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.

WHAT WOULD DARWIN DO?

WHAT WOULD DARWIN DO?

By Paul Johnson

With the 200th anniversary of his birth,the preeminent historian reconsiders the influential theorist

The more I see of the intellectual world and its frailties, the more I appreciate the truth of G.K. Chesterton's saying: 'When people cease to believe in G-d, they do not believe in nothing. They believe in anything.' It is one of the tragedies of humanity that brain-power is so seldom accompanied by judgment, skeptical moderation or even common sense. The vacuum left by the retreat of formal religion is most commonly filled, today, by forms of pantheism. Zealots devote their lives to 'saving' the rainforests, deserts or habitats of endangered species. They believe, passionately, in pseudo-scientific myths like climate change, global warming and the greenhouse effect. Some worship science as a faith and a way of life. Others hate it. Occasionally on the Quantocks I see fierce young men in semi-military kits, often crudely armed, who vary their activities between physically attacking staghound followers and besieging laboratories where animals are used for experiments.

I do not exactly fear them, any more than I fear the Muslim suicide bombers whom they so much resemble. But their appearance, on the heath once tramped by those gentle nature-lovers Coleridge and Dorothy and William Wordsworth, adds to my concern about what is happening to the world.

The atheistic pantheists who have now taken to advertising their beliefs on buses stand close to those who wish to deify Charles Darwin, and have taken the opportunity to do so on the 200th anniversary of his birth. Of course they are not the first. Leslie Stephen, a former clergyman who lost his faith as a result of On the Origin of Species, 'admired Darwin as a god', and some of the things he wrote, about his centrality in modern intellectual history, have the flavor of the Apocalypse. Much rubbish is currently being published about Darwin as a 'super-scientist' and 'transcendental prophet of the humanist triumph' (two expressions I have noted in the last week, one on the BBC). They do not do the poor man justice, for he was not only a fine scientist but a modest man of rare decency and dignity who would have found his current apotheosis repellent and frightening. If ever a good man needed to be saved from his followers, it is he.

It is important to realize that Darwin was a man of exceptionally strong emotions, albeit capable, in his work, of cool ratiocination. The central event of his emotional life was not the development of his theory of natural selection, although that gave him great joy and satisfaction. It was the death, from fever, of his ten-year-old daughter Annie in 1850. Annie was his favorite child and his intense affection for her was reciprocated in full. He said he had never needed to rebuke her for the slightest fault; she was 'an angel'. When she became chronically ill in her ninth year, from some kind of gastroenteritis, or typhoid, Darwin's concern for her was overlaid with guilt, for he suffered from similar complaints all his life and he believed she had inherited his constitution. He attended her throughout her final prolonged illness, marked by phases of recovery followed by relapses, and he often sat with her all night. His description of her sufferings — and his own — make harrowing reading. When she finally died, emaciated, a skeleton, he could not bring himself to attend her pathetic funeral. He was tortured by remorse and rage, and quoted Tennyson's 'In Memoriam':

Are G-d and Nature then at strife,
That Nature lends such evil dreams?
So careful of the type she seems,
So careless of the single life?

Twice during her death-agony, Annie made touching efforts to sing, and her destruction seemed to Darwin such an act of unthinking wickedness as to destroy for ever his faith in a benevolent universe. He was to write in The Descent of Man, 'The highest possible stage in moral culture is when we recognize that we ought to control our thoughts.' But this was something Darwin himself could never do. His thoughts continued to circulate around the death of his beloved child. He never got over it. It killed his belief in G-d and eternity much more comprehensively and finally than anything uncovered in his scientific enquiries. Darwin never forgot Annie: her fate overshadowed the rest of his life and colored his thoughts indelibly. He wrote a letter, six years after her death: 'What a book a devil's chaplain might write on the clumsy, wasteful, blundering, low, and horridly cruel world of nature!'

This quotation illustrates what seems to me a weakness in Darwin's theory of natural selection, and one shared by almost all his followers, especially his most enthusiastic ones. He and they have a tendency to attribute moral qualities to a process which, by its nature, ought to be entirely impersonal. Nature is not, and cannot be, cruel. The weakness is illuminating because it points to a more fundamental one. Although natural selection eliminates design (and so G-d the Creator), Darwin seems reluctant to drop design entirely. He drops it logically but it keeps popping back. He often implies that Nature 'designs' things.

I find it hard to believe that Darwin worked out a perfect explanation of the origin of species, as some of his present-day followers seem to suppose. On the contrary, Darwin's writings raise as many questions as they answer. For instance, why does natural selection lead to endless complexity? Complex organisms are more fragile than simple ones. They are less capable of repairing themselves when things go wrong. If natural selection has a purpose, surely it is durability rather than complexity. How can it become more durable by becoming more complex? It may be that selection leads to complexity in the short run but in the long run it ought to lead to simplicity, which must make it more durable. Again, there appears to be no mechanism which links lifetime changes in phenotypes to genetic variation. Why is this? Why have not organisms, in the process of natural selection, acquired the ability to pass on acquired characteristics by genetics? There are many other riddles.

My guess is that Darwin's general theory will eventually be overthrown, or fundamentally modified, as Newton's was by Einstein's relativity. Unlike his fundamentalist followers, Darwin was not afraid of change, even if it proved him wrong about some things. He saw science as progressive. He continued to practice science in old age. He studied earth-worms. He found them to be surprisingly intelligent. He turned his billiard room into a working laboratory so he had more room to examine them and see how they responded to stimuli. He had them in earth-pots covered in glass. At night he flashed lights at them — lanterns, candles, paraffin lamps. He found that intense light frightened them but anything dim had no effect. He organized his household to see how they reacted to noise. One played the piano, another the bassoon, or shouted, or shrilled on a tin whistle. He puffed scent and tobacco fumes at them. I wish his followers and panegyrists today would engage in such entertaining and possibly useful activities, instead of treating him as a god.

And I wish the spirit of Darwin would forbid them to engage in the vulgar activity of advertising atheism on buses.

What Would Mises Say?

by Joseph Keckeissen

Far from being prosperous, our America is now being buffeted by the worst financial tsunami in generations. All of us want to know what happened. What really caused this unbelievable turbulence?

To answer this, why not turn to the teachings of my late professor, Ludwig von Mises, the greatest economic analyst of the past century?

In the early 1920s, Mises predicted that the newly organized Soviet Union had set up an unviable economic system that would not be able to survive. Mises based his death verdict (made in his book, Socialism, shortly after the Russian Revolution) on the principle that a society cannot rely on political committees to set market prices as the commissars were trying to do; only the freely demonstrated choices of the market can produce functioning prices. All artificial prices are unworkable; they cannot tell the central planners which goods are expensive and which are cheap, so it would be impossible for them to organize production in an efficient way.

Without real prices, there could be no economization. Mises was derided for this analysis, even to the end of his life. But Mises was right, and history has approved his verdict, although he passed away without receiving due accolades. Even posthumously — when the Russian monster collapsed in 1989 — recognition of his genius was scant.

For this reason I consider myself justified in naming him as the greatest analyst ever.

A Flood of New Money

Although Mises is no longer with us to comment on our present debacle, we know which economic principles (truths) he relied on, and it is certainly apropos to raise the question, what would Mises say about the present crisis?

The scene is muddied by so many diverse factors — the low and then high rates of interest, the proliferation of mortgages that could never be paid off, the delirious purchase of those leveraged investments by the banking system, the overzealous federal promotion of home ownership and bailouts — but his reply would be clear as day.

The true cause of the economic instability is what he labeled inflationism.

By this he meant the unlimited creation of new money on the part of governments — fiat money without any backing whatsoever. The modern conviction is that our economic system is inherently unstable and that banking authorities must continually create more and more money out of nothing in order to maintain a prosperous economy. And this is certainly what our present monetary chiefs have been doing — to the extent of magically producing 9 trillion newly hatched dollars since the crisis began, with no end in sight!

They have made the world awash with liquidity. This is a violation of the basic principle that Mises held to be indispensable for a sound monetary system: you must never increase the existing amount of money.

The prevailing quantity of money is uniquely adjusted to the actual availability of goods and services. Augmenting or reducing the number of dollars in circulation only creates distortions in the economy. It causes prices and costs to rise, destroys the meaning of the accounting ledgers, creates all sorts of bubbles in the prices of stocks and of housing, and (even now) of government bonds. It turns new "investments" into nothing but the destruction of capital.

Inflationism, Mises held, has always been the worst of all social evils. This fact has gone unnoticed by historians, who dedicate their studies to rulers and wars and discoveries, but have never realized the impoverishing effects of debasing money (in the metallic period) or, similarly, of multiplying the monetary units (in our international financial system), causing each unit to lose its prior value.

It is the avalanche of new dollars (in some years growing by as much as ten percent, and now, with the new recovery packages, at an exponential rate yet to be determined) that has produced and sustains without remedy the mess that we are in. Were it not for this flood of new money, the prices of housing could never have risen to unsustainable heights, the securitized mortgages would not have multiplied, and our financial institutions would not have been gluttonously attracted to them. It was the unlimited creation of new cash that was the cause of all these disasters, and it provided both governments and institutions the temptation to distort and disrupt reality.

But what is astounding is that the remedy proposed by our ignorant politicians is the flush of unbounded new liquidity that they are creating for renewing reserves, multiplying bailouts, sustaining the overpriced mortgages, and on and on. This excess has been pushed by two presidents and almost unanimously promoted by a Democratic congress. Liquidity was the cause of the crisis, and now excess liquidity is presented as its solution! For this reason the crisis cannot possibly end in the short run. The remedy proposed is worsening things all over, and assures us that we will never get back to a sound and prosperous economy as long as we defy monetary sobriety.

The very life of our dollar is at stake. That would be Mises's message today. The quantity of money must never be increased.

The Interest Rate: Breaking the Levees

Another fundamental cause of all this mischief, Mises would instruct us, is the reckless rollercoaster tampering with the rate of interest — made low in the 1990s, raised five times in 2000, lowered down nearly to zero with 12 reductions in 2001, and held there until the fear of inflation raised it in 2004. Our monetary gatekeepers consider the interest rate a tool (or better, a toy) at their disposal, to be raised whenever there is fear of impending price rises (what they commonly mislabel as inflation) and to be lowered when there is danger of recession.

It is not that the Fed really raises or lowers interest rates or tampers with the scale of risk that the different levels of interest rate reflect. It has no power or means to do that. What the Fed does is to set a "target" rate for the securest type of loans (those from one bank to another), and then adjust the creation of new money to secure this goal. When the Fed wants to expand or restrain economic activity, more or less new money is created, respectively. But there is always new money in the works.

Interest is commonly considered something like a monetary faucet to be opened wide to pump the economy and to be shut off when prices get out of hand. But interest is not a monetary toy, as Mises has told us. It is not a price that can be adjusted at will. Rather, interest is meant to be a measure of the real savings accumulated at any one moment in the economy. Interest is high when the economy embarks on a spending spree and savings are reduced (as has been the case in recent years). Interest is low when consumption is reduced and savings are being generated to fuel new investment. The interest rate is like a semaphore, telling the investor whether to promote more current consumer goods as people are spending more and the interest rate is high, or, when the interest rate is low, to transfer resources to new investments that will develop more and better products for future, not present, consumption.

Thus the interest rate is not monetary but temporal: a ratio representing the tradeoff between current and future consumption.

This Misesian idea is entirely alien to the would-be managers of the American economy. The Fed was holding rates as near to zero as it could while America was on a spending spree — with negative savings to boot — when it should have let the market raise them to new heights. This gave our entrepreneurs a false green light to pursue investments in multiple new projects like home building, generous mortgage lending, securitized packages, and whatnot.

The true rate of interest is the levee that holds back unsound investments. The levee was broken and the hurricane of inflated money washed out the economy.

The wild consumption and even wilder investment (well leveraged with debt) surpassed the ability of our limited resources to satisfy this hyperdemand, and thus made inevitable the rise in prices. This rise then burdened all the new investments with higher operating costs that became so unmanageable that firms began to fail, the hallmark of a recession. There was no more economizing. We were trying to do everything at once, spending beyond our means, without the accumulated savings required to safely finance all this activity.

"Liquidity was the cause of the crisis, and now excess liquidity is presented as its solution!"

Now, with the recession in full swing, we should be tightening our belts and reducing our expenditures. But what are our leaders doing? Reducing interest rates again as close to zero as they can, and washing us with money in order to "stimulate" everything in sight.

The sky is, once again, the projected limit. We must resurrect the economy — with yet more reckless buying and investing.

The worst thing that the Fed does is to distort the vital semaphore of the economy, making it red when it should show green and vice versa. The near-zero rate will be fatal to any possible chance of an early recovery. It should be high until the rate of savings justifies a lower rate.

We can thank the good Lord that the country, on its own — and not due to the master plans of Washington — has begun to buy less and save more. This new source of savings will tend to offset the annulment of the interest rate. But it won't be enough to hold back the continuous reflooding of the economy with unbacked fiat dollars. No relief is in sight, as Mises would tell us.

Can't Someone Do Something!

The authorities, however, insist that it is their solemn duty to ward off all this downturn negativity. They must reduce the threat of unemployment and ward off the effects of home foreclosures. Through bailouts, they must rescue once-prestigious beacons of capitalist enterprise and repurchase all the overbloated securities. All of this, of course, demands the creation of trillions and more — infinite new money and infinite new debt.

We have an activist government: nothing passive can be tolerated. Don't stand there, they are all saying. Do something! We are told on all sides that the government and the central bank must act immediately and forcibly. And it could be that the trillions in proposed remedies might not be sufficient to force an upturn in the economy. We must do something drastic. The response must be unprecedentedly virile. Both our presidents have been buttressed by the nearly unanimous verdict of the Democratic portion of the Congress, by all of the Nobel-winning supereconomists, and by a united press. In unison, they all are insisting that we can't be timid; we must act boldly. All our reserves must be committed at once. No experiment must be left untried.

Socialism

What would our mentor, Mises, the lone voice predicting the fall of the Soviet economy, tell us now? He warned us not to augment the supply of money and not to tamper with the rate of interest. Here again, we find him, almost alone in the world, although many new and saner voices are day-by-day echoing Mises.

His resounding reply: do nothing. Tell the government to stay out of the picture and let the chips fall where they may. Let the folks in the market take care of restoring the economy. That means no more fiat money, much higher interest rates, no more bailouts, rescues, bolstering of prices, purchasing or creating make-work. Do nothing. Period.

When economic affairs are left to the judgment of the ordinary participants in the economy, things tend rapidly to straighten themselves out.

We saw this in a striking manner when the American people, confronted with an unprecedented rise in the price of gasoline, merely decided, spontaneously, to park their cars; the price of fuel quickly fell to seemingly bargain prices. When Lehman Brothers failed last September, the government abstained from interfering, and foreign companies rapidly bought up what was good in Lehman's assets. There are millions of good thinkers in the market, and there will always be someone there to save the day.

Does it make sense to bail out companies that have wantonly invested in overpriced and overextended mortgages? Their leaders have wasted the scarce capital entrusted to them. Leveraging their mortgage purchases with substantial increments of colossal corporate debt; they have betrayed not only their stockholders but also the entire economy, the rest of us, who had entrusted them with the creation of enriching and safe investment projects. These traitors must not be artificially propped up, forgiven, and even rewarded. Bankruptcy is the only sensible route to oust them. It will force down the prices of their remaining good assets, and new entrepreneurs will promptly appear to buy them up at bargain prices and get the companies going again at modest cost.

Of course, there will always be unavoidable suffering involved, especially on the part of the employees who must temporarily be displaced, but the pains will be minimized by the rapid resolution of the problem through the forces of the market.

Then why should anyone be buying up all the overbloated assets at their bubble values? That is ridiculous. It only serves to perpetuate the phoniness of a phony economy. All prices must be allowed to sink, as rapidly as economic gravity can suck them down, to the value that the market would normally assign them. We can't have a livable economy with houses that cost hundreds of thousands of dollars. Who would be able to afford them? Only reasonable prices can survive in the market.

Moreover, it is inherently unjust to create liquidity to rescue those who have behaved with total disdain for prudence, those who issued or contracted mortgages without healthy foresight, those who overextended their credit to buy all sorts of surplus stuff. They are the very ones who have contributed to the general malaise. If some credit agencies are failing, let them go bankrupt. Other entrepreneurs would get together the new capital needed to replace them. This would promote greater prudence in the future.

The opponents of the market deride this solution, saying that it smacks of laissez-faire. But was it not the exaggerated intromission of both the central bank and the Congress in promoting liquidity, massive home ownership, unrestrained interest rates, etc., that got us here in the first place? Prosperity will never come from experiments that violate common sense, experience, and the norms of sound economic theory, especially when such experiments are wilder than ever before. On the contrary, if we follow the Misesian wisdom and the government not be allowed to upset the applecart, the market will shortly make the crisis fade away. Otherwise, who knows how long it will take for prosperity to return?