Friday, October 17, 2008

Milton Friedmand, Banking Crisis, Paulson: Two bad, one good....

This is an interesting article relating what Milton Friedman's thoughts would have been on the banking crisis. Two Economists (research economists) - Thomas MaCurdy and Jay Bhattacharya, both close students of Milton - use Friedman's theories and their personal relationship with him to answer the big question: What would Milton Friedman Say?
"Would Milton have seen this crisis coming?

Of course. The moment the housing bubble burst Milton would have recognized that we were in for trouble. Why? Because as banks limited their lending, the money supply contracted. And whereas Milton believed that changes in the money supply affect only the price level over the long term, he recognized that over the short-term changes in the money supply can produce dramatic effects in the real economy.

"What would Milton have told you caused the recession in the early 1980s?" Tom asks. "[Federal ReserveChairman] Paul Volcker's reduction in the rate of growth of the money supply. And what has happened now? Another relativecontraction in the money supply. Milton would have told us we're headed right into a recession."

Whom would Milton have blamed?

For the bubble itself? Probably nobody. From the tulip mania in Holland more than three-and-a-half centuries ago to the dot-com bubble here in the U.S. less than a decade ago, wildly irrational behavior sometimes develops in markets. "Friedman never argued that markets are perfect," says Jay, "only that over the long run they're a lot more efficient than any other method of allocating resources." Sometimes, Milton recognized, bubbles just happen.
Whatever the origin of the bubble, however, Milton would have blamed Congress for making it much, much worse. Congress, after all, created Fannie Mae (nyse: FNM - news - people ) and Freddie Mac (nyse: FRE - news - people ), institutions that spent tens of billions of dollars on subprime instruments. "Congress told Fannie and Freddie to subsidize bad loans for the purposes of social engineering," says Jay. "It was terrible, just terrible."

What would Milton have made of government efforts to address the crisis?

He would have approved of such efforts in Britain--but expressed grave reservations about those here in the U.S.

"Milton would have wanted the authorities to find very, very aggressive ways of expanding the money supply," says Tom. The Bank of England did just that, placing large deposits in banks throughout the British financial system. "What they did in England was quick, clean and direct."

Here in the U.S., by contrast, Treasury Secretary Henry Paulson's original bailout plan, under which the Treasury would have spent hundreds of billions of dollars purchasing subprime and other instruments from major banks, went at the problem backwards. "The government should take responsibility for the money supply, but not for setting prices," says Jay. "The problem with subprime assets is that nobody knows what they're worth. Friedman would have told you that bringing the government in wouldn't have helped that."

With his new plan, under which the Treasury has now taken equity stakes worth $125 billion in nine big banks, Paulson has finally begun to make sense. "Direct injections of capital into banks--Milton would have approved of that," Tom says. "But why did it take so long? Why did we have to wait for the Bank of England to set the example?"

What would Milton have seen as the principal danger to the economy that the crisis now poses?

The very same equity stakes mentioned above. It is one matter for the government to make deposits in banks, as the Fed regularly does, Milton would have held, but another for the government to purchase equity, as Paulson has just done.
"Look, if the government wraps up its equity positions and gets out of the banks quickly, then okay," says Tom. "The danger is that the government will stick around and start managing the banks, setting loan policies, establishing salary limits for the top executives and stuff like that. Friedman would have been really clear on this. Banks should be run by bankers, not politicians."

Would Milton have seen the crisis as a setback for capitalism?

Only in the short term.
RW: I still don't understand why Paulson never sold the direct capital injection to Congress and the public in the first place. It is one thing to slosh liquidity from balance sheet to balance sheet, but a very different thing to hit the banking system directly with $250 billion in new capital. On 9/22/08, the difference between World capital losses and capital raised was $150 billion; $250 billion would have been more than sufficient! Paulson has just confused the public with his flip-floppy tactics.

Buying confidence and stabilizing the banking system are two very different things. Confidence is difficult to regain if the Treasury Secretary is so ostensibly flying by the seat of his pants (selling the public a liquidity asset program, but initiating a catpial injection program). Obviously, governments are facing unprecedented shocks to the banking system - shocks without a policy formula, but if the public doesn't have faith in the Treasury Secretary, how can the Treasury Secretary instill confidence in the financial system? Hopefully, Ben Bernanke and Co. can clean up the mess through its ongoing behemouth liquidity injections. And with the help of Congress, who will surely pass a huge stimulus bill, the economy may just skirt a serious downturn, but at what cost? The long term debt gains and efficiency losses could be huge.

Rebecca Wilder

1 comment:

  1. thanks for the report on Milton Friedman - he has been slammed in other media lately.

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