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The Bailout is Not Enough: The End of the Age of Friedman, Part 2

10/19/2008 08:45 am ET | Updated May 25, 2011

Many economists, even some liberal ones, seem to think that ending a "run" on banks and supplying them with capital is essentially the solution needed to right the economy again. Any further help is useful but secondary. This is wrong. The $700 billion bailout package sponsored by Treasury Secretary Paulson is necessary but not sufficient to rescue the American economy. Credit in America will not flow adequately just because banks have the funds to do it.

Serious misunderstandings about the Great Depression, and how to avoid another, have been generated in the wake of Milton Friedman's influence. Supplying capital will not likely make business or consumers spend adequately again; it will not even make banks lend again. What is needed is a simultaneous and substantial fiscal stimulus--a significant increase in the budget deficit. We are talking several hundred billion dollars here. As part of this, the government, as many now urge, should also develop a mortgage rescue policy to minimize further defaults.

Unless we do this, the recession, already serious, will probably deepen rapidly and lead to further mortgage defaults, a new and unexpected round of corporate defaults on debt, and another frightening round in the banking crisis.

Friedman is the godfather of the credit rescue--though he would almost surely have opposed federal ownership in the banks. But what Milton Friedman (and Anna Schwartz) actually wrote is different than even many scholars seem to realize. A Harvard historian recently wrote in Time Magazine that it was Friedman who made it clear that credit contractions caused the Great Depression. Friedman did not write this. He wrote that the credit contraction had some direct effect on the real economy but itself was not the primary cause of the Depression on Main Street. Rather, the fall in the supply of money was what made a severe recession into a depression in the real economy.

This is a distinction with a significant difference because the fall in the stock of money could have been offset, according to Friedman, only by the Federal Reserve's aggressively buying securities to provide more reserves to the banks. Merely stanching the bank runs and making banks solvent would not have done it, even though the credit crisis contributed to the money supply decline.

In fact, what gave Friedman pause was that the Fed more often than not did supply these reserves in the early years of the Depression and the banks usually did not lend anyway. As a consequence, the money supply actually fell. Friedman rationalized these episodes away misleadingly, including the glaring experience of Canada, where the money supply did not fall very much; our northern neighbors had a serious Depression nevertheless--contrary to the Friedman theory. Instead, Friedman focused on a couple of episodes between 1929 and 1933 when the Fed refused to supply the reserves. What was impossible for Friedman to determine is that, if the Fed had supplied the reserves, how much the banks would have lent. He merely claimed they would have.

Enough on Friedman. Few pay any serious attention to the money supply, anymore. Its relationship to Fed policy and, in turn, its relationship to the economy, turn out to be tenuous and probably not even causal--a direct refutation of Friedman's claims.

But Friedman's distinction is important. Not only did the banks have to be made whole, but they had to lend more. His claim that if the reserves were supplied in those two or three instances, they would have lent adequately, was unlikely. Today, a more aggressive Fed policy, though needed, will also not be adequate.

Many in the early 1930s argued that the Fed's supplying reserves was not enough. And the view was formalized by John Maynard Keynes in his famous work of 1936. You can bring a horse to water but can't make him drink. Friedman ridiculed it. But especially in deep recessions, Keynes was right. Why will banks lend? Only if consumers start to buy again and business generates adequate business and profits to justify the borrowing. They will probably do that only if the government begins to generate demand through spending.

Now we are rolling into a serious recession. Recessions take on lives of their own, undermining business and consumer confidence, not just credit market confidence. Raising capital at the banks won't alone solve the problem. It is a necessary first step to unfreezing the capital market, as it was during the Depression. But the recession has come too far to be saved in one fell bank bailout swoop.

How do you make the horse drink? What is tragic is that war spending and the Bush tax cuts have produced such large deficits that Washington will hesitate to pass a sufficient fiscal stimulus package, replete as it should be with infrastructure investment, aid to the states, the beginnings of healthcare reforms and universal pre-k, and a remake of the unemployment insurance system, to get banks lending again and business investing again. This will be one of the two or three major tests of political leadership in the next 12 months.

Some traditional economists, abetted by the credulous press, are with customary knee-jerk wisdom already lamenting the big deficits. One step should be to separate the costs of the government rescue package from the budget. It is not part of the deficit because much of it will come back as banks and markets recover. This will give us a truer representation of the deficit.

Fortunately, we have automatic stabilizers like unemployment insurance, Social Security and Medicare, which will keep federal spending up. These will prevent a Depression of 1930s depth but probably not on their own a severe recession with further credit crises. If Obama wins, you can bet that the Republicans, defenders of budget deficits under Bush, will again become the great critics of government profligacy. But it won't be profligacy. Such stimulus is urgently necessary to get America back on track. And it will be tragically sad if it is not done. The latter is the likely case.