Is America still depression-proof?
Milton Friedman's famous prediction may need revising.
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1. "Federal deposit insurance has made bank failures almost a thing of the past. A bank no longer fails when it has been badly managed and its assets fall short of its liability. The F.D.I.C. takes over its bad assets, or assumes responsibility for them, and arranges a merger of the 'bad' bank with a 'good' bank."Skip to next paragraph
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Clearly, bank failures are not a thing of the past, and there have been runs on commercial banks and other financial institutions (money market funds), although Friedman is right that the government has been able to take over a failed bank or force a merger with a bigger, safer bank.
2. "There has been no major depression that has not been associated with and accompanied by a monetary collapse…. Monetary contraction or collapse is an essential conditioning factor for the occurrence of a major depression."
Yet the US came awfully close to an economic collapse last year without any monetary contraction. In fact, during 2008, the money supply (M2) grew every month and 9 percent for the year. Clearly, monetary contraction isn't the only source of instability in the economy. Economic disaster can also be precipitated by too much monetary inflation, irresponsible banking practices, or perverse tax and regulatory policies.
One of the weaknesses of the Friedman/Chicago school approach is their belief that inflationary asset bubbles only have micro effects on the economy and can be defused without having a debilitating macroeconomic impact. The real estate crisis of 2007-09 demonstrated otherwise. Inflation caused by Keynesian-style government spending and easy money policies can have unintended consequences and create economy-wide unsustainable imbalances that can lead to disaster.
As the great Austrian economist Ludwig von Mises once said, "We have outlived the short-run and are suffering from the long-run consequences of [Keynesian] policies."
At the end of our special session, I asked members of the Mont Pelerin Society how many of them still agreed with Friedman, that the American economy is "depression-proof." Only a handful raised their hands, and they were all American economists. The rest of the crowd, mostly from abroad, pointed out that most other countries did not suffer a banking crisis. The financial crisis was largely American-induced. They agreed that until the US adopts a stable monetary and banking system, it can no longer be considered depression-proof.
One thing almost everyone agreed on was a statement Friedman made at the end of his lecture, speaking of the Federal Reserve System: "It simply seems to me that their task is one in which mistakes are bound to be made from time to time, and such mistakes, under the kind of a system we have had, are likely to be exceedingly serious even with the best of intentions in the world…. The desirable solution is rather to reduce as far as possible the necessity or possibility of discretionary action."