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Friday, March 09, 2007

Monetary Policy and the Great Depression

Anna Schwartz and Edward Nelson respond to Paul Krugman's essay "Who Was Milton Friedman?," and Paul Krugman replies. The debate is about whether Fed policy during the depression made things worse. Krugman contends that the debate itself is puzzling - the simple observation that the monetary base went up, not down, should settle the issue, particularly since there are no plausible explanations of how the Fed's actions made things any worse than they would have been if banks had still been using specie for reserves. There is the claim that before the Fed there was an informal safety net, but that doesn't seem to have anything to do with free-market economics. But the Friedman faithful persist on this point.

For a little more background, let me repeat part of Krugman's original essay that is under dispute. Recall Keynes' contention that monetary policy may be ineffective in a depression. Keynes said "there's many a a slip twixt the cup and the lip" meaning lots can go wrong with monetary policy - a change in the money supply must lower interest rates, which must then stimulate investment, which in turn must stimulate output. If, for example, interest rates don't fall when the money supply is increased (as in a liquidity trap), or if people are unwilling to invest even if interest rates do fall, monetary policy is ineffective. Keynes noted that fiscal policy, by contrast, operates directly on aggregate demand so it can work even in severe depressions where monetary policy has too many slips twixt cup and lip to be effective.

Friedman and Schwartz claim to refute the idea that monetary policy was powerless during the Great Depression. They claim that monetary policy could have been effective in reducing the severity of the depression, and this is the point of disagreement with Krugman (one part of the dispute is over whether a liquidity trap existed during the Great Depression, or if a liquidity trap is even possible. I was in the "there is no such thing as a liquidity trap" camp for awhile, but the experience in Japan changed that view). This is one of the sections of Krugman's original essay that brought the reaction from Schwartz and Nelson:

Friedman and Schwartz claimed to have refuted Keynes's pessimism about the effectiveness of monetary policy in depression conditions. "The contraction" of the economy, they declared, "is in fact a tragic testimonial to the importance of monetary forces."

But what did they mean by that? From the beginning, the Friedman-Schwartz position seemed a bit slippery. And over time Friedman's presentation of the story grew cruder, not subtler, and eventually began to seem —there's no other way to say this—intellectually dishonest.

In interpreting the origins of the Depression, the distinction between the monetary base (currency plus bank reserves), which the Fed controls directly, and the money supply (currency plus bank deposits) is crucial. The monetary base went up during the early years of the Great Depression... But the money supply fell sharply... This divergence mainly reflected the fallout from the wave of bank failures in 1930–1931: as the public lost faith in banks, people began holding their wealth in cash rather than bank deposits, and those banks that survived began keeping large quantities of cash on hand rather than lending it out, to avert the danger of a bank run. The result was much less lending, and hence much less spending, than there would have been if the public had continued to deposit cash into banks, and banks had continued to lend deposits out to businesses. And since a collapse of spending was the proximate cause of the Depression, the sudden desire of both individuals and banks to hold more cash undoubtedly made the slump worse.

Friedman and Schwartz claimed that the fall in the money supply turned what might have been an ordinary recession into a catastrophic depression, itself an arguable point. But even if we grant that point for the sake of argument, one has to ask whether the Federal Reserve, which after all did increase the monetary base, can be said to have caused the fall in the overall money supply. At least initially, Friedman and Schwartz didn't say that. What they said instead was that the Fed could have prevented the fall in the money supply, in particular by riding to the rescue of the failing banks during the crisis of 1930–1931. If the Fed had rushed to lend money to banks in trouble, the wave of bank failures might have been prevented, which in turn might have avoided both the public's decision to hold cash rather than bank deposits, and the preference of the surviving banks for stashing deposits in their vaults rather than lending the funds out. And this, in turn, might have staved off the worst of the Depression.

An analogy may be helpful here. Suppose that a flu epidemic breaks out, and later analysis suggests that appropriate action by the Centers for Disease Control could have contained the epidemic. It would be fair to blame government officials for failing to take appropriate action. But it would be quite a stretch to say that the government caused the epidemic, or to use the CDC's failure as a demonstration of the superiority of free markets over big government.

Yet many economists, and even more lay readers, have taken Friedman and Schwartz's account to mean that the Federal Reserve actually caused the Great Depression—that the Depression is in some sense a demonstration of the evils of an excessively interventionist government. And in later years, as I've said, Friedman's assertions grew cruder, as if to feed this misperception. In his 1967 presidential address he declared that "the US monetary authorities followed highly deflationary policies," and that the money supply fell "because the Federal Reserve System forced or permitted a sharp reduction in the monetary base, because it failed to exercise the responsibilities assigned to it"—an odd assertion given that the monetary base, as we've seen, actually rose as the money supply was falling. (Friedman may have been referring to a couple of episodes along the way in which the monetary base fell modestly for brief periods, but even so his statement was highly misleading at best.)

By 1976 Friedman was telling readers of Newsweek that "the elementary truth is that the Great Depression was produced by government mismanagement," a statement that his readers surely took to mean that the Depression wouldn't have happened if only the government had kept out of the way—when in fact what Friedman and Schwartz claimed was that the government should have been more active, not less.

Here's the letter from Schwartz and Nelson, and the reply from Krugman:

'Who Was Milton Friedman?' By Anna J. Schwartz, Edward Nelson, Reply by Paul Krugman:

To the Editors:

We begin this response to Paul Krugman's "Who Was Milton Friedman?" [NYR, February 15] by noting a few of the many inaccuracies in his essay and then go on to note the errors in his references to technical matters concerning monetarism and Keynesianism. ...

Krugman claims that Friedman engaged in crude assertion by stating that the Federal Reserve "permitted a sharp reduction in the monetary base." In fact, the monetary base declined over 5 percent from April 1928 to October 1930, certainly a sharp reduction; details are in pages 290, 340–342, and 803 of the Monetary History... The 1930–1933 increase in the monetary base did not reflect official ease, as Krugman implies, but the general public's flight into currency in response to their distrust of banks. Only the currency component of the base rose; the bank reserves component declined (pp. 739–740).

Krugman contends that Friedman distorted the Monetary History in journalistic outlets, offering as evidence Friedman's statement that the Depression was "produced by government mismanagement." ... If Friedman's intention was to distort the Monetary History to noneconomist readers, then his 1973 Playboy interview offered an ideal opportunity. Yet Friedman told Playboy:

Just as banks all around the country were closing, the Fed raised the discount rate; that's the rate they charge for loans to banks. Bank failures consequently increased spectacularly. We might have had an economic downturn in the thirties anyway, but in the absence of the Federal Reserve System—with its enormous power to make a bad situation worse—it wouldn't have been anything like the scale we experienced.

Friedman clearly characterized the problem as Federal Reserve failure to support commercial banks. Friedman did not imply —as Krugman suggests—that "the Depression wouldn't have happened if only the government had kept out of the way." Furthermore, Friedman's emphasis on the discount-rate episode agrees with the Monetary History...

Krugman embraces a hard-line Keynesianism exceeding that of Friedman's contemporary Keynesian critics. Does Krugman really believe that US monetary policy was helpless in the 1930s? There is no reason why the Fed could not have conducted large-scale open-market purchases to keep the money supply from collapsing. The so-called liquidity trap has no empirical basis.

Krugman creates the impression that monetary policy today has returned to the pre-Friedman status quo. But there has been no return to the wage-price guideposts and controls of the 1960s and 1970s. Replacement of these failed measures by arrangements in which central banks accept responsibility for inflation control is a major legacy of Friedman—which Krugman, in arguing that "monetarism is now widely regarded as a failure," overlooks. Does Krugman really believe that the principles monetarists advocated no longer influence monetary policy in all major countries? ...

Krugman doubletalks throughout his essay. How can he say Friedman was a great economist and a great man, if he believes Friedman to have been intellectually dishonest? Or argue that Friedman was a man of courage, if he misled people?

Krugman praises Friedman's work on consumption as a "triumph," yet compares it unfavorably with other work that used "more care," thus treating a work as capable of being a triumph even if it is not careful. We leave it to others to judge whether Krugman's essay is a triumph. We are certainly not its target readership; one of us knew and worked with Friedman for decades, so does not need telling "who was Milton Friedman." But we do judge that Krugman's essay is not careful. Milton Friedman's contributions to economic science and public policy deserved better.

Anna J. Schwartz
National Bureau of Economic Research
New York City

Edward Nelson
Research Affiliate
Centre for Economic Policy Research

Paul Krugman replies:

I'm sorry that Anna Schwartz, one of the world's greatest monetary scholars, is so upset at what I wrote. Rather than getting into a point-by-point argument, let me address three issues.

First, the letter from Anna Schwartz and Edward Nelson actually illustrates Friedman's slippery treatment of the Fed's role in the Depression even better than the examples I used in the article. On one side the letter says, as Friedman did, that the problem was that the Fed did too little—that it failed to exercise its power to rescue the banks. But on the other side the letter approvingly quotes Friedman saying that the Fed did too much—that in the absence of the Fed, with its "enormous power," we wouldn't have had a downturn on "anything like the scale we experienced." I'm sorry, but those are contradictory positions. If there's doubletalk here, it's not on my part.

Second, do I believe that monetary policy was helpless in the 1930s? Yes, I do. At the beginning of the Depression, expansionary monetary policy might have averted the worst. But after the banking crisis had run its course, and interest rates were almost zero, what could open-market operations have accomplished? They would simply have pushed cash into idle hoards, as happened in Japan in the late 1990s.

And given Japanese experience, I'm truly puzzled by the assertion that the liquidity trap—a situation in which interest rates are so low that there's no incentive to lend, so that increasing the money supply doesn't do anything to stimulate the economy—has no empirical basis: here we had a modern central bank, which knows all about what modern theory says you should do to fight a slump, and did in fact conduct large open-market operations under the rubric of "quantitative easing" And despite all that, the Bank of Japan still found itself impotent.

Finally, about monetarism: I don't think anything I said implies that "monetary policy today has returned to the pre-Friedman status quo." But to say that central banks now take responsibility for inflation is a long way from saying that monetarism has succeeded. And it is, by the way, very strange to imply that only monetarists thought that Nixon's wage and price controls were a mistake.

The point is that monetarism doesn't mean supporting responsible monetary policy; by that criterion everyone is a monetarist, and almost everyone always was. Nor does it mean accepting the fact that monetary policy matters. If monetarism means anything at all, it means believing that a stable money growth rate is the key to a stable economy. And it isn't.

[Update (3/23): See another response to Krugman's article, "Milton Friedman in China."]

    Posted by on Friday, March 9, 2007 at 01:17 PM in Economics, Macroeconomics, Monetary Policy | Permalink  TrackBack (0)  Comments (39)


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