Hirsh: Milton Friedman vs. the Fed Bailout

Anna Schwartz is 93 and has been working at the same place since 1941. She's that rarity in economics, or indeed any field: a living legend from another era who hasn't lost a step mentally and who grasps everything that's going on around her in the present. Or at least she seems to—but more on that later. Schwartz is one of the most renowned monetary scholars in the world. She's the woman who authored, with Milton Friedman, The Monetary History of the United States—the book that launched the free-market counterattack against Keynesianism in the early '60s. And now, as she surveys the wreckage of the last two years, Schwartz has one thought: if only Milton were here. "Ever since his death I have lamented the fact that he has not been around to express his views on what's going on," she told me the other day at her mid-Manhattan office at the National Bureau of Economic Research.

Despite constant criticism of the Obama administration and the Federal Reserve over their handling of the financial crisis, opponents of their policies don't have a leader—especially on the right. Their problem is "the big lack of a voice like Friedman's, someone who's got instinctive understanding of the way markets operate, a very profound knowledge of history," Schwartz told me. Had Friedman been around to speak out (he died in 2006), "I don't believe we would have had a Fed balance sheet currently that has doubled, or tripled, in such a short period of time without any kind of Fed acknowledgment that it was creating a problem for itself [with] inflation already baked into the economy." In clear, strong tones marked by her New York accent, Schwartz said: "Everybody's talking about what kind of exit strategy does the Fed have, given that its balance sheet has exploded. It's something [Fed chair Ben Bernanke] doesn't discuss. It's as if he isn't willing to acknowledge that it is a problem."

Slamming the Fed, of course, is old hat for Schwartz and her alter ego, Friedman. They concluded in Monetary History that had the Federal Reserve not existed, the Great Depression might never have happened. Their argument: the Fed bungled things by tightening money from 1929 to 1932, something the New York bankers who used to be in charge of resolving crises would never have done. But Schwartz says that Friedman—who along with John Maynard Keynes, his polar opposite in thought, was the 20th century's most influential economist—would be just as disturbed by what Barack Obama is doing today. "Obama nowadays is the typical believer that government can do everything. So he's going to change the way electricity is produced in this country. He's going to change the way energy is going to be produced in this country. And it's all going to be a government effort. And Friedman would say, 'Look, if these really are such desirable things, why isn't it that the private sector has taken advantage of an opportunity to make money and to improve things?' "

Schwartz is more than a prominent voice for free markets; she is a breathing intellectual link to the Depression and its lessons. All of modern economics—and every major debate currently raging over the financial crisis—dates back to the 1930s. All the policy options we now discuss without even thinking about them—deficit spending, monetary policy, the role of the Fed, government intervention in general—spring out of what economists learned from that period. It was thanks to the Depression that Keynes created macroeconomics. It was in response to the Depression, and his finding that the Fed dramatically deepened it by tightening money supply, that Friedman developed his theory of monetarism, rebutting Keynes. (Monetarism holds that the money supply is the primary driver of prosperity and recession, and that Keynesian fiscal spending doesn't work. Government should therefore stay out of the way, other than to adjust the money supply.) And it was because of the Depression that Bernanke, another renowned scholar who studied its causes, expanded the Fed's lending by more than $2 trillion, angering Anna Schwartz.

Schwartz's criticism is unpleasant to hear for Bernanke, who has long admired both her and Friedman. He has said that reading Monetary History "hooked" him on monetary economics when he was an MIT student. Against her arguments now, Bernanke has one main counterargument, and it's a pretty good one: if he hadn't done what he did, we would be in another depression. The banking and financial system would have melted down; ironically enough, the near meltdown that occurred after the collapse of Lehman Brothers last September, which Bernanke was criticized for, is the best proof of that. Bernanke knows more about this than perhaps anyone in the world; the academic work for which he was most noted showed that a serious recession became the Great Depression when, in the critical three and a half years between the 1929 stock-market crash and FDR's New Deal, the Hoover administration allowed a third of the nation's banks to go under. As a result, Bernanke and Friedman/Schwartz are now considered the leading theorists of the Depression. Indeed, in a touching and generous gesture—considering the importance of his own work showing that bank failures were mainly responsible—Bernanke turned to the aging Friedman at a 90th-birthday celebration in 2002 and told him and Schwartz, who was there, "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we [the Fed] did it. We're very sorry. But thanks to you, we won't do it again."

He's made sure of that, by flooding the system with liquidity. The effect of Bernanke's actions has been to increase the money supply, which is what you might think Milton Friedman would have wanted. But Schwartz still believes that, as she told The Wall Street Journal last fall, Bernanke is fighting the last war. Yes, he's studiously taken the opposite course from what the Fed did in the early 1930s. But she maintains that the current crisis is less a liquidity problem and more a crisis of confidence because of the market's doubts about the toxic assets on banks' balance sheets. "What disturbed me particularly about Bernanke's performance was the insistence on bailouts," said Schwartz in a flood of passion. "If he had been absolutely candid to the markets and explained on what basis he would choose to bail out firms, and which ones he would not consider as meriting bailout, I think if the market had understood that he had principles and they would be able to understand a decision in light of these principles, there would have been much less bewilderment about why did they rescue Bear Stearns and pass over Lehman Brothers. Even though he has made a lot of rhetorical statements about the importance of transparency, he has not been transparent. I think that's a real failure. I think the Fed or the government has no business bailing out a firm that is not solvent."

Bernanke has no particular response to this criticism—the Fed did not respond to a request for comment. But I'll hazard a try at channeling him. Schwartz is right: this crisis is different from the Great Depression. But it's because this is true that it might be a little unfair to judge his actions in the way Schwartz does. First, it's no accident that neither Bernanke, then-Treasury Secretary Hank Paulson, nor current Treasury Secretary Tim Geithner has found any effective way to dispose of the toxic assets. For most of the past 10 months or so, selling them at any price the market might pay would have made many of the major banks automatically insolvent. Which means you're automatically in a depression. So what "principles" should Bernanke have applied? Who should he have saved, and who not?

Beyond that, there is another lesson, one that shows just how deep and systemic this disaster has been—far worse, in fact, than the crash that began the Great Depression or any other crisis that even the esteemed Anna Schwartz has dealt with. In capitalism, bankruptcy is supposed to be the fate of market players who make bad choices. The system gets cleaned out, the survivors deservingly pick up their failed rivals' business and get richer, and the economy comes back to life quickly. That, after all, was Andrew Mellon's infamous response after the 1929 crash. "Liquidate labor, liquidate stocks, liquidate the farmers," Herbert Hoover's Treasury secretary said—earning himself a permanent place in the annals of American villainy. But all Mellon was really doing was administering standard economic wisdom: allow the market to clear by selling. The problem was, things were probably too far gone for that to happen without a very painful depression.

Similarly, today the government is keeping failing banks artificially afloat. Interestingly, this policy has angered critics on the left, like economists Joseph Stiglitz and Paul Krugman, as much as critics on the right like Schwartz. They want the Obama team and Bernanke to be tougher on the banks. But here is the kind of thing Bernanke might say, if he were to respond: so out of control was Wall Street in recent years, and so unbalanced were global capital flows, that almost every major global bank grew weighed down with toxic assets (a few, like Goldman Sachs, handled things better than others). The system came so horribly unglued, in other words, that there was no longer any way to allow capitalist forces to restore the system to health—without a massive failure of banking and therefore another depression. So what exactly should Bernanke have done? Yes, there is a case to be made that the Obama administration and Bernanke's Fed could have taken over a couple of banks at the outset, broken up or restructured pathological monstrosities like Citigroup. But there was very little time to develop "principles" for a crisis the likes of which no one had ever seen before.

The evidence is precisely the omnipresence of those toxic assets, and the inability of both a Republican and a Democratic administration to figure out how to dispose of them.

All of which suggests that it may be time for modern economics, created around the Great Depression, to reinvent itself. New ideas are needed. It's a debate that Ben Bernanke would no doubt love to have with Milton Friedman, were the great man still around.