What Rule Should the Fed Follow?, by Bruce Bartlett, Commentary, NY Times: ...[T]he “Austrian” theory of the Great Depression ... says that even though there was no inflation during the 1920s, somehow or other inflation nevertheless caused the Great Depression. According to ... the Austrian school ... there was actually some sort of double-secret inflation because the money supply increased. They believe the same thing is happening right now.
When the Austrian theory was first put forward, conservative economists were keen to refute the widespread view that capitalism itself had caused the Great Depression and that the cure was full-bore socialism. The Austrians ... and others, were desperate to show that government was responsible...
Although the Austrian theory was initially viewed sympathetically by conservative economists..., it was abandoned when it became clear that there is no Austrian cure for depressions; the only course ... is to suck it up, let unemployment rise, and purge the mal-investment no matter how painful. Anything ... whatsoever the government does to ... counteract the economic downturn ... is inherently counterproductive...
In the 1960s, conservative economists adopted a different view. The government error was ... responding inappropriately to a garden-variety recession that began in August 1929. ... This “monetarist” theory of ... Milton Friedman and Anna Schwartz ... argued that if the Fed had acted as a lender of last resort, as it was created to do, it could have stopped the Great Depression in its tracks...
The monetarist theory was a far more attractive explanation for the Great Depression that also blamed government. It was largely adopted by conservatives except for a few Austrian holdouts... One attraction of the monetarist theory is that it allows for government action to respond to economic downturns, as opposed to the Austrian do-nothing policy.
When economic downturns arise, monetarists say the Fed should respond by expanding the money supply, not through an expansionary fiscal policy, as Keynesian economics recommends. ...
In the years since, however, the monetarist theory has lost favor among conservatives. They now assert, along with the Austrians, that the only “cure” for recessions is not to sow their seeds in the first place. Those seeds, all conservatives now agree, are sown primarily by the Fed, especially by holding interest rates “too low.”
Thus almost all conservatives, including many regional Federal Reserve bank presidents, believe the Fed should raise interest rates soon to prevent a reemergence of inflation, another boom and, inevitably, another bust that may be even worse than the one we have yet to emerge from. ...
The Austrian analysis of the Great Depression and the recent recession are wrong, I think. Unfortunately, that will not deter the conservatives.
David Glasner comments:
All in all, a worthwhile and enlightening discussion, but I couldn’t help wondering . . . whatever happened to Hawtrey and Cassel?
And Paul Krugman has argued the monetarist view has been tested in this recession (and in Japan), and failed.
...whatt Friedman ... argued was that the Fed could easily have prevented the Great Depression with policy activism; if only it had acted to prevent a big fall in broad monetary aggregates all would have been well. Since the big decline in M2 took place despite rising monetary base, however, this would have required that the Fed “print” lots of money.
This claim now looks wrong. Even big expansions in the monetary base, whether in Japan after 2000 or here after 2008, do little if the economy is up against the zero lower bound. The Fed could and should do more — but it’s a much harder job than Friedman and Schwartz suggested.
Beyond that, however, Friedman in his role as political advocate committed a serious sin; he consistently misrepresented his own economic work. What he had really shown, or thought he had shown, was that the Fed could have prevented the Depression; but he transmuted this into a claim that the Fed caused the Depression.
And this debased and misleading version is what has filtered down to the likes of Ron Paul, who then use it to argue against the very activism Friedman was really advocating.
Bad Milton, bad.