What if Friedman were alive?

A few days ago I did a post commenting on James Grant´s take on the 1921 crash (here). Burton Malkiel has written a review of Grant´s book:

For Mr. Grant, the heroes of the narrative are the price mechanism itself and Adam Smith ’s invisible hand. Prices and wages stopped falling “when they became low enough to entice consumers into shopping, investors into committing capital, and employers into hiring.” Hence the book’s subtitle: “1921: The Crash That Cured Itself.”

Does this experience have relevance to policy today? The answer, for Mr. Grant, is a confident “yes.” No fiscal stimulus was administered in 1920-21, and a powerful, job-filled recovery followed. Today our “overmedicated” economy is in its fifth year of a “lackluster recovery.” In the current environment, he believes, we should take a more laissez-faire position.

Perhaps so, but there are important differences between then and now, and there is more to the story. In their definitive “A Monetary History of the United States” (1963), Milton Friedman and Anna Schwartz share Mr. Grant’s essential take on the cause of the 1920-21 recession, describing it as a reaction to an overzealous tightening of monetary policy to fight the post-World War I inflation. But monetary policy, they note, also played a role in the recovery. The discount rate was cut several times in 1921, and the monetary base had stopped falling by the end of the year. Credit conditions eased, the money supply rose and the monetary base started rising sharply in early 1922. Monetary policy caused the downturn, and the recovery occurred when monetary policy changed course. The recession did not cure itself.

Just as important, monetary policy did not cause the recession of 2008. The crisis was precipitated by the unraveling of a housing bubble and excessive leverage by individuals as well as financial institutions, creating a crisis whose remedies are different from 1920-21. To take but one example: Short-term interest rates today have already been reduced essentially to zero, and yet the economy still lags.

So, to Malkiel (who belongs to a very large group) monetary policy did not cause the 2008 recession. That means monetary policy had nothing to do with the large drop in nominal spending that took place.

Friedman would have enlightened Malkiel by:

  1. Telling him that you cannot escape a (great) recession if the Fed allows nominal spending growth not only drop precipitously but to turn negative.
  2. Reminding him that interest rates do not define the stance of monetary policy (in fact, if rates are low it means monetary policy has been tight), and
  3. Sending him to read this (among others) Scott Sumner post

4 thoughts on “What if Friedman were alive?

  1. It didn’t hurt that Germany was paying us war reparations and had to buy our goods. Of course, some of us think that policy turned out to be worse than self-defeating.

    • Germany´s first reparation payment was made in August 1921. By that time the 1920-21 “depression” was about over. It was the Eurpean victors, especially France, who demamded harsh payments. That wasn´t Woodrow Wilson´s initial idea (14 points).

  2. That’s a fair point. However, I’m a strong believer in the role of expectations influencing economic behavior, so when Harding was elected, I think higher tariffs were priced in. In any case, my point is simpler than that, and I agree with a monetary-ish view of events, in general. My point is that I don’t consider raising tariffs and negotiating reparation payments as non-governmental intervention in the economy, and there was the Fed as well. I’ll read Grant’s book, and do some more reading about this, but stimulus is a more robust concept than simply the Fed Govt spending money. The idea that the Federal Govt wasn’t doing anything to help the economy doesn’t work for me. Donald Pretari

  3. Harding also said this in his inaugural address: ” Perhaps we never shall know the old levels of wages again, because war invariably readjusts compensations, and the necessaries of life will show their inseparable relationship, but we must strive for normalcy to reach stability.” Seems I’ve heard that recently.

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