Relentlessly Progressive Political Economy

Some Ironies just should not be passed over.

The Collapse of Monetarism and the Irrelevance of the New Monetary Consensus
25th Annual Milton Friedman Distinguished Lecture at Marietta College, Marietta, Ohio
March 31, 2008.

by James K. Galbraith

The Conclusion….

On November 8, 2002, then-Fed Governor Ben S. Bernanke spoke in Chicago to honor
Milton Friedman on his 90th birthday. Bernanke said, “As everyone here knows, in their
Monetary History Friedman and Schwartz made the case that the economic collapse of 1929-33
was the product of the nation’s monetary mechanism gone wrong. Contradicting the received
wisdom at the time they wrote…Friedman and Schwartz argued that ‘the contraction is in fact a
tragic testimonial to the importance of monetary forces.” In that era, Bernanke argued, the Fed
tightened to thwart speculation. One would argue that in 2005-7 it tightened to pre-empt
inflation. No matter. You can see the difficulty without my help. At the close of his speech,
Bernanke stated, “Let me end my talk by slightly abusing my status as an official representative
of the Federal Reserve. 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.”

26. Less than six years later, Chairman Ben Bernanke faces an intellectual dilemma. He can
stick with Milton, in which case he must admit that the only possible cause of the present
financial crisis and evolving recession is the tightening action of the Federal Reserve, against
which, when it started back in 2004 only two voices were heard: that of Jude Wanniski, the
original supply-sider, and my own, in a joint Op-Ed piece no one would publish except the
Washington Times. Or he can stick with the so-called “new monetary consensus,” which holds
that the Fed should now return to its inflation targets, pursue a much tighter policy, and that no
recession will result. If Bernanke chooses the first, he must of course assume responsibility for
the unfolding disaster. He cannot, logically, stay with Friedman without admitting the error of
the late Greenspan years and his own first months in office. If he chooses the second, he must
repudiate Friedman, and hope for the best. The two courses are absolutely in conflict.

27. My own view is that Friedman and Schwartz were right on the broad principle — monetary
forces are powerful — but wrong in its application. The Federal Reserve alone did not “cause”
the Great Depression. Intrinsic flaws in the financial, corporate and social structure, combined
with bad policy both before and after the crash, were jointly responsible for the disaster, while
the crash itself played a precipitating role. The danger, today, is that something similar could
again happen. Thus I do not think that rising interest rates alone caused the present collapse, and
I do not think that cutting them alone will cure it. They did so in conjunction with the failure to
regulate sub-prime loans, with the permissive attitude to securitization, with the repeal of Glass-
Steagall, and with the general calamity of turning the work of government over to bankers.

28. But if Friedman was wrong, the “new monetary consensus” is even more wrong. That
consensus, having nothing to say about abusive mortgage loans, speculative securitization and
corporate fraud, is simply irrelevant to the problems faced by monetary policy today. Its
prescriptions, were they actually followed, would lead to disaster. Its adherents, who of course
never had a consensus on their side to begin with, have made themselves into figures of fun.
There is, mercifully, no chance that Ben Bernanke will actually choose to follow their path.

29. And if both sides of Bernanke’s dilemma are wrong, what is a beleaguered central banker to
do? I have an answer to that. Let Ben Bernanke come over to our side. Let him acknowledge
what is obvious: the instability of capitalism, the irresponsibility of speculators, he necessity of
regulation, the imperative of intervention. Let him admit the intellectual victory of John
Maynard Keynes, of John Kenneth Galbraith, of Hyman Minsky. Let him take those dusty tomes
off the shelf, and broaden his reading. I could even send him a paper or two.

Travis Fast

Sometimes when I read my brain just skips over the revolting hyperbola of certain social scientists–especially the exceedingly smug variety (usually economists). It must be said that Krugman ranks atop of the list in this regard. However, today I was forced to reread this nonsense and my brain just could not suppress. Krugman writes of Keynes that:

There has been nothing like Keynes’s achievement in the annals of social science. Perhaps there can’t be. Keynes was right about the problem of his day: the world economy had magneto trouble, and all it took to get the economy going again was a surprisingly narrow, technical fix.

This is so odd because it flies so directly in the face the historical record, a historical record which Krugman partially relates some paragraphs prior:

In fact, the arrival of Keynesian economics in American classrooms was delayed by a nasty case of academic McCarthyism. The first introductory textbook to present Keynesian thinking, written by the Canadian economist Lorie Tarshis, was targeted by a right-wing pressure campaign aimed at university trustees. As a result of this campaign, many universities that had planned to adopt the book for their courses cancelled their orders, and sales of the book, which was initially very successful, collapsed. Professors at Yale University, to their credit, continued to assign the book; their reward was to be attacked by the young William F. Buckley for propounding “evil ideas.”

So how was it that Keynes was right? That is, how could it be that the ideas of Keynes had been proved right if his ideas, “narrow and technical” as they were, were repressed until after the crisis of global capitalism had been resolved?

But for argument sake let us assume that there was a shadowy group of economic mandarins who had covertly read Keynes, who were staffing the back rooms of advanced capitalist states and secretly implementing policies of the Keynesian variety. What then was the narrow “technical fix” which remedied the crisis? Let me answer just in case my readers are as dumb as Krugman thinks his are: The Second World War!

It is nice to know that Krugman regards the Second World War as a “narrow technical exercise”. Come to think of it Krugman might just have more in common with the Bush administration than he thought.

With such high caliber social scientists staffing the hallowed Ivy halls no wonder Keynes and the rather confused General Theory stands out as a singular achievement in the social sciences.

Compared to what… indeed.

Things must be getting really hot given that the chairman is down to defending the hard core by nefarious means in the pages of the FT. Inter alia Greenspan claims that it is not possible for central bankers to lean against the prevailing winds. This seems odd given that monetarism and its subsequent incantations was and is entirely premised on the capacity of central bankers to lean against the prevailing winds. It makes me wonder why credibility therefore matters at all, if at the end of the day central bankers are so helpless. The problem is that the evidence suggest the contrary and thus the chairman’s defense seems rather like a put for posterity.

Here is the chairman’s concluding paragraph.

I do have an ideology. So does each member of the forum. I trust our views are subject to the same standards of evidence that apply to all rational discourse. My view of how the efficiency of global capitalism has evolved over the decades as new evidence has appeared contradicts some earlier judgments and confirms others. I have been surprised by the fierceness of investors in retrenching from risk since August. My view of the range of dispersion of outcomes has been shaken but not my judgment that free competitive markets are the unrivalled way to organise economies. We have tried regulation ranging from heavy to central planning. None meaningfully worked. Do we wish to retest the evidence?

If you are going to read one article from the financial press this is it.

False ideology at the heart of the financial crisis

By George Soros

Published: April 2 2008 18:11 | Last updated: April 2 2008 18:11

The proposal from Hank Paulson, US Treasury secretary, for reorganising government regulation of financial institutions misses the point. We need new thinking, not a reshuffling of regulatory agencies. The Federal Reserve has long had authority to issue rules for the mortgage industry but failed to exercise it. For the past 25 years or so the financial authorities and institutions they regulate have been guided by market fundamentalism: the belief that markets tend towards equilibrium and that deviations from it occur in a random manner. All the innovations – risk management, trading techniques, the alphabet soup of derivatives and synthetic financial instruments – were based on that belief. The innovations remained unregulated because authorities believe markets are self-correcting.