by Linda Yueh
A few years earlier, in 1977, Friedman had retired from the University of Chicago at the age of sixty-five. He took a role at the conservative Hoover Institution at Stanford University as a senior research fellow, where his wife also had an office. His intention was to do academic work at a more leisurely pace, and he and Rose collaborated on a number of papers, essays and books in the years that followed.
In 1980 the Friedmans published Free to Choose, which was the best-selling non-fiction title in the US that year, shifting some 400,000 copies. It was based on two principles. The first was the political freedom inherent in Thomas Jefferson’s Declaration of Independence: the preservation of life, and liberty, and the pursuit of happiness. The second was Adam Smith’s notion of economic freedom, where free exchange is to the benefit of the economy and was largely free from government intervention.
At the time, his old friend Allen Wallis had become chairman of the Corporation for Public Broadcasting (PBS) and had recommended Friedman for a programme. The Harvard economist John Kenneth Galbraith had recently filmed a series on the history of economic thought, and Friedman was thought to offer an ideological balance to Galbraith’s more Keynesian views. So, $2.5 million was raised to film a documentary series consisting of ten episodes. Each show consisted of a half-hour presentation by Friedman on a specific topic followed by a discussion for the same period of time. Free to Choose earned Friedman more in royalties than all his other books combined, and the television series it accompanied made him a household name.
Friedman’s political influence
After the publication of A Monetary History in 1963, Friedman stepped back from academic economics to pursue more political writing. In his early life, Friedman had never really exhibited any strong political leanings, but by then his teaching load had been much reduced and his academic endeavour was less intense than before. He felt the US was heading in a more libertarian direction, and compulsory conscription to fight in the Vietnam War had made his ideas popular among college graduates. It was also the time of libertarian thinkers such as Ayn Rand and Friedrich Hayek.
Milton Friedman was also becoming increasingly well known as a leading conservative economist. He became involved in Arizona Republican Senator Barry Goldwater’s presidential campaign in 1964. A Newsweek article had suggested he could do for Goldwater what J. K. Galbraith had done for John F. Kennedy. Although Goldwater lost by a landslide to incumbent President Lyndon B. Johnson, the campaign gave Friedman exposure and a huge boost to his public profile. It led to a regular column in Newsweek, for which he wrote over 300 pieces between 1966 and 1984.
In the 1968 presidential race he was once again brought into the fray on the Republican side. His former mentor Arthur Burns, now a presidential counsellor and chairman-in-waiting of the Federal Reserve, had been asked to set up an advisory committee on the economy to provide recommendations to Richard Nixon, should he win. He did, and between 1970 and 1971 Friedman and the president met on several occasions, but the relationship was becoming fraught. Nixon had tried to persuade Friedman to use his relationship with Burns to put pressure on the Fed to lower interest rates but he refused. The 1971 wage and price controls introduced by Nixon were anathema to Friedman’s free-market orthodoxy. In his memoirs, Friedman described this as the most damaging thing Nixon had done to the US, including the Watergate scandal that led to his resignation in 1974. His initial strong support for Nixon had become rather tepid as early as 1972.
In 1976 Friedman threw his support behind Ronald Reagan. He had first met Reagan in 1967 while he was a visiting professor at UCLA and Reagan had just been elected governor of California. They shared similar views on the funding of higher education. Reagan was ideologically close to Friedman. He had read some of the most free market of economists, including Ludwig von Mises and Friedrich Hayek. It was said he read Capitalism and Freedom while running for governor. In 1975 Reagan vacated that office, and a short while later Friedman indicated he would support his presidential campaign.
Reagan failed to win his party’s nomination that year, but in 1980 became the Republican presidential candidate. Reagan made clear his economic convictions: control federal spending and rein back regulation, reduce personal income tax rates and introduce predictably sound and stable monetary policy. All of these could have come from Friedman. Reagan won a landslide victory over the Democratic incumbent, Jimmy Carter. Although Friedman did not serve in the Reagan administration, he was widely seen as the guru behind the scenes through the Economic Policy Advisory Board.
Despite his outspoken views, it was never thought that Friedman wanted a full-time political position. He turned down a seat on the Council of Economic Advisers, the highest body advising the US president, on numerous occasions. He would almost certainly have accepted the post of Chairman of the Federal Reserve,12 though it seems he was never offered it. He enjoyed, with Rose, a lifestyle that saw them spend various parts of the year in Chicago, Vermont, California and, of course, Washington, DC. Perhaps he also thought it would be better for his longer-term influence to not be hamstrung by having always to toe the party line as a government official.
Across the Atlantic, Friedman’s thinking had found an additional home in the UK. Prime Minister Margaret Thatcher was ideologically similar to Reagan, and Britain was set for a radical change in direction. In the 1970s the economic policy debate in Britain was essentially Friedman versus Keynes. Friedman had even debated with well-known Keynesians on British TV, which revealed him to be an effective communicator. Friedman’s style was to have a very simple, punchy message and stick to it. His opponents pointed to all the complexities and difficulties, and probably lost the audience as a result. After one such debate a journalist asked a Keynesian who would win if Friedman had debated Keynes himself. The answer was: Friedman would win, but Keynes would be right!
In addition, much of Friedman’s thinking had been disseminated through the right-wing think tank, the Institute of Economic Affairs, where his views on the inadequacy of Keynesian stabilization policy and the benefits of a low-tax, low-regulation economy and monetary stability had enjoyed an enthusiastic audience. In Reagan and Thatcher, Milton Friedman had found two world leaders who were acolytes of the free-market capitalism and monetarist ideologies he had championed over the previous two decades.
Friedman’s influence didn’t end there. His seminal work in economics was no less influential in shaping how modern central banking still works today. A Monetary History of the United States, 1867–1960 was perhaps Milton Friedman’s magnum opus in terms of economic ideas. It was jointly authored with Anna Jacobson Schwartz, with whom he began work in 1948, but it wasn’t until 1963 that their 884-page treatise was published. The work had initially been commissioned by the National Bureau of Economic Research. Arthur Burns had replaced Wesley Mitchell as director and he asked Friedman to study monetary factors in economic activity, especially in the business cycle.
The research was to question the Keynesian view of the Great Depression. Keynes had identified the weakness of aggregate demand stemming from an excess of saving and a dearth of investment in the aftermath of the stock market crash of 1929 as the main cause. This gave credence to the idea that the New Deal programmes of President Franklin D. Roosevelt helped to resolve the crisis. The Keynesian view gave little weight to monetary factors. With interest rates having fallen close to zero, an active monetary policy which sought to stimulate the economy through changing rates would be like ‘pushing on a piece of string’. Just as pushing on a piece of string does nothing of substance, interest rates that low likewise cannot move the economy in any direction. So, the Keynesians concluded that the Fed had done everything it could and that monetary policy had simply run out of bite.
Friedman and Schwartz categorically disagreed and placed monetary forces at the heart of the crisis. The project was very data intensive, mainly because much of the necessary information on the stock of money had not yet been collected. Until Friedman and Schwartz d
eveloped the M1 and M2 metrics of measuring the money supply, the Federal Reserve had no way of gauging the amount of money in the economy. They were to conclude that, had the Federal Reserve been publishing these statistics between 1929 and 1933, the Great Crash may have never become the Great Depression, or at least the magnitude and persistence of the downturn would have been mitigated because the negative impact of monetary policy would have been evident.
In fact, they said the stock market crash of 1929 was partly the result of the Federal Reserve’s actions in 1928. The stock market had risen sharply at the back end of the 1920s, causing the Fed to implement a deliberate tightening of policy in the spring of 1928 to curb speculation on Wall Street. The governor of the influential New York Fed, Benjamin Strong, had strong reservations about using monetary policy to constrain the boom, but died in October 1928. His death created a leadership vacuum at one of the twelve regional banks that feed into the US central bank’s decisions. Friedman and Schwartz argued that, had it not been for the premature death of Strong, many of the subsequent mistakes made by the Fed might have been avoided. His successor, George Harrison, was more in line with the rest of the thinking of the central bank in pushing for an interest rate hike. Rates subsequently rose to 5 per cent, the highest since 1921. This was sufficient to slow the growth of the US economy, which hit its cyclical peak in August 1929. The downturn in the economy was a precursor to the stock market crash in October.
Friedman and Schwartz, though, did not see the Great Depression as the inevitable conclusion of the crash of 1929. The stock market did lose half its value between September and November, including a big drop on Black Tuesday, 29 October. However, the market had doubled in the previous eighteen months and stocks actually recovered 20 per cent in the six months after the crash. There had also been plenty of other significant falls in the stock market in recent history that had not resulted in depression. The US economy had experienced bigger shocks that were not followed by a protracted downturn.
In the first year of the Great Depression, US GDP dropped by a massive 12 per cent and unemployment increased to 9 per cent. However, falling prices or deflation in 1920–21 had seen a decline in national output of some 7 per cent and a rise in unemployment to between 9 and 12 per cent. Despite this, the rest of the 1920s had been a rip-roaring time for the American economy.
One of the key findings in A Monetary History was what Friedman and Schwartz described as the ‘Great Contraction’ between 1929 and 1933. They were referring not to a large drop in GDP or prices, but to a decline in the amount of money available in the economy as a consequence of widespread bank failures. In the year following the crash, the US money supply fell by a relatively small 2.6 per cent as the Federal Reserve cut interest rates and lent heavily to the banking sector. Injecting a great deal of cash into banks gave them some much-needed liquidity and prevented the stock market collapse from precipitating an immediate banking crisis. However, the Fed believed that further loosening of monetary policy might pump up the stock market bubble and lead to inflation.
Between 1930 and 1933 the US money supply contracted by over a third, coinciding with a raft of bank failures. Between October 1930 and March 1933 there were four major bank runs. Most of these occurred between August 1931 and January 1932, when there were 1,860 bank failures and the money supply fell at an annual rate of 31 per cent. As deposits were withdrawn for fear of failure, banks had less money to lend, so the supply of credit to the economy evaporated, which led to downward pressure on output and prices.
It was not just fear of encouraging a further run-up in prices of assets such as stocks that had made the Federal Reserve reluctant to pump money into the economy, where it was especially needed by a banking sector which was haemorrhaging deposits. The US had maintained its membership of the gold standard, an international system of fixed exchange rates. In September 1931 a wave of speculative attacks on sterling had forced Great Britain out of the standard. Speculators thought the economy was weak, so the currency should weaken too, which was not possible since it was fixed to a set amount against gold. They sold off sterling, which meant the British government needed to use its gold reserves to maintain the value of the currency. That was considered too expensive, so Britain abandoned the gold standard. As speculators turned their attack towards the US, the Fed was forced to raise interest rates to make buying the dollar more attractive. They tightened monetary policy between August 1931 and January 1932 to stem the outflow of gold as international investors liquidated their dollar deposits.
Friedman was not an advocate of fixed exchange rates. Continued membership of the gold standard, he believed, had held the Fed back from a more convincing monetary stimulus. He observed that the best performing countries through the early 1930s were those that were not in the gold standard, those that had abandoned the system and those that were in the standard but had large gold reserves. In each of these three cases, the countries involved could exercise more flexibility in monetary policy in response to the economic depression.
Friedman and Schwartz argued that this might have prevented the Federal Reserve from being more active and forceful. To emphasize the point, they cited the events of April to August 1932, when the Fed, under pressure from Congress, made a $1 billion open-market purchase (a monetary injection equivalent to about 2 per cent of national income) which was successful in stemming the drop in the money supply and stimulating a small rise in GDP and industrial production. But when Congress broke for recess and the economy looked like it was on the turn, the loosening of policy ended. Friedman and Schwartz argued that, had it not done so, the economy may well have continued to improve.
The Fed was also a poor lender of last resort to the banking system. There was little coordination between the Federal Reserve Board of Governors based in Washington and the Regional Reserve Banks. There was also a stigma attached to accessing the Federal Reserve’s discount window facilities, which allowed financial institutions access to emergency funding from the central bank in times of stress as banks did not want to advertise their vulnerability in case it might ignite a run on their deposits. In any case, access to the window was limited and only associated banks were eligible. The liquidity support for the banking system was severely flawed.
In November 1932, Franklin D. Roosevelt won a landslide victory against Herbert Hoover, with the Democrats also taking large majorities in both Houses of Congress. However, FDR didn’t assume office until March 1933 and in the meantime, bank failures continued. It was widely believed that FDR would devalue the dollar or leave the gold standard altogether. It was costly to maintain a currency peg to gold, especially when the economy was in serious trouble. This encouraged the large-scale conversion of dollars into gold, putting further pressure on the banking system as dollar deposits were withdrawn.
One of FDR’s first acts on taking office was a week-long banking holiday from which 5,000 banks never reopened their doors. However, this allowed the insolvent banks to be weeded out. The New Deal programme that significantly increased government spending to boost the economy was also in force, but Friedman and Schwartz pointed to the dollar devaluation of 60 per cent and its exit from the gold standard as the more important factors in halting the Great Contraction. It returned monetary freedom to US policymakers.
Between 1933 and 1936 there was a strong recovery and reflation in the US economy. The 1933 and 1935 Banking Acts introduced changes to the Federal Reserve System to enhance the ability of the Fed to stabilize the banking system. The measures included extending the ability of the Federal Reserve to more easily lend money based on receiving collateral, including to non-financial firms; the Glass–Steagall Act, resulting in the separation of commercial and investment banking functions; regulation of deposit interest rates; and strict limits on entry to the market. Also important was the creation of the Federal Deposit Insurance Corporation (FDIC) in 1933 to stem the problem of ruinous bank runs. The FDIC remains in place today and guarantees that depositors won
’t lose their money (currently up to $250,000) if a bank goes under.
The bottom line from A Monetary History was that the Fed caused the crisis, turning a stock market crash into a full-blown depression by failing to pump sufficient liquidity into the economy to support the banks. Instead, they allowed runs on bank deposits to proceed relatively unchecked, resulting in bank failures and a severe deflation in output and prices. In a speech given in 2002 to commemorate Milton Friedman’s ninetieth birthday, then Fed chairman Ben Bernanke apologized on behalf of his organization. He said: ‘You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.’13
Little did he know that soon, he would be given the opportunity to live up to these words.
Friedman and the 2008 financial crisis
The global financial crisis occurred in 2008 with repercussions across the world economy. Financial deregulation since the 1980s meant that financial markets and global linkages across national borders became much more diverse. Then, in 1999, the Gramm–Leach–Bliley Act repealed the Glass–Steagall Act of 1933 that had previously separated retail from investment banking. More of the risks undertaken by investment banks could be transmitted to retail (deposit-holding) banks. In the 2008 crisis, we were at the cusp of the first potential systemic banking failure since the 1929 crash that had led to the passage of Glass–Steagall in the first place.