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I've been setting up a discussion of Milton Friedman's version of the 1920s
and 1930s, as expressed in his book A Monetary History of the United States,
1867-1960. It has been very influential over the years. A more recent update
of basically the same theory is in Allan Meltzer's History of the Federal
Reserve, Volume 1, from 2004.
June 5,
2016: Irving Fisher and "Debt Deflation"
May 14,
2016: Credit Expansion And Contraction Of The 1920s and 1930s #2: Paying Off
Debt
April 3,
2016: Credit Expansion and Contraction in the 1920s and 1930s
February
7, 2016: Blame Benjamin Strong 2: So Obvious It's Hard To Believe
January
31, 2016: Blame Benjamin Strong
It is also, basically, bunk. It is a testament to the very poor understanding
of economics today that more people do not call it so.
The book basically blames the Federal Reserve for essentially all of the
Great Depression, as it does not make mention of any other factors.
Supposedly, the Federal Reserve caused a great "deflation." The
word "deflation" has no specific meaning, but is applied to a great
many entirely different situations. The fuzzy use of the word typically
indicates fuzzy understanding by the people who use it.
One situation is where the value of the currency rises. This has recessionary
effects. Historically, this has been the case monstly after a wartime
depreciation, when the curreny is returned to its prewar gold parity. This
happened in Britain 1815-1821, the U.S. 1865-1879, and Britain 1919-1925.
Similar, but more minor events happened in the U.S. 1816-1820, U.S.
1919-1922, and the U.S. 1951-1953. In all of these cases, the value of the
currency rose, vs. gold and other currencies. Some of them involved a
contraction of the monetary base, and some did not. Meaningful deflation has
been rarer in the floating currency era after 1971, but it did occur in the
U.S. 1980-1982, U.S. 1997-2000, and Japan 1990-2000.
So, we know what that is, and what it looks like. Let's call that Situation
A.
Another situation, or genre, is a wide variety of conditions in which the
economy is doing poorly, and nominal prices are generally falling, but the
currency's value is not changing. These can be Situation B.
The British "deflation" of 1919-1925 involved raising the value of
the British pound back to its prewar parity. Situation A.
The word "deflation" also gets thrown around for no reason at all,
basically because it seems to add a bit of street-cred to the user. Thus, we
get "deflation in the cost of computer memory," and that sort of
thing. They mean that prices are going down. They could call it a
"decline in the price of computer memory," but that would be a
little too obvious, I guess.
Now, obviously, a currency whose value is linked to gold is not rising, at
least vs. gold. You could argue that the value of gold itself rose by some
meaningful amount, thus leading to a rise in the value of currencies linked
to gold, but Friedman does not make this claim. Thus, it is not a Situation
A, but rather a Situation B. A gold standard system has many mechanisms to
prevent such a rise, by increasing the monetary base by as much as is
necessary. So you can't really claim that the monetary base ("money
supply") was somehow insufficient, because there are many mechanisms to
make sure that it is sufficient. The primary one is gold convertibility. If
the value of the dollar was 1/19th of an ounce of gold (1.6922 grams) , while
the parity value was 1/20.67th (1.5555 grams), then the Federal Reserve would
be the highest bidder for gold. The Federal Reserve would be paying $20.67
for an ounce while all the other buyers were at $19.00. Obviously, this would
cause all the gold for sale in the world to be sold to the Federal Reserve,
and the Federal Reserve would experience gold inflows and an increase in the
monetary base, until the value of the dollar fell back to the $20.67/oz.
parity. This is why even this 5%-or-so discrepancy in price from the parity
value never occurs. It would be corrected far before that time.
A similar thing happens in reverse, when the value of the currency is too
low. Thus, the monetary base is, in effect, a residual -- it is the amount
that causes the currency to be at its parity gold value.
This is pretty easy to see in a situation where the currency manager only
transacts in one asset -- whether it be gold bullion in a gold standard
system, or perhaps a foreign target currency in a currency board system
today.
However, things were a little more complicated in those days. The Federal
Reserve, and other central banks loosely modeled on the Bank of England,
engaged in a wide variety of other transactions. Primarily, these were a)
discounting and direct lending; b) open-market operations in securities,
usually government debt; c) foreign-exchange operations.
Now, the thing to see here is that, whatever these other actions may have
been, the result would be the same. The monetary base would be essentially
unchanged, because the monetary base is the amount necessary to produce the
gold parity value. Thus, if discounting increased by $500 million, but the
monetary base necessary to produce the parity value was unchanged, then $500
million would have to be removed by some other mechanism. If no other
mechanism were present, this would be gold convertibility. $500 million of
gold would flow out.
Sometimes, open-market operations and discounting interacted with each other.
If large purchases were made via open-market operations, this would tend to
depress the overnight interest rate. This in turn would tend to reduce loans
and discounting. So, the cancellation could occur that way too.
Foreign-exchange operations would act as basically a proxy for gold. It was
easier and cheaper to transact in foreign currencies than in gold bullion.
Plus, it would result in the acquisition of interest-bearing foreign debt
securities, rather than gold. So, purchases and sales of foreign
exchange--with an international gold-based currency like the British
pound--would be made to keep the currency in line. This was common practice, both
before and after 1914, for almost all central banks outside of the "big
four" reserve currencies -- the U.S., France, Britain, and, before 1914,
Germany. Even Germany did a little with foreign exchange before 1914.
By the 1920s, central bankers and academic economists were already pretty
fuzzy about all these things. Discounting and open market operations in debt
were highly discretionary by the central bank. They didn't really understand
that they couldn't really alter the monetary base -- that any discretionary
action would be cancelled out, mostly by gold conversion, to produce the same
result, namely, the monetary base quantity necessary to produce the gold
parity value. They saw gold inflows and outflows as a somewhat mysterious
effect, somehow related to the "balance of payments" perhaps via a
"price-specie flow mechanism," or differences in interest rates,
all of which was fallacious nonsense.
Friedman's basic rhetorical trick was to imply and suggest that a Situation B
was really a Situation A. This was done by creating a measure of
"money" that did not have anything to do with either the supply or
value of the actual currency -- base money -- but rather with measures of
credit, especially bank deposits. In effect, Friedman took Irving Fischer's
"debt-deflation" effect, and instead of looking at the asset side
of the bank balance sheet (loans), he looked at the liabilities side
(deposits). By implying and suggesting that this was a monetary effect --
when it was really a nonmonetary one -- he was then able to blame the
monetary managers, the Federal Reserve, for supposedly causing this disaster.
I hope you can see how dopey and obvious this really is. You don't really
have to peer into statistical details, or follow intricate twists of history.
Before Friedman, it was already conventional wisdom that the onset of the
Great Depression (before the British devaluation of September 1931) was
basically nonmonetary in nature. Central banks were thought to be somewhat
powerless to address a dramatic downturn that came from mysterious,
unidentified nonmonetary sources. The Keynesians argued that, although the
source was nonmonetary (they called it an "autonomous decline in
aggregate demand," which means: "we have no idea"), that central
banks could nevertheless attempt to mitigate the problem with some kind of
monetary response, which involved devaluation and some sort of lower interest
rates.
Friedman basically argued the same thing, but couched it in somewhat monetary
terms. Instead of an "autonomous decline in aggregate demand," we
have what amounts to an "autonomous decline in bank deposits,"
which is Irving Fischer's "debt-deflation" observation. Remember
that Fischer himself didn't really identify why things were spinning into
disaster. It was more of a symptom than a cause.
June 5,
2016: Irving Fisher and "Debt Deflation"
By way of suggestion and implication, Friedman argued that this decline in
"money" (bank deposits) was the Federal Reserve's responsibility.
This is actually almost indistinguishable from the Keynesian view -- it
amounts to a monetary response to a nonmonetary problem -- with a layer of
rhetoric that basically puts more responsibility on the Federal Reserve, as
if it was negligent in its duties. The Keynesians didn't really regard the
Federal Reserve, or other central banks, as being negligent. They regarded
the gold standard as "golden fetters," to use the phrase introduced
by Keynes in 1931 and later the title of a 1996 book by Barry Eichengreen,
that prevented central banks from taking the activist policy (devaluation,
basically) that they felt the situation warranted.
The Federal Reserve actually did its duties rather well -- which were to
maintain the value of the currency at the gold parity value, and also resolve
any "liquidity shortage" issues, in the 19th century meaning of the
term, which meant systemically high interbank lending rates between banks of
high solvency. The Federal Reserve was never supposed to "bail out"
insolvent banks, and in fact there were several explicit provisions to
prevent it from doing exactly that.
Here we see the Federal Reserve's liabilities. The most important one is the
top line, which is total base money. As you can see, it did not contract in
the early 1930s, it rose. Remember, this was not a "discretionary"
expansion, it was the automatic outcome of the gold parity mechanism.
However, you can't accuse the Fed of not expanding when it should have. It
did expand, when it should have.
In 1932, the Federal Reserve came under a lot of political pressure, from
Congress and elsewhere, to "do something" about the great problems
of the day. The Federal Reserve, just to show that it was absolutely doing
all that it could, undertook a $1,000 million expansion in its government
securities holdings via open-market purchases. The result of this was, first,
that the expansion caused a decline in the overnight rate, which in turn
resulted in a decline in discounting. Second, there was a substantial gold outflow.
The expansion of the monetary base, from open-market purchases, led to an
incipient decline in the dollar's value, which caused gold redemption, thus
cancelling out the expansion. The net result was $1,000 million in purchases,
offset by a $400 million decline in discounting and a $500 million decline in
gold, for $100 million of net expansion -- expansion that would have happened
anyway. If the Federal Reserve had purchased another $1,000 million of
government bonds, there would have been another $1,000 million of gold
outflows (since discounting had already contracted about as much as
possible). Actually, there probably would have been more than $1,000 million
of additional gold outflows, because people would have started to panic by
then, and would have started dumping dollars.
The point is: the Federal Reserve really could do nothing meaningful, while
it remained on the gold standard. Base money is basically a residual. The
Federal Reserve can change the asset mix, by purchasing government bonds and
experiencing reductions in holdings of gold and discounts. But, the overall
base money does not change. Look at base money for 1932. It is a smooth
upward trend, without even a ripple caused by the $1,000 million in
open-market purchases.
Friedman's arguments served a sort of political role. By the 1960s, the
Keynesian idea that Great Depressions just happened for no good reason, was
making people uncomfortable. It was like an asteroid struck the Earth ... but
they couldn't even identify the asteroid. Peter Temin, in his 1976 book Did
Monetary Forces Cause the Great Depression?, neatly laid out the two general
categories of explanatory narrative: one, which I am calling
"Keynesian," which was basically nonmonetary in nature, and the
other, the "Monetarist," in which a monetary cause is implied (but
never proved or identified). Temin concluded that the "Monetarist"
explanation was unsatisfactory, and that he favored the "Keynesian"
version. However, by his 1989 book Lessons From the Great Depression, he basically
switches sides.
Another political role was to allow a way out for those economists, mostly
conservative-leaning, to basically adopt the Keynesian standpoint. Since
nobody had been able to identify any particular cause of the Great
Depression, the conservative economists, if they rejected the Keynesian
money-manipulation strategy, basically had nothing left to offer except for
"do nothing." Well, "do nothing" in the face of such an
epic economic collapse was not really tenable, in 1931 or in 1962.
The idea that economies just collapsed for no good reason bothered the
conservative-leaning economists. The natural conclusion -- embraced by a wide
variety of Keynesians -- was centrally-planned state control. But, if we
could blame some kind of "government error," (to the extent that
the Federal Reserve represented a government agency), then we would avoid the
conclusion of communistic central planning, and also, in a roundabout way,
also vaguely blame something like government intervention, or at least government
error, which is always popular among small-government conservatives, as
Milton Friedman was in virtually all aspects except for monetary affairs.
The intellectual path out of all of this had to wait until the 1970s, with
the "supply side" branch of Classical economics. The supply-siders
focused on the importance of nonmonetary factors -- especially taxes,
tariffs, regulation and so forth -- on economic outcomes. The idea that
"nonmonetary factors might be a big deal" is so obvious that you
might think it is hardly worth making mention of. The great Classical
economists from before 1870 or so -- Mill, Ricardo, Smith -- always
considered nonmonetary topics, if sometimes in a haphazard way. However,
after roughly 1870, around the time of Carl Menger, economists had narrowed
their field of vision to topics involving money, interest rates, and prices.
These lend themselves nicely to quantification, and thus to "general
theories" of "equilibrium" loosely mimicking the mathematial
constructs that were revolutionizing engineering and chemistry of the time.
Something like a tax system is not quantifiable in any way, so they just left
it out. Fiscal policy tends to be reduced to a simple quantity of
"spending." It probably sounds absurd that economists would be
basically unaware of all nonmonetary factors for a hundred years -- in fact,
it is absurd -- but, as we know by now, people really are rather dumb, and
that is what they did.
By identifying nonmonetary factors -- basically tariffs and domestic taxes,
plus a variety of new statist regulations -- for the onset of the Great
Depression, we don't have to embrace either the Keynesian "autonomous
decline in aggregate demand" ("it just happened for no good
reason"), or any of the dozens of fallacious monetary theories including
those of Milton Friedman, or the "blame France" variations, or any
others. Our policy prescription is not "do nothing", but rather:
first, don't do the many stupid things that were done, and then, either
correct those errors or engage in new beneficial nonmonetary policies.
Between 2010 and 2015, the nominal GDP of Greece fell by 25%. This was
basically due to "austerity" tax increases -- not even including
bank default, tariff wars, sovereign default, capital controls, a
simultaneous downturn worldwide, "beggar thy neighbor"
devaluations, or any of the many other negative factors at work during the
Great Depression. A sensible solution, which I made many times, would be
something like a flat-tax reform for Greece, mirroring that of neighboring
Bulgaria.
July 12,
2015: Greece Is On The Brink Of Disaster -- Or Raging Success
June 25,
2015: Greece: Planning The Bank Holiday
June 5,
2015: Greece: It's Time For Your Default and Debt Restructuring
May 28,
2015: Greece's 1-2-3 Plan For Default and Amazing Recovery
April 3,
2015: The Greek Government's Revenue Would Rise -- Immediately -- After Tax
Reform
March
26, 2015: Greece Needs the Magic Formula to Become the Wealthiest Country in
the Eurozone
March
19, 2015: Greece Could Rise To Greatness, Or Become The Next Venezuela
March
12, 2015: Greece's Syriza Could Launch a Libertarian Revolution
When I make this recommendation for Greece, it probably seems simple and
obvious. The idea that the same basic cause, and the same basic solution,
could have been effective in the Great Depression is probably harder to
embrace, simply because we have eighty years of faulty economic opinion to
clear away. Most people are uncomfortable being that far out of consensus.
Not surprisingly, bank liabilities declined also.
Many economists have argued that Greece should leave the eurozone and
devalue. This is basically a rehash of the Great Depression strategy for a
lot of countries. The common currency of the eurozone, they say, is something
like the gold standard of the 1920s--"golden fetters" preventing a
monetary response. But, I think that almost nobody would claim that Greece's
problems are monetary in nature. Germany has been doing well enough, with the
same currency. (Pre-1931, France was doing fine with the same gold-based
currency, even as tax-hiking Britain, U.S. and Germany spiraled into
disaster.)
I think that is all I will say about Friedman today. I am using rather blunt
language -- "bunk", "dopey and obvious" -- because I want
to clear away the fog a little bit, so you can understand that I am not just
saying that the Emperor has no clothes, but so that you can see with your own
eyes that it is so.
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