Tyler Cowen, Milton Friedman, and Bailouts
By David Henderson
In my responses (here and here) to Tyler Cowen’s posts (here and here) on whether Milton Friedman would have supported the bailout of banks, I let myself be distracted by Tyler’s use of the word “pretend.” I accused Tyler of being particularly harsh on libertarians and Tyler has replied that he is often harsh on non-libertarians. In a comment on my post, Tyler backed up his claims.
I should not have gotten distracted. There’s an important substantive issue in economics here and I would like, as I’m sure Tyler would, to get back to it. I think Tyler and I have been speaking past each other because we seem to disagree about what a “bailout” is. I think I’ve found a way of focusing the discussion to see where out differences lie. Here goes.
Ben Bernanke concludes from his research on the Great Depression that the Fed’s failure had a devastating effect on the economy’s supply side, by letting financial intermediaries fail. In Bernanke’s view, therefore, there is such a thing as “too big to fail” and even financial intermediaries that are insolvent need to be bailed out.
Milton Friedman, on the other hand, concluded from his research with Anna Schwartz that the Fed failed to keep the money supply from contracting and that simply providing liquidity to the banking system, without favoring any insolvent banks, would have made the Great Depression not “great,” that is, would have made it shorter and shallower.
To put it another way, Friedman and Schwartz argued that the deflationary impact of banking panics on the price level is what increased the severity of the Great Depression. Bernanke appears to believe that individual bank failures could so impede financial intermediation that even without any price deflation they will generate a severe depression. Otherwise, why did he sterilize the effect on the money stock of his early bailouts, particularly of Bear Stearns?
My question for Tyler: which of these views do you think is correct? Also, a related question, do you see any distinction between propping up particular banks and reflating the system as a whole?
Our substantive discussion has really involved two interrelated issues: what Milton Freidman believed and what is the proper policy in the face of a potential financial panic. Friedman obviously modified his views over time, becoming more libertarian, and it may be true that the early Friedman might have accepted direct bailouts as a stopgap MEANS of preventing monetary contraction. But I do not believe that the logic of Friedman’s monetarist business-cycle theory requires direct bailouts. Would Tyler agree?