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Is America still depression-proof?

Milton Friedman's famous prediction may need revising.

By Mark Skousen / August 31, 2009

New York

The free-market Mont Pelerin Society held a special session at its meeting in Stockholm earlier this month to reassess Milton Friedman's famous lecture, "Why the American Economy Is Depression-Proof." Friedman gave this optimistic lecture in Sweden in 1954, at a time when some prominent economists and financial advisers were predicting another crash on Wall Street and a collapse in the economy.

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Now, 55 years later, in the face of the worst financial crisis since the Great Depression, everyone at the meeting wanted to know if Mr. Friedman, one of the founders of the international society, would change his mind.

Nobody knows for sure, since Friedman died before the crisis started. I do know that he consistently refused to make any changes in his bold prediction.

From 1954 until his death in late 2006, the United States suffered numerous contractions in the economy, a savings-and-loan crisis, a major terrorist attack, and even a few stock market crashes, and still it has avoided the "big one," a massive 1930s-style depression characterized by an unemployment rate of 15 percent or more (Friedman's definition of a depression).

In his lecture, Friedman pointed to four major institutional changes to keep another Great Depression from happening: federal bank deposit insurance; abandonment of the international gold standard; the growth in the size of government, including welfare payments, unemployment insurance, and other "built-in" stabilizers; and, most important, the Federal Reserve's determination to avoid a monetary collapse at all costs.

Because the public and officials are petrified by the possibility of another depression, Friedman predicted that any signs of trouble would lead the Federal Reserve to take "drastic action" and shift "rapidly and completely to an easy money policy." Consequently, according to Friedman, inflation would be far more of a threat to postwar America than another Great Depression.

So far so good. But now, following the financial crisis of 2008, I suspect Friedman would be forced to revise his views if he were alive.

Admittedly, Friedman is still technically correct. There still has been no Great Depression. The Fed and the federal government appear to have averted disaster once again. Yet they were able to do so only by taking unprecedented actions that resulted in trillions of dollars in new debt that may so weaken the government and the public's trust in its financial capacity that a deflationary collapse, hyperinflation, or centrally planned economy sometime in the future may be unavoidable.

Two of Friedman's statements are suspect in light of the recent meltdown: