Hayek and Friedman’s Conflicting Diagnoses of the Great
Depression
In the beginning was the Great Depression.
It was from that mysterious episode that there emerged modern
macroeconomic debates. Not only the familiar divide between ‘Keynes and the
Classics’, but also the less well known but (I believe) ultimately more significant
divide between ‘Historical Liberalism’ and ‘Neoliberalism’.
This last divide is manifested in Hayek’s and Friedman’s differing
diagnoses of the Depression. Both Hayek and Friedman blamed central banking for
the disaster. But for different reasons. And for different type of reason.
Put simply, Friedman had a Political Economy account of central
banking’s responsibility for the Depression, whereas Hayek had a Pure Economics
account of central banking’s responsibility for the Depression.
Hayek provides his account in Prices and Production of 1931, the book of a series of lectures he
gave as a newly appointed professor at LSE. (The man who had him appointed him –
Lionel Robbins - gave a popularised version of Hayek’s contentions in his The Great Depression of 1934.)
Prices and
Production argued that an actively monetary policy amounted
to a price distortion. Specifically, a loose monetary policy reduced the market
price of investment below the opportunity cost of investment. Loose policy was,
in effect, a subsidy on capital accumulation, and like all subsidies it could only
do harm. Thus in the 1930s Hayek was criticising activist monetary policy on market success grounds. The free market would
generate a socially efficient outcome, and active monetary policy distorted that
outcome, and so wasted welfare.
By contrast Friedman’s Monetary
History of United States of 1963 criticises activist monetary policy on government failure grounds. To explain: Friedman’s
case against central banking was not that central banking took something good (the
free market outcome), and made it bad. That was not his position. To Friedman active
monetary policy could often do good. Years
later Hayek would spotlight Friedman’s optimism about the potential of monetary
policy:
I don't like criticizing Milton Friedman … but … if I told
him … that I very much doubt whether monetary policy has ever done anything
good, he would disagree. http://www.cato.org/pubs/policy_report/cpr-6n3-hayek.html
Friedman’s optimism about the potential of monetary policy arose
from his judgement that there could be ‘market failure’ (in the form of bank
runs, for example). The problem with active monetary policy was that the Central Bank did not with
any reliability correct such market failures; rather it frequently mismanaged
interventions that could be managed improvingly, and so making things worse.
Thus Friedman’s criticism of active monetary policy was not pinned on the perfection of the market; but a defect in government.
Friedman’s position flags a key differentiation of Neoliberalism
from ‘Historical Liberalism’ (that is, classical liberalism before the Great
Depression): Neoliberalism shifted the burden of the case for limited
government from market success to
government failure.
The starting point of this shift was the Neoliberal acknowledgment
that the free market outcome need not
be the best of all feasible worlds. But this left neoliberal supporters of economic
freedom with problem; why reject shifting that imperfect market outcome by some ‘economics
of control’? To plead the incapacity of the state to implement a perfecting
shift would be beside the point; the advocate of regulation hardly needs the
state to be capable of a perfecting shift
to make their case for regulation; an improving shift would be sufficient. And
pleading the incapacity of the state to make even a small improving shift would
be implausible. The inevitable bungling and ignorance of government will not
convict the state of such complete incapacity. Bungling and ignorance does not (after
all) imply that laws against theft are worse than useless: so why should it imply
that laws against (say) monopoly pricing are worse than useless? In the face of
some market failure, surely the government was capable of making things at
least marginally better? As Friedman would be the first to insist, while the
Fed could not have prevented a recession in 1929, it could have prevented a
depression.
The riposte of neoliberalism to the regulatory advocate was
not that government could not
intervene improvingly, but that government would
not intervene improvingly. It would choose (perhaps unwittingly) to not to
intervene in a way that would be improving. This is the meaning of ‘government
failure’.
Both Hayek’s and Friedman’s positions were, to be sure, underargued. There
were gaps in ‘the pure economics’ of Hayek, while Friedman’s Political Economy
was a collection of observations rather than a theory.
Hayek never articulated with the requisite rigor how
looser a monetary policy would constitute a subsidy for investment. For it is not
clear how in a competitive market a looser monetary policy can reduce ex ante real interest rates. It should only
affect nominal interest rates (to the extent that the policy innovation is
predicted), or ex post real rates (to
extent that the policy innovation is unpredicted). But not ex ante real interest rates. In the same vein, it was
also unclear how a looser policy would increase investment in the face of a
wish of the public not to save any more. On this particular, Hayek’s references
to ‘forced saving’ were more evocative than clarifying.
Friedman in a similar way can be criticised for having little
offer in terms of a fundamental theory of government failure. With specific respect
to the Great Depression, he argued that, in the absence of strong personalities, the
Fed's committees drifted between policies, and never maintained a course.
In post-War period Friedman’s criticism of policy drift became a criticism of
policy ‘churning’; where ‘importance-maximising’ central bankers made waves in
order to maintain their role as ‘players’. Both these are interesting suggestions,
but far from a fully-fledged theory of government failure.
Nevertheless, one can still reasonably dichotomise
criticisms of current monetary policy activism into market success critiques, and government
failure critiques. Market success critiques would in the contemporary world
turn, I suggest, on the thesis that monetary policy was underpricing risk; reducing
the private price of risk beneath the social opportunity cost of risk. And government
failure critiques ? I think they might find some material in the premium our
time places on celebrity and self-dramatisation. In economic life we hail the
risk-taking, rule breaking, routine-smashing ‘entrepreneur’ over the prosy
Marshallian ‘saver’ and ‘firm’. And in policy I put to you we are all now Schumpertarian
policy pirates; engrossed in innovative, ‘aggressive’ ‘blue-sky’ polices.
If you look at the history of financial crises, it shows that an
aggressive and creative response is the best way to ensure minimal damage to
the economy.
Ben
Bernanke, Time, 27 December 2010
