Austrians and Keynesians Agree: Milton Was Wrong About the Depression
I don’t usually find much of value in Paul Krugman’s articles, but in this piece he relates something very important:
For many years most economists believed that preventing another Great Depression would be easy. In 2003, Robert Lucas of the University of Chicago, in his presidential address to the American Economic Association, declared that the “central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.”
Milton Friedman, in particular, persuaded many economists that the Federal Reserve could have stopped the Depression in its tracks simply by providing banks with more liquidity, which would have prevented a sharp fall in the money supply. Ben Bernanke, the Federal Reserve chairman, famously apologized to Friedman on his institution’s behalf: “You’re right. We did it. We’re very sorry. But thanks to you, we won’t do it again.”
It turns out, however, that preventing depressions isn’t that easy after all. Under Mr. Bernanke’s leadership, the Fed has been supplying liquidity like an engine crew trying to put out a five-alarm fire, and the money supply has been rising rapidly. Yet credit remains scarce, and the economy is still in free fall.
Don’t let Krugman’s smarmy tone fool you: He is right. According to the monetarists, the Fed behaved just fine during the 1920s. After all, output was booming, and consumer price inflation was virtually nonexistent. (In my forthcoming book I will have quotes from people like Irving Fisher saying how the Fed had done a great job achieving the much ballyhooed “price stability” during the period.)
If the Fed behaved OK during the 1920s, then if you’re a fan of the free market, you have to blame the Great Depression on either the Smoot-Hawley tariff and/or Fed behavior in the early 1930s. And, as Krugman says, that’s just what Milton Friedman and other supply-siders have done. I myself adopted this view when I was younger, since it fit so neatly into my anti-government worldview: “Ha! You think it was laissez-faire that caused the Great Depression? Nonsense! The Fed let the money supply fall by a third. What do you expect to happen when the authorities are such nincompoops?”
Well now the proponents of “scientific” economics have their chance. As my favorite chart below reminds us, the Fed certainly hasn’t allowed the money supply to drop. Yet I think we are in store for the worst depression since the Great one.
If nothing else, this episode will discredit the monetarist interpretation of the 1920s and 1930s. (Poor Alex Tabarrok! Look at what he was reduced to in trying to defend the Friedman position. He actually argued that the Fed hasn’t been injecting liquidity into the system; it’s all a statistical illusion.) That will leave us with the Austrian theory, versus those (such as the Keynesian and Marxist) that blame the Depression on the inherent instability of capitalism. Proponents of free markets, take your pick.
(Incidentally, for a refutation of Friedman’s theory that it was government “intervention” to not inflate the money supply amidst the bank runs of the early 1930s, see Matt Machaj’s great article.)
