Will Pump Priming get the Economy over the Hump?
Milton Friedman, a Nobel Laureate in Economics, was one of the greatest and most influential economists of the past 100 years. He was a contemporary of Hyman Minsky and may have even taught Minsky at the University of Chicago. Much of his work suggests the influence of Minsky and most likely, vice versa. His theories made their greatest impact on the economy during the period of the Kennedy administration and can take credit for the excellent economy of the early 1960s (before Johnson's "guns and butter" policies over-stimulated the economy and began a period of excessive inflation). Years later, in the early 1980s, Fed Chairman Paul Volcker employed monetarist ideas to break the back of inflation, by contracting money supply and driving interest rates high enough to precipitate a recession. The medicine worked, further validating Friedman's theories.
Contrary to the active role of the Fed and Treasury in managing the money supply and influencing economic growth, Friedman was also known for promoting "laissez faire" which we have recently rediscovered has its limits (this was well known in the 1930s as a similar approach to "free markets" during the 1920s exacerbated the Great Depression. If nothing else, in the past couple years we have learned that while monetarism and fiscal policy have their place in managing economies, "laissez faire" free market policy has now twice failed us, and does not.
Friedman was the perfect counterpoint to John Maynard Keynes whose influence occured a generation before during the 1930s and thereafter. Keynes created a school of economic theory that was mimicked and adopted in part by the Roosevelt administration. This school of thought is based on the idea that central governments are at their best when pulling an economy out of a financial crisis like the Great Depression. Keynes preached the power of "fiscal policy" which is the stimulation of the economy through changes in government policies regarding taxation and spending. The basic idea is to tax less and spend more during an economic crisis and don't worry about deficits.
Milton Friedman, on the other hand, was an advocate of using "monetary policy" or "monetarism" as administered by the Federal Reserve and Treasury. It was his idea that money supply is what controls the economy and that central government monetary institutions should bear the responsibility of managing money supply to manage steady growth in the economy. Friedman's prescription for a financial crisis was to expand money supply to fill the void left by a debt contraction. During an economic expansion where a strong economy leads to high demand for products and services which can lead to inflation, Friedman would counsel reigning in money supply by both interest rate policy (increasing Fed funds rates and the discount window) and administrative policy: buying back Treasuries from the public to reduce the available supply of those instruments which has the effect of bidding up interest rates and increasing bank reserve requirements to reduce leverage in the banking system.
Who is right? History has proved that both fiscal and monetary policy can be very effective. Today we are experiencing a dual pronged attack on the Great Recession. Monetary policy has an advantage in that the Treasury and Federal Reserve Bank are pre-approved by Congress to administer their policies as needed. So, monetary policy can be very responsive to a crisis, as we saw last September and October, although such broad powers are often called into question by the public and Congress.
Ben Bernanke is a Monetarist and his theories and philosophies closely parallel those of Milton Friedman. In fact, Bernanke's famous reference to "dropping money from a helicopter" to combat deflation and credit contraction is actually attributed to Milton Friedman. Friedman also predicted in the 1960s that a blind adherence to fiscal policy, the use of taxation and spending to manage the economy, would lead to "stagflation" a term he coined that eventually did become a reality in the 1970s when Keynesian policies were most popular.
Fiscal policy, on the other hand, requires Congressional action, which can be slow at the best of times, often lagging the time of need by a year or two. So, the use of fiscal policy is said by critics to do the opposite of what is intended. By the time stimulative fiscal actions are passed through Congress, the opposite is needed to slow the economy and vice versa. With all this said, here is a great piece on Milton Friedman taken from the Barrons on March 20:
Friedman's Influence Lives On at the Fed
While Keynes star is ascendant again, monetarist ideas inform the FOMC's policy moves.
"WE ARE ALL KEYNESIANS NOW," Richard Nixon famously proclaimed in 1971. And with the massive expansion of government spending with the America's $787 billion fiscal stimulus, Lord Keynes is being rediscovered with pictures of his mustachioed visage popping up in the popular media.
But the ideas of the man who led the counter-reformation against Keynes, Milton Friedman, are being implemented to an unprecedented degree by the Federal Reserve.
Keynes and Friedman arguably were the two most influential economic thinkers of the twentieth century. And while Friedman is identified mainly with the revival of free-market precepts in the last quarter of the century, he and Keynes both made their marks in their respective diagnoses and prescriptions of the Great Depression.
Keynes' main thesis was that insufficient demand in the private economy should be countered by government tax and spending policies that would counter the shortfall. The orthodoxy at the time held that insufficient demand in the overall was an impossibility since prices would decline to clear the market. The economy would self-correct (Brian's note: laissez fair, "free markets rule" theory).
With unemployment at over 20%, it seemed this simple model didn't apply to the labor market. Moreover, interest rates had fallen to close to zero, so it appeared that monetary policy had become impotent. Hence, government spending would have to take up the slack.
That became the new Keynesian orthodoxy, as acknowledged by Nixon 35 years after Keynes elucidated his principals in "The General Theory of Employment, Interest and Money." His principle of countering declines in the economy was expanded by his acolytes to claim that government policies could prevent wide fluctuations by judicious fine-tuning.
But an alternative view of the Great Depression emerged from Friedman's work. In his 1963 masterwork, "A Monetary History of the United States, 1867-1960," co-authored with Anna J. Schwartz, Friedman determined that the Great Depression was caused by Federal Reserve policies that allowed the money supply to drop by one-third, resulting in plunging output, employment and prices.
But, when the Fed acted to expand money by purchasing government securities, the economy did revive starting in 1933 until 1937. Then the Fed became concerned about excess reserves in the banking system and tightened policy. The result was a renewed downturn starting in 1938.
While monetarists such as Friedman say monetary policy was the key to explaining the experience 1930s, other economists attribute the downturn to sharp increases in income tax rates under Herbert Hoover and the recovery to Franklin D. Roosevelt's New Deal policies. Others also blame the Depression on the collapse in trade following the enactment of the protectionist Smoot-Hawley tariff in 1930.
Despite the impact of higher taxes and barriers to trade, gross domestic product actually grew at a blistering compound annual rate of 9.4% in the four years to 1937, according to Paul Kasriel, director of economic research at Northern Trust Co. That strong real growth followed the huge expansion of bank reserves of 25% annually starting in 1933 through 1936.
That reserve growth was the result of Fed purchases of government securities, which creates credit figuratively "out of thin air," Kasriel explains. Because of the Fed's actions, the economy began to recover in March 1933 -- the month in which FDR was inaugurated. In 1937, however, bank reserves contracted by nearly 19%, and the economy went into a renewed decline.
The dramatic effect of the Fed's purchases of securities on bank reserves, and thus money, credit and, finally, the economy in the 1930s should put into perspective the importance of the decision of the Federal Open Market Committee Wednesday (March 18) to expand dramatically its purchases of Treasury notes and bonds, agency debentures and mortgage-backed securities. The FOMC authorized buying $1.15 trillion additional securities, which would expand its balance sheet by more than 50%.
Building on Friedman's ideas to a great extent, Fed Chairman Ben Bernanke's past academic research focused largely on the impact of monetary policy on the Great Depression. Friedman also held that adherence to the gold standard worsened the downturn by forcing the Fed to sharply raise interest rates in 1931 to defend the dollar. Bernanke in various speeches has cited research saying countries that abandoned the gold standard or never adhered to one recovered faster from the Depression.
Bernanke, moreover, has asserted that monetary policy can still be effective even after its policy rate, federal funds or overnight interbank loans, was at or close to zero, as it is currently. Purchases of lengthier securities can bring down long-term interest rates. This buying, which colloquially results in "printing money," also lowers the dollar, which he says also effectively results in monetary easing.
Thus, Bernanke is putting into action Friedman's key precepts -- expansion of the Fed's holdings of securities to pump liquidity into the system and allowing the exchange rate to fall. Long-term Treasury yields plunged in response to Wednesday's (March 18) announcement while the dollar fell hard.
Now, we have Keynesian fiscal pump-priming combined with Friedman's monetary expansion. Kasriel points out that fiscal policy can't stimulate without money printing. But put the two together and you can get explosive results, at least in the short term.
"Never underestimate the initial positive impact on aggregate demand of that power combination of increased government spending/tax cuts and a central bank running the monetary printing press at a high speed," he concludes. On that, both Keynes and Friedman would agree.
Related posts:
- Dialogue on Housing Deflation – from ArizonaRealEstateNotebook.com
- Dealing with the Success of Reflation
- Who is Congressman Issa and can he be Impeached?
- What ECB Must Do to Save European Economy
- Whose Fault Was the Crisis? Fed or Free Market?
