21 October 2008

WWMS: What Would Milton Say?

If only Friedman were still alive and could pen a column for the Wall Street Journal on the Modern Great Depression (note: this is a parodic title). As it is, the only "influential" economist whose columns we can read are former Enron adviser, Paul Krugman's. And we already know what he's going to say: Blame Bush.

Fortunately and in an altogether different sort of way, we can also suss out what Milton Friedman might have said, were he alive. I'll leave it to his still-living colleague, Peter Robinson:
The day after Milton Friedman died in November 2006, The Wall Street Journal published an article about monetary policy that Friedman had written. Unable to recall when the article had first appeared, I asked the editor. "Today," he said. "Milton adapted it just a couple of weeks ago from a research paper he was working on."

This took a moment to sink in. Friedman, by universal consent one of the two or three most consequential economists of the 20th century, had still been performing original economic research then describing his findings for ordinary readers--at the age of 94.

What would Milton have said if he were still with us today? Friedman spent his final three decades at the Hoover Institution--my office was just two doors down the hall from his--and earlier this week I sat down with two of my Hoover colleagues, economists Thomas MaCurdy and Jay Bhattacharya, both close students of Milton, to decide what questions we would have asked him--and how he might have replied.

Would Milton have seen this crisis coming?

Of course. The moment the housing bubble burst Milton would have recognized that we were in for trouble. Why? Because as banks limited their lending, the money supply contracted. And whereas Milton believed that changes in the money supply affect only the price level over the long term, he recognized that over the short-term changes in the money supply can produce dramatic effects in the real economy.

"What would Milton have told you caused the recession in the early 1980s?" Tom asks. "[Federal ReserveChairman] Paul Volcker's reduction in the rate of growth of the money supply. And what has happened now? Another relativecontraction in the money supply. Milton would have told us we're headed right into a recession."

Whom would Milton have blamed?

For the bubble itself? Probably nobody. From the tulip mania in Holland more than three-and-a-half centuries ago to the dot-com bubble here in the U.S. less than a decade ago, wildly irrational behavior sometimes develops in markets. "Friedman never argued that markets are perfect," says Jay, "only that over the long run they're a lot more efficient than any other method of allocating resources." Sometimes, Milton recognized, bubbles just happen.

Whatever the origin of the bubble, however, Milton would have blamed Congress for making it much, much worse. Congress, after all, created Fannie Mae (nyse: FNM - news - people ) and Freddie Mac (nyse: FRE - news - people ), institutions that spent tens of billions of dollars on subprime instruments. "Congress told Fannie and Freddie to subsidize bad loans for the purposes of social engineering," says Jay. "It was terrible, just terrible."

What would Milton have made of government efforts to address the crisis?

He would have approved of such efforts in Britain--but expressed grave reservations about those here in the U.S.

"Milton would have wanted the authorities to find very, very aggressive ways of expanding the money supply," says Tom. The Bank of England did just that, placing large deposits in banks throughout the British financial system. "What they did in England was quick, clean and direct."

Here in the U.S., by contrast, Treasury Secretary Henry Paulson's original bailout plan, under which the Treasury would have spent hundreds of billions of dollars purchasing subprime and other instruments from major banks, went at the problem backwards. "The government should take responsibility for the money supply, but not for setting prices," says Jay. "The problem with subprime assets is that nobody knows what they're worth. Friedman would have told you that bringing the government in wouldn't have helped that."

With his new plan, under which the Treasury has now taken equity stakes worth $125 billion in nine big banks, Paulson has finally begun to make sense. "Direct injections of capital into banks--Milton would have approved of that," Tom says. "But why did it take so long? Why did we have to wait for the Bank of England to set the example?"

What would Milton have seen as the principal danger to the economy that the crisis now poses?

The very same equity stakes mentioned above. It is one matter for the government to make deposits in banks, as the Fed regularly does, Milton would have held, but another for the government to purchase equity, as Paulson has just done.

"Look, if the government wraps up its equity positions and gets out of the banks quickly, then okay," says Tom. "The danger is that the government will stick around and start managing the banks, setting loan policies, establishing salary limits for the top executives and stuff like that. Friedman would have been really clear on this. Banks should be run by bankers, not politicians."

Would Milton have seen the crisis as a setback for capitalism?

Only in the short term.

"If this election goes the way it looks as though it's going to go," says Tom, "then the political system is about to get a major overcorrection to the left. And that means the American people are about to get an extreme illustration of just how badly government intervention screws stuff up."

"If Milton were here," Tom says, "he'd tell us to remember what happened during the Clinton administration. After just two years, the Republicans ended up in control of both houses of Congress."

As much as anything else about Friedman, I appreciate his eternal optimism. This is a characteristic he shared with Ronald Reagan and William F. Buckley Jr.

And why were they optimistic? Because they shared a faith in the goodness and greatness of America.

(thanks to Branden B.)

If you have tips, questions, comments or suggestions, email me at lybberty@gmail.com.