Just Another Republican Keynesian?

David Stockman

by David Stockman: Social
Security: The New Deal’s Fiscal Ponzi

Great Deformation: The Corruption of Capitalism in America

by David A. Stockman. Published by PublicAffairs.

When Professor
Friedman Opened Pandora’s Box: Open Market Operations

At the end
of the day, Friedman jettisoned the gold standard for a remarkable
statist reason. Just as Keynes had been, he was afflicted with the
economist’s ambition to prescribe the route to higher national
income and prosperity and the intervention tools and recipes that
would deliver it. The only difference was that Keynes was originally
and primarily a fiscalist, whereas Friedman had seized upon open
market operations by the central bank as the route to optimum aggregate
demand and national income.

There were
massive and multiple ironies in that stance. It put the central
bank in the proactive and morally sanctioned business of buying
the government’s debt in the conduct of its open market operations.
Friedman said, of course, that the FOMC should buy bonds and bills
at a rate no greater than 3 percent per annum, but that limit was
a thin reed.

Indeed, it
cannot be gainsaid that it was Professor Friedman, the scourge of
Big Government, who showed the way for Republican central bankers
to foster that very thing. Under their auspices, the Fed was soon
gorging on the Treasury’s debt emissions, thereby alleviating
the inconvenience of funding more government with more taxes.

Friedman also
said democracy would thrive better under a régime of free
markets, and he was entirely correct. Yet his preferred tool of
prosperity promotion, Fed management of the money supply, was far
more anti-democratic than Keynes’s methods. Fiscal policy activism
was at least subject to the deliberations of the legislature and,
in some vague sense, electoral review by the citizenry.

By contrast,
the twelve-member FOMC is about as close to an unelected politburo
as is obtainable under American governance. When in the fullness
of time, the FOMC lined up squarely on the side of debtors, real
estate owners, and leveraged financial speculators – and against
savers, wage earners, and equity financed businessmen – the latter
had no recourse from its policy actions.

The greatest
untoward consequence of the closet statism implicit in Friedman’s
monetary theories, however, is that it put him squarely in opposition
to the vision of the Fed’s founders. As has been seen, Carter
Glass and Professor Willis assigned to the Federal Reserve System
the humble mission of passively liquefying the good collateral of
commercial banks when they presented it.

the difference between a “banker’s bank” running
a discount window service and a central bank engaged in continuous
open market operations was fundamental and monumental, not merely
a question of technique. By facilitating a better alignment of liquidity
between the asset and liability side of the balance sheets of fractional
reserve deposit banks, the original “reserve banks” of
the 1913 act would, arguably, improve banking efficiency, stability,
and utilization of systemwide reserves.

Yet any impact
of these discount window operations on the systemwide banking aggregates
of money and credit, especially if the borrowing rate were properly
set at a penalty spread above the free market interest rate, would
have been purely incidental and derivative, not an object of policy.
Obviously, such a discount window-based system could have no pretensions
at all as to managing the macroeconomic aggregates such as production,
spending, and employment.

In short, under
the original discount window model, national employment, production
prices, and GDP were a bottoms-up outcome on the free market, not
an artifact of state policy. By contrast, open market operations
inherently lead to national economic planning and targeting of GDP
and other macroeconomic aggregates. The truth is, there is no other
reason to control M1 than to steer demand, production, and employment
from Washington.

Why did the
libertarian professor, who was so hostile to all of the projects
and works of government, wish to empower what even he could have
recognized as an incipient monetary politburo with such vast powers
to plan and manage the national economy, even if by means of the
remote and seemingly unobtrusive steering gear of M1? There is but
one answer: Friedman thoroughly misunderstood the Great Depression
and concluded erroneously that undue regard for the gold standard
rules by the Fed during 1929–1933 had resulted in its failure
to conduct aggressive open market purchases of government debt,
and hence to prevent the deep slide of M1 during the forty-five
months after the crash.

Yet the historical
evidence is unambiguous; there was no liquidity shortage and no
failure by the Fed to do its job as a banker’s bank. Indeed,
the six thousand member banks of the Federal Reserve System did
not make heavy use of the discount window during this period and
none who presented good collateral were denied access to borrowed
reserves. Consequently, commercial banks were not constrained at
all in their ability to make loans or generate demand deposits (M1).

But from the
lofty perch of his library at the University of Chicago three decades
later, Professor Friedman determined that the banking system should
have been flooded with new reserves, anyway. And this post facto
academician’s edict went straight to the heart of the open
market operations issue.

The discount
window was the mechanism by which real world bankers voluntarily
drew new reserves into the system in order to accommodate an expansion
of loans and deposits. By contrast, open market bond purchases were
the mechanism by which the incipient central planners at the Fed
forced reserves into the banking system, whether sought by member
banks or not.

Friedman thus
sided with the central planners, contending that the market of the
day was wrong and that thousands of banks that already had excess
reserves should have been doused with more and still more reserves,
until they started lending and creating deposits in accordance with
the dictates of the monetarist gospel. Needless to say, the historic
data show this proposition to be essentially farcical, and that
the real-world exercise in exactly this kind of bank reserve flooding
maneuver conducted by the Bernanke Fed forty years later has been
a total failure – a monumental case of “pushing on a string.”

Erroneous Critique of the Depression-Era Fed Opened the Door to
Monetary Central Planning

The historical
truth is that the Fed’s core mission of that era, to rediscount
bank loan paper, had been carried out consistently, effectively,
and fully by the twelve Federal Reserve banks during the crucial
forty-five months between the October 1929 stock market crash and
FDR’s inauguration in March 1933. And the documented lack of
member bank demand for discount window borrowings was not because
the Fed had charged a punishingly high interest rate. In fact, the
Fed’s discount rate had been progressively lowered from 6 percent
before the crash to 2.5 percent by early 1933.

More crucially,
the “excess reserves” in the banking system grew dramatically
during this forty-five-month period, implying just the opposite
of monetary stringency. Prior to the stock market crash in September
1929, excess reserves in the banking system stood at $35 million,
but then rose to $100 million by January 1931 and ultimately to
$525 million by January 1933.

In short, the
tenfold expansion of excess (i.e., idle) reserves in the banking
system was dramatic proof that the banking system had not been parched
for liquidity but was actually awash in it. The only mission the
Fed failed to perform is one that Professor Friedman assigned to
it thirty years after the fact; that is, to maintain an arbitrary
level of M1 by forcing reserves into the banking system by means
of open market purchases of Uncle Sam’s debt.

As it happened,
the money supply (M1) did drop by about 23 percent during the same
forty-five-month period in which excess reserves soared tenfold.
As a technical matter, this meant that the money multiplier had
crashed. As has been seen, however, the big drop in checking account
deposits (the bulk of M1) did not represent a squeeze on money.
It was merely the arithmetic result of the nearly 50 percent shrinkage
of the commercial loan book during that period.

As previously
detailed, this extensive liquidation of bad debt was an unavoidable
and healthy correction of the previous debt bubble. Bank loans outstanding,
in fact, had grown at manic rates during the previous fifteen years,
nearly tripling from $14 billion to $42 billion. As in most credit-fueled
booms, the vast expansion of lending during the Great War and the
Roaring Twenties left banks stuffed with bad loans that could no
longer be rolled over when the music stopped in October 1929.

during the aftermath of the crash upward of $20 billion of bank
loans were liquidated, including billions of write-offs due to business
failures and foreclosures. As previously explained, nearly half
of the loan contraction was attributable to the $9 billion of stock
market margin loans which were called in when the stock market bubble
collapsed in 1929.

Likewise, loan
balances for working capital borrowings also fell sharply in the
face of falling production. Again, this was the passive consequence
of the bursting industrial and export sector bubble, not something
caused by the Fed’s failure to supply sufficient bank reserves.
In short, the liquidation of bank loans was almost exclusively the
result of bubbles being punctured in the real economy, not stinginess
at the central bank.

In fact, there
has never been any wide-scale evidence that bank loans outstanding
declined during 1930–1933 on account of banks calling performing
loans or denying credit to solvent potential borrowers. Yet unless
those things happened, there is simply no case that monetary stringency
caused the Great Depression.

Friedman and
his followers, including Bernanke, came up with an academic canard
to explain away these obvious facts. Since the wholesale price level
had fallen sharply during the forty-five months after the crash,
they claimed that “real” interest rates were inordinately
high after adjusting for deflation.

Yet this is
academic pettifoggery. Real-world businessmen confronted with plummeting
order books would have eschewed new borrowing for the obvious reason
that they had no need for funds, not because they deemed the “deflation-adjusted”
interest rate too high.

At the end
of the day, Friedman’s monetary treatise offers no evidence
whatsoever and simply asserts false causation; namely, that the
passive decline of the money supply was the active cause of the
drop in output and spending. The true causation went the other way:
the nation’s stock of money fell sharply during the post-crash
period because bank loans are the mother’s milk of bank deposits.
So, as bloated loan books were cut down to sustainable size, the
stock of deposit money (M1) fell on a parallel basis.

Given this
credit collapse and the associated crash of the money multiplier,
there was only one way for the Fed to even attempt to reflate the
money supply. It would have been required to purchase and monetize
nearly every single dime of the $16 billion of US Treasury debt
then outstanding.

incorrigible money printers undoubtedly would say, “No problem.”
Yet there is no doubt whatsoever that, given the universal antipathy
to monetary inflation at the time, such a move would have triggered
sheer panic and bedlam in what remained of the financial markets.
Needless to say, Friedman never explained how the Fed was supposed
to reignite the drooping money multiplier or, failing that, explain
to the financial markets why it was buying up all of the public

Beyond that,
Friedman could not prove at the time of his writing A Monetary History
of the United States in 1965 that the creation out of thin air of
a huge new quantity of bank reserves would have caused the banking
system to convert such reserves into an upwelling of new loans and
deposits. Indeed, Friedman did not attempt to prove that proposition,
either. According to the quantity theory of money, it was an a priori

In actual fact,
by the bottom of the depression in 1932, interest rates proved the
opposite. Rates on T-bills and commercial paper were one-half percent
and 1 percent, respectively, meaning that there was virtually no
unsatisfied loan demand from creditworthy borrowers. The dwindling
business at the discount windows of the twelve Federal Reserve banks
further proved the point. In September 1929 member banks borrowed
nearly $1 billion at the discount windows, but by January 1933 this
declined to only $280 million. In sum, banks were not lending because
they were short of reserves; they weren’t lending because they
were short of solvent borrowers and real credit demand.

In any event,
Friedman’s entire theory of the Great Depression was thoroughly
demolished by Ben S. Bernanke, his most famous disciple, in a real-world
experiment after September 2008. The Bernanke Fed undertook massive
open market operations in response to the financial crisis, purchasing
and monetizing more than $2 trillion of treasury and agency debt.

As is by now
transparently evident, the result was a monumental wheel-spinning
exercise. The fact that there is now $1.7 trillion of “excess
reserves” parked at the Fed (compared to a mere $40 billion
before the crisis) meant that nearly all of the new bank reserves
resulting from the Fed’s bond-buying sprees have been stillborn.

By staying
on deposit at the central bank, they have fueled no growth at all
of Main Street bank loans or money supply. There is no reason whatsoever,
therefore, to believe that the outcome would have been any different
in 1930–1932.

Milton Friedman:
Freshwater Keynesian and the Libertarian Professor Who Fathered
Big Government

The great irony,
then, is that the nation’s most famous modern conservative
economist became the father of Big Government, chronic deficits,
and national fiscal bankruptcy. It was Friedman who first urged
the removal of the Bretton Woods gold standard restraints on central
bank money printing, and then added insult to injury by giving conservative
sanction to perpetual open market purchases of government debt by
the Fed. Friedman’s monetarism thereby institutionalized a
régime which allowed politicians to chronically spend without

Likewise, it
was the free market professor of the Chicago school who also blessed
the fundamental Keynesian proposition that Washington must continuously
manage and stimulate the national economy. To be sure, Friedman’s
“freshwater” proposition, in Paul Krugman’s famous
paradigm, was far more modest than the vast “fine-tuning”
pretensions of his “saltwater” rivals. The saltwater Keynesians
of the 1960s proposed to stimulate the economy until the last billion
dollars of potential GDP was realized; that is, they would achieve
prosperity by causing the state to do anything that was needed through
a multiplicity of fiscal interventions.

By contrast,
the freshwater Keynesian, Milton Friedman, thought that capitalism
could take care of itself as long as it had precisely the right
quantity of money at all times; that is, Friedman would attain prosperity
by causing the state to do the one thing that was needed through
the single spigot of M1 growth.

But the common
predicate is undeniable. As has been seen, Friedman thought that
member banks of the Federal Reserve System could not be trusted
to keep the economy adequately stocked with money by voluntarily
coming to the discount window when they needed reserves to accommodate
business activity. Instead, the central bank had to target and deliver
a precise quantity of M1 so that the GDP would reflect what economic
wise men thought possible, not merely the natural level resulting
from the interaction of consumers, producers, and investors on the
free market.

For all practical
purposes, then, it was Friedman who shifted the foundation of the
nation’s money from gold to T-bills. Indeed, in Friedman’s
scheme of things central bank purchase of Treasury bonds and bills
was the monetary manufacturing process by which prosperity could
be managed and delivered.

What Friedman
failed to see was that one wise man’s quantity rule for M1
could be supplanted by another wise man’s quantity rule for
M2 (a broader measure of money supply that included savings deposits)
or still another quantity target for aggregate demand (nominal GDP
targeting) or even the quantity of jobs created, such as the target
of 200,000 per month recently enunciated by Fed governor Charles
Evans. It could even be the quantity of change in the Russell 2000
index of stock prices, as Bernanke has advocated.

Yet it is hard
to imagine a world in which any of these alternative “quantities”
would not fall short of the “target” level deemed essential
to the nation’s economic well-being by their proponents. In
short, the committee of twelve wise men and women unshackled by
Friedman’s plan for floating paper dollars would always find
reasons to buy government debt, thereby laying the foundation for
fiscal deficits without tears.

2, 2013

Congressman David A. Stockman was Reagan’s OMB director, which he
wrote about in his best-selling book,
Triumph of Politics
. His latest book is The
Great Deformation: The Corruption of Capitalism in America
He was an original partner in the Blackstone Group, and reads LRC
the first thing every morning.

© 2013

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Republished with permission from:: Lew Rockwell