Two Untimely Deaths

Benjamin Strong was President of the New York Fed during the 1920s, which effectively made him the Ben Bernanke of his time.  According to Liaquat Ahamed (p. 293-94), Strong favored a policy that attempted to stabilize the economy by looking at “the trend in prices and the level of business activity.”  Today we would call those variables the price level and real GDP, i.e. NGDP.  His policies were highly successful during the 1920s, as NGDP grew at a fairly low but steady rate after 1921.

A good example occurred during the very mild recession of 1927.  Contrary to the Austrian view, policy wasn’t particularly easy by modern standards.  Short term rates were cut to 3.5%, but that would be like 5.5% under our modern 2% inflation regime.  (In those days the trend rate of inflation was roughly zero.)  In any case, this policy insured that the recession was very mild, and the economy soon recovered.

Unfortunately, Strong died on October 16, 1928, and a year later a tight money policy by the Fed began driving both RGDP and prices far lower than they had fallen in 1927.  Irving Fisher, Ralph Hawtrey, Milton Friedman and Anna Schwartz all argued that his death deprived the Fed of “Strong” leadership, and that the resulting power vacuum contributed to the Fed’s passivity during the Great Contraction.  I’d say that praise from those 4 scholars represent a pretty good testimonial!   Sometimes I think that if Strong had lived another 10 years, WWII might never have happened.  (Or maybe it would have been fought between the US and Soviets in 1959, with nukes.)

Are there any analogies to the current crisis?  Greenspan left the Fed in 2006, about a year before the sub-prime crisis blew up.  But I am not going to argue that he could have prevented the current crisis.  His recent policy statements don’t inspire much confidence on that score.

Elsewhere I have argued that the economics profession is to blame for the recession.  We promised policymakers that we had the models and tools to stabilize nominal aggregates, and then we refused to do so when the time came for action.  The reasons are complex, but I believe that part of the problem is that all the activity at the Fed in late 2008 and early 2009 lulled many economists into thinking that the Fed had adopted a highly accommodative policy.  How many times have you read something to the effect that; “Bernanke was a student of the Depression, and was determined not to make the same mistakes.  Hence policy was very active, and prevented another Great Depression.”  If only it were true.

Of course policy was extremely contractionary during late 2008.  But why was this not recognized?  Among Keynesian economists you can point to an unhealthy fixation on nominal interest rates as an indicator of policy.  On the other hand Keynesians weren’t the main problem—they were not opposed to unconventional easing, just rather apathetic.  The real opposition came from those on the right, who were alarmed at the massive increase in the monetary base.

Milton Friedman died on November 16, 2006, one year before the sub-prime crisis.  I’d like to suggest that his death was the closest equivalent to the death of Strong in 1928.  In 1998 Friedman pointed out that the ultra low interest rates were a sign that Japanese monetary policy was very contractionary, at a time when most people characterized the policy as highly expansionary.

There is little doubt that Friedman would have recognized the low interest rates of late 2008 were a sign of economic weakness, not easy money.  But what about the big increase in the monetary base?  First of all, the base also rose by a lot in Japan, and in the US during the Great Contraction.  Second, Friedman would have clearly understood the importance of the interest on reserves policy, which was very similar in impact to the Fed’s decision to double reserve requirements in 1936-37.  And in his later years he became more open to non-traditional policy approaches, for instance he endorsed Hetzel’s 1989 proposal to target inflation expectations via the TIPS spreads.  Note that the TIPS markets showed inflation expectations actually turning negative in late 2008.

Why was Friedman so important?  I see him as having played the same role among right-wing economists that Ronald Reagan did among conservatives.  Reagan was really the only conservative that all sides respected; social conservatives, economic conservatives, and foreign policy (or neo-) conservatives.  After he left the scene, the conservative movement cracked-up.

Friedman was respected by libertarians, monetarists, new classicals, etc.  Last year I criticized Anna Schwartz for adopting the sort of neo-Austrian view that she and Friedman had strongly criticized in their Monetary History.  If Friedman was still alive, and strongly insisting that money was actually far too tight, then I doubt very much that Schwartz would have gone off in another direction.  It would be like Brad DeLong disagreeing with Paul Krugman on macroeconomic policy.  Once in a blue moon.

Today there is no real leadership among right wing economists.  They are all over the map.  There are new classical types focusing on the role of labor market imperfections.  Well-known monetarists like Schwartz and Meltzer insist that the real danger is easy money, not tight money.  It is true that a few monetarists such as Robert Hetzel, Mike Belongia and Tim Congdon have spoken out against the view that low interest rates imply money is easy, but they aren’t as influential as Friedman.  Austrians are split, with the loudest voices on the internet often drowning out the more thoughtful Austrians who recognize the dangers of a “secondary deflation.”  Inflation hawks at the Fed seem to think this is a good time to get inflation down closer to 0%, where it should have been all along in their view.  When a conservative like John Makin does speak out, it is treated as a sort of freak occurrence.

If only Milton Friedman had lived a few more years, and made the sort of bold clear statement he made in 1998 about the situation in Japan:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.


I can’t say every conservative would have accepted his view.  But they couldn’t ignore it the way they ignore me and Earl Thompson and David Beckworth and David Glasner and Robert Hetzel and Bill Woolsey and Tim Congdon.  Milton Friedman was an intellectual giant, and his voice is dearly missed.

PS.  In January Allan Meltzer had this to say about recent Fed policy:

Mr. Volcker publicly and privately discarded the Phillips Curve in favor of bringing inflation down by high interest rates and better control of the money supply. The result: about 15 years of low inflation and low unemployment. But the Fed abandoned its success by keeping interest rates too low after 2003. And now the Phillips Curve is back in fashion, with strong support from the Fed Board of Governors.

Interestingly, since the Fed abandoned its “success” in 2003, inflation has been considerably lower than in the 15 year golden age ushered in by Volcker in 1982.  And that is precisely the problem—too little inflation.  Low interest rates usually mean low inflation; Friedman understood that.

HT:  Mike Belongia, David Glasner

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About Scott Sumner 492 Articles

Affiliation: Bentley University

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.

Visit: TheMoneyIllusion

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