The Libertarian Ideas That Wrecked the Fed

Last week I explained the pernicious long-term effect of Milton Friedman’s theory of the corporation. But the famed libertarian economist’s baleful legacy doesn’t end there: Friedman’s ideas about monetary policy have long created negative economic consequences. And now, more than 40 years after the monetarist recession that former Fed chief Paul Volcker engineered under the influence of Friedman’s theories, Jay Powell’s Federal Reserve is trying to break free from them.

Friedman’s ardent libertarian faith was central to his monetarist thinking; like all libertarians, he was always extremely wary of anything that would cause the size of government to grow. He saw personal liberty as a zero sum: If government grew, then personal liberty was automatically reduced. Friedman thus crafted most of his important theories to limit government and provide free-market alternatives to proposals that would expand government.

One area that Friedman was particularly concerned about was using government to avert or soften the impact of economic downturns. He feared that government jobs programs and similar interventions could too easily become permanent, even if they were temporarily justified by high unemployment.

So Friedman argued for using monetary policy rather than fiscal policy to counteract recessions. His prime example was the Great Depression, which he saw as primarily a failure of the Federal Reserve. By the time the Depression hit, Friedman contended, the Fed had allowed the money supply to shrink by about a third, which brought on a deflation that caused the price level to drop by about 25 percent. Deflation stifles economic activity because it raises real interest rates and wages, increases the burden of debt, and forces producers to sell commodities for less than the cost of production, among other things.

But Friedman’s account glossed over why the money collapsed. When banks failed in those days, their deposits simply disappeared: There was no deposit insurance, and the bulk of the money supply consisted of bank deposits, not cash. The Fed lacked the legal authority to buy banks and keep them solvent, which is the only thing that would have helped. (Needless to say, Friedman would also have opposed nationalization of the banks on libertarian grounds.) The Fed was also constrained by the gold standard, which many foolish right-wingers still advocate.

The only thing the Fed can really do to counteract a downturn is buy Treasury securities on the open market using newly created money. But if the banking system is basically frozen, as it was in the early 1930s, there is no transmission system to get money circulating. So in the great tradition of academic economics, Friedman just assumed away this problem, insisting that the Fed could have prevented the Depression simply by aggressively buying Treasury securities and flooding the economy with money.

A key benefit of the Friedman approach is that once the money supply surges, the rest of the federal government doesn’t have to do anything. In a strict monetarist regime, there’s no need for public works or jobs programs that would increase the size of government. Monetary policy was relatively benign, whereas fiscal policy was potentially pernicious by virtue of the perennial threat it poses to individual liberty.