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.
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:
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."
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."