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What did Milton Friedman favor?
Responding to my initial post, David Henderson gets himself into a bit of trouble when he writes:
He's [Tyler] correct that Friedman wanted the Fed to increase the money supply. I don't think I'm pretending when I say that I don't think Friedman advocated bailing out banks during the Depression. As I think Friedman would have, last fall I advocated an increase in the money supply while opposing a bailout. Those two, contra Cowen, are separable.
When it comes to 1929-1931, Friedman favored the Fed a) buying up a lot more bonds, and b) serving as a lender of last resort to failing banks. They are separable but Friedman favored both.
In the Monetary History, Friedman and Schwartz approvingly quote Walter Bagehot about the need to do whatever is required, however bold or desperate, to stop a banking panic. Part of the passage runs like this:
The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. “We lent it,” said Mr. Harman [one of the Bank’s more senior directors] on behalf of the Bank of England, “by every possible means and in modes we have never adopted before;...
Here is Charles Goodhart quoting Friedman on why the Fed should have been a lender of last resort to troubled banks. Or see p.269 of the Monetary History, where Friedman and Schwartz explain how it was too difficult for banks to borrow from the Fed at favorable rates in the early 1930s. Or read this Friedman interview.
In the comments Bruce Bartlett, channeling Friedman, responded:
There's no way the Fed could have expanded the money supply in the early 1930s without bailing out the banks. How do you think the money supply declined in the first place? It's because banks failed and their deposits disappeared. To keep those deposits from disappearing in an era before deposit insurance would have required keeping bankrupt banks afloat.
Friedman's model was not one of allowing a boost in currency to substitute for the broader monetary aggregates. An article in The Freeman is clear, if perhaps even a bit exaggerated:
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.
You might try to draw a distinction between "lender of last resort" and "bailout" but Bernanke's emergency lending is usually considered part of the bailout package. No one is suggesting Friedman would have favored each and every part of the bailouts that we have seen. The point is that Friedman favored some bailouts in the past and probably would have favored some this time around as well. You don't have to think he would have voted for the first Paulson proposal.
Oddly, Henderson in his post takes offense because I suggest that libertarians try to run away from the idea that Friedman favored Fed action beyond simple monetary policy. Henderson then tries to run away from the idea that...Friedman favored Fed action beyond simple monetary policy.
I now recall that a related point was made by Paul Krugman, although I find that piece problematic in some other ways.
Here are a few sounder history of thought claims:
1. Friedman and Schwartz argued that if the Fed had been more on the ball with monetary policy earlier on, the lender of last resort actions would not have been needed. That is distinct from opposing such actions in the time of necessity, when necessity comes.
2. At times Friedman suggested that the rise of deposit insurance limited the importance of the lender of last resort role. (How he would have thought about rescuing the shadow banking system is an interesting question.) A related issue hovers here, namely whether support for deposit insurance constitutes support for bailouts. It seems to me it does, though my original point does not rely on this judgment.
3. Friedman thought that "simple" monetary policy, combined with "simple" Fed lending would go pretty far in stopping a banking panic, yet this view was not borne out in the very recent crisis. In any case it's wrong to conclude that Friedman was necessarily opposed to more vigorous action, if such action would turn out to be needed. If you read Friedman as a whole his focus is not on drawing particular lines to circumscribe Fed action, but rather doing whatever is needed to keep the banking system up and running.
On the broader issue of the bailouts, read Megan McArdle's latest, excerpt: "To a first approximation, I'd say that the bailouts are the reason that we won't have a single-payer health system or actual national automakers any time soon."
Posted by Tyler Cowen on August 27, 2009 at 06:53 AM in Economics, History | Permalink
Comments
'You might try to draw a distinction between "lender of last resort" and "bailout" but Bernanke's emergency lending is usually considered part of the bailout package.'
You absolutely must do this. For instance, the initial specifics of the AIG deal did not constitute a bailout, and I was fine with it. The revised deal does, and it's terrible. To "lend freely at a penalty rate" is not to bailout.
Posted by: Robert Simmons at Aug 27, 2009 8:13:58 AM
Is 'the banks' too broad? Can't we produce lending funding the top 50% sound banks while not bailing out the bottom, unsound banks?
Posted by: Tom at Aug 27, 2009 8:32:35 AM
So, where does this tie in with Friedman's argument that the Fed should basically be a computer? In other words, that later in life he apparently favored taking away much of the Fed's discretionary power. To me that seems to sum up what he told Russ Roberts in the EconTalk interviews. Was he being flip or had he changed his mind?
Posted by: Seward at Aug 27, 2009 8:40:39 AM
Tylers next post: What would Jesus drive?
Posted by: Tom at Aug 27, 2009 8:57:14 AM
I don't think one can focus solely on the money supply now or in the 1930s because velocity also fell. Since nominal GDP equals the money supply times velocity, a decline in velocity will have exactly the same effect in terms of reducing GDP as a decline in the money supply. But increasing velocity is a lot harder than increasing the money supply.
Friedman and Schwartz mention that velocity declined as well as the money supply in the early 1930s, but they don't emphasize it. The current downturn, however, is almost entirely a function of a decline in velocity. The decline in wealth resulting from collapse of the housing bubble reduced spending very significantly, thus reducing velocity. Those focusing only on the money supply have been looking at only half the equation.
When velocity falls by a small amount the Fed can compensate by raising the money supply. But when velocity falls a lot, as it has over the past year, the Fed can't increase the money supply fast enough to prevent a decline in nominal GDP, which will result in both falling prices and reduced output. That is why an expansionary fiscal policy is essential to compliment monetary policy. Otherwise the Fed is pushing on a string.
Posted by: Bruce Bartlett at Aug 27, 2009 8:57:31 AM
Touchy touchy. It seems like the post hit a nerve.
Posted by: student@studentcom at Aug 27, 2009 8:59:26 AM
Perhaps a good test of how great an economist is is whether people ask what would s/he do after they are dead.
Posted by: Mo at Aug 27, 2009 9:11:23 AM
In the sentence prior to the sentence that leads into the Bagehot quote, F&S say: "The system [Fed] took no active measures to ease the internal drain, as it could have done through open market purchases." They they quote Bagehot quoting Harman, all of whose "means" and "modes" were involving what I would call rough equivalents of OMOs, just on all kinds of different securities. That's a different thing altogether from the sorts of bailouts we saw last fall, including the purchasing of bank stocks etc..
Henderson's point is the same one I made in response to Pete Boettke's response to Tyler here: http://austrianeconomists.typepad.com/weblog/2009/08/can-i-bring-myself-to-utter-those-words.html
Posted by: Steve Horwitz at Aug 27, 2009 9:27:48 AM
I think this is a pretty good post, and it highlights Friedman quotes I've read to the effect that von Mises was "unreasonable" when discussing fiscal policy and started screaming that all other economists were socialists.
So I guess the only difference between a New Classicist and a New Keynesian is at what point one decides printing money is "necessary."
As for Greenspan's argument from the 1960s (okay, okay - we all know that it was really Ayn Rand's argument articulated via Greenspan) that capital markets would provide stern enough checks on the financial system to prevent a widespread collapse if we put an end to our seemingly unanimous decision to constantly increase the money supply, I guess no one's really interested in thinking about that anymore.
But isn't it sad that so many people argue so fervently about when to print money to avoid a collapose without ever considering that these crises need never occur in the first place. Truly, capitalism is the only economic system without a philosophical basis. :(
Posted by: Ryan at Aug 27, 2009 9:36:27 AM
Was this a liquidity crisis? Or was it a period when uncertainty about the true value of assets and firms froze the markets?
I think Friedman would agree that in a liquidity crisis the Fed can step in and calm jitters from turning into a panic. The Friedman view, I think, is to keep the fear from spreading to healthy institutions. I am less certain that he would have been as happy to try and salvage poorly managed banks.
I am also less certain of the correct role of the Fed when the crisis is about the true value of the assets a bank, or a shadow bank, holds. The issue of toxic assets and how to price them was a core issue. One the Fed was not very good at resolving without just pumping tax dollars into an institution until the toxic assets become less of an issue for the balance sheets.
I'm not sure that Friedman would agree that the best way to resolve a credit crisis is to have taxpayers buy toxic assets just to make sure that a large bank doesn't close it's doors.
Posted by: DanC at Aug 27, 2009 10:17:59 AM
"If you read Friedman as a whole his focus is not on drawing particular lines to circumscribe Fed action, but rather doing whatever is needed to keep the banking system up and running."
I think there is an important point for discussion here. Is "saving banks" synonymous with "saving the banking system"? During the Great Depression, bailing out individual banks may have been crucial for saving the banking system. We know that an entire generation lost its confidence in the banking system and permanently reduced their demand for banking services, disrupting the flow of credit and capital.
I think this key question should be asked: were the recent bailouts key to restoring (confidence and demand for) the banking system, or simply large banks?
The Fed went on and on about confidence, suggesting that the answer was yes, and it was crucial for restoring the banking SYSTEM in 2008-9. Were banks seriously in danger of a permanently lower demand for their services? If not, why isn't that simply resolved by the Fed's lender of last resort function (designed for short term losses in confidence)?
More pointedly, if there were no bailouts, and some major banks failed, do we have reason to believe that new and existing banks wouldn't have expanded to supply banking services (given that demand for those services may have survived the current recession)?
Posted by: Scott Wentland at Aug 27, 2009 10:28:44 AM
"If you read Friedman as a whole his focus is not on drawing particular lines to circumscribe Fed action, but rather doing whatever is needed to keep the banking system up and running."
I think there is an important point for discussion here. Is "saving banks" synonymous with "saving the banking system"? During the Great Depression, bailing out individual banks may have been crucial for saving the banking system. We know that an entire generation lost its confidence in the banking system and permanently reduced their demand for banking services, disrupting the flow of credit and capital.
I think this key question should be asked: were the recent bailouts key to restoring (confidence and demand for) the banking system, or simply large banks?
The Fed went on and on about confidence, suggesting that the answer was yes, and it was crucial for restoring the banking SYSTEM in 2008-9. Were banks seriously in danger of a permanently lower demand for their services? If not, why isn't that simply resolved by the Fed's lender of last resort function (designed for short term losses in confidence)?
More pointedly, if there were no bailouts, and some major banks failed, do we have reason to believe that new and existing banks wouldn't have expanded to supply banking services (given that demand for those services may have survived the current recession)?
Posted by: Scott Wentland at Aug 27, 2009 10:28:57 AM
Bernanke has answered many of these questions in this talk:
http://federalreserve.gov/newsevents/speech/bernanke20090821a.htm
"Following the Lehman collapse, panic gripped the money market mutual funds and the commercial paper market, as I have discussed. More generally, during the crisis runs of uninsured creditors have created severe funding problems for a number of financial firms. In some cases, runs by creditors were augmented by other types of "runs"--for example, by prime brokerage customers of investment banks concerned about the funds they held in margin accounts. Overall, the role played by panic helps to explain the remarkably sharp and sudden intensification of the financial crisis last fall, its rapid global spread, and the fact that the abrupt deterioration in financial conditions was largely unforecasted by standard market indicators.
The view that the financial crisis had elements of a classic panic, particularly during its most intense phases, has helped to motivate a number of the Federal Reserve's policy actions.19 Bagehot instructed central banks--the only institutions that have the power to increase the aggregate liquidity in the system--to respond to panics by lending freely against sound collateral.20 Following that advice, from the beginning of the crisis the Fed (like other central banks) has provided large amounts of short-term liquidity to financial institutions."
He believes that he was following Bagehot:
"The case of the investment bank Lehman Brothers proved exceptionally difficult, however. Concerted government attempts to find a buyer for the company or to develop an industry solution proved unavailing, and the company's available collateral fell well short of the amount needed to secure a Federal Reserve loan of sufficient size to meet its funding needs."
Time will tell if the govt's actions work out:
http://www.economist.com/blogs/freeexchange/2009/08/america_savvy_investor.cfm
For those of us who favored saving Lehman, here's why:
http://www.frbatlanta.org/news/CONFEREN/09fmc/gorton.pdf
"The 'shadow banking system' at the heart of the current credit crisis is, in fact, a real banking system – and is vulnerable to a banking panic. Indeed, the events starting in August 2007 are a banking panic. A banking panic is a systemic event because the banking system cannot honor its obligations and is insolvent. Unlike the historical banking panics of the 19th and early 20th centuries, the current banking panic is a wholesale panic, not a retail panic. In the earlier episodes, depositors ran to their banks and demanded cash in exchange for their checking accounts. Unable to meet those demands, the banking system became insolvent. The current panic involved financial firms 'running' on other financial firms by not renewing sale and repurchase agreements (repo) or increasing the repo margin ('haircut'), forcing massive deleveraging, and resulting in the banking system being insolvent. The earlier episodes have many features in common with the current crisis, and examination of history can help understand the current situation and guide thoughts about reform of bank regulation. New regulation can facilitate the functioning of the shadow banking system, making it less vulnerable to panic."
In the past, a bank run ( Liquidity Crisis )was stopped by Deposit Insurance. This is MF's view ( Essence of Friedman, p.515 ). The question then was whether or not we had a Collateral Run ( Liquidity Crisis ) in the Shadow-Banking sector after Lehman. If you think so, then , according to MF, only a govt guarantee can stop this panic ( EF p. 515. ). Since there was no Deposit Insurance to stem this panic, the govt needed to step in and provide a kind of Deposit Insurance to stop this run. Bagehot's main point is not the particular rules, but that a panic should be stopped. His entire approach was pragmatic. Also, for Bagehot, expectations are key, as evidenced by his explanation for why the B of E could not be closed down.
This post makes the case:
http://research.stlouisfed.org/publications/es/09/ES0907.pdf
"Bagehot wrote “in a panic, the holders of the ultimate Bank reserve should lend to all that bring good securities quickly, freely, and readily.” To him, “good securities” included those that, while easily traded in normal times,may have no market value during a panic."
Finally, it is interesting in considering what might cause a financial crisis, and what new measures should be taken if one occurs, MF does not mention Deflation ( EF p.424 ). In that essay, he gives various proposals about what to do should a crisis occur. Some commenters have talked about about a specific Fed regime proposed by MF. I don't see how this would easily work in the present crisis. In order for it to work, it must be credible. This was so important that MF calls for a Constitutional Amendment to make it work ( EF p. 414 ).
Since I'm not an economist and am always willing to be instructed, and MF is very important to my views, it would help me if people could give references to his works where I can look up their points.
Posted by: Don the libertarian Democrat at Aug 27, 2009 10:38:37 AM
The question of bailouts is who ends up profiting on the upside. Are we just giving bank shareholders and bondholders free money? That seems to be the case.
The government should have taken the banks into FDIC receivership and sold them off over time. Whatever losses are taken on the sale have to come out of the pockets of shareholders and bondholders.
If you support the bailouts then you support giving free money to bank shareholders, bondholders, and employees. Cause that is what happened.
Quoting Bagehot is a waste of time. Bagehot advocating lending at penalty rates against good collateral. This is a method to deal with a liquidity crisis. As has been said 1,000 times this is no a liquidity crisis, but a solvency crisis. The Fed is lending at subsidized rates against dodgy collateral, i.e. it is taking on a fiscal policy role and providing subsidies to private sector banks.
Posted by: dave at Aug 27, 2009 10:56:35 AM
But Tyler, you ignored the main point of David's post--reflected in his title, his opening sentence, and his closing paragraph that begins, "But here's the bigger question..."
You accused the libertarians who disagree with you of "pretending" that Milton Friedman said the problem was that the Fed let the money supply collapse. And so David asked (I'm now paraphrasing), "Has anyone ever seen Tyler accuse leftist statists of pretense in the same way?"
I don't remember you doing that. If you have, I apologize for the accusation of a double standard.
Posted by: Bob Murphy at Aug 27, 2009 11:09:15 AM
Bob, I give some examples in the comments to David's post. I didn't want to raise that broader issue here and distract from the substantive issue about Friedman. It's a separate question. More generally, let's say I didn't think a particular group of people was worth criticizing. Have I ever criticized Nazis on this blog? Probably not. It wouldn't mean much, one way or the other.
Posted by: Tyler Cowen at Aug 27, 2009 11:16:38 AM
The most telling fact indicative of the failings in Friedman's understanding of the money/credit/production nexus is that Friedman as late as 2006 thought that there were no problems in the macro economy and that Greenspan / Bernanke were making no mistakes with money/credit/production policy.
Friedman was the Irving Fisher of the 2000s.
Posted by: Greg Ransom at Aug 27, 2009 12:00:40 PM
The most telling fact indicative of the failings in Friedman's understanding of the money/credit/production nexus is that Friedman as late as 2006 thought that there were no problems in the macro economy and that Greenspan / Bernanke were making no mistakes with money/credit/production policy.
Friedman was the Irving Fisher of the 2000s.
Posted by: Greg Ransom at Aug 27, 2009 12:01:56 PM
I could picture Friedman saying to himself "I'm one libertarian in a room of 99 Keynesians. I better push hard for the most libertarian option available."
It's harder for me to picture Friedman saying to himself "This is probably a good idea because Milton Friedman promoted it."
Excerpt from John Hussman's commentary is interesting:
"Solving economic problems, to our Fed Chairman, is as easy as throwing money out of helicopters. Not surprisingly, throwing money out of helicopters has been the basic core of his strategy during this crisis. This does not involve complex thought about debt restructuring, moral hazard, incentives, equitable distribution of resources, or other factors. All it requires is the three second tape playing in Bernanke's head - "We let the banks fail in the Great Depression, and look what happened." And then the tape repeats. Never mind that the cause of the upheaval was not the failure of banks per se, but the disorganized Lehman-style failure of banks. The tape isn't long enough to encompass such nuances."
Posted by: Andrew at Aug 27, 2009 12:12:49 PM
Friedman favored abolishing the Federal Reserve and replacing it with a computer that would increase the money supply at a constant rate. With no Federal Reserve there would have been no bailout of mismanaged banks. Logically, Friedman would not have been in favor of a bailout which would require the existence of the Federal Reserve which he opposed.
Next up: What would Jesus eat?
Posted by: Tom at Aug 27, 2009 12:40:21 PM
"When velocity falls by a small amount the Fed can compensate by raising the money supply. But when velocity falls a lot, as it has over the past year, the Fed can't increase the money supply fast enough to prevent a decline in nominal GDP, which will result in both falling prices and reduced output. That is why an expansionary fiscal policy is essential to compliment monetary policy. Otherwise the Fed is pushing on a string."
This intellectually obtuse explanation seems to be a crummy excuse to rob trillions of dollars from the average taxpayer and hand it over to the politically connected.
Obviously this "expansionary stimulus" does not need to be channelled through Goldman Sachs, JP Morgan, GE, GM and Lockheed Martin...yet it is. To pretend it isn't and to pretend that this is preferable over letting Goldman Sach fail is absurd. A continuation of these policies will lead to violence and people like Bartlett will be morally responsible in my mind.
Posted by: Gabe at Aug 27, 2009 12:47:04 PM
I recall Milton Friedman discussing the definition of money, so I am certain that if he and Anna were reincarnated as 30 year olds today, they would be revisiting the definition of money and then seeking to retrospectively determine how much shadow money has existed since 1950. Wasn't it circa 1970 when the first sliver of shadow money began developing, in the very money market fund that collapsed last fall?
He did point out circa 1970 that the Fed could only control part of the money supply, as I recall, he felt that this was enough to regulate the greater money supply. But he noted that because the greater money supply couldn't be tightly regulated, that argued for a very robotic approach to the portion the Fed controlled.
But it seems to me that by 2000 financial innovation had creatd a shadow banking system that was far more powerful and well disconnected from the Fed policy and regulation, so I suspect that what Milton Friedman could convincingly argue in 1970 (convincing to me) needs to be dismissed as delusional in 2009. Not because he was wrong in 1970, but because money has changed so radically since 1970 in ways that he could never have imagined, and he was the expert.
Posted by: mulp at Aug 27, 2009 1:43:17 PM
The government should have taken the banks into FDIC receivership and sold them off over time.
But what you fail to take into account is the libertarian solution of getting government out of the business of deposit insurance. Instead of FDIC insuring regulated deposits, we had AIG and Lehman and other unregulated banks playing at the game of FDIC.
So, in the fall, we had the libertarian shadow FDIC's failing as the libertarian shadow banks failed causing a run on the shadow banking demand deposits of all those commercial money market funds and the mutual money market funds.
How much money was in the shadow banking sector and how underfunded were the shadow FDICs and how much money did the shadow Federal Reserve have to be the shadow lender of last resort? And what was the shadow Fed - it seems like whoever it it was, they ran for the hills at the first sign of trouble.
Posted by: mulp at Aug 27, 2009 2:20:15 PM
There are a number of possible ways to see this crisis. If the question is whether or not the Fed could have done better, then I like this post:
http://blogsandwikis.bentley.edu/themoneyillusion/?p=2114
Since I like it, I believe that MF would as well.
However, once Lehman was about to occur, I believe some options were no longer possible because we were on the verge of a Debt-Deflationary Spiral.
Posted by: Don the libertarian Democrat at Aug 27, 2009 2:53:53 PM
In "The Paradox of Money", Friedmann said that in the 60s when both "Capitalism and Freedom" and the" Monetary History" were written he still believed in the Fed because he has not read yet the works by Buchannan and Public Choice school
Posted by: k at Aug 27, 2009 3:46:02 PM
You might try to draw a distinction between "lender of last resort" and "bailout" but Bernanke's emergency lending is usually considered part of the bailout package.
Indeed you must draw such a distinction, as the first commenter notes, if you want to avoid confusion. A "bailout" in the usual jargon means lending to keep an insolvent firm open as a going concern, delaying its resolution (acquisition or liquidation) in hope of its recovery to solvency. A lender of last resort policy as classically prescribed by Bagehot involves lending only to illiquid and NOT to insolvent banks, and NEVER to firms other than commercial banks. In Bagehot's prescription the borrowing bank had to offer good collateral to demonstrate its solvency. A lender of last resort lets insolvent banks fail.
Bernanke's emergency loans to insolvent firms (or their acquirers) were indeed bailouts. Doubly so in cases where the borrowers weren't even commercial banks. He may call it "lender of last resort" policy, but he's fudging the term for the obvious reason that he wants to obscure his departure from traditional policy.
The point is that Friedman favored some bailouts in the past and probably would have favored some this time around as well.
Not shown. Friedman retrospectively favored classical lender of last resort policy for the period before deposit insurance. Classical LOLR policy, to repeat, is not a bailout policy. After deposit insurance, he explicitly favored closing the discount window. Thus he would have denied the Fed any mechanism for bailout loans. Friedman (1960) favored LOLR policy only in the sense of Goodfriend and King, meaning expanding the monetary base to prevent the broader money stock from collapsing. In which case "lender" is actually an anachronism.
Posted by: Lawrence H. White at Aug 27, 2009 4:01:02 PM
Holy cow! Tyler just admitted he was a Nazi. I knew it! (j/k)
Posted by: Bob Murphy at Aug 27, 2009 4:05:45 PM
I'm admitting that I wanted to violate the rules that Bagehot had for a LOLR. I'm arguing that, if that could not stop a panic, he would have favored stronger measures, including lending to some, but not all, insolvent financial concerns. He makes it plain that a panic must be stopped. Period.
The case of Lehman and the other bailouts rests on whether we were having a run on other financial concerns than banks, that were not propped up by the FDIC. If we were, then we needed to arrest that run. Some of us believe that the govt needed to act like a sort of FDIC to stop the run. I'm pretty sure that Friedman believed that Deposit Insurance was responsible for stopping bank runs. See pp. 20 and 21 of "A Program for Monetary Stability."
I don't have any problem with people disagreeing with the view that this was a run on the shadow banking system, which necessitated applying rules learned from banks runs to a new situation. I'm simply disagreeing, for the reasons that Bernanke gives in his talk, and the sources that he bases his views on, like Gorton.
Hetzel says the following:
http://www.richmondfed.org/publications/research/economic_quarterly/2009/spring/pdf/hetzel2.pdf
"The failure of Lehman Brothers on September 15, 2008, created uncertainty in financial markets. Hetzel (2009a) argues that the primary shock arose from a discrete increase in risk due to the sudden reversal of the prevailing assumption in financial markets that the debt of large financial institutions was insured against default by the financial safety net ( NB DON ). A clear, consistent government policy about the extent of the financial safety net would likely have ( NB DON ) avoided the uncertainty arising from market counterparties suddenly having to learn which institutions held the debt of investment banks and then having to evaluate the solvency of these institutions. Nevertheless, the turmoil in financial markets and the losses incurred by banks would likely have been manageable without the emergence of worldwide recession."
I agree with this analysis. Expectations matter.We were past some solutions being possible. Since investors were counting on this safety net, not supplying it in some form would have led to a Debt-Deflationary Spiral. China was already selling Agencies and buying Treasuries. The Flight to Safety had already begun. Letting it go was a risk I sure wouldn't take. I understand that some people don't consider this a possibility, but I do. As Henry Simons said:
"Once a deflation has gotten under way, in a large modern economy, there is no significant limit which the decline in prices and employment cannot exceed, if the central government fails to use its fiscal powers generously and deliberately to stop the decline. Only great government deficits can check the hoarding of lawful money
and the destruction of money substitutes once a general movement is under way. While the technical limits of cumulative movements are more nearly significant in the case of upswings or booms, the proper checks in this direction also are to be found in the taxing, borrowing and spending activities of the national government."
Posted by: Don the libertarian Democrat at Aug 27, 2009 4:40:14 PM
I'm not an economist, so I'll shut up. But the comments on this thread had been very interested to me. Thanks.
Posted by: Don the libertarian Democrat at Aug 27, 2009 5:06:51 PM
Try "interesting to me". Don
Posted by: Don the libertarian Democrat at Aug 27, 2009 5:08:07 PM
Tyler, there are two different issues here. Friedman would have said:
First, systemic panics are harmful and the TARP stopped them.
Second, the free market way of stabilizing the insolvent banks is partial conversion of bonds to equity, public money is not needed at all.
Posted by: 123 at Aug 27, 2009 5:22:15 PM
Reducing FDIC insurance is definitely a good long run goal. Such insurance offers a useful purpose in allowing regular people to place a reasonable amount of savings in an institution knowing it is safe. However, it turns capital owners, who have a responsibility to oversea their capital wisely, into absentee landlords of capital. I'm ok with Joe Blow just throwing his money in the bank, but those with significant capital have a responsibility to start managing it. Offering a free one way put option when you give it to an agent reducing oversight of agents (banks). When the crisis is resolved a more reasonable approach to FDIC insurance needs to be looked into.
As for shadow "depositers" they are not protected by FDIC insurance. I think it is dangerous to extend FDIC insurance to these entities, and should it be done it should focus on protecting smaller depositors first. We can't guarantee every reckless action money market funds decide to take. When a bank like Lehman is taken into receivership the Fed can provide lost shadow banking capital, but it should not bail out providers of shadow banking capital. Should this result in a withdrawal from money market accounts the Fed can temporarily fulfill the role of money market liquidity (as it did with the CP facility). However, it is key that when it lends it fulfills a liquidity role (against good collateral and at high rates) rather then a fiscal role (deciding which entities deserve capital and subsidy and which don't).
The roots of the growth in shadow banking is a whole nother issue to be addressed, and lie largely at the feet of the CB.
Posted by: dave at Aug 27, 2009 5:22:35 PM
Friedman would have wanted a way to bankrupt the banks without causing mass hysteria. If that seems like a contradiction in terms, I suggest you read some of Luigi Zingales' work over the past year.
Posted by: Greg at Aug 27, 2009 5:33:54 PM
Friedman might be critical in a few ways.
One. Bernanke vacillated on Bears and AIG. Mixed signals by the Fed on future policies causes trouble.
Two. Bad policies can cause liquidity traps. Financial institutions have an incentive to do nothing in a crisis. If you think the value of your assets are temporarily depressed you hold onto to them and do nothing. If the assets increase in value you make a profit, if they drop in value you get a bailout. Government policies create a liquidity trap. And you give credit to people for solving a problem they contributed to creating.
Three. When markets are in turmoil transaction cost increase rapidly. Perhaps government intervention can help to lower these costs and encourage trust. More frequently, the government adds to the transaction costs. Still, using the threat of a government death panel may encourage wobbly firms to take actions. Unless you view the government as your potential saviour. Then the liquidity trap can worsen and drag out.
Four. A price shock from rising oil prices had the Fed trying to tighten money. This after easing money for an extended period. As Milton would say, pressing the pedal to the metal and then slamming on the brakes is no way to get to a destination smoothly.
Posted by: DanC at Aug 27, 2009 7:30:06 PM
Perhaps there's a distinction to be made between providing liquidity and providing capital, that is, taking ownership.
Posted by: jorod at Aug 27, 2009 8:39:48 PM
Bartlett:
You state that if velocity falls (which means that people choose to hold an amount of money that is a larger fraction of their income on average,) a little bit, then the Fed can compensate for this by increasing the quantity of money. This is true.
Then you assert that if velocity falls a lot (so people choose to hold a substantially larger amount of money in proportion to their income,) the Fed cannot increase the money supply fast enough to prevent nominal income from falling. Cannot? Why not?
"Pushing on a string" refers to interest rate policy. If the Fed tries to control base money by setting an interest rate and waiting for banks to borrow, then it depends on how much the banks want to borrow. Open market operations increase the quantity of money rapidly. Now, if the Fed follows a policy of gradually lowering its target for the overnight interbank lending rate, then if there is a rapid drop in velocity, perhaps gradually adjusting interest rates will fail to cause an increase in the money supply sufficient to prevent a decrease in nominal income. I call that a failed policy, and not a call for deficit fianance of government spending.
Now, it may be that increases in the quantity of money, no matter how large, don't immediately offset decreases in velocity. (People want to hold more money relative to their incomes, and the Fed provides that money, but, still, they cut their spending anyway to increase the amount of money they hold even more than they want... well.. maybe somehow.)
Personally, I think you should just go with the Liquidity Trap argument. Increases in the quantity of money cause further declines in velocity. Increases in the quantity of money cause an increase in the demand to hold money. Not very plausible, but better than claiming that open market operations are slow and talk about pushing on strings.
But I would really just suggest reading a little Yeager.
Posted by: Bill Woolsey at Aug 27, 2009 8:50:07 PM
Cowen:
Friedman advocated an M2 growth rule for decades. He also advocated using open market operations to hit that target. That implies that if the currency deposit ratio changes, the composition of the quantity of money will shift between deposits and currency. If he really was concerned with controlling the quantity of deposits, then he wouldn't have favored targetting M2. He would have favored targetting something else, maybe M2 less currency held by the public. So the total of checkable deposits, savings accounts, and CD's less than 100k would be put on a target growth path.
If Friedman really did think that it was bank lending that was important, then we are left with the puzzle as to why he supported closing the discount window. Shouldn't he have advocated having it wide open so that changes in the currency deposit ratio would be accomodated by advances to banks, so that the banks could continue to fund the same amount of loans?
Maybe you forgot, but there is a concept of "lender of last resort" to the banking system. It has nothing to do with lending money to particular banks, much less insolvent ones. Quote Friedman (and any number of other monetarists) all you want about the Fed failing to act as lender of last resort, but you prove nothing about support for bailouts. The orthodox monetarist position was always lender of last resort to the banking system and not particular banks.
Further, Friedman claimed that the reason banks were insolvent during the Depression was the reduction in output and deflation caused by the decrease in the quantity of money. If the Fed had followed the right policy, the banks would not have been insolvent. That view is going to create all sorts of quotes that will suggest bailouts of the banks. The Fed should have acted in a way that prevented the failure of banks. But that doesn't mean that the Fed should have bailed out banks that would have been insolvent if the quantity of money had remained growing on target.
If all the banks were really insolvent (conditional on nominal income continuing to grow on target,) because they all made bad loans, then closing them all down at once and selling off all their asseta and paying off deposits with the proceeds, and letting people who want to organize new banks do so, is probably not a good policy. I don't think this has anything to do with the Great Depression, and trying to guess what Friedman would favor in the face of general insolvency despite a proper monetary policy by looking at what he said about the Depression is just wrongheaded. One would hope he would have a sensible view.
I certainly agree that monetary policy over the last year could have been worse. And I think there are some libertarians who advocate policies that would have been worse. Freezing base money and liquidating all the insolvent banks (conditional on a big drop in nominal income,) and then letting people start new banks if they wanted, would have been much worse, in my view.
On the other hand, expanding base money even more so that nominal income continued on its previous growth path, and keeping FDIC for the time being so that involvent banks remain open until the FDIC can reorganize them, seems like a better policy to me. Having the conventional banking system expand to replace the failed shadow banking system seems like the better policy to me. I think having the Fed pay interest on reserves balances and target loans in ways that look to be aimed at jump starting securitization markets is an inferior policy.
In my view, the key element of the "bailout" was the Treasury buying stock in banks. I opposed that as much as I opposed proposals to have the Treasury buy bad assets from banks. I have no problem with the Fed lending money to solvent banks. I don't really care about collateral. I don't even care if the Fed lends to insolvent banks, but only as part of an FDIC reorganization process that involves wiping out the stockholders. Generally, I think other bank creditors should take a loss. I think the reality is that debt with longer terms to maturity should be targetted for loss. The key is to make it clear who is safe and who is not. But even if they all are subject to loss, isn't it obvious that it just means that insured deposits would play a bigger role in funding reorganized banks?
Posted by: Bill Woolsey at Aug 27, 2009 10:26:19 PM
Corrupt institutions have very very large discount rates, which increase with every iteration of the game.
Posted by: Punditus Maximus at Aug 28, 2009 12:53:13 AM
It seems like the monetarist/Keynesian nexus is that the money illusion only works on the way down, and like a trained tiger, only works when the feds are holding the whip.
Posted by: Andrew at Aug 28, 2009 5:29:00 AM
A couple more nitpicks.
The deposits won't go "poof." They actually already went poof. First, they went poof the day they were lent out. Then the loans went bad. The poof sound was actually the deflating confidence in the fractional reserve system.
Second, these weren't exactly runs on banks. They were massive loan losses. There couldn't really have been runs because there was nothing there, less than nothing in fact.
It seems like panic is the name given for when there are assets but people fear there are not. When there really aren't any assets, panic may not be quite the right diagnosis.
Lender of last resort is a necessity necessitated by protection of the fractional reserve system and non-date-certain, non-renegotiable, non-recourse lending. It is different, though not distinct from a bailout.
Posted by: Andrew at Aug 28, 2009 7:43:41 AM
Milton Friedman very clearly supported bailing out the banking system. In fact, he criticized the Depression-era Fed for not doing so. Just watch his PBS documentary "Free to Choose".
Posted by: Bubble Meter blog at Sep 2, 2009 12:08:19 PM
The 'Monetary Price Level Equation' is P = (M x V) / Q where Price Level equals Quantity of Money multiplied by its Velocity (Money Turnover expressed against Nominal GNP as V = nGNP/M), then divide by Real GNP, rGNP. What can we see from this equation? The Fed has pumped money into the economy yet inflation seems subdued. How can this be? Well, look at the V factor, money velocity. If the credit market is mucked up, Velocity will be decreased so that M x V offsets somewhat. In fact, the FED is now decreasing M3 in the belief that V is increasing. If the FED is wrong, this equation shows we should expect deflation and/or a decreased rGNP.
Posted by: Dan at Jan 23, 2010 9:24:09 PM
