Sunday, April 20, 2008

How not to prevent a recession

by William L. Anderson

I recently heard a radio interview with a prominent economist who was defending Federal Reserve Chairman Ben Bernanke's moves to shore up the markets on Wall Street. Bernanke, the economist said with emphasis, had spent years studying the "mistakes" of the Fed during the Great Depression and was not going to repeat the "errors" that the Fed directors committed from 1930 to 1933.

The "errors" of which the economist spoke were outlined by the late Milton Friedman both in his 1963 A Monetary History of the United States (written with Anna Schwartz) and his popular Free to Choose (with Rose Friedman), published in 1979. According to Friedman and his coauthors, the economic collapse that occurred in the United States from 1930 to 1933 came about because the Federal Reserve System failed to act in the face of bank failures and banking panics, leading to a massive contraction in the amount of money in circulation, which ultimately led to the calamity.

Friedman made his arguments as a means to counteract the common explanation of the Great Depression — that it was the result of the "internal contradictions" of capitalism. The typical explanation, popularized by John Kenneth Galbraith as well as the gaggle of Keynesians that proliferated in US universities, was that the capitalist system tends toward "underconsumption" or its evil twin, "overproduction."

(Galbraith held that underconsumption occurred because the income "gap" between the wealthy and poor grew during the 1920s — another "natural" outcome of capitalism — while John Maynard Keynes and his followers held that private investment spending was volatile because of the "animal spirits" of investors. The system had a built-in, self-multiplying, downward spiral whenever private investors were unwilling to throw more money into the economy.)

Those who blamed the Great Depression on the "failures" of the free market were all too happy to come up with their own "solutions," including attempts to cartelize the entire US economy or to force up wages via increased minimum-wage legislation or through the endorsement of expanding labor unions. Some, like Galbraith, went further and advocated out-and-out socialism and central economic planning. The free-market system, they have argued, is too inherently unstable to be left to its own devices. (This is the same argument that Paul Krugman makes twice a week from his perch on the New York Times op-ed page)

Thus, Friedman was seeking not only to explain why he believed the Great Depression occurred, but he also was trying to defend the free-market system, or at least was trying to defend most of the free market system. There was one portion of the system that was prone to failure, he argued, and that was the monetary system.

For more on this article, go to the Ludwig von Mises Institute's Website

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