Friedman, Schwartz, Keynes, and Bernanke

Penn Bullock has written a piece for Reason explaining that, despite being called such by the popular press, Bernanke is not a Keynesian. Quite the contrary, Bernanke is following the prescriptions laid out in Friedman and Schwartz’s Monetary History of the United States. Unfortunately, while Bullock is correct in claiming that Bernanke is following Friedman’s economics, he gets the story regarding The Great Contraction wrong. (Two Notes: First, The Great Contraction is a text that was released after F&S’s monetary history. However, it is actually just the chapter on the Great Depression. Henceforth, all references will be referred to as F&S. The second point is that it is a bit unfair for me to criticize Bullock here as he is not an economist and therefore I do not expect him to be acquainted with some of the literature that I reference. Nonetheless, it is my view that certain points raised in his piece need a proper rebuttal.)

Bullock begins his argument as follows:

Friedman and Schwartz, however, denied that speculation had ever posed a problem, or that there had even been a credit bubble in the 1920s. In their narrative, a paranoiac Federal Reserve had needlessly constricted the money supply and thereby crashed an otherwise prosperous economy.

After the Great Crash of 1929, the Federal Reserve drastically cut interest rates; but, on occasion, the Fed was forced to abruptly raise them again in complicated maneuvers to stem outflows of gold into Europe. Friedman and Schwartz blamed these sporadic interest rate hikes for smothering several incipient recoveries, opening a vortex of deflation, and turning a recession into the Great Depression.

Friedman and Schwartz’s overarching thesis was that the Depression would have never happened if the Federal Reserve had inflated the American economy.

Bullock makes three specific points here. First, he states that F&S reject the claim that there was a credit bubble in the 1920s. I suppose that this depends on how one defines a credit bubble. Nonetheless, most consider the rising stock market as the impetus behind the Fed’s decision to tighten monetary policy. People routinely mock the great Irving Fisher for claiming that the stock market was at “what looks like a permanently high plateau” and claiming that stocks would likely move higher shortly before the stock market crash. The question regarding whether the stock market was overvalued, however, is not as crystal clear as many perceive. For example, Eugene White’s JEP paper entitled, “The Stock Market Boom and Crash of 1929 Revisited”, shows that the Dow Jones Index closely tracked dividends throughout the 1920s until roughly April of 1928. More recently, Ellen McGrattan and Ed Prescott have suggested that Irving Fisher was correct at the time that he made his statements.

Bullock’s next point is that while the Federal Reserve reduced interest rates, there were times when they raised interest rates and that is what F&S attribute as the Fed’s failure. This is incorrect. In fact, what F&S emphasize (as Bullock mentions later in the article) is the decline in the money stock. From 1929 – 1933, the money supply fell by one-third. Thus, the main failure of the Federal Reserve was to allow the money stock to decline so drastically. What’s more, what F&S are really emphasizing is that the Fed’s actions were often too little and too late in responding to shocks. In essence, the stock market crash, a series of banking failures, and Britain’s abandonment of the gold standard produced declines in the currency-deposit ratio thereby resulting in multiple deposit destruction and a decline in broader measures of the money supply (broader, that is, than the monetary base). It is F&S’s view that the Fed could have expanded the monetary base to offset the increase in the demand for base money. (Paul Krugman recently argued that such an increase would not have been possible given the fact that the US was on the gold standard in the Journal of Monetary Economics, which Anna Schwartz and Ed Nelson thoroughly refuted in the same publication.) Thus, while F&S mention the initial policy failure of a tightening of monetary policy as well as other policy errors, the main error that they emphasize is the failure to prevent the decline in the money stock, not changes in the interest rate. In fact, monetarists have long argued that the nominal interest rate was not a reliable indicator for evaluating the stance of monetary policy. Frederic Mishkin’s paper on real interest rates provided empirical support to this point by showing that real interest rates were quite high. Taking this point further, Allan Meltzer has shown that the behavior of real money balances is a better gauge for the business cycle than the real interest rate.

Bullock’s final point mentioned above is that the Federal Reserve needed to inflate the American economy. This is either a misuse of terms or an incorrect view of inflation. The context suggests the latter as he quotes Anna Schwartz:

“What the Fed had to do was increase the money supply. By taking that action, it would’ve revived the economy. That’s the lesson of the Great Depression.” In The Great Contraction, she and Friedman argued that the Fed had an infinite capacity to inflate. “The monetary authorities,” they wrote, “could have prevented the decline in the stock of money — indeed, could have produced almost any desired increase in the money stock.”

The concept of inflation is defined by a sustained increase in the price level. What F&S were emphasizing was not inflation, but rather increasing the monetary base to prevent a decline in more broadly defined money stocks.

So while Bullock is largely correct to consider Bernanke a follower of Friedman, his description of the work of F&S is somewhat lacking in specific areas. While it is not my intention to come across as criticizing Bullock, I do nonetheless believe that these points are all fundamentally important to assessing Ben Bernanke’s performance as Federal Reserve chairman. Thus, it is imperative that we get these facts correct.

5 responses to “Friedman, Schwartz, Keynes, and Bernanke

  1. Thank you for your measured reply to my article. A few points that I’ll make at this late hour. Schwartz told me in her interview her view that the Great Depression was “produced” when the Fed raised its discount rate in 1928. This was the action that was too little, too late. For the Federal Reserve had already set the stage for the crash by keeping interest rates low throughout the 20s. That there was no credit bubble, or only a little one, is inconceivable. The chief problem on Wall Street was leverage (eg, borrowing money using borrowed money – or securities or otherwise risky assets – as collateral). Note the 475 billion (in today’s) dollars that vanished in Goldman Sachs’ levered investment trusts, which were really a kind of pyramid scheme. Leverage only works when there’s a presumption that prices will go up forever and infinitely, and that deluded euphoric mindset prevailed in the 20s. The parallel with today’s crisis is most striking in the way leverage limits were removed and banks took advantage to lever up 30 or more times. That’s not the only parallel. In 2007, income inequality rose to its highest since 1928-29, a fact that was not lost on observers of the economy.


    True, F&S emphasized more than just interest rates – and unfortunately I had to omit their arguments that the gold standard held down economies, that the Federal Reserve should have gone along with the NY Fed’s proposed massive open-market purchases and that it should have bailed out banks too. I had to omit those arguments for space.

    I also had to omit the reasons the the Federal Reserve Board enumerated for choosing not to feverishly expand the money supply. It would lead to speculation on commodity and stock markets. Excess liquidity would be hoarded by banks. There would be no exit strategy. There would be no money left to help the recovery once it came into full swing. And it should be said that we got the phrase “pushing on a string” when a Federal Reserve Board member told Congress that monetary policy could only “push” the economy so far.

    It’s also worth giving a second look to Friedman’s chart on Canada. The chart shows that the money supply in Canada contracted only 13%, versus America’s one-third shrinkage, in the early 30s. At the same time, GDP shrunk by about half – in both countries. And Friedman also points out that Canada had few if any bank failures.

    Yet paradoxically Friedman twists this into proof of his thesis. In fact, the chart suggests that both Friedman’s emphasis on the money supply, and Bernanke’s corollary emphasis on banking failures, missed the point. The Great Depression was a massive contraction in production, first and foremost.

    I agree with you that monetarists are skeptical of interest rates at “face value”. It would seem to me that is precisely why Friedman was so big on qualitative easing for Japan in the late 90s. Since interest rates could only be lowered so far by the central bank, laying a liquidity trap, Friedman said that interest rates could be pushed down still further by buying of government bonds with printed money, which amounts to a spiral of money printing, since T-bonds are always bought by the Fed when new currency is produced. In qualitative easing, that new currency is reinvested in creating still more new currency, and Friedman assumed that this kind of easing would also force down interest rates by flooding bond markets with artificial demand. Not very libertarian of him, I must say. And it’s no coincidence that Bernanke has bet this country on qualitative easing.

    Finally, about the money supply and inflation. It was Friedman who said that “inflation is always and everywhere a monetary phenomenon,” so if F&S were calling for monetary expansion or an increase in the money stock, it follows that they were calling for inflation – bu in other words.

    The irony, it seems to my admittedly non-economist’s eye, is that the Federal Reserve has wholeheartedly gone with Friedman, but he’s downplayed the danger of inflation by citing Keynesian models to prove that output gaps hamstring inflation. It’s worth remembering Friedman’s statement to the effect that even if all of the newly created money piled up as bank reserves, that would still qualify as inflation.

    Friedman’s crime was that he convinced America that the Depression was caused not by interest that were too low, but by interest rates that weren’t low enough. So America was blind to the danger of low interest rates in the zeroes, and blind again to the danger of lowering interest rates to zero.

    Anyway, thanks again for your feedback on this article. It was very thought-provoking and I look forward to your reply!


  2. P.S. Pardon some of the typos and stuff, it’s almost 4am here on the East Coast.

  3. It should read: “the Federal Reserve has wholeheartedly gone with Friedman, but IT downplayed… etc.”

  4. Penn,

    Thanks for visiting the blog. I have a few follow-up points.

    First, you write, “That there was no credit bubble, or only a little one, is inconceivable.” As I mentioned, this entirely depends on how one defines the bubble. I have read JK Galbraith’s The Great Crash more than once and I am thus very familiar with the amounts of leverage and the vast pyramid of investment trusts. I am not taking the position that there wasn’t a bubble. Nevertheless, I am pointing out that the evidence is not so clear cut in terms of whether the stock market was in a bubble. The evidence regarding dividends and stock prices suggests that asset prices were not out of line with fundamentals until the 1928:Q2. What’s more, McGrattan and Prescott actually argue that prices could have and should have continued to rise (or at least that Fisher’s prediction of rising stock prices was correct given the data available at the time).

    Whether or not you accept this work, a massive literature has spawned in recent years discussing whether or not the Fed can (and if so, whether they should) respond to asset price bubbles. There is little consensus on this point.

    Second, as Schwartz mentioned to you, the increase in the discount rate was important as policy tightened substantially in 1928 compared with earlier years. Nonetheless, the majority of The Great Contraction focuses on the shocks that I mentioned in the post. I mention these because I would argue that these shocks have important implications for a point that I will make below.

    Third, you reference income inequality. I am not sure what this tells us or why this is important. You would have to go to great lengths to convince me that this is relevant for explaining the Depression.

    Fourth, regarding Canada. I do not have the text in front of me right now, so I will have to look at this when I have a chance. Please note that I am not questioning the validity of your reference. I know from multiple sources that Canada did not have the banking failures that were experienced in the United States. However, in order to properly assess the point regarding the money stock, I would have to look at comparisons of real GDP and nominal GDP, etc.

    Fifth, you mention that inflation is always and everywhere a monetary phenomenon. I wholeheartedly agree with you (and Friedman) on this point. However, it is an excess supply of money that causes inflation, not the money supply in and of itself. I have written about this point recently here:

    Finally, you write that, “Friedman’s crime was that he convinced America that the Depression was caused not by interest that were too low, but by interest rates that weren’t low enough.” This was not Friedman’s point. What he argued is that there was an increase in the demand for base money and that the Fed failed to meet this excess demand with the necessary supply. His argument was not that we needed lower and lower interest rates. In fact, one of the key points that grew out of the monetarist literature is that low interest rates can be misleading during periods of deflation. One of the key insights of the monetarists was that real interest rates were quite high during the depression and therefore nominal rates were misleading.

    Regardless of our disagreements, I appreciate you response. Thanks again for visiting the blog.

  5. You folks are obviously knowledgeable in economics. I would like your opinion of the question of whether the problem could be in production. The value of the goods produced being less than the cost of producing the goods.

    If so would the use of government programs and growing the government be increasing the problem as production will have to support higher taxes?

    Would it not be most advantageous to lower the cost of production? Programs such as reducing the cost of electrical power, (wind power is 4 times as costly as coal power) reducing the cost of fuel (green efforts have lowered the efficiency of petroleum powered engines through lower temperatures-see Carnot Cycle; additional functions on engines; more expensive refinery procedures, etc.). Drilling policies have not lessened the cost of fuel.

    Would lower taxes not incourage more production, hence more jobs?

    The idea of capturing carbon in trees is very temporary (maybe 200 yrs in most forests, carbon neutral long before this). Geo-sequestering must be 99% efficient for 1000 yrs.

    Would these things not be a burden on production and the cost of producing goods? In an international competition will these loads be disastrous?

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