Milton Friedman had a rule: Increases or decreases in the money supply take six to nine months to alter economic output and as much as two years to move prices. As the Senate takes up the president’s stimulus package, the administration argues that, to avert another Great Depression, it is better to do too much than too little. But a Friedmanesque look at today and the 1930s tells a different story: The analogy with the Depression is wrong; the current downturn may be all but over; and doing too much, not too little, is the real danger.
Start with the Depression. Two catastrophic American policy mistakes triggered the global downturn: congressional passage of the protectionist Smoot-Hawley tariff bill (producing overseas retaliation and a contraction of international trade) and the Federal Reserve’s squeezing of the money supply.
Both Herbert Hoover and Franklin Roosevelt responded vigorously to the crisis, but neither understood these seminal blunders. Monetary policy remained constricted until World War II, with reform an accidental byproduct of financing the conflict. Not until the first postwar multilateral trade agreement in 1948 did trade barriers start to fall. Instead, to finance expanded budgets, both Hoover and Roosevelt increased taxes, while Roosevelt preempted more efficient private investment with direct government spending on industry (particularly in the electrical power industry) and promiscuously prosecuted business people. These policies worsened and prolonged the downturn.
The current crisis’s origin is simpler than the Depression’s, and the recently departed Bush administration’s response more apt than that of the administrations of the ’30s.
Ours is a crisis of monetary aggregates. In mid-2007, a large class of securities—first thought to be packages of mortgages, later understood to include all so-called derivatives—was found to be fundamentally flawed. As the value of these instruments started to fall, the reserves of institutions heavily invested in them fell too. Those institutions included banks, but also firms and funds functioning as banks though not covered by the banking laws. The result was a suddenly much smaller quantity of base money.
Every Economics 101 student learns that base money is composed of currency plus bank reserves, with lending on top of the base making up the rest of the money supply. When reserves shrank, so did all lending. Commercial paper and other derivative-driven markets seized up. Banks wouldn’t do business with each other. The structured-finance markets (major drivers of U.S. lending) ceased functioning.
Here is where Milton Friedman’s rule begins to apply.
Unlike U.S. policy in the ’30s, the 2008 Treasury and the Federal Reserve attacked the problem at its source. The Fed added more than $1.1 trillion in new facilities to its balance sheet. Each facility was designed to restart the markets for one or another of the troubled classes of assets, strengthening the balance sheets of institutions holding those assets. To supplement these efforts and to augment bank reserves directly through preferred stock purchases, the Treasury received authority to commit up to $1.5 trillion—about a quarter of which had been deployed when the new administration took office. Nonbanks acting as banks were brought under the banking laws where legal authority existed to shore them up too. Currency, bank reserves, assets underpinning bank reserves: Every component of base money was addressed. The question now is, how much is enough—or too much?
In 2007, a dollar of M1—base money plus demand deposits—supported 10 dollars of gross domestic product, up from $6.30 of GDP in 1993. Allowing for 3 percent growth from mid-2008, a healthy GDP in 2009 would total about $14.8 trillion. If you put the new money in the Fed balance sheet and the Treasury’s emergency spending on top of the midyear total, M1 would need to support only $5.30 of GDP to achieve that 2009 target. This is the lowest ratio of GDP to M1 the United States has seen since the early 1970s. New perceptions of risk certainly mean that fewer dollars will be lent on each dollar of M1 for the foreseeable future. But even accounting for that change, it is very likely that enough has been added to the base to restore economic activity.
Following Milton Friedman’s rule, the severe downturn of the last three months of 2008 almost certainly originated in the monetary events of January through May when, among other things, the structured finance markets went dead and Bear Stearns folded. By the same rule, following the massive actions the Treasury and Fed took between September and December last year, the economy should rebound between May and September this year.
What could go wrong? In contrast to what the Obama administration is arguing, having done enough, the government could now do too much. The administration could repeat the Hoover-Roosevelt mistakes. Working with Congress, it could mandate trade protection, increase tax rates, divert resources from productive private investment to uneconomical government-sponsored activities, intrude in the management of major industries, or prosecute business people to make populist political points. The stimulus package takes major steps in several of these directions.
Magnitude matters. Small mistakes may not derail a recovery powered by such massive monetary movements as are already in place, while doing too much of what was done in the ’30s could prove fatal.
The irony here is that, if it keeps such errors to a minimum, the Obama administration is well positioned to take the bows for the Bush administration’s response to the crisis. All it needs is a few months of restraint—and an understanding of Milton Friedman.