having nationalized the roles of the clearinghouse associations [CHAs], particularly the lender-of-last-resort role, did less to mitigate the panic than the CHAs had done in earlier panics like 1907 and 1893. In that sense, the economy would have been better off if the Fed had not been created. This position is perfectly consistent with the position that, provided we take the Fed’s nationalization of the clearinghouse roles for granted, the Fed was guilty of not doing its job.
Thus the Fed’s failure in the early ’30s shows the dangers of excessive centralization of important market functions that were previously dispersed among multiple private institutions. Friedman’s bottom line remains intact: The Fed caused the Great Depression.
The Perfect Storm
In the decades following Friedman and Schwartz’s work economists started examining other government-policy failures in the aftermath of the crash. They have found an abundant supply of them. Here are several key examples of these bad policies: 1) In response to a sharp decrease in tax revenues in 1930 and 1931 (caused by a slowdown of economic activities), the federal government passed the largest peacetime tax increase in the history of the United States, which clearly applied the brakes on any recovery that could have taken place; 2) the federal government also passed the Smoot-Hawley Tariff Act in 1930, substantially increasing tariffs and leading to retaliatory restrictions by trading partners, which resulted in a considerable decrease in demand for U.S. exports and a further slowdown in production (not to mention a loss of mutually advantageous division of labor); 3) the federal government also instituted all sorts of “public works” programs, beginning under Herbert Hoover and increasing dramatically under FDR; the programs removed hundreds of thousands of people from the labor market and engaged them in economically wasteful activities, such as carving faces of dead presidents into the sides of a mountain, preventing or delaying necessary labor-market adjustments; 4) another federal policy that prevented (labor and other) market adjustments was the price and wage controls enacted under the National Recovery Administration and in effect from 1933 until 1935 (when ruled unconstitutional); this policy massively distorted relative market prices, impairing their ability to function as guides to entrepreneurs; 5) the Fed was not blameless after 1933 either. It increased bank-reserve requirements in three steps in 1936 and 1937, leading to another significant decrease in the money supply. The result was the 1937–38 recession within the Depression, adding insult to injury.
Economists have come to understand the Great Depression as a “perfect storm” of policy failures. A truly frightening number of destructive policies were carried out nearly simultaneously. In retrospect it seems as though whenever the economy began showing the slightest inkling of recovery, a policy would be enacted that would put a quick stop to it.
The better explanation of the Great Depression revealed it was not caused by unfettered market forces. There is nothing in the operation of free markets that would create depressions or even recessions. Rather, we now know that we must look for causes of these phenomena in mismanaged and erroneous government policies. And much of the credit for this change in the way economists look at the Depression must go to Friedman and Schwartz’s groundbreaking work on the Fed’s role. Friedman provided—and ultimately persuaded most economists of—this alternate explanation because of his insistence on honest intellectual inquiry, untainted by ideological biases. It was a courageous thing to do at the time of absolute Keynesian dominance of the economics profession, and it could have been damaging or even destructive to his career. But Friedman’s personal strength of character and intellectual honesty obliged him to stick to the truth, and we are all much better for it today.
Ironically, as a result of the banking crisis of 1930–33, the Fed was granted more responsibilities and more control over banking. As is often the case in politics, failure was used to justify an expansion of power. That expansion of the Fed’s power resulted in a great amount of economic destruction through the subsequent decades. In 1980 Milton and Rose Friedman wrote of the Fed’s record over the 45 years after the banking crisis of 1930–33:
Since 1935 the [Federal Reserve] System has presided over—and greatly contributed to—a major recession of 1937–38, a wartime and immediate postwar inflation, and a roller coaster economy since, with alternate rises and falls in inflation and decreases and increases in unemployment. Each inflationary peak and each temporary inflationary trough has been at a higher and higher level, and the average level of unemployment has gradually increased. The System has not made the same mistake that it made in 1929–1933—of permitting or fostering a monetary collapse—but it has made the opposite mistake, of fostering an unduly rapid growth in the quantity of money and so promoting inflation. In addition, it has continued, by swinging from one extreme to another, to produce not only booms but also recessions, some mild, some sharp.
The Fed’s performance has improved since 1980, but that does not mean it is no longer capable of mistakes that would have devastating consequences for our lives. Friedman’s work should serve as a warning of what can happen when so much power is artificially concentrated in one institution. It is for this reason that it is so vitally important that people today be taught the real story of the Great Depression. Their faith in government institutions might be considerably undermined if they understood what really happened.
Comment by Felipe on 12 March 2009:
Good article, thanks.
Comment by Hugo on 8 June 2009:
Great article, thanks for sharing. I would like to translate this in Dutch to repost it up on some ”freeman” site(s?) over here (Holland). Ofcourse you get full credits. If you have a problem with this, let me know. Ill post links to site(s?) where it has been reposted. Keep up the good work!
Pingback by What did Milton Friedman favor? | Everyone Read It! on 27 August 2009:
[...] not one of allowing a boost in currency to substitute for the broader monetary aggregates. An article in The Freeman is clear, if perhaps even a bit [...]
Comment by mark on 4 October 2009:
Those who were the quickest to grasp the truth in Friedman theory were the banking executives. When Ben Bernanke sent the signal “lesson learned,” some of the powerful investment bankers could safely embark on a risky business knowing that the Fed will not just stand by if their financial adventures happen to fail. With the exception of Lehman Brothers bankruptcy, they were correct.
The Federal Reserve System didn’t cause the Great Depression; it poured a sea of oil into the fire instead of water, but it did not toss the match, as evidenced by the banking crisis of 2008.
Comment by chevy smith on 22 October 2009:
this was very inqusative and i think you.
Comment by RJ Cornell on 30 October 2009:
Good article. The Fed did cause the depression, but Friedman missed the boat. It was Fed expansion of the money supply in the mid to late 1920′s that caused not only the speculative bubble in the stock market, but major strucural imbalances in the capital structure on the overall economy. Higher interest rates (brought about by eliminating all of the bad credit that was created by inflationary policy in the 1920′s) were necessary in order to unwind these mistakes and restrucure the economy along lines sustainable given actual savings and consumption preferences. The depression was necessary, but it could have been a lot shorter (like the depression of 1920-21) if Hoover and Roosevelt hadn’t enacted their disastrous trade and domestic policies which prevented the needed restructuring from occuring.
Comment by Rocco Stanzione on 5 November 2009:
I agree with RJ Cornell, and I’m a bit surprised by Friedman’s failure to spot this. Still studying, but maybe the Austrians hadn’t penetrated American economic thought by this time?
Comment by Dave true liberal on 1 December 2009:
I too agree with RJ Cornell. It seems rather obvious that the roaring 20′s perhaps should not have been quite so roaring. It paved way for the great crash. The recovery may have been overcome if it were not for the bad policies put in place to prevent a natural market adjustment like those blasted tariffs…
Good article.
Austrian Economics is showing light on the economy and its getting much needed attention by regular people like me. I decided to get my economics degree after reading some Austrian economics. More are starting to understand as well. The elitists would prefer economic liberalism dies but it will not with educated individuals.
Comment by Byron on 21 January 2010:
If the readers examine the St. Louis Federal Reserve graph of the M1 money supply (http//research.stlouisfed.org/fred2/series/M1), they will note that whenever the Fed maintains a restrictive monetary policy (flat M1 growth rate) the economy enters a recession. The evidence is particularly striking for the 2008 recession. From 2003 to the fourth quarter of 2008, the Fed restricted the growth of M1; the result was the 2008 recession. The Fed knows fully well that they created the recession as demonstrated by their subsequent loosening of M1 growth.
Milton Freedman and Anna Schwartz were correct in their assessments of money.
Comment by Jonathan Finegold Catalán on 21 January 2010:
Byron,
Well, the two cases are difficult to compare, so I am not sure your assessment is entirely correct. Take, for example, the book period of 1935-1936. Federal Reserve interest rates were relatively low, yet their ability to expand credit was restricted. So, within this context, Murray Rothbard’s analysis seems more plausible, given that he holds that the Federal Reserve’s ability to expand credit was restricted, and so they could not act faster than the contraction in credit (and increase in the money in circulation; i.e. M1).
Comment by Mark Martin on 11 February 2010:
While I agree that Friedman’s analysis of the Fed’s mismanagement was certainly a major contributing factor to the Great Depression, even the major contributing factor in turning free market excess into the Great Depression, there are nevertheless a number of issues I have with his conclusions about a free market economy. First, separating out monetary policy as somehow not part of a government’s preemptive intervention in the economy would be laughable in Bernanke’s world of 2010. The Fed’s policies today are and should be consistent with the Federal Government’s response to economic calamities. While I appreciate the role that J.P. Morgan and other bankers played during the Panic of 1907-08, this was not always the case during the destructive boom and bust cycles of the previous 40 years. Yes, an inexperienced Fed could play a poor policy role as it did for much of the Great Depression, but it doesn’t have to. With the help of Theodore Roosevelt and J.P. Morgan, private bankers did get it right in 1907-08, but this is the exception not the rule of that period of U.S. economic history. There are dangers if the Fed is inexperienced and stupid, but thank intelligence they have learned the right lessons. Laissez-faire policy makers on the fiscal side of government spending during the 1920s played a equally negative role in the creation of the economic problems of the 20s which reduced the demand of the middle class by increasing their taxes and encouraging market excess by a lack of regulation in the Stock Market. Moreover, they ignored some of the other underlying problems of the economy, e.g. the Agricultural depression of the 20s and the lack of diversification of the economy which the government could have positively impact with the proper economic incentives. Finally, by the time FDR took office businessmen were unwilling to expand their productive capacities in order to alleviate unemployment. How long would Friedman like to live with the misery that Free market excess created? To repeat the Fed’s actions would amazingly short-sighted and wrong, but that justify an unregulated free market answer for all economic problems.
Pingback by February 20, 2010: Weekly 5 minute update (Audio file and links to articles) « Watchman of Zion on 21 February 2010:
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Pingback by Atlas Sound Money Project » Blog Archive » “The Great Depression According to Milton Friedman” on 16 June 2010:
[...] and Anna: Regarding the Great Depression, you’re right. We did it. We’re very sorry.’” Read more. “The Great Depression According to Milton Friedman” Ivan Pongracic, Jr. The Freeman, [...]
Pingback by A Uniques Situation « Frank’s Case Book on 4 July 2010:
[...] of monetary policy and in part on his analysis of monetary policy during the Great Depression. Friedman argued that that collapse of the economy in the 1930s after its initial signs of trouble wa… The central back tightened rather than loosenes the money supply cause radical deflation and a lack [...]
Pingback by Frank’s Case Book » Blog Archive » A Unique Economic Situation on 4 July 2010:
[...] of monetary policy and in part on his analysis of monetary policy during the Great Depression. Friedman argued that that collapse of the economy in the 1930s after its initial signs of trouble wa… The central back tightened rather than loosenes the money supply cause radical deflation and a lack [...]
Comment by Tony Mannucci on 29 August 2010:
This analysis is interesting, but inconclusive. Although the government may have contributed to enlarging the effects of the economic downturn, the fact remains that capitalism is not stable. Failures happen. It is hard to blame the government for all the failures of capitalism. The government has become more involved because capitalism has failed in the first place. Had capitalism been perfectly stable in terms of increasing economic opportunities, jobs and incomes, the government would never have become involved. So the Friedman argument is wrong on its face.
Politically, the free economy is viewed as a “service” that is expected to create jobs. As productivity increases, the jobs should increase in number and the pay should increase. It’s not at all clear capitalism produces that result, at least not in a linear fashion. To obtain more political will towards a freer market, we need to teach people to accept the vagaries of the market. The service people expect from the free economy will not be delivered. Lowered expectations of what the free market will provide will in turn reduce demands that government intervene. That’s a tough sell until the free market produces more jobs, higher pay, and whatever it is that people want.
Comment by John Barksdale on 18 September 2010:
Wow Tony, you draw some strange conclusions. “The government has become more involved because capitalism has failed in the first place.”
What? An economy that has a central banking system that decides what the cost of capital should be via central-planning is not capitalism.
Let’s abolish the Federal Reserve, repeal regulations that benefit large companies and end the perpetual charters of corporations before we indict the “free market”.
Comment by Billy on 26 October 2010:
The only problem with capitalism is government regulations. If socialism/marxism/communism was so great, then why isn’t places like Korea, China, Cuba, and Venezuela the light towers of the world. The free market and individual liberties worked so well that, in fact, the USA has became the leading country in the world in wealth and innovation. Could anyone even imagine what this country would be had it been founded on the principles that some of you speak of… Who needs another Chairman Mao or Hugo Chavez. When the people fears government, there is tyranny. When the government fears the people, there is freedom.
Comment by LARA CROFT on 11 November 2010:
Ma uimeste ipocrizia si cinismul acestui personaj Friedman,eu l-am “cunoscut” cand am studiat la “Doctrine economice” teoria lui de neinterventie a statului. M-a intrigat neomenia si lipsa de compasiune fata de oamenii care muncesc cinstit , nu fac averi din abuzuri sau impovararea crestinului de langa ei!Este evidenta neexactitatea teoriilor lui vis-a -vis de impozitarea profitului negativ!Aplicarea teoriei schizoide a distrus viata chilienilor a jupuit averile zdruncinate ale mosierilor chilieni si a infiintat o noua distributie a veniturilor statului !Acum ne distruge si pe noi,romanii, prin politica FMI prin simpa aplicare a unei forme care nu corespund fondului!Ce se creaza artificial nu are continuitate asigurata.Statul este reprezentat de institutiile sale in relatia cu populatia.Populatia de cine este reprezentata ? de parlamentari corupti si retardati mintal!Daca institutiile au oameni prost pregatiti,corupti si incuiati ce face statul????????/ se “arunca pe cetatean” il impoziteaza de-i merg fulgii il ameteste cu politica si lipsa de masa monetara si i-i baga in cap tampenii de genul “faci parte dintr-o generatie de sacrificiu!”!!!!!!!!Asta nu e teorie e o prostie !!!!un anticoncept economic!Personal i-as trage un sut in cur evreului asta ipocrit!
Pingback by Wednesday Morning Reads « Sky Dancing on 24 November 2010:
[...] The Fed’s being using a modified Taylor rule for some time and has very much taken a stand in keeping with Anna Schwartz and Milton Friedman’s seminal work on the Great Depression. That’s the CONSERVATIVE economist Milton Friedman, remember him? He basically said that the FED botched monetary policy and let deflation ruin the economy. What most… [...]
Pingback by If the Turkey didn’t put you to sleep … « Sky Dancing on 26 November 2010:
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Comment by Rick T on 21 December 2010:
I beleive today as many ecomonists that Bernard Bernanke is following the prescriptive mehtods outlined by Mr Friedman. A great thanks is owed to Milton.
However, Roosevelt and useless work projects, drawing faces of dead presidents?
Let me advise the WPA built over 160,000 bridges to name one area of projects. Two of which are still in use today over the Cape Cod Canal. Useless?
My father worked for the WPA and was able to bring home enough money to help his Mother feed his siblings. Useless?
God Bless Milton Friedman for instructing our current Fed Chief. Just leave the usual baloney out it.
Comment by DanM on 27 December 2010:
One man’s opinion. Rick T’s comments about the bridges assumes that these worth while projects would not have been constructed. This is equivalent to the current administration’s position that the stimulus saved untold jobs, jobs that would have been lost if not for ……..
Also, your father brought home money because your father was loving, loyal, responsible, and industrious. You can rest assured that in the absence of the WPA, your father would have found a way ot provide for the family needs. God Bless our parents for their courage during this time.
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We now have another complication to recovery. As explained in this article consumer demand and private investment are critical to a healthy economy and both are psychologicaly driven. We now have 24 hour news coverage, often politically motivated [for example Fox News] that constantly harps on the negatives of the current administration’s efforts at saving the economy.
The only thing we have to fear is fear itself. Yet those like Fox News constantly engage in fear mongering.
Self fulfilling prophecy. And they have no shame.
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Ms. M. Wilson, to finger Fox as harping on the negatives of the current administration’s efforts to “save” the economy speaks to a lack of objectivity along with a concern that the inept policies of this administration get exposed. NBC,MSNBC,ABC, CBS, PBS, CNN constantly bash anything other than the Democratic, Hollywood Socialist agenda. Good Social Policy does not look to “redistribute wealth” but provide incentives for all to work towards wealth within a truly free American Society. I don’t think Fox is great but it does provide the Other Side of issues, whether you want hear them or not.
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Pingback by Ponzi Economics – Steve Keen « Paper Money Illusion Jailbreak on 10 October 2011:
[...] Bernanke, echoing claims by Milton Friedman, believed that the first Great Depression in the US was …, which, he said, “reinforced … declines in the money multiplier”. But, Keen shows, there is a weak association between M0 supply and depression. There were six occasions after the second world war when M0 supply fell faster than it did in 1928 and 1929. On five of these occasions there was a recession, but nothing resembling the scale of what happened at the end of the 1920s. In some cases unemployment rose when the rate of M0 growth was high and fell when it was low: results that defy Bernanke’s explanation. Professor Keen argues that it’s not changes in M0 that drive unemployment, but unemployment that triggers changes in M0: governments issue more cash when the economy runs into trouble. [...]
Pingback by It’s in all our interests to understand how to stop another Great Depression | George Monbiot | on 11 October 2011:
[...] Bernanke, echoing claims by Milton Friedman, believed that the first Great Depression in the US was …, which, he said, “reinforced … declines in the money multiplier”. But, Keen shows, there is a weak association between M0 supply and depression. There were six occasions after the second world war when M0 supply fell faster than it did in 1928 and 1929. On five of these occasions there was a recession, but nothing resembling the scale of what happened at the end of the 1920s. In some cases unemployment rose when the rate of M0 growth was high and fell when it was low: results that defy Bernanke’s explanation. Professor Keen argues that it’s not changes in M0 that drive unemployment, but unemployment that triggers changes in M0: governments issue more cash when the economy runs into trouble. [...]
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[...] Bernanke, echoing claims by Milton Friedman, believed that the first Great Depression in the US was …, which, he said, “reinforced … declines in the money multiplier”. But, Keen shows, there is a weak association between M0 supply and depression. There were six occasions after the second world war when M0 supply fell faster than it did in 1928 and 1929. On five of these occasions there was a recession, but nothing resembling the scale of what happened at the end of the 1920s. In some cases unemployment rose when the rate of M0 growth was high and fell when it was low: results that defy Bernanke’s explanation. Professor Keen argues that it’s not changes in M0 that drive unemployment, but unemployment that triggers changes in M0: governments issue more cash when the economy runs into trouble. [...]
Pingback by It's in all our interests to stop another Great Depression | on 11 October 2011:
[...] Bernanke, echoing claims by Milton Friedman, believed that the first Great Depression in the US was …, which, he said, “reinforced … declines in the money multiplier”. But, Keen shows, there is a weak association between M0 supply and depression. There were six occasions after the second world war when M0 supply fell faster than it did in 1928 and 1929. On five of these occasions there was a recession, but nothing resembling the scale of what happened at the end of the 1920s. In some cases unemployment rose when the rate of M0 growth was high and fell when it was low: results that defy Bernanke’s explanation. Professor Keen argues that it’s not changes in M0 that drive unemployment, but unemployment that triggers changes in M0: governments issue more cash when the economy runs into trouble. [...]
Comment by Simon Pringle on 19 October 2011:
So if the Fed was abolished tomorrow every bank would stand behind every other bank,big or small,and keep the money supply at optimal levels and instantly stop any “bank run”?!Surely, you are joking Mr Friedman.
Comment by Dear idiot, on 2 November 2011:
Tim,
“It is hard to blame the government for all the failures of capitalism”
In the following chart you will see the “failures of capitalism” seem to coincide with terrible regulation (that’s the gov. btw), meanwhile when regulation is removed or constant the chart is nice and smooth. So before you go about touting how terrible capitalism is, you should educate yourself.
http://www.economics-charts.com/gdp/gdp-1929-2004.html
In the next chart you’ll see how bumpy and flat the ride is when govt. is in control, but when they start to de-regulate (as china has) its amazing how smooth and rapid the growth is.
http://www.google.com/publicdata/explore?ds=d5bncppjof8f9_&met_y=ny_gdp_mktp_cd&idim=country:CHN&dl=en&hl=en&q=gdp+chart+china
Take your communism and socialism and you know where to put it. Capitalism has done more for the world in the last 200 years than communism has done in it’s entire lifetime.
TEA!
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Comment by Jim on 29 December 2011:
Author fails to distinguish a business cycle, recession, and depression. Should see the recent publication of Reinhart & Rogoff “This Time is Different.” Also, while earlier noting that Keynes said either monetary or fiscal interventions were possible treatments, he sees one as displacing/disproving the other. Both consumer demand and monetary supply can contribute to an economic downturn.
Referencing a quick recovery from 1907 to 1908 through private bank intercessions, the author ignores the longer downturn of the panic/great recession of the 1870s-90s (dates?). If private responses worked so well, there would have been little support in a laissez-faire gold-standard era for creating the Fed.
Listing of Friedman & Schwartz’s suggestions for why Fed failed to act doesn’t address conservative economic
ideologies.
“The better explanation of the Great Depression revealed it was not caused by unfettered market forces. There is nothing in the operation of free markets that would create depressions or even recessions. Rather, we now know that we must look for causes of these phenomena in mismanaged and erroneous government policies.”
The Free Market Fallacy. The have never been significant unfettered markets (although Polanyi argued that
capitalism introduced an unpreceded era of economic institutions separated from social institutions. Sentences 2 and 3 are unchecked ideological premises rather than empirical findings, ignoring history of bubbles (Kindleberger).
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