Commentary: Two great theories, neither up to today's task
NEW YORK (MarketWatch) — Some of the biggest names in economics gathered at the University of Chicago in November 2002 for a 90th birthday celebration of the brightest star of them all. Milton Friedman, a Nobel laureate and seminal thinker, was returning to the university where he had made his name.
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One of the speakers was a Federal Reserve governor, Ben S. Bernanke. In a scholarly address, he endorsed Friedman's view that the Fed was instrumental in causing the Great Depression with a tight monetary policy that turned a contraction into something much, much worse.
In concluding, he addressed Friedman and Anna Schwartz, co-authors of the magisterial "A Monetary History of the United States," in which that thesis originally appeared. "I would like to say to Milton and Anna…regarding the Great Depression: You're right, we did it. We're very sorry. But thanks to you, we won't do it again," Bernanke said.
He kept his word. When the financial crisis and recession descended six years later, Bernanke, now the Fed chairman, followed Friedman's monetarist playbook to a "T": He flooded the system with liquidity and stuffed banks full of reserves in a series of desperate efforts to stanch the new Great Contraction.
"Bernanke is following a monetarist depression-prevention model laid out by Nobel laureate and libertarian patron saint Milton Friedman," the libertarian magazine Reason wrote in 2009. "Trillions of dollars have been staked on the insights of ‘monetarism'… A series of Fed policies many libertarians find repugnant are being championed by a man claiming to take his chief inspiration from the most influential libertarian economist of the 20th century. "
Meanwhile, Presidents Bush and Obama took the route of another legendary economic theorist, John Maynard Keynes. In two, maybe 2 1/2, economic stimulus packages, they used all the Keynesian tools — direct tax rebates, temporary tax cuts, boosting unemployment insurance, bailing out state and local governments and building infrastructure — to boost consumption and thus make up for the sharp plunge in private demand.
The government spent nearly $1 trillion on stimulus programs. The Fed boosted its reserves by $2 trillion. Now, almost three years after the fall of Lehman Brothers, gross domestic product is growing at less than 3% annually, while the official unemployment rate is 9.1%. Add those who are working part time and the total is over 15%.
Theories of a previous century
Many economists agree that the drastic measures taken probably prevented a repeat of the Great Depression. But the "recovery" has been so weak that much of the public thinks, with good reason, that we never emerged from recession.
Truth is, the giants Friedman and Keynes have met their Waterloo in a housing depression that shows few signs of recovery, a financial crisis that has suppressed growth and a looming debt crisis in Europe and the U.S.
We're witnessing the collision of theory and reality. And when that happens, no matter how elegant or persuasive the theory, reality always wins.
"This stuff doesn't work the way it used to work," said Mark Skousen, who edits the Forecasts and Strategies investment newsletter and has written many books about economics, including "The Making of Modern Economics."
Skousen, who founded the annual FreedomFest conference, is a free-market libertarian. But he doesn't stick to a party line and knows the strengths and weaknesses of the economists he writes about.
Keynesianism, he told me, "always comes back during a crisis. It's not good as a growth promoter." We learned that during the 1970s, when Keynesian policies led to stagnation.
Keynes believed that recessions were the result of shortfalls in demand, and the government needed to spend money to get us out of that deep hole. It didn't matter what it spent on — roads, bridges, wars, even pyramids, as Keynes famously suggested to President Roosevelt — just as long as it spent.
Fervent Keynesians like economist Paul Krugman argue that the stimulus package wasn't big enough to bridge an "output gap" (the drop in economic activity caused by the recession) so deep it became a chasm. Krugman recommended a stimulus nearly twice what Congress passed, about $1.3 trillion to $1.4 trillion.
Unfortunately, the Obama stimulus package was a big mess, containing tax cuts nobody knew about, transfer payments to state and local governments and only a third spent on infrastructure, which should have been the whole thing. And of course it added greatly to an already ballooning deficit.
Skousen pointed out that "all of the studies show the spending multiplier is relatively weak — one to two times." In other words, for every dollar you spend on Keynesian programs, you get a dollar or two added to national income.
But, he said, "the money multiplier has been estimated to be three or four times," meaning that for every dollar the central bank injects into the economy, it generates three or four dollars in commercial banks. Presumably the banks would then loan that money to businesses.
Unfortunately, housing remains so weak and consumer spending so fragile that U.S. business owners are reluctant to hire new workers. And banks, stung by the financial crisis, are hoarding cash to meet more stringent capital requirements rather than lending.
No wonder money is sitting on their balance sheets rather than circulating in the economy, as Friedman's theory predicted it would.
The Fed's easy money policy is also weakening the dollar and creating some food and energy inflation, which in turn crimps domestic demand as consumers pay more in the grocery store and at the pump. And although stock prices have risen, the gains have been offset for many by the decline in home values.
Meanwhile, technological innovation has allowed businesses to raise output without hiring more people. And globalization continues to drive jobs overseas where multinationals are hiring big time.
The bottom line: The tools that governments have used for decades just aren't doing the job anymore, including supply-side tax cuts, which didn't boost GDP growth or employment much in the 2000s.
The Canadian way
Skousen would like to see a more business-friendly restructuring of the tax and regulatory system of the kind Canada started in the mid-1990s. "They cut everything — government went from 53% of GDP to 39%," he said. Result: 11 years of balanced budgets, lower unemployment than the US, and a milder recession.
Some of those ideas are worth trying, but Canada has one-tenth our population and more tightly regulated banks, is a big energy and commodity producer and already has government-run health care.
Maybe all that money sitting in our banks' coffers will begin to circulate in the economy again, ultimately vindicating Friedman. But most likely we're in for a long period in which government action can't fix our problems.
"There's no free lunch in monetary policy," said Skousen. Nor is there one in fiscal policy, either. That could mean tough times for a lot of people.
Somewhere some brilliant economist might be figuring out a new way to solve these knotty problems. If he or she succeeds, there'll be a Nobel Prize with his or her name on it. Only then will we be able to move beyond great 20th Century thinkers like Friedman and Keynes, whose moment has now passed.
Howard R. Gold is a columnist for MarketWatch and editor at large at MoneyShow.com. You can follow him on Twitter @howardrgold and read more commentary at www.howardrgold.com . He blogs on politics at www.independentagenda.com .___
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