What would Milton Friedman say?

Capitalism Still Has Legs That Are Long and Sexy: Caroline Baum

Commentary by Caroline Baum

April 30 (Bloomberg) -- What would Milton Friedman say?

Everywhere you turn, billboards are advertising the failure of capitalism. Not literally, of course, but the equivalent. The view that the current financial crisis is always and everywhere a market failure is cropping up in the most unlikely places, including that bastion of free-market capitalism, Chicago.

The latest convert to the cause is Richard Posner, judge on the U.S. Court of Appeals for the Seventh Circuit, senior lecturer at the University of Chicago Law School and author of a new book, “A Failure of Capitalism: The Crisis of ‘08 and the Descent into Depression.”

I haven’t read Posner’s book yet. I heard him talk earlier this week at the New York City chapter of the Federalist Society. He never made the connection between his diagnosis of the crisis and the title of his book.

Posner made two points: one, banking is “inherently risky” and was made riskier, starting in the 1970s, by deregulation; and two, the Federal Reserve kept short-term rates too low for too long, sparking a real-estate bubble whose undoing proved near-fatal to the banks.

Let’s start with the claim that deregulation was to blame.

“It’s exactly the opposite,” said Sam Peltzman, professor emeritus at Chicago’s Booth School of Business, when I asked him what Friedman, his former professor and colleague, would have said. “Regulation was there to make the banking industry safe. It conduced to do just the opposite.”

Regulation Aversion

Financial institutions respond to regulation in ways that offset the original intent, according to Peltzman.

When regulators increased capital requirements, banks took greater risk with their capital, Peltzman said.

When the Basel Accord sought to align capital requirements with risk, “banks took risk off their balance sheet,” creating structured investment vehicles to house the wayward assets, he said. “That made it worse.”

Regulation didn’t prevent the savings and loan industry from getting into trouble in the 1980s, he said. Nor did it prevent large banks from lending to Asia a decade later. Latin America’s “less developed countries” of the 1970s and 1980s may have morphed into Asia’s “emerging markets” by the 1990s, but that did nothing to change the nature of risky loans.

Regulation is unlikely to prevent the next crisis either, Peltzman said.

For the record, Friedman was in favor of deposit insurance, if only as a way to prevent destabilizing bank runs.

Price Fixer

As for Posner’s contention that the Fed’s erring on the side of low interest rates constitutes a failure of capitalism, Friedman “would have said it was total nonsense,” said Michael Bordo, professor of economics at Rutgers University in New Brunswick, New Jersey, who earned his Ph.D. in economics from Chicago. “It was not a failure of capitalism; it was a failure of the central bank.”

The odds that 19 men and women (a.k.a. the Federal Open Market Committee) will be able to select the overnight interest rate that keeps the U.S. economy growing at its potential in perpetuity are next to nil.

There would be a huge outcry if the Fed set the price of oil or copper or soybeans. Yet we accept the central bank as a price setter, a monopolist, when it comes to the interbank lending rate.

No one should be surprised to learn that Friedman would have disapproved of the bailouts.

“He would have said GM and Chrysler should have been gone a long time ago,” Bordo said.

And what about his take on the 19 largest banks that have been declared too big to fail?

Friedman’s view was that no one is too big to fail, that bankruptcy is a way of reallocating resources, according to Bordo.

Whose Failure?

I asked Posner why the Fed’s errors constitute a failure of capitalism. He said the central bank was part of the “capitalist structure,” along with property rights and a judicial system to enforce them. To the extent that the Fed mismanaged the money supply (or interest rates) and failed to assure “a reasonable degree of economic stability,” it has to be regarded as a failure of capitalism.

“I make clear in my book that I am not advocating the replacement of capitalism by any other economic system!” Posner wrote in an e-mail exchange.

The alternative explanation for the crisis is a failure of government, well-intentioned as its policies may be. Friedman is solidly in that camp.

Channeling Friedman

“He wouldn’t agree” it was a failure of capitalism, said Anna Schwartz, a research associate at the National Bureau of Economic Research and Friedman’s co-author on “A Monetary History of the United States, 1867-1960.” “It was a failure of government.”

The Fed conducted “very easy monetary policy, which permitted the asset-price boom,” she said yesterday in a telephone interview. “It had nothing to do with capitalism failing. It had to do with the policies and institutions that conducted them.”

Even Posner, the title of his book notwithstanding, said he’d like a “moratorium on regulatory reform until this is over.”

Milton Friedman would have said the same thing, only his moratorium would have been permanent.