I wrote the following letter to National Review Magazine in response to an article by my friend Kevin D. Williamson, which appeared in the September 21, 2009 edition.
Re: “Blame Milton Friedman” by Kevin D. Williamson
I am tempted to respond to the excellent essay by Kevin D. Williamson (“Blame Milton Friedman”) as would the Kung Fu master of the old TV show: “Ah, grasshopper, you are established on the road to wisdom but you have a long way yet to travel.”
The gist of Mr. Williamson’s essay is that the bank bailouts (TARP, TARP II, and who knows what else) were necessary under the circumstances, because the forces of statism wanted to go even further, plus there is the possibility that these programs will be limited somehow. Furthermore, these programs probably did stem the danger of massive depositor losses and—Oh, the Horror!—uncontrolled deflation.
The Friedman/Schwartz analysis of the cause of the Great Depression as a failure of the Fed to prevent a decrease in the money supply has been challenged and, in my humble opinion, refuted by that of the Austrian School economists. Murray N. Rothbard’s breakthrough analysis of the economy of the 1920s and Hoover’s interventionist response—America’s Great Depression--explained why a recession was inevitable and intervention made things worse, much worse. The newly created Fed had created a bubble economy in the 1920s through its fairly continuous expansion of bank reserves, which became the building blocks of bank deposits. The subsequent crash is explained by the Austrian Business Cycle Theory, whereby artificially lowered interest rates from the expansion of bank reserves fostered unsustainable investments in longer-term, more time-consuming economic processes that were not funded by real savings.
(That is saying a mouthful in one sentence and hardly does justice to this elegant theory. The best book for an introduction to this theory is a compilation of four essays by noted Austrian School economists, Rothbard included, titled The Austrian Theory of the Trade Cycle, compiled by Richard M. Ebeling. Both the Rothbard book and the Ebeling book are available on line at www.Mises.org.)
Fiat money expansion cannot paper over these malinvestments forever. Either the bubble comes to an end and the unprofitable investments are liquidated, as occurred rather quietly in the unheralded and forgotten American depression of 1920/21, or hyperinflation destroys the economy, as occurred in Weimar Germany of 1923. The damage has been done. Socializing the loss through bank bailouts does not cure anything; it merely spreads the losses over the entire economy in the form of higher prices down the road and encourages future bubbles through moral hazard. Despite Mr. Williamson’s hopes, the damage has not been minimized either—the damage was done long ago--; it will not be temporary—as happened in 1920/21 but not in 1929/45--; and there is no political consensus to undo the federal incursions into the economy. Quite the contrary. Because the incursions kick the can down the road a few more yards, there are calls for more of them and in greater amounts. But this solves nothing and makes the necessary correction even greater, because malinvestment in unsustainable processes continues to expand.
Unfortunately, the best for which we can hope under our current set of policies is a repeat of the 1929/45 Great Depression and not a collapse of the economy as occurred in Germany in 1923. But almost of trillion dollars of excess reserves just waiting to be turned into bank deposits via a growth in lending, combined with other policy errors that will exacerbate the problem, tell me otherwise.