Cant and Recant: Milton Friedman's Latest Research on the Federal Reserve Challenges Key Assumptions of a Very Prominent Economist: Milton Friedman

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MORE THAN ANY OTHER INDIVIDUAL, MILTON Friedman was the intellectual inspiration of the conservative counterrevolution against activist government as an engine of economic efficiency and social justice. In his scholarly work contending that government intervention invariably makes things worse, and in his popular polemics equating capitalism with human freedom, Friedman inspired conservative academic economists and movement activists alike. He is the high priest of the ideology that can be reduced to a bumper sticker: Markets work; government doesn't. More narrowly, Friedman is famous for the economic theory known as monetarism and the corollary view that the Federal Reserve System works best when it is essentially passive, contenting itself with maintaining stable prices.

Now in his 94th year, Friedman has just published new research with implications that are curiously double-edged. On one level, his study, in the latest issue of the Journal of Economic Perspectives, confirms his early scholarly work demonstrating that wrongheaded policy by the Fed drastically deepened the Great Depression. Friedman wrote, in his 1963 history of U.S. monetary policy with Anna Schwartz, that the Fed's error was to let the money supply shrink while the real economy was imploding. This conclusion is now accepted by scholars of all stripes, though Friedman gives the Fed's role far more weight than most. But on another level, Friedman's new work can be read as inviting a most un-Friedmanlike inference--that competent, creative, and vigorously interventionist government, in this case by central bankers, matters immensely. Friedman, of course, recoils from this conclusion. Yet the implications of his own research, read against the Fed's actual history, drive a stake in his anti-government ideology.

In his new work, Friedman compares three great bull markets, three ensuing stock-market crashes, and the recovery path after each: the Great Crash of October 1929, the Japanese slow collapse of the late 1980s and early 1990s, and the U.S. market meltdown of 2000-2001. He then looks at the money supply in each case and treats the results as a natural experiment. After 1929 in the United States, money supply plummeted and so did the economy. In the late 1980s in Japan, the money supply and the economy were fairly stagnant. But in the United States after 2001, money supply and economic growth, after a brief pause, resumed growing.

Friedman rightly credits Man Greenspan's Fed for avoiding the mistakes of its 1929 predecessor. (Given the immense dependence of the United States on foreign borrowing, it remains to be seen whether Greenspan's successor, Ben Bernanke, can do as well.) For Friedman, what Greenspan did right was to keep the money supply and price level on a steady course. However, Friedman entirely glosses over what Greenspan actually did. For Friedman, the moral of the story is his usual one: The money supply is paramount, and the central bankers can do no better than to "target price stability" in their conduct of monetary policy. "Monetary policy," his paper concludes, "deserves much credit for the mildness of the recession that followed the collapse of the U.S. boom in late 2000."

But the Fed of the Greenspan era did far more than keep prices stable. It was the most interventionist Fed ever.

WHEN FINANCIAL MARKETS IMPLODE, INFLATION IS the least of a central banker's problems. In percentage terms, the stock market collapse of October 19, 1987, was nearly double the one-day crash of October 29, 1929. In the 1987 collapse, the market lost 22.6 percent of its value in a single day, compared to only 11.7 percent in the worst day of 1929. More shareholder equity was wiped out, relative to the gross domestic product, in the dot-com bust of 2000-2001 than in the Great Crash of 1929-1930.

In both the crashes of 1987 and 2000-2001, the Greenspan Fed prevented the crash from triggering a depression by flooding money markets with liquidity, jawboning bankers to keep lending, and all but commandeering Wall Street to continue credit flowing. …