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

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.

Comments

[castlerider]

I'm not an economist, but from my reading a lot of books and articles and comments here recently about Friedman and his philosophies, it seems that Friedman was greatly hailed by many conservatives who unapologetically let this system do its worst in ravaging economies all over the globe, confident that it would improve things.
Maybe it did help the rich elite, corporations, and the power hungry, but after all's said and done, it really appears that Friedman's philosophies are a disaster for one simple reason... A reason that as it was
being employed, many would scoff at, if mentioned. However, it is a reason that after the meltdowns, the disasterous cleanups of what's left, and after witnessing such incredible looting by those in power,
becomes very clear as to why it is a reason that Friedman so foolishly has underestimated all this time: Human Greed.

[RichHayes]

All of this was a completely understood and inevitable situation.

When an economy becomes over reliant on non-productive means of generating wealth it is already on the road to failure. All of us who actually work for a living and produce something tangible have been wasting our time. The path to riches has been pure speculation, enabled by access to easy (global) credit.

One of the only people who is talking about all of this in the context it deserves is Max Keiser. I agree with him when he says it is (the failed banking model) effectively a criminal enterprise.

[rich misty]

I just read the article and was going to post almost exactly what you said... Including the line about criminal enterprise.

[RichHayes]

I would recommend listening to the podcasts at www.karmabanqueradio.com

And entertaining and very informative view of the markets today.

Max Keiser saw all of this coming from a long way off and was effectively laughed at as a conspiracy theorist. Well it turns out he was almost completely right. He predicted Icelands collapse (nearly 2 years ago), he predicted major US banking collapses, UK banking collapses. He has demonstrated how the markets are severly rigged and tells everyone to get out of the markets altogether as they are now almost complete a swindle.

For my part i predicted (not to measure myself to Max) that the show down would be between the USA and Europe (and not China). That now looks to be a fair predicition. Either rationality re-enters economic discourse or war-torn feudalism is the next obvious step. Personally i dont hold out much hope. My own thesis on all off this is that we just witnessed the final looting of the world economy before the inevitable decline of the oil age, which i think is now fully underway.

[wiredbrain]

Cold hard truth:
By Peter E. Pflaum, PhD
The explanation of the financial crisis is a simple as the common practice of rolling over debts. If a household, firm, bank or financial institution is holding assets bought with borrowed money, such as a mortgage, car, credit card debt, mortgage backed security, or stocks and bonds and the money has to be rolled over on a credit market; they are at risk of having to sell assets in a down market, losing their net worth or capital, or going bankrupt or getting a government bailout (rescue). The fancy models of risk calculated the costs of funds and the returns on the assets owned. They did not figure on the market going dead, friezing up because everyone was in the same condition and in no shape to make new loans but needing to call in their existing loans to maintain equalium. The cash came from societies that have saving into societies that ran up debt buying stuff they can"t afford.
If someone has a house that is "underwater" so the value is less than the market price. If a scheme such as proposed by McCain offers to refinance at a lower mortgage and interest rate the neighbors will notice. Those that are paying their debts will be attracted to go into default so they can get better terms. This is more than a moral hazard it is a financial one of huge proportions.

[KillTheMessenger]

One still has to wonder how much ignorance it takes to link the recession to the banking crisis. The country was overspent for years and on its way to an economic collapse long before the first banks went belly up. That we spend every single dime on things we don't need and have no stomach for long term investments that will actually show returns is the underlying disease. The banking crisis is just one of the symptoms.

[dshwa]

True, it was one of the symptoms. But it was the one that sent the patients running to the doctor, to continue the metaphor.

What the bankning crisis did was bring the underlying problems into play. When the banks started getting tight, the parts of the economy that hadn't been doing well (the middle class, for starters) for the last several years couldn't soften the blow.

The reason I don't think the bailout will help is it doesn't address the underlying problem. Too many people in this country are reliant on credit to support their lifestyles. Even if you unfreeze the credit markets for banks, the middle class is too tapped out to draw more from that well, especially if there's a recession. A downward spiral in consumption (already in progress) will simply finish off buisness interests already weakend by the market instability. Without a direct infusion of money to middle America, things are going to continue to spiral.

To finish with the medical mataphor, what's going on here is what they call in health care "Train-wrecking" One organ failure causes too much strain on a second organ which then fails, which leads to a third organ, and so on until death. That's where we're at now. One massive failure setting of another and another.

[WASanford]

Jeff, I"ve long believed that the first job of government is to protect its citizens. That"s why we have armies, police, and government programs. We have seen over most of the last decade an abject failure of our government in that regard. The "credit crisis" is simply the last and hopefully final iteration of that failure.

If our economy needed an injection of "cash" our government should have provided it by acting as a lender of last resort, guaranteeing that the money would make its way into our economy. Banks seeing themselves in competition with the government may then have freed up the assets they are currently hanging onto, providing a multiplying effect to that injection of cash.

On stopping the free fall of real-estate prices, there"s less reason for hope. Between the turn of the century and 2007 real-estate became unreasonably overpriced. I"m afraid it will be long fall until it becomes affordable again. In the last quarter of 2007, the BLS* reported that the average California worker was earning $1053 per week or just under $54,000 in a year. Using the 2 1/2 times the annual wage affordability formula, which has served me well during my lifetime, the average house in California should sell for $135,000. We are a very long way from that.

* Federal Bureau of Labor Statistics

[larry278]

What wil convince the money mavens that the deep recession has become a depression? When will they dare utter the word depression? If customers don't buy; banks don't lend, even after massive infusions of federal funds. JMK will continue his peaceful, eternal, rest. JMK is beyond earthly problems & concerns. It will take more than simply reading JMK to introduce federal policies which will induce banks to resume lending.

[JBS]

The old joke is "If you get laid off - it's a recession. If I get laid off - THEN it's a depression."

When Wall Street thieves start getting laid off, you can be sure they'll finally see that it's a depression.

But all the banking reforms in the world won't pull us out of this depression. The only way it's going to happen is when people have money to spend beyond holding off the creditors for one more minimum payment; staving off bankruptcy another week; forestalling foreclosure for one more month while they pray for a miracle to come along and save them.

The only way that's going to happen is for wages to rise drastically. I ain't talking cost of living adjustments. I mean real income for WORKING people has got to rise 20%, 50% and more ... while costs for food, clothing, health care, housing and transportation have to fall.

And I don't see anybody who's got a plan to accomplish that.

Because there ain't no way to do it in an economy based on the top 1% hogging everything and renting money (especially renting money that doesn't actually exist) to each other.

[avraamjack]

.
As you said, we cannot force private banks to lend.
.
We should use part of the .7 trillion to create new banks.
.
Those banks, owned by the government, would lend.
.
In a few years, the stock of the new entities could be sold to the public.
.

[tompoe]

The Party of Corporate Welfare has more to worry about than what the Democrats might be doing under Obama. Their biggest problem is now how to keep from disappearing into the ether. America does not tolerate corporate welfare. The next Republican you meet, remind them they belong to the Party of Corporate Welfare. The Independent Party is really excited about their future, right now. And, this is a good thing.