Scott Sumner: Friedman and Schwartz vs. the Austrians

TheMoneyIllusion » Friedman and Schwartz vs. the Austrians: I’m certainly no expert on Austrian economics, but I have always viewed Friedman and Schwartz’s Monetary History as a sustained attack on both the Austrian and Keynesian views of the Great Depression.  Now we have a revival of the Austrian view from an extremely unlikely source.  Before considering her arguments, let’s first look at the F&S analysis of monetary policy during an asset price bubble.

On page 291 of the Monetary History , F&S consider the “difficulties raised by seeking to make policy serve two masters”:

There seems little doubt that, [beginning in 1927] had it been willing to take such [contractionary] measures, it could have succeeded in breaking the bull market.  On the other hand, if it had single-mindedly pursued the objective implicit in its 1923 policy statement of promoting stable economic growth, it would have been less restrictive in 1928 than it was and would have permitted both high-powered money and the stock of money to grow at something like their usual secular rates.  In the event, it followed a policy that was too easy to break the speculative boom, yet too tight to promote healthy economic growth.

In our view, the Board should not have made itself an “arbiter of security speculation or values” and should have paid no direct attention to the stock market boom, any more than it did the earlier Florida land boom.

This is a strikingly anti-Austrian position.  Not only do they dispute the view that policy was too easy during the stock bubble, they actually argue that it should have been even easier!  And this despite that fact that they implicitly acknowledge that easy money helped fuel the boom.  I think it’s safe to say that F&S would not have been among those arguing that the Fed should abandon inflation targeting to focus on the housing boom in 2003-06.

Any doubts about the anti-Austrian message of this chapter is erased in the final paragraph, where (on page 298) they summarize their argument:

The economic collapse from 1929 to 1933 has produced much misunderstanding of the twenties.  The widespread belief that what goes up must come down and hence also that what comes down must do so because it earlier went up, plus the dramatic stock market boom, have led many to suppose that the United States experienced severe inflation before 1929 and the Reserve System served as an engine of it.  Nothing could be further from the truth.  By 1923, wholesale prices had recovered only a sixth of their 1920-21 decline.  From then until 1929, they fell on the average of 1 percent per year.

Thus contrary to the Austrian view, as long as the overall inflation rate is under control, one can ignore asset price bubbles.

It also might be interesting to contemplate what would have happened had the Fed followed their advice after the 1929 crash, and if that advice had succeeded.  They acknowledged that a recession was almost inevitable after the crash, but insisted that a major depression could have been avoided with a more expansionary monetary policy.  Although the Fed did cut rates significantly in the early 1930s, F&S insisted that these cuts were too little to late.  So suppose the Fed had cut rates even more sharply, and that we had merely experienced an ordinary recession.  Wouldn’t that outcome have looked a lot like 2001-03?

Furthermore, F&S consistently argue that interest rates are a highly misleading indicator of monetary policy–if the money supply is falling then policy is tight even if rates are also falling.  They argued that one should not use interest rates as an indicator of the stance of policy.  Now let’s contrast the F&S view of the Depression with the modern neo-Austrian view of recent events:

The Fed was accommodative too long from 2001 on and was slow to tighten monetary policy, delaying tightening until June 2004 and then ending the monthly 25- basis-points increase in August 2006. The rate cuts that began on August 10, 2007, and escalated in an unprecedented 75-basis points reduction on January 22, 2008, were announced at an unscheduled video conference meeting a week before a scheduled FOMC meeting. The rate increases in 2007 were too little and ended too soon. This was the monetary policy setting for the housing price boom.

This is about as far removed from F&S as one can get.  The stance of monetary policy is judged by interest rates, not the money stock.  And policy is judged to have been too expansionary because it fed a housing boom, not because it increased the overall rate of inflation (which was relatively low.)  Even worse from the perspective of F&S, she argues that monetary policy should have been tightened further after the housing boom peaked in mid-2006, and indeed argues that policy should have been even tighter than it was in late 2007 and early 2008, just as the economy was entering a recession.

Or consider the following views by the same economist:

How did we get into this mess in the first place? As in the 1920s, the current “disturbance” started with a “mania.” But manias always have a cause. “If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset.

“The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it’s so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses.”

The house-price boom began with the very low interest rates in the early years of this decade under former Fed Chairman Alan Greenspan.

So not only the recent housing boom, but earlier booms such as the 1920s stock bubble, were caused by excessive monetary ease.  And she is not going to accept any excuses that “policy [cannot] serve two masters.”:

In other words, Mr. Greenspan “absolves himself. There was no way you could really terminate the boom because you’d be doing collateral damage to areas of the economy that you don’t really want to damage.”

[She] adds, gently, “I don’t think that that’s an adequate kind of response to those who argue that absent accommodative monetary policy, you would not have had this asset-price boom.” Policies based on such thinking only lead to a more damaging bust when the mania ends, as they all do. “In general, it’s easier for a central bank to be accommodative, to be loose, to be promoting conditions that make everybody feel that things are going well.”

By now you’ve probably guessed that these neo-Austrian quotations from here and here, are by Anna Schwartz.  Many people forget that the argument in the Monetary History would have actually been considered quite progressive in the late 1920s and early 1930s.  Were he alive today, Friedman would be horrified by the neo-Austrian views of Anna Schwartz.

In fairness to Ms Schwartz, one is entitled to change one views, I have done so many times.  However in her WSJ piece she clearly presents her current views as being representative of the sort of analysis that she did with Friedman in the Monetary History.  Nothing could be further from the truth.

(For what it’s worth, I favor the F&S view.  However, because I prefer nominal GDP targeting to inflation targeting, I think that policy should have been a bit tighter in 2004-06 (but not 2007-08).)

Comments

[Michael Meeropol]

Isn't there a middle ground? Given that the Chair of the Fed has a great "bully pulpit" (witness what happened when AG used the term "irrational exhuberence") when there are asset bubbles it would be very easy to deflate them with a few choice words.

Imagine if Alan Greenspan had stated in 2005 (or even earlier) that by any sense of market fundamentals (rate of inflation, rate of increase in market rents), housing prices were inflating much too rapidly to be anything but a bubble. AND -- that executives in companies buying fancy mortgage-backed securities based on these bubble-inflated housing prices were failing in their fiduciary responsibility to their shareholders.

The bubble would have deflated long before it reached its peak.

The "neo-Schwartz" view seems to require the FED to hit the entire economy over the head not just to restrain inflation but to restrain asset bubbles -- but this other approach, targeting the bubbles directly would work and not produce the collateral damage that a macroeconomic slowdown would.