How Would Milton Friedman Have Reacted to the Financial Crisis?

The repercussions of the financial crisis that began in 2007 are still being felt. In the United States and in Europe, the crisis led to the strong resurgence of a theory, Keynesianism, that seemed to have been discredited since the 1970s. One of the main opponents of John Maynard Keynes’s statist and interventionist conception of the economy, Milton Friedman, who died in 2006, would have turned 100 this year. Friedman was a fierce defender of the free market and is considered one of the most influential economists of the last century.

What would Friedman think of the Keynesian stimulus policies adopted practically everywhere in 2008, namely the spending programs of governments and the money-creation programs of central banks? Would he have systematically opposed them? The answer is not as obvious as one might think.

The Logic of Stimulus Plans

For Keynesians, capitalism is a profoundly unstable economic system that inevitably finds itself in crisis at regular intervals.

An unexpected shock is all that’s required to disrupt the behaviour of market actors and derail economic growth. Investors, driven not by a rational evaluation of risks and opportunities but by “animal spirits,” shift suddenly from a blind optimism to an equally arbitrary pessimism.

This change of attitude leads to a slowing down of production, a rise in unemployment and a decrease in household income. Consumers in turn lose confidence, save more and buy less, which leads production to drop further.

Since a capitalist economy, according to Keynes, possesses no automatic stabilization mechanism, this spiral can go on indefinitely, until the total collapse of the economy. Only the government, which has the means to substitute its own actions for those of private actors in order to sustain demand, can turn the situation around.

By spending on various programs and public works, the government puts idle factors of production back to work. In addition, by lowering interest rates and increasing the supply of money in circulation, the central bank encourages consumers to spend and businesses to invest. For Keynes, the debt and inflation that could result from these policies are not serious threats.

With regard to the first aspect of stimulus plans, Friedman considered the notion that public spending could raise overall demand and stimulate the economy an unfounded presumption that focused solely on one part of the equation.

It is easy to understand that if the government raises taxes in order to spend more, then higher public spending will be offset by lower private spending.

Even when government borrows funds, those who lend them will have to reduce their own spending or lend less to other, private actors. “All that happens is that government expenditures go up and private expenditures down,” he wrote in Capitalism and Freedom, published in 1962.

For Friedman, this propensity to increase spending and multiply programs during a recession illustrates above all the dominance of intellectual fashions and statist policies, and only served to feed the growth of the state all through the 20^th century. Indeed, most of the programs supposedly created to stabilize the economy during the New Deal and subsequent recessions were maintained afterward, and governments continued to post deficits even in periods of economic growth.

Friedman would not have been at all surprised to see the mixed results of the budgetary stimulus plans put in place since 2008, or the government budgetary crises provoked by the taking on of massive debt observed today in the United States and Europe.

Milton Friedman’s main contribution to the analysis of business cycles is contained in his monumental A Monetary History of the United States, 1867–1960, published in 1963 in collaboration with Anna Schwartz.

It is in this work that he lays down the foundations of his monetarist theory. This theory replaced Keynesianism as the monetary orthodoxy starting in the late 1970s, when Paul Volker was named Chairman of the Federal Reserve. Volker put the brakes on monetary creation and implemented draconian interest rate hikes in order to rein in the runaway inflation of the preceding years, at the cost of the recession of 1980-1982.
 

“According to Milton Friedman and Anna Schwartz, the reasons the crisis lasted so long is not because of the inherent instability of a market economy, but rather because of the ineptitude of the Fed.”

The feature of Friedman’s monetary theories that is most often noted is his opposition to a too-rapid increase in prices. Contrary to Keynesians who had a very different explanation for such an increase, and in accordance with classical economists, Friedman maintained that it was inevitably provoked by a monetary policy that was too expansionist.

As he famously put it: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

Monetarism also offers an explanation of the causes of the Great Depression. According to Friedman and Schwartz, the reasons the crisis lasted so long is not because of the inherent instability of a market economy, but rather because of the ineptitude of the Fed.

According to them, during the 1930s, the Fed did nothing to prevent—and it even at times deliberately provoked—a substantial reduction in the money supply.

This policy led to the bankruptcy of thousands of banks and a drop in national income, and it nipped any burgeoning economic recovery in the bud.

At first glance, monetarism therefore appears to be a theory that criticizes government action—central banks being monopolies established by governments to create and manage the currency—and that defends the free market.

Paradoxically, this explanation nonetheless makes Friedman an ally of Keynes when it comes to monetary policy, the second aspect of stimulus plans. Although their evaluations of the dangers of inflation diverge considerably, Keynesians and monetarists actually agree on a crucial point: that the central bank must, in the financial jargon, “inject liquidity” into the economy in times of crisis. In other words, it must artificially create currency in order to support economic activity, protect banks from failure and prevent a temporary readjustment from turning into a recession or an extended depression.

It is this policy that Volker’s successor, Alan Greenspan, put in place for 19 years while he was Chairman of the Fed. Each time the American economy showed signs of slowing down or experienced any crisis (the stock market crash of 1987, the Savings and Loan Crisis, the Mexican crisis, the Asian crisis, the Y2K bug, the September 11, 2001 attacks, the bursting of the tech bubble, etc.), Greenspan stepped on the monetary accelerator. An open supporter of the free market, he took inspiration not from Keynes, but from Friedman.

During a conference on the occasion of Friedman’s 90^th birthday in 2002, the current Chairman of the Fed, Ben Bernanke, also endorsed the analysis of Friedman and Schwartz: “I would like to say to Milton and Anna: Regarding the Great Depression, you’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

Since 2007, Bernanke has set up, not surprisingly, a series of “quantitative easing” programs, another euphemism for the creation of money from nothing. According to American journalist Penn Bullock, by all accounts, Friedman would have approved of these measures. He writes in Reason.com that while it is true that the Obama administration is pursuing Keynesian fiscal stimulus, the Federal Reserve under Bernanke has deliberately put in practice the lesson of Friedman and Schwartz on the need to grow the money supply.

It is after all the same quantitative easing policy that Friedman had suggested to the Japanese government, itself facing an economic crisis following the bursting of a housing bubble starting in 1990: “The surest road to a healthy economic recovery is to increase the rate of monetary growth,” he wrote in 1997.

The Austrian Critique

More than three years after the start of the current crisis, there are no signs that the stimulus plans, budgetary or monetary, have succeeded in getting the economy back on a sustainable track.

For Keynesians like Paul Krugman, this is proof that they did not go far enough. Monetarists inspired by Friedman are, for their part, on the defensive. It is another theory, much more intransigently opposed to government interventionism, that is gaining influence: that of the Austrian School of economics, represented by economists Friedrich A. Hayek and Ludwig von Mises, among others.

For adherents of the Austrian School (who, despite their name, are found just about everywhere in the world today), supporters of a return to the gold standard and a denationalisation of the currency, it is the very existence of fiat money that is the source of the problem. Monetary creation from nothing is a fraud perpetrated by the government upon holders of currency, which moreover entails a misallocation of resources and leads inevitably to recessions.

We cannot, as Friedman recommends, solve the problem by resorting to the policies that caused it in the first place. By coming to the rescue of the markets every time there was a slowdown, Greenspan only postponed the crisis, and made it worse. From an Austrian point of view, therefore, monetarists are in the end just as responsible for the crisis, and for its continuation, as Keynesians are.

The most well-known proponent of Austrian economics is undoubtedly Ron Paul, a Representative in Congress and a current Republican presidential candidate. The author of a book entitled End the Fed, he warned Americans about the danger of an overly expansionist monetary policy and of a potential crash years before it happened, as did other commentators inspired by the Austrian School.

According to Ron Paul, “Friedman’s very, very libertarian—except on monetary issues.” Indeed, almost all of Friedman’s body of work was in defence of individual liberty and the free market. He would no doubt have denounced the Keynesian-inspired budgetary stimulus plans put in place for the past three years.

However, if we take him at his word, he would have sided with the Keynesians in favour of the monetary stimulus plans. Perhaps the current crisis will bring about a paradigm change on this subject in favour of another school of thought.


*This article was originally published in French on January 21, 2012, in the Montreal daily paper Le Devoir. Translation by Bradley Doucet.