Most macroeconomists see the boom-bust cycle as an unsolved problem.  Like physicists in search of a Grand Unified Theory, they long for a model that accounts for all the major aspects of the business cycle.  Perhaps they are hampered by looking through the wrong end of a telescope.  Mansharamani uses not just one but five “lenses” to examine the subject. In addition to micro- and macroeconomics, they include psychology, politics, and biology.  He is not the first economist to invade these fields.  Rather his accomplishment lies in assembling ideas from each of those areas, applying them to past boom-bust cycles, and putting his ideas on the line by issuing a brave prediction of a forthcoming Chinese economic train wreck.

Austrian Business Cycle Theory

The author’s macro lens includes Austrian business cycle theory. That theory says inflation of the money supply causes a drop in interest rates, which is misinterpreted as an increased aggregate preference for saving over consumption, leading to investments in more roundabout means of production.  When it becomes clear that there has been no such preference shift, these undertakings are seen to be at least partial mistakes, requiring write-offs and retrenchment – a bust.  The boom is the problem, not the bust, which is the market’s attempt to realign itself to the realities of time preference.  Austrian business cycle theory has great merit but leaves some things unexplained.

Mansharamani’s micro lens includes the concept of reflexivity.  Market participants don’t just observe prices but also influence them.  Reflexive dynamics occasionally give rise to instabilities in which rising prices lead to increased demand.  A simpler term would be a “bandwagon effect.”  I recall an office party in 1980 where one of the secretaries asked about buying gold – precisely at the peak, as it turned out. All she knew about gold was that it was way up and therefore must be going higher.  I should have realized that when you see financially unsophisticated people like her climbing on a bandwagon, you can be pretty sure there’s no one left to sell to and nowhere for prices to go but down, which is where gold and  silver prices went in 1980, and in a big hurry.

From psychology Dr. M. borrows ideas and data about cognitive biases.  For example, subjects asked to guess some bland statistic, like the number of African countries that belong to the UN, are influenced by the spin of a wheel of fortune: When the wheel lands on a high number, they guess higher.  He translates this and a dozen other cognitive biases into irrational market behavior that can foster booms and busts.

He introduces his biology lens with an analogy to the spread of an infectious disease.  When the prevalence of a disease reaches a high level, the infection rate necessarily slows and the disease begins to wane, just like the 1980 gold market.  But it is devilishly difficult to “inoculate” oneself against infectious ideas.  Individual investors who can do so have a decent chance to beat the market averages over time, I believe.  (Those who would pursue these ideas in greater depth would do well to find James Dines’s quirky and expensive but worthwhile book, Mass Psychology.)

Unintended Consequences

Turning to politics, Mansharamani illustrates unintended consequences of taxes and regulations.  The U.S. Tax Code (Title 26, Subtitle A, Chapter 1, Subchapter B, Section 179) allows businesses to expense purchases of vehicles heavier than three tons, a provision aimed at helping farmers. Guess what. The BMW X5, a luxury SUV, weighs 3.003 tons!  On a more serious note, he cites the mortgage interest deduction as a magnifying factor in the housing boom and bust.

Mansharamani examines the tulip mania, the Great Depression, the Asian financial crisis, and other past cycles. For each he cites a dozen or so aspects of the cycle and categorizes them under his five lenses.  He summarizes the housing boom, for example, with 14 observations on things including reflexive credit/collateral dynamics, anchoring on prices, perverse tax policies, and popular media.  None of these is particularly surprising, but I found it instructive to see them listed and categorized.

When I was young a book appeared called Are the Russians Ten Feet Tall? It was the post-Sputnik era when Paul Samuelson’s economics textbook pronounced Soviet socialism a workable alternative to markets and CIA “intelligence” analysts  projected that Soviet GDP would overtake ours.  We know how that worked out.  Fast forward to the 1980s when the Japanese were paying top dollar for iconic U.S. real estate.  We know how that turned out too.  Now it’s China.  I can’t help thinking: I’ve seen this movie before.

Chinese Bubble?

Mansharamani goes far beyond my gut feeling, marshaling evidence of a Chinese bubble from each of his lenses.  He gathers tidbits such as garlic fanatics bidding prices up 10- 30-fold in 18 months; the skyscraper indicator – starting with the Empire State Building, record high buildings are consistently started in a boom and finished well into the subsequent bust — and the $230,000 that a Chinese man paid for three bottles of 1869 Château Lafite. Then there’s Ordos, a massive new city meant to house one million souls but left incomplete and unoccupied.

Mansharamani looks at Chinese state-owned enterprises through his political lens, reporting that if they had to pay a market rate of interest, their reported profits would be wiped out.  Through his reflexivity lens he saw Chinese steel production exploding from 23 million tons in 1977 to 650 million through the first half of 2010 — with up to 20 percent being used to construct more steel mills!  “Truly a reflexive dynamic if ever there was one,” he gasps.

Boombustology is a worthwhile read for anyone who seeks a better understanding of booms and busts.  I especially recommend it to individual investors.

Yet some data and sound theory, which take into account more than simple macroeconomic aggregates—higher GDP good, lower GDP bad—indicate that the U.S. economy has not fully recovered. The official unemployment rate is still over 9 percent, private long-term investment remains at low levels, and even GDP growth has been weak, in spite of the great increase in government spending for final goods and services (which adds directly to GDP, defined as consumption plus investment plus government spending plus net exports).

The weak recovery is clearly recognized by policy-makers, who have advocated and implemented additional fiscal and monetary stimulus by the Obama administration and perhaps the Federal Reserve. They seem to take for granted that an unexpectedly slow recovery requires even more expansionary government policies to keep the economy on track.

The slow recovery from the recession presents an analytical challenge, provoking debate among macroeconomists and pundits. As usual, there are many diverse explanations, some complementary, some contradictory. To an important extent these divergences reflect different conceptions of the business cycle. I will describe and briefly analyze four of the most common explanations.

The Keynesian Story

Let us start with the Keynesian story, filtered through the writings of Paul Krugman. (There are much more nuanced versions of Keynesianism than Krugman’s.) In his weekly column and popular blog at the New York Times, Krugman declares that the slow recovery and the persistence of high unemployment arise from a “lack of aggregate demand,” which is the main cause of the poor sales by private businesses and hence of the high unemployment rate.

In his characteristic self-confident argumentative style, Krugman asserts, “Businesses aren’t hiring because of poor sales, period, end of story.” This sentence is followed by a graph showing a substantial increase since late 2008 in the percentage of small businesses that named “poor sales” as their “single most important problem.” The remedy for this malaise is, of course, more public spending: “[T]he best thing government could do to help business would be to spend more, increasing demand.”

However, as many economists have written in recent years, Krugman’s focus on aggregate demand is simplistic, to say the least. First, one needs to ask, why is the growth of aggregate demand so weak? It may very well be that spending less and saving more is a healthy reaction to the previous unsustainable boom. Thus weak demand might be an inevitable consequence, not the deep cause, of the current bust.

Furthermore, what particular parts of the economy—which markets or industries—suffer most from low sales? As Austrian economists argue, we need to disaggregate the macroeconomic picture to understand what is going on. Nevertheless, such disaggregated analysis does not seem to be important for some Keynesians, such as Krugman and Brad DeLong. In November 2009, DeLong wrote, “At this point, anything that boosts the government’s deficit over the next two years passes the benefit-cost test—anything at all.”

The Monetarist Story

The monetarist story of Milton Friedman’s followers is usually presented as the free-market alternative to the Keynesian interpretation. However, these explanations have important though subtle points in common.

In simple terms the monetarist thesis focuses mainly on sudden bank credit contraction. Monetarists argue that the accumulation of vast amounts of excess reserves by banks—which basically means that instead of lending money to the private sector, they are keeping it to themselves—has negative effects for the whole economy. Given that credit is usually considered the economic equivalent to the human body’s blood circulation, a credit contraction is seen as invariably dangerous. If a person suffers a sudden loss of blood, the cure would be to inject blood into him. The same cure applies to credit, the monetarists claim.

Economists from this perspective usually refer to how the velocity of money—the average frequency with which a unit of money is spent in a specific period—collapsed in the second half of 2008. To compensate for this reduction, monetarists recommend an expansionary monetary policy by the central bank.

Although one might think that Fed Chairman Ben Bernanke’s strategy has been to respond precisely in this way, some economists, such as Scott Sumner, argue otherwise. Sumner claims the Fed’s monetary policy since the end of 2008 has actually been contractionary relative to what the economy needed at that time. Bernanke should have been more aggressive, Sumner argues, to avoid the contraction of nominal GDP that finally occurred.

This explanation suffers from several problems, similar to the shortcomings of the Keynesian story: (1) excessive aggregation of key concepts—making extensive use of GDP as the key indicator of the cycle does not allow the monetarists to explain the crux of the matter, which is the real microeconomic distortions in the productive structure of the economy that had been created during the boom; (2) the analysis of the crisis and the sharp credit contraction as exogenous shocks, rather than consequences of the previous unsustainable credit expansion. From Sumner’s point of view, it seems that the fall in nominal GDP was something to be avoided.

The Austrian Story: The Adjustment Problem

For economists drawing on the Austrian story, GDP contraction was a symptom of the bust, the inevitable hangover after a credit spree that led to bad decisions—malinvestments and excessive leverage. As the Austrian business cycle theory emphasizes, the economy has to go through a process of adjustment that cleanses the massive errors resulting from economic decisions taken in the past. This restructuring involves not only reallocating factors of production (capital and labor), but also reducing debt a significant amount (deleveraging), which has contractionary effects on demand and aggregate economic activity.

This consideration leads to the first element of the best explanation for the prolongation of the recession: the fact that the necessary adjustment process has not been completed. As a recent report by the Bank for International Settlements (BIS) concludes, the debt reduction of private economic agents still has a long way to go. But as the Spanish economist J. R. Rallo argues, keeping interest rates extremely low for a prolonged period, as the Federal Reserve has, creates incentives for people not to reduce debt and adjust to the new circumstances. Moreover, government “stimulus” policies may have made things worse by massively increasing federal government debt.

Furthermore, the necessary reallocation of the factors of production—both intersectoral (from sectors overexpanded during the bubble to sectors that will yield higher profits in the future) and intrasectoral (among different products and services in the same sector) may take a long time, especially in the labor markets. Apart from the fact that the adjustment in relative prices and wages may take longer than desirable because of rigidities, there are additional issues worth considering.

Research on markets with search frictions—which won Peter Diamond, Dale Mortensen, and Christopher Pissarides the 2010 Nobel prize in economics—may fit in this context. For several decades mainstream neoclassical economists have depicted the market as a mechanism that perfectly and instantaneously coordinates supply and demand. The Nobel laureates, however, have emphasized that economic agents often have to spend time and resources in making that adjustment (search frictions). Moreover, finding satisfactory employment for people who have just lost jobs may require the acquisition of substantially different skills and capabilities. The features of this process depend on the degree of specificity and complexity of the economy’s capital structure. Thus not only physical capital but also human capital has to go through an adjustment process. All this takes time.

Regime Uncertainty

The second main piece of the puzzle of the recession’s duration is the “regime uncertainty” argument formulated by Robert Higgs. He first elaborated this concept to explain why the Great Depression lasted so long, finding that the Roosevelt administration, with its constant attacks (in rhetoric and in policies) on the free-enterprise system and its threats to private property, was largely responsible for the failure of long-term private investment to recover fully until World War II ended.

Not surprisingly, in a series of commentaries since 2008, Higgs has found parallels in the Obama administration’s actions and in the stagnant private investment that help to explain why sustained economic recovery has not yet taken place.

Higgs points to several particular causes: the surge in the federal deficit and debt; the likely introduction of new taxes to finance the recent massive public spending, or changes in existing tax rules; the potential burdens on businesses brought about by environmental and energy regulations; and the still uncertain real effects of Obamacare and the new financial regulatory framework.

Problems related to the adjustment process, along with the existence of regime uncertainty, might form a relatively complete explanation of why the U.S. economy is still suffering from the Great Recession, complementing the analysis expressed in the Mises/Hayek business cycle theory.

The importance of this debate, and how current economic events are interpreted, can hardly be exaggerated. As economist Mario Rizzo has noted, the resolution of this puzzle “will affect economics and public perceptions for a long time to come,” just as the debate between Hayek and Keynes in the 1930s had profound (and unfortunate) consequences for the future of the economics discipline. Let us hope that the outcome will be different this time.

That column caught the notice of some folks at FoxBusiness.com, who invited me on one of their shows. To my surprise the questions quickly turned to the current unemployment rate and what we should be doing to bring it down.  Toward the end of the interview I began to realize the source of the confusion: The host was thinking that the “creative destruction” of jobs I had described is the same thing as “unemployment.”  This week, I’d like to try to untangle those ideas.

Economists recognize that there are multiple reasons for unemployment.  We normally divide them into frictional, cyclical, and structural.  Frictional unemployment refers to people between jobs for the short term.  Think of the waiter whose restaurant closes and is now looking for a new job at a different eatery.  Cyclical unemployment refers to changes in the macroeconomy, such as the boom and bust we’ve experienced in the last decade.  Structural unemployment involves a longer-term mismatch between the skills of workers and the kinds of jobs that are in demand.

It’s often difficult to determine how much of the unemployment rate is represented by each type, but certainly we can make some broad observations, including that the current 9.5 percent rate includes a significant degree of cyclical unemployment.

Frictional unemployment is, of course, unavoidable in a dynamic, growing economy.  People want new jobs, businesses fail (except for banks and auto companies, apparently), and some folks just get fired.  Structural unemployment is also, to some degree, unavoidable.  Most of us are trained for a range of future jobs early in life, and if our skills are overly specific and become outdated, we will need time to retrain for the new jobs in demand.  Such retraining happens continuously, but people often will be unemployed, or underemployed, in the transition.  Both forms of unemployment are likely unavoidable in a free market, which means we should never expect the unemployment rate to be near zero in a healthy economy.  However, both are usually signs of economic progress: Bad businesses should fail, unproductive employees should be fired, and people should be free to find new jobs. As last week’s column pointed out, even though technological change has short-run costs, over time it improves life for everyone, including those who lost jobs.

Avoidable Unemployment

By contrast, cyclical unemployment, is largely avoidable.  The boom and bust of the business cycle are products of misguided government monetary and fiscal policies.  The recession we are now experiencing could have been avoided had the Fed not driven interest rates down too low after 9/11 and had other government policy not channeled the new money into the housing market, which then became the basis for a host of problematic investment vehicles.  Suffice it to say that a 9.5 percent unemployment rate is no cause for celebration.

Undoubtedly the recession destroyed a lot of jobs created during the boom. But those are jobs that never should have been created in the first place! So given the boom, it’s a good thing the bust destroyed those jobs: They represented misallocated resources.  However, from a broader perspective, we should not be cheering this destruction, as the whole boom-and-bust process that it represents involves a great deal of wasted resources, not even counting the trillions spent on the bailouts and “stimulus” plans.

In an economy suffering from an inflation-induced boom, too many of the wrong kinds of jobs get created, then the bust comes and destroys them, leaving us with high unemployment.  In a healthy economy, growth and technological progress destroy jobs first, then create new kinds of demands that lead to new, sustainable jobs — more than were destroyed.  A healthy economy creates more and better jobs by destroying ones we don’t need.  A sick economy create jobs only to destroy them.

Thus not all job destruction represents economic health.  When government policy generates booms and busts, it creates unsustainable jobs that eventually will be destroyed, harming millions in the process.  That’s not the “creative destruction” of the market. That’s just destruction, pure and simple.

The “first book” is replete with unsung heroes, such as industrialist Thomas Weston and nobleman Thomas Dale. These two Englishmen observed, diagnosed, and treated the free-rider problem that subjected the Jamestown and Plymouth Bay colonies to impoverishment, famine, and death. Their prescription was not, as today’s conventional economic wisdom would have it, enlisting the government to provide food, but rather replacing communal property rights with private property rights. Within a year, poverty was succeeded by plenty, initiating a process that would make America the wealthiest country the world had ever known.

The “second book” shows that identity theft has been a problem since long before the Internet, credit cards, and Social Security numbers. The culprit here is mercantilism and the victim capitalism. Few who have not studied the history of economic thought even know what mercantilism is, a problem that wide readership of this book would remedy. Yet this system, in which the state extracts large amounts of resources from the populace to subsidize favored corporate interests, is what most people think capitalism is. This deception has led to a double injustice: the vilification of market entrepreneurs whose wealth came from solving the problems of millions within the capitalist system and the hailing as the “saviors of capitalism” politicians who conjure up phony problems or phony solutions to real problems.

DiLorenzo sets this out clearly and provides many historical examples. For instance, he contrasts the private road systems that sprang up throughout the United States in the early 1800s with the “public improvements” subsidized by state governments that were so corrupt and inefficient that by 1860 most states had banned such boondoggles. Unfortunately, after the Civil War the newly empowered central government picked up where the states left off by subsidizing railroads. While most historians paint all railroad owners as “Robber Barons,” this book makes the crucial distinction between market entrepreneur and political entrepreneur to separate the Vanderbilts and the Hills from politically connected railroad magnates such as Jay Cooke and Thomas Durant, who were truly deserving of that ignominious title.

This book elucidates many other examples of capitalism delivering the goods while its opponents fraudulently take the credit. For one, it demonstrates how capitalism enriched the working class through that most capitalist practice, capital accumulation, while union leaders and politicians claimed their beloved income-redistribution policies had done the trick—and some trick it would have been, since you cannot redistribute what has not been produced. For another, it illustrates how capitalism, in the person of the entrepreneur John D. Rockefeller, solved the problem of providing cheap energy, enabling supply to grow and price to fall year after year. Simultaneously, nearly every measure promulgated by the government to tame the “excesses” of capitalist production of oil, including antitrust prosecutions, worked against the interests of consumers. Especially worthwhile is the discussion of the antitrust bait-and-switch scam, which promises to promote competition while actually seeking to rein in those who compete too successfully.

Finally, no discussion of how government problem-solving makes matters worse would be complete without surveying its sorry record of ameliorating the business cycle. DiLorenzo’s detailed analysis of the policies adopted from the onset of the Great Depression obliterate any justification for believing that Herbert Hoover was a practitioner of capitalism and Franklin Roosevelt was its savior.

The author writes with a clarity and passion rare for economists. How Capitalism Saved America is scholarly yet accessible. While not theoretical, it uses theory to help us understand the facts. I did note a couple of inaccuracies, however. For example, the author says a worker must generate at least as much profit as the wage he is paid, when he means revenue. He also confounds the First and Second Banks of the United States. While neither of these undermines the main themes of this powerful work, they are the kind of errors that will be pounced on by those who cannot counter his arguments on the merits.

The Foundation for Economic Education is pleased to announce that Richard W. Fulmer of Humble, Texas, is the winner of the second annual Eugene S. Thorpe writing competition. Mr. Fulmer holds a bachelor’s degree in mechanical engineering from New Mexico State University and for over 20 years has worked as a systems analyst in the energy industry. With Robert L. Bradley, Jr., he is the author of Energy: The Master Resource. His article, “Legends of the Fall: The Real and Imagined Sources of our Bubble Economy,” is published below.

We have for the better part of a century now lived in a world of fiat money, and fiat monetary systems are sophisticated versions of central planning. The belief system that supports them carries an inherent hubris that the planner’s vision of the future is sufficiently precise to chart the path of the chaotic interaction of variables that made up an economy. It is a recurring myth, with consistent historical outcomes. Mr. Fulmer’s paper goes directly to first causes and discusses the real estate bubble as a predictable consequence of our central- banking system.

One hundred eighty-two authors responded to FEE’s call for papers in competition for the 2009 Eugene S. Thorpe Award, and many wrote eloquently of multiple secondary causes. The unintended consequences of the Community Reinvestment Act? Fannie, Freddie, Ginnie, and assorted ill-conceived cousins? Zigging instead of zagging by our central bankers? Political opportunism and legalized graft? All surely true. Greed and other venal motives? Of course. But it misses the point to blame either human motivation or human error. The problem is systemic and foundational. It’s not what people do with or to the system—it’s the system itself.

The selection committee thanks all the contestants for their contributions. The rules allow for only one winner, but special recognition and honorable mentions are in order for several of the runner-up contributors. Erin Mundahl of Independence, Minnesota, wrote of government policies that disrupted the natural brakes on risk taking: “Free-market policies naturally limit risk exposure. Regulations which encouraged or even mandated an expansion of risk counteracted this natural limitation.” The risks were ultimately socialized to the taxpayers. The returns accrued to the congressional and bureaucratic elites that benefited both financially and politically. Government operates outside the confines of the natural constraints imposed by profit and loss, and grants political rewards based on the social choices valued by bureaucratic actors.

Charles N. Steele of Hillsdale, Michigan, observed that government not only did what it shouldn’t; government also failed to do what it should. A free market cannot function without the supportive infrastructure of the rule of law, and one of the legitimate functions of government is to prosecute criminal activity. Mr. Steele observes that “Deception, false representation of products, and failure to live up to contractual terms are not legitimate methods of competition in the free market. They are criminal activity, and the free market requires that such activities be policed.” Just so.

From Nero to FDR, emperors and their kin have listened to the sirens of monetary manipulation. The voices are enchanting and sing of wealth without work. But the ships of many states have foundered on the rocky shores to which such fantasies inevitably draw them. Real wealth creation cannot be manipulated; it results from increased efficiencies of resource allocation and production. A drunken Saturday night party may be fun while it lasts, but the Sunday morning hangover that follows is a predictable consequence of the shortsighted behavior that created it. Unless and until our system of monetary creation and control is redesigned to benefit from the power of market pricing mechanisms, we can expect the recurring cycle of boom and bust to continue.

Congratulations to Richard W. Fulmer on his winning article.

* * *

Businesses, competing for consumer dollars in a free market, must deal with the world as it is in order to survive. Politicians, competing for constituent votes, spin facts to recreate the world as they want it to be in order to gain support for their policies, hide mistakes, and shift blame. In this world of spun reality, the failure of government intervention provides the rationale for still more intervention. So spins the endless cycle in which legislatures create unintended consequences, condemn “market failure,” and demand further legislation. Government grows in crisis, even if it created the crisis.

Our current financial problems provide an illustration of this all-too-familiar pattern. In response to the housing bust, politicians hid behind long-discredited myths, moving swiftly to lay blame variously on Wall Street greed, oil speculation, investors’ animal spirits, deregulation, unrestrained capitalism, predatory lending practices, and, of course, the business cycle. Yet even a brief look at the facts reveals government intervention throughout.

The Monetary Cycle

Supply and demand regulate prices in a free-market economy. Increased borrowing (demand for loanable funds) or decreased saving (supply) leads to rising interest rates (prices). Conversely, lower interest rates stem from less borrowing, more savings, or both. More saving means that consumers favor future consumption over current spending. Banks, with rising deposits on hand, drop their interest rates to compete for borrowers. Capital investments deemed infeasible when interest rates were higher now appear attractive. Companies borrow to expand productive capacity, anticipating future rising demand made possible by rising present consumer saving.

Suppose, however, that the government intervenes to artificially lower the price of money. Reduced interest rates make saving less attractive and consumption more so. At the same time businesses, taking advantage of lower rates, borrow to fund expansion. Prices rise as consumers and producers compete for scarce resources—a sack of seed corn cannot be both eaten and planted. Sales increase and markets boom. Eventually, however, the central bank must raise interest rates to prevent inflation, and the boom goes bust. Businesses find that they have overinvested or invested in the wrong things.

Such malinvestment is an unsustainable allocation of scarce resources to create goods and services for which there is insufficient demand. A correction occurs when resources are reallocated to produce what people actually want. Corrections can be very painful as industries that overexpanded during the boom now downsize, shedding employees and suppliers. Avoiding the adjustments, however, simply postpones the pain. Resources often continue to be poorly invested, compounding the damage and making the inevitable correction that much more agonizing when it comes.

Boom and bust cycles nearly always result from monetary expansions that disrupt the price signals regulating an economy. Such expansions preceded Holland’s Tulip Mania in 1636–1637, the nineteenth-century banking panics in the United States, the Great Depression, the dot-com bubble, and the current housing debacle.

Ironically, these monetary cycles are called “business cycles,” as if they were an inherent part of the free market. Proponents of some business-cycle theories believe that, left unregulated, businesses will overproduce, creating a glut of unwanted goods. Factories must then reduce production or even shut down until the glut is eliminated.

Yet what mechanism would drive businesses in different industries across an entire nation to produce unwanted goods? How could, to cite the most recent example, home builders in California, Nevada, Arizona, Florida, and markets in between have simultaneously misread local demand to such an extent? A nationwide spike in greed? Irrational exuberance? Bankers’ bonuses? A simpler, more rational explanation is that they were misled by government policies that artificially inflated housing prices, giving the appearance of greater demand than was actually there. Overproduction is a symptom, not a primary cause.

The Housing Bubble

Early in the new millennium, the Federal Reserve slashed interest rates in response to the dot-com collapse and the 9/11 attacks. Other nations’ central banks soon followed suit. Now awash in liquidity, investors from around the world needed investments that would yield returns higher than the rate of inflation. Coincidentally, American local and federal policies—including land-use restrictions, preferential tax treatment, buyer subsidies, and regulations favoring low-income buyers—had made investing in residential housing more attractive than other options. Housing prices rose as homeowners upgraded and renters became owners.

Home loans were sold in the secondary mortgage market, which is dominated by the government-sponsored enterprises: the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). Mortgages were then bundled into “packages” in order to diversify risk. Individuals and institutions worldwide purchased these packages as investments. “Derivatives” such as credit-default swaps (essentially insurance against bond or, in this case, loan failure) and other such securities created a “multiplier effect,” as these investment vehicles were based on other vehicles that were, in turn, based on mortgages.

The complex system that resulted was inherently unstable and was made more so by regulations that coerced lending institutions into making home loans to borrowers who could not afford to repay them. In addition, Congress encouraged Freddie Mac and Fannie Mae to buy trillions of dollars worth of these “subprime” loans, enabling lending institutions to engage in even more such dangerous lending with little (or reduced) incentive to vet borrowers.

Credit-rating agencies, members of a cartel created by the Securities and Exchange Commission, gave unrealistically high ratings to packaged debt containing subprime loans. Basel II, an international banking accord, similarly understated the associated risks and encouraged banks to hold mortgage-backed securities by requiring them to keep smaller cash reserves to back such instruments than it required for traditional loans. Implicit government support for Freddie Mac and Fannie Mae and the “Greenspan put” (an unstated Federal Reserve policy of injecting liquidity into the economy in response to any serious difficulty) encouraged investors to take risks in the belief that the government would cover any losses.

Speculators exploited zero-down loans and “adjustable-rate mortgages,” intended for disadvantaged home buyers, and began “flipping” homes (buying houses only to quickly resell them at a profit). In some cases, houses were built strictly as investments—built to be sold and sold again, not to be occupied. Such overbuilding could not be sustained and, when the Federal Reserve raised short-term interest rates—contracting the money supply—the bubble burst. The value of investments based on bundled home mortgages quickly plummeted.

Mark-to-market accounting rules enforced by the Securities and Exchange Commission (SEC) compounded the problem. SEC rules required financial instruments to be valued at current market prices, amplifying the effects of both boom and bust. Mortgage-based securities, overvalued when housing prices soared, became undervalued as the panic grew and financial institutions saw their assets become virtually worthless almost overnight.

The key intervention and primary cause of the entire cycle of events, however, was the Fed’s initial monetary expansion. Government policies all but dictated that the resulting boom would be concentrated in residential housing and that the eventual bust would be far worse than it would otherwise have been. Even without these policies, though, a boom would still have occurred. Perhaps it would have been concentrated in another sector of the economy; or perhaps there would have been a general rise in capital investment. Either way, once the Federal Reserve triggered the expansion, a boom was inevitable. And, because the boom was artificial (that is, the credit expansion was not based on real savings), a bust had to follow.

Government control of a nation’s money supply guarantees boom and bust cycles. To illustrate this, imagine a car with some very special features. Its windshield is frosted so that the driver cannot see where he is going, and its side windows are just clear enough to allow him only a vague idea of where he is. The rear window alone affords an unobstructed view. Finally, the steering linkage is on a 30-second delay. The car will not change course until half a minute after the driver turns the steering wheel.

Now imagine trying to drive such a car. You steer a straight course as long as you see the highway stretched out behind you in the rear view mirror. When the road curves, you realize it only after the fact. You turn the wheel to get back on the highway, but nothing happens. So you turn the wheel some more. Again, nothing happens, so you turn the wheel still farther. Suddenly, the steering kicks in, and the car veers wildly. Desperately, you swing the wheel in the other direction, but the car continues turning the other way. What follows is a series of violent overcorrections ending in a crash.

Trying to regulate a nation’s money supply works about the same way. Central bankers cannot see into the future. They see only dimly where they are, and it is only in hindsight that their vision is clear. The impact of adjustments they make to the money supply may not be fully felt for a year or more. Such a system, like our car, is inherently unstable.

In response to the bust the Federal Reserve has moved quickly to re-inflate the economy, just as it had done after the dot-com collapse. The result is being termed a “recovery,” but more likely it is another overcorrection, the beginning of yet another boom and bust cycle, and a further misallocation of scarce resources. We cannot spend our way into prosperity. Production, not consumption, creates wealth.

The Road Back

We face two basic issues: How do we recover from the current recession, and how do we stop monetary boom and bust cycles? The answer to both is to increase economic freedom.

Our immediate problem stems from an imbalance between money and goods and from resource misallocation resulting from government interference with the market. The money-goods balance can be restored by shutting off the federal money spigot. This requires reining in government spending (which competes with the private sector for scarce resources), cutting taxes, and freeing markets. Correcting the misallocation of resources requires eliminating the policies that favor residential housing over other consumer needs.

The longer-term problem of taming boom and bust cycles can be addressed only by eliminating the Federal Reserve’s money monopoly. Repealing legal tender laws (which grant a monopoly on the creation of media of exchange to the Federal Reserve) would free Americans to choose forms of money that both meet their needs and maintain their value.

Before any of this can happen, though, the myth of the “business cycle” must be dispelled. Legends are luxuries we cannot afford. Reality is not optional.

Americans are saving more of their paychecks than at any time since February 1995, a shift toward thrift that could prolong the recession but strengthen the financial health of U.S. households and the overall economy if it lasts…..Americans’ thrift puts the Obama administration in a quandary. On the one hand, it is preaching the need for Americans to live within their means and exercise more fiscal responsibility. But on the other, to get the economy back on firm footing, Americans need to return to spending, from large-ticket items such as cars to smaller impulse buys like perfume and chocolate. [Emphasis added.]“In the United States, saving rates will have to increase, and the purchases of U.S. consumers cannot be as dominant a driver of growth as they have been in the past,” Treasury Secretary Timothy Geithner said Monday in a speech at Peking University in Beijing.

Now hold on. When people save, they don’t typically stuff their mattresses with the money. They put it into the bank or buy bonds or stocks. The money is then available for investment. Why would anyone invest if consumers are spending less and saving more? Because people save in order to buy things in the future. So the savings represent resources being released for longer term projects — at stages  remote from the consumer-goods level — that won’t yield products until some time in the future. Notice how this harmonized with what consumers want. If workers are laid off in retail businesses, they can take newly created jobs in earlier stages, such as businesses engaged in resource extraction and research and development.There isn’t  one labor marketWhat regulates all this are interest rates. When rates go down as a result of increases in saving and loanable funds, longer term projects become more worthwhile than previously. Thus to work properly the system needs freedom from government intrusion. If the central bank or other government agencies tamper with the price signals, things will go awry. The market regulates itself just fine, thank you, if allowed to.So much error in economic analysis is committed because analysts treat the economy as though it were one-dimensional.Time is of the essence!

One of the two most striking features of the current financial contretemps is the way it has seemingly come as a complete surprise to most financial commentators and economists. (The other is the way that financiers and bankers who have spent the last few years presenting themselves as buccaneering entrepreneurs have suddenly discovered a fondness for taxpayer bailouts.)

As recently as a year ago, most commentators in the financial press were convinced there was no real prospect of a major correction to the real-estate market, much less a serious financial crisis. There were dissenting Jeremiahs who warned that things could not go on as they had been, but they were in the minority. (They included the most successful investor in America, Warren Buffett.)

With no sense of satisfaction I report that I was, in my own small way, one of the Jeremiahs. I did not foresee all that has happened—neither did anybody else—but the broad outline was clear. Why did the majority miss it? The answer is a combination of common sense and a historical perspective informed by a certain approach to economics.

Trends and the Popular Mind

The first is easy enough to explain. A recurring feature of the popular mind is the belief that whatever trend is dominant at the moment can only continue indefinitely. Thus if the prices of houses and other assets are rising and have been rising for some time, then they must continue to do so indefinitely into the future. Talented and intelligent people then come up with all sorts of elaborate explanations of why this must be so. These are little more than elaborate rationalizations of assumptions. The contrary, common-sense view was captured by the chairman of Richard Nixon’s Council of Economic Advisers, Herbert Stein: “If something cannot go on forever, it will stop.”

However, common-sense observations and instinct do not help us understand precisely what has happened to the U.S. financial system and economy over the last decade, or why it happened and why it has now come to a messy end. The thing to grasp is that this kind of phenomenon has happened before. The current “credit crunch” is only the most recent of several such financial crises going back to the mid-nineteenth century or even the 1820s. Besides the events of 1929–1932, there were severe financial crises (“panics”) in 1873, 1893, and 1907. There was nearly a similar panic in 1997, and in many ways it is the response of the authorities to that year’s events which produced the situation we face today.

Although the details of the crises are distinctive, they all have something in common: they were the dramatic system-wide effects of manipulation of the money supply. The distinctive details are produced by the way monetary policy interacts with the most recent innovations in the financial markets.

Because of errors of public policy, the government’s monopoly central bank increased the money supply above the underlying level of actual economic growth. This can lead to a general rise in money prices (inflation), but that is not inevitable. Frequently a rise in the amount of money needed to buy consumer goods is concealed by a rise in productive efficiency, which reduces production costs so much that money prices still decline. However, the rise in the supply of money and credit leads in all cases to a rise in the money prices of assets and investment goods, such as securities, stocks, land, real estate, and even such things as antiques and fine wine.

This sparks off a speculative spiral in which people invest in capital goods not because of the anticipated return or because of their utility (as in the case of houses), but because they expect the money value of the good to rise. To return to Herbert Stein, this cannot go on forever, and eventually the underlying expansion of the money supply that drives the whole process will stop. (In fact it doesn’t have to actually stop; it is only necessary for the anticipated rate of increase to decline.)

Problems Are Exacerbated by Monetary Disorder

At this point two things become apparent. One is that a lot of investments are unsound and will never justify themselves. The other is that many people are left holding assets that are worth less than what they paid for them. The result is a period of economic pain in which the malinvestment has to be liquidated.

Paradoxically, the speculative spiral, or bubble, is actually amplified by open and competitive investment markets and tends to be most pronounced in newly developing sectors or with regard to newly created investment vehicles (railroad stocks and bonds in 1893, derivatives in the current events). The problem is that the more efficient and open a market is, the better it will respond to market signals as expressed in prices. If those signals are systematically distorted by an underlying monetary disorder, the response will amplify that disorder. The more efficient the market, the greater that effect. Because this bubble tends to be most pronounced in areas that have seen financial innovation, each particular panic has an element that is novel and typically completely unforeseeable.

Looked at in this way and with the benefit of historical perspective, the events of the last decade become clear. In response to the crisis of 1997 (brought about in turn by the policies of governments in various parts of the world), the world’s monetary authorities (above all, the Fed) expanded the money supply. This led to an asset bubble in shares, particularly those in cutting-edge hi-tech sectors. The bubble burst in 2001. The Fed, along with other central banks, then increased the supply of money and credit even further to avoid the painful reckoning. However, by trying to avert a recession in 2001–03 they precipitated an even-more-severe one now. The continued expansion simply led to another asset bubble, this time mainly in real estate, which has also burst. In this case the novel element is complex financial instruments based not on prices set by markets but rather elaborate mathematical models—which we now realize are useless precisely when you need them most: during a sudden shock.

A common response to these events is to blame the inherent qualities of financial markets. Certainly the response of people within those markets to adversity does not help their cause. However, the underlying active agency behind recurring crises of this kind is the government’s money monopoly. As long as its policy errors can have large-scale disastrous consequences, three sentences should fill you with fear: “The price of X cannot fall”; “We have managed to get rid of the business cycle”; and “This time it’s different.”

It can. We have not. And it isn’t.

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.

On average, Federal Reserve chairmen come and go at about the same rate as U.S. presidents. Dating from the creation of this country’s central bank (1913), we have seen 16 presidents (Wilson to Bush) and 14 Fed chairmen (Hamlin to Bernanke). The Fed chairmanship, however, has seen more variation in years of service—Franklin D. Roosevelt notwithstanding. Spanning four presidencies, Alan Greenspan’s reign (1987–2006) was the second longest. Greenspan was outdistanced (but only by a few months) by William McChesney Martin (1951–1970), who served five presidents.

The first half-dozen Fed chairmen belong to a different era—during which the primary locus of control on policy matters was the New York Federal Reserve Bank. It was that bank’s Benjamin Strong and, following him, George Harrison who were key operatives during the late 1920s’ expansion and the subsequent crash and descent into deep depression. And it was just as the economy was bottoming out that Congress passed legislation (in 1933 and 1935) that, among other things, shifted power to Washington. Though there is no Federal Reserve Bank in the nation’s capital, the Eccles Building on Constitution Avenue, built in 1937 and now named for the seventh Fed chairman, houses the Board of Governors and, most importantly, the chairman of the Board.

Like Marriner Eccles, the early and middle Fed chairmen were not economists. Instead, they had backgrounds in law, banking, or finance. But starting with Arthur Burns (1970–1978) and allowing for one short gap of 17 months, an economist has been at the top of this country’s banking pyramid. A nearly unbroken reign of economist-chairmen—Burns, Volcker, Greenspan, and now Bernanke—has characterized modern Fed history. Having an economist at the top does not necessarily translate into better policy, but it does make the policy regime more understandable in terms of economic theory.

The one short gap—between the Keynesian-oriented Burns and the monetarist-oriented Volcker—was bridged by the unlikely G. William Miller (March 1978–August 1979). Appointed by President Carter and somehow confirmed by the Senate, Miller was a marine engineer turned lawyer. He was a long-time executive of Textron, Inc., and, on several occasions, had served the Carter administration in an advisory capacity. Clearly out of his element, Miller oversaw the acceleration phase of that period’s double-digit inflation. Following established procedure for managing total bank reserves and hence deposit money, Miller and the other members of the Board (plus some Reserve Bank presidents) met about every month and a half to set short-term interest rates. They literally “set” the discount rate, the rate at which the Fed lends reserves directly to commercial banks, and they “targeted” (about which more below) the federal funds rate, the overnight rate at which commercial banks lend to one another for the purpose of meeting their reserve requirements, those requirements themselves having been imposed by the Fed.

During the 17 months of Miller’s tenure the discount rate was increased from 61⁄2 to 101⁄4 percent, the fed-funds target rate from 63⁄4 to 11 percent. Though responding to political pressures to keep interest rates low, the Miller Fed was constrained in each policy meeting by the inflation that had resulted from decisions in earlier meetings. With prices and wages rising at double-digit rates by the end of the decade, the Fed-controlled interest rates (both set and targeted) continued to rise in nominal terms, but were actually near zero or even negative in real terms. And as was well understood in financial and academic circles, holding nominal rates of interest below the inflation rate is a policy that cannot be sustained.

Finally, to stop the bleeding and to appease fiscal conservatives, Carter moved the chairman from the Federal Reserve to his own cabinet—where, as secretary of the treasury, Miller could borrow lots of money but couldn’t create any. Paul Volcker, then president of the New York Fed, was brought in as the new chairman of the Board. The circumstances under which Volcker assumed the chairmanship were unique and significant: (1) interest-rate targeting as a means of limiting inflation had lost its credibility. (2) Milton Friedman’s monetarism, which focused attention on the growth rate of the money supply rather than on short-term interest rates, was gaining acceptance in academic circles and beyond. And (3) the new Fed chairman had the support of fiscal conservatives both in Washington and on Wall Street.

In early October 1979, the Federal Reserve switched its modus operandi from fed-funds targeting to money-growth targeting. It never quite adopted Friedman’s monetary rule—according to which it should increase the money supply at a constant and pre-announced low-single-digit rate. But deliberations at the policy meetings were conducted in terms of money-growth rates rather than fed-funds rates. The money-growth rate and hence the inflation rate were brought down, while the fed-funds rate found its own level at record highs—topping out twice at 19 percent in 1981 and not returning to pre-Miller levels for several years.

As an episode in money-growth targeting, the so-called monetarist experiment lasted only three years (1979–1982). The key monetary aggregate, christened M1, was made up of coins, currency, and checking-account balances. M1 provided a solid anchor for money-growth policy at the beginning of the experiment, but the experiment itself led to a complete unanchoring of monetarism at the end. The story involves a heavy dose of monetarist irony.

The 1930s’ banking reforms that restricted policymaking to Washington also restricted the behavior of banks in critical ways. A Federal Reserve statute (Regulation Q) imposed key restrictions on demand deposits and time deposits. In effect, depositors were precluded from having a single account on which they could (1) write checks and (2) earn interest. The statute also set strict limits on savings-account interest rates. Though not implemented with money-growth targeting in mind, Regulation Q gave rise to a sharp distinction between money (that is, checkable accounts) and savings (that is, interest-earning accounts). This either-or aspect of money and savings allowed for a crisp definition of the money supply. M1 was money that people could actually spend and hence was unquestionably the basis for policymaking. The larger monetary aggregates (M2, M3, and still-more-encompassing M’s) included heavier and heavier doses of savings and thus were not so relevant to the issue of inflation.

And herein lies the monetarist irony. According to this free-market school of thought, the Federal Reserve can keep the economy performing at its laissez-faire best by ignoring interest rates and focusing instead on the money supply. But having a money-supply magnitude worthy of the Fed’s attention required this one critical departure from laissez faire called Regulation Q. Compounding the irony was the effect of the monetarist experiment on the viability of Regulation Q. As long as market interest rates hovered in the low single digits, the distortions caused by interest-rate ceilings (including a ceiling of zero percent on checkable accounts) were relatively minor. But the Miller Fed and subsequent monetarist experiment produced market rates of interest in excess of 20 percent, creating strong incentives for the banking industry to circumvent Regulation Q. The circumvention started with NOW accounts (Negotiable Order of Withdrawal), which were, in all but name, checkable savings accounts. Soon after, money-market mutual funds arose to help savers take advantage of the high treasury-bill rates. These and other such financial innovations threatened the very existence of commercial-bank savings accounts. The legislative reaction was bank deregulation, initiated during the Carter administration and accelerated in the early years of the Reagan administration. By 1982 Regulation Q was gone—and so too was the crisp distinction between checking accounts and savings accounts and the special significance of M1.

Though the Volcker Fed persistently missed its money-growth targets on the high side, it could claim to have done fairly well in dealing with inflation, at least in comparison to the Miller Fed. But in setting relatively low money-growth targets, it had destroyed (through high interest rates and bank deregulation) its ability even to identify a relevant money-supply magnitude. In 1982 the Volcker Fed reverted to targeting the fed-funds rate, not really by choice but because that was the only target left standing.

The Greenspan Era

When Alan Greenspan became Fed chairman on August 11, 1987, the interest-rate targeting continued. There was early and continued criticism of Greenspan because of his focus on interest rates rather than on monetary aggregates. As Bob Woodward reports in Maestro: Greenspan’s Fed and the American Boom (2000), the notion of money-supply targeting was still alive in 1989 in the person of Richard Darman, President George H. W. Bush’s budget director. Darman complained that Greenspan was mismanaging the money supply and, in particular, that the money-growth rate was too low. Greenspan responded dismissively with the claim that Darman had some sadly out-of-date notions. Without actually explaining to his readers just why those monetarist notions were out of date, Woodward remarked, “The Fed couldn’t even measure the money supply accurately, let alone control it” (p. 63).

As was true before the short period of money-supply targeting, the only interest rate that the Federal Reserve could actually get in its crosshairs was the fed-funds rate. That rate comes highly recommended as a target if the only criterion is the answer to the question “Can the Fed actually aim at—and hit—the target?” The answer is yes. The Fed can add to (or subtract from) bank reserves by buying (or selling) treasury bills. When the trading desk at the New York Fed buys a treasury bill from a commercial bank, the bank’s earning assets are reduced by the value of the treasury bill and its reserves (funds not lent out) are increased by that same amount. (Key to understanding these open-market operations, as they are called, is the fact that, unlike ordinary purchasers of treasury bills, the Federal Reserve buys treasury bills with funds that were not in existence before it made the purchase. It spends new money into existence.) And because the fed-funds rate is the rate that governs interbank transactions made on an overnight basis (as banks with excess reserves lend to banks with reserve deficiencies), the impact of increased reserves on the fed-funds rate is immediate. The timely feedback observed by the Fed’s trading desk allows it to adjust the volume of treasury bills bought or sold so as to achieve the targeted fed-funds rate. The Federal Reserve is never very far off target on any given day. On the basis of weekly averages, the Fed’s aim looks even better, and on the basis of monthly averages, the Fed scores a bull’s-eye every time.

Hitting the chosen fed-funds rate is not a problem. But choosing the particular fed-funds rate to target is another matter. Some choices are clearly non-viable, as was roundly demonstrated by the Miller Fed. Targeting too low a fed-funds rate requires a large infusion of reserves, which gives rise to a dramatically increasing money supply, which causes substantial inflation, which puts an inflation premium on all interest rates, which precludes the Fed’s having such a low target rate. The Miller Fed persistently failed to raise its target rate enough to keep up with the rising inflation premium.

Targeting too high a fed-funds rate might require a shrinkage of reserves, which would force a monetary contraction and put the economy into recession, weakening the business community’s demands for loans and hence reducing market rates of interest. The targeted fed-funds rate that was already too high is thrown even further out of line with actual market conditions.

Unfortunately for central banking, there is a wide spectrum of potential fed-funds target rates between clearly too low and clearly too high. Here, the root problem faced by the Fed is no different from the problem associated with a more general central control of economic activity. The Food Czar of a command economy can easily conceive of too many chickens or too few chickens. But the Goldilocks number of chickens—like the Goldilocks fed-funds target rate—doesn’t identify itself. Of course, in a thoroughly decentralized economy, it is the market-determined price of chickens—and the market-determined interest rates—that keep the economy functioning smoothly.

In choosing a fed-funds target rate, Greenspan’s thinking—at least early in his reign as Fed chairman—seemed to acknowledge the significance of having a rate that was just right. Referring to a 1989 episode, Woodward accurately captures Greenspan’s view: “[T]he Fed’s interest-rate policy had to be credible. A particular fed-funds rate had to be seen by markets as the best rate for the economy, not as an artificially low rate influenced by political pressure” (p. 62). Here, we see not only a bow to the market economy but a teasing hint at the Mises-Hayek theory of the business cycle: Holding interest rates artificially low sets the economy off on an unsustainable growth path. The policy-induced boom eventually ends in a bust. To avoid boom and bust, resources had to be allocated on the basis of the “natural rate of interest,” so named by Swedish economist Knut Wicksell and adopted as the market benchmark by Mises and Hayek.

Unfortunately, the very existence of a central bank precludes its knowing what the natural rate of interest is. That rate is the rate that would prevail “naturally,” that is, as the result of the give and take of decentralized forces in the absence of a central bank. Whatever theoretical understanding Greenspan retained from his early studies in Austrian economics, his practical approach to managing the monetary system was very conventional: raise the fed-funds target to counter inflationary pressures; lower the fed-funds target to counter unemployment.

Too High for Politics

While keeping with convention, interest rates were kept too high for George H. W. Bush’s political purposes in the 1992 presidential campaign. That was the claim made by the Republican leadership—and the reason for the widely perceived bad blood between Bush and Greenspan. But Greenspan was not always blind to political objectives. He signed on as a team player early in the Clinton administration and played a strong supporting role in Clinton’s 1996 campaign. Clearly (in retrospect and even at the time) the Fed’s lowering of the fed-funds target rate early in that election year was intended to counter the Republican Party rather than to counter unemployment.

While departing from the principles of central banking to give the Clinton campaign an edge, Greenspan departed from his Austrian roots in explaining the mid-to-late-1990s boom. He articulated a theory—or, at least, a belief—that ran completely counter to the Austrian theory. As reported by Woodward (pp. 171ff.), Greenspan persistently held to the belief—though a belief without proof—that productivity had increased on an economywide basis, creating what was popularly called the “New Economy.” Higher productivity would mean increasing output, which would hold price and wage inflation in check even as the Fed pursued an easy-money policy.

Greenspan’s calculations, however, are especially revealing. Inexplicably, he made his estimates of the supposed increase in productivity on the basis of the assumption that non-labor costs are constant. Surely, though, this is a peculiar assumption for the Fed chairman to make in light of the fact that non-labor costs include the cost of borrowing, which are affected rather dramatically by Fed policy. Lower borrowing costs—a.k.a. artificially low rates of interest—get reflected in increased profits for a wide variety of business firms. If non-labor costs are (counter to fact) assumed to be constant, then those increased profits will be mistakenly seen as evidence of a general increase in labor productivity. But since productivity gains are rarely across-the-board gains, it is much more likely that what Greenspan was observing was not some New Economy at all but rather the Old Economy goosed up by credit expansion.

In any case, the economywide downturn that began in late 2000 put an end to both the Clinton-Greenspan expansion and the so-called New Economy. Perhaps the only thing new about that period was the increasing irrelevance of the monetary aggregates. As already indicated, the once-all-important M1 had lost much of its significance with the 1980s monetary deregulation and in particular with the phasing out of Regulation Q. But during the increased globalization of the 1990s, this one-time key monetary magnitude lost virtually all its significance. As M1 actually declined from the mid-1990s through the turn of the century, its currency component rose dramatically. The ratio C/M1 rose from well below 30 percent at the beginning of the Greenspan years to well over 50 percent at the end—with most of that increase occurring during the last half of the 1990s. The dramatic change reflected not the increased use of currency in the United States but the increased use of U.S. currency outside our borders. Stashes of dollars in unstable Middle Eastern countries as well as the widespread circulation of dollars in former Soviet-bloc countries and in Latin American countries that have become (officially or unofficially) dollarized help account for the high demand of U.S. currency.

Friedman’s monetarism and especially his monetary rule, as articulated with the aid of the bedrock equation of exchange (MV = PQ), requires that the M and the P and the Q all refer to the same piece of geography. It just won’t do, for instance, to take P and Q to be the U.S. Consumer Price Index and the U.S. Gross Domestic Product and to take the corresponding M to be M1—much of which is outside the United States. But the Federal Reserve has no way of tabulating M1US. That is, Greenspan knew how much M1 had been created, but he didn’t know where in the world it was. Trying to manage the money supply directly, then, that is, adopting a policy of money-supply targeting, was increasingly problematic. More so than ever, fed-funds targeting was all there was to do.

“Neutral Interest Rate”

Fed watchers during the last years of Greenspan’s chairmanship have repeatedly encountered the term “neutral rate of interest” in discussions of the Fed’s choice of fed-funds target rates. That term could be taken as evidence that Greenspan had returned to his Austrian roots and wanted to target a fed-funds rate consistent with the “natural rate of interest,” that is, the rate of interest that would prevail in a market unhampered by a central bank. But “Greenspan-neutral” is not the same thing as “Austrian-natural.” The Fed knows that if it sets interest rates too low, there will be worries about inflation, and if it sets interest rates too high, there will be worries about unemployment. The goal, then, is to balance the worries—that is, to find the equi-worry fed-funds rate. That’s what’s meant by the neutral rate.

But just whose worries count? The worries emanating from financial markets? Traders in financial markets might worry about interest rates being too low or too high—but mainly because of the implications about future actions by the Federal Reserve. Is the Fed going to raise rates? Is it going to lower them? The neutral fed-funds rate, then, would be the rate that causes the financial markets to have no net worry about the fed-funds rate changing in one direction or the other. If this is the balancing act that underlies Federal Reserve policy, then both the Fed and financial markets are living in a house of mirrors.

Is there any known market mechanism that causes the neutral rate to be brought into line with the natural rate? That is, is there any reason to believe that equi-worry about inflation and unemployment translates into interest rates that are consistent with sustainable growth? Or is it quite possible that the Greenspan-neutral rate lies below the Austrian-natural rate? We have the answer to this question from Greenspan himself—as summarized by Woodward: “There was no rational way to determine that you were in a bubble when you were in it. The bubble was perceived only after it burst . . .” (p. 217). Evidently, the equi-worry rate itself is something to worry about.

On the last day that Alan Greenspan served as Fed chairman, Milton Friedman penned a commentary in the Wall Street Journal (January 31, 2006) titled “He Has Set a Standard.” Some readers of the WSJ might have been led to believe that Greenspan had somehow followed Friedman’s monetary rule. We now see, though, that there was no well-grounded rule; there was no standard. In truth, Greenspan pitted worry against worry and was lucky enough to make it to the end of his final term despite there being no standard at all.

And now, Ben Bernanke has pledged to continue the policies of the Greenspan Fed—possibly with a little less worry about inflation. We can only wonder how long his luck will hold out.