Streetwise Professor

October 27, 2009

Not So Fast

Filed under: Economics,Financial crisis,Politics — The Professor @ 8:31 pm

I can’t count the number of times I’ve heard that the financial/economic crisis has discredited Milton Friedman and Chicago School economics.  This argument was raised repeatedly during the shrill debate over the creation of the Milton Friedman Center at UC, but it has been made repeatedly in other contexts as well.

I say let’s look at the record.  First consider Friedman’s scholarly work.  Note that one of his most important contributions, with Anna Schwartz in A Monetary History of the United States, was to demonstrate the salient role of the Federal Reserve in causing economic contractions–including the Great Depression.  He subsequently argued quite presciently that Fed policy during the 1960s and 1970s would cause inflation, and were the cause of the inflation that in fact occurred.

If anything, the monetary policy of the 2000s, which played a central role in the 2008-2009 crisis, provides a ringing confirmation of Friedman’s fundamental point about how a discretionary, fine-tuning monetary policy is ultimately highly disruptive and likely to end in economic misery.  The crisis of 2008-2009 would therefore be fertile ground for another chapter-or four–in an updated version of Friedman’s history.  Thus, a compelling argument can be made that the crisis is actually a testament to Friedman’s prescience in warning of the dangers of bad monetary policy.

It should also be noted that in setting monetary policy during the crisis, Bernanke was consciously striving to avoid the Fed’s mistakes of the 1930s–mistakes that Friedman pointed out long ago.  Note too that Bernanke’s own research on monetary policies and depressions owes a great debt to Friedman’s (and Schwartz’s) pioneering scholarship.

One of Friedman’s other seminal contributions–the theory of the consumption function/permanent income hypothesis–has also stood up extremely well.  The temporary tax cut in 2008 was about as close to a controlled experiment of an economic theory as you can get, and the permanent income hypothesis came through with flying colors.  (The effects of the stimulus are much more difficult to test, given that the stimulus occurred simultaneously with a massive monetary policy intervention.)  Also, the sharp decline in personal consumption resulting from the large decline in personal wealth due to the fall in housing prices is just what one would have predicted based on Friedman’s permanent income hypothesis.

Now consider Friedman’s more polemical advocacy of capitalism.  The current crisis is commonly considered to be a resounding failure of capitalism requiring government correction.  But note well: The Great Depression was also widely considered a failure of capitalism, but scholarship emanating from Chicago, much of it done by Friedman, eventually largely refuted that verdict.  As Friedman notes in his joint memoir with his wife Rose, Two Lucky People (p. 41), at Chicago

teachers widely regarded the depression as largely the product of misguided policy–or at least greatly intensified by such policies. . . . During that period, the small minority of economists who did not succumb [what a choice of verbs!] to the Keynesian Revolution consisted disproportionately of Chicago-trained economists.

Friedman’s above-mentioned scholarship on monetary policy during the Depression was instrumental in overturning the conventional wisdom, and convincing most economists that perverse monetary policy and perverse banking legislation was the primary culprit for the onset of the Depression, and its persistence.  Moreover, Friedman was also an outspoken proponent of the view that government policy during the Depression, most notably the NRA and the Wagner Act, by cartelizing the product and labor markets, also undermined normal recovery.  This view has recently received considerable support from the research of Cole and Ohanian.  This goes to show that early, facile judgments that economic crises demonstrate the inevitable failures of capitalism do not necessarily stand the test of time.

It’s not sporting to pick on the dead; or put differently, the silent dead can’t resist the efforts of the living to discredit them.  I daresay that if Friedman were alive today, and in his form of the 1960s and 1970s, those who state with such assurance that the current situation is evidence of the inevitable instability of a capitalist system that requires a firm government hand to fix would have quite a fight on their hands.  And I’d put my money on Friedman.  The thought of him slicing Krugman or Stiglitz to ribbons is too delicious for words.  Alas, it is not to be.  (Not to mention the fact that Friedman had so much more class than those two.)

Friedman’s absence does not mean that the facile snap judgments are going unanswered.   There are many scholars active today that have a decidedly Friedmanesque take on the current crisis, arguing that in fact the events of 2007-2009 (and the years leading up to the explosion of the crisis) are traceable in large part to egregious government failures.  Some of these are monetary policy failures, but others relate to the perverse regulation of the supposedly unregulated banking and financial systems.  And no, I’m not talking about the repeal of Glass-Steagall, or the CFMA.

For a very clear explanation of this view, I strongly recommend this interview (by former colleague and fellow Chicago guy Russell Roberts) with Charles Calomaris.  Charles deftly destroys most of the shibboleths that dominate today’s discourse on the crisis, and makes a very persuasive case that myriad government policies were necessary conditions for the crisis.  These policies (some of the most egregious traceable directly to Barney Frank) created a perverse incentive system that made it rational for banks to do what they did.  All I can say is, listen to this and you’ll realize that the Beltway conventional wisdom is 99.99 percent unadulterated BS.  (His disquisition on Glass-Steagall is particularly choice, making it clear that people as various as Paul Volcker and Mara Liasson–whom I heard blame the financial crisis on G-S repeal last week–have no clue.  None.  Zero.  Zip.)

The Calomaris interview is long, but worth it.  If for nothing else, it is worth it to hear him tell, with considerable relish, the story of how Joe Stiglitz and Peter Orszag (now Obama’s head of OMB, who presumes to tell us the best way to reorganize the entire health care system) wrote a paper for Fannie Mae in which they confidently stated that the probability that Fannie or Freddie would ever cost the taxpayers a penny “was essentially zero.”  Calomaris says that they were right!  It didn’t cost a penny!  It cost $350 billion.

Keep that in mind the next time you hear Stiglitz bloviate on the crisis, or regulation, or the financial system, or capitalism.  Or whether the sun rises in the east.

Even though Russ Roberts is sympathetic to Calomaris’s arguments, he is a good interviewer, and challenges him repeatedly.  Another reason for listening.

As I’ve said over and over, the great lesson of the Great Depression was that people learned the wrong lessons from the Great Depression.  Milton Friedman was instrumental in helping us unlearn the wrong lessons, and grope for the truth.  There are many parallels between the thirties and the noughties, and I think that two of the most important ones are the rush to heap responsibility on the market system and the related drive to swell the power of government.  Some of the blame the market-laud the government sentiment is intellectual error; some (probably more) is an opportunistic power grab.

Those who are so anxious to dance on Milton Friedman’s grave today should remember that the easy verdicts of lazy minds about the Depression did not withstand the power of his scholarship.  They should take this as a lesson, and consider the very real possibility that their easy, lazy verdicts about the implications of the recent crisis are similarly vulnerable.

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  1. How is possible, on your view, that less than 10 years ago, Texas had the same sub prime mortgage blow-up, and we cannot learn the right regulatory lessons or how to implement what we know?

    Comment by michael webster — October 28, 2009 @ 8:16 am

  2. Incentives, incentives, incentives… create proper incentives.

    I have to say that the discussion between Calomiris and Roberts was extremely useful for me. They were able to describe all the forces that led to the crisis in such a patient, thorough, and thoughtful way, that it clarified in my mind what really happened. Suffice it to say, the “political populists” (both the politicians and the actual voting populists), as usual, got (and continue to get) cause and effect backwards.

    False incentives that start with trying to escape the reality of risk leads to the downward spiral in behavior that so many people seem to hate. Once everything collapses, they start pointing at the wrong links in the chain. As long as people continue to fan the flames of the fantasy that government can remove risk, socially engineer a well-behaved market, and create a foolproof safety net, this vicious circle will never stop. As long as Roosevelt is considered to be our savior from the Great Depression, we can not move forward. It was fascinating to listen to how each of the regulations Calomiris mentioned created such perverse behaviors in the market. It was one of those pleasant moments where I actually understood economics. (but, SWP, if you start talking about derivative clearing again, I’ll go back to doing my best imitation of Homer Simpson trying to construct a complex thought) :)

    I get sick and tired of listening to people complain about the tragic results of the crisis which was created by false incentives and a rotten foundation in the first place. They do the exact opposite of what should be done, vote for more “guarantees” and put the CEO’s necks under the guillotine. It only makes the problems worse next time. (the statistics about bank failures and the impact of FDIC were eye-opening)

    Anyway, whenever you talk about government regulation, in the spirit of Milton Friedman, please remember my only words of wisdom: Less is more, folks.

    Comment by Howard Roark — October 28, 2009 @ 2:38 pm

  3. Howard:

    D’OH! I am hurt to the quick that my posts on clearing make you go all Homer on me. :) Actually, understood completely. The blog has a disparate readership, some of whom actually like that stuff. Go figure. It also serves as a first draft on my thoughts on research-related issues. I know it goes way too far inside baseball for most, but it serves my purpose.

    Re your other points: very well put. Glad that the Calomaris podcast was useful.

    Many of these tales of regulation remind me of the story about the Indian village that tried to rid itself of rats by bringing in the cats; the cats by bringing in the dogs; and so on. The other analogy that always comes to mind is the Sorcerer’s Apprentice. Or Rube Goldberg contraptions.

    The tragic part about it is that the people who wreak such havoc are almost never held accountable. Yet they bray indignantly about holding others accountable.

    And you are quite right re regulation: KISS. (“Keep it simple, stupid.”)

    The ProfessorComment by The Professor — October 28, 2009 @ 4:52 pm

  4. Thanks for this article. It’s about time that someone spoke up for Milton Friedman. He is one of the greatest Economist of all time and fellow Rutgers Grad. I became interested in Economics due to Rose & Milton Friedman’s “Free TO Choose” TV Show & Book. I wish that Milton Friedman was still with us. He would be ripping Obama, Bernanke and Crew new a holes! While I’m dreaming, why not have Mises and Hayek as his wing men. In a hockey sense I think Mises would have been a relentless forechecker, Hayek the playmaker who dishes off to Friedman to bang the puck home. Keep up the good work. I especially enjoy your sarcastic accounts of scum bags Putin & puppet Medvedev.

    Comment by Bob — October 28, 2009 @ 6:22 pm

  5. Well, certainly don’t change your blogging habits on my account! It is often interesting how economics burrows into so many other parts of life and can explain so many social phenomena in the world. How people respond to your economic opinions is a treasure chest of self-revelation. Keep it up and maybe one day I’ll catch up. Meanwhile, back to my Russian grammar…

    Comment by Howard Roark — October 29, 2009 @ 7:58 am

  6. Bob–Thanks very much. I share your dreams :) I would pay large money to see him take Krugman and Stiglitz apart, before schooling Bernanke. As for Geithner and Obama, he could probably do that in his current state. And you definitely must not be Bob From Canada. LOL. (If that statement mystifies you, you might want to search the comments for some of his gems, which definitely do not express appreciation for sarcasm directed at Russian scumbags.)

    My thesis advisor, Les Telser, was a Friedman student (so I guess that makes me a Friedman grandson, huh?). Les says that Frank Knight was actually the greatest Chicago economist. Which means that Knight must have been one major bad-ass.

    Howard–thanks to you too. Yes, as they say, economics is an imperialistic discipline. And I sympathize with you on the Russian grammar. I fly a lot, and study my cheat sheet (from BarCharts1, which is available at Borders-quite useful) on most flights. Finally have committed most of pronouns and possessives to memory, and now am making progress on figuring out which case goes with which preposition. What a chore, though. I also listen to Pimsleur’s lessons while working out. I figure if I keep it up for another 10 years I’ll be able to converse with a 5 year old, which doesn’t actually seem like a very good exchange rate :) Hope you’re making better progress.

    The ProfessorComment by The Professor — October 29, 2009 @ 9:45 pm

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