A version of this article by Jeffrey Snider appeared last week on Real Clear Markets:
For those who appreciate the powerful abilities of free markets to advance the cause of humanity, the occasion of Milton Friedman’s birthday is a time to celebrate. For many it is also an opportunity to revisit his work and muse about how it applies to our current situation. Friedman’s greatest achievement was certainly changing the conventional wisdom about the Great Depression. Friedman’s insights, with his research partner Anna Schwartz, soundly refuted the supposed failure of free market capitalism as the cause of the miseries of the 1930s. He rightfully saw that the blame for the catastrophe lay not with capitalism, but with government monopoly over money and the failure of the Federal Reserve to live up to its mission. Capitalism may be messy but centralized failure is why the depression of the 1930s requires a modifier.
Friedman is best known as an economic scholar who valued individual freedom. He believed the only economic system of arrangements that would allow full expression of that individual freedom was free market capitalism. He quite clearly described and advanced these notions in all his works and his philosophies and theories found wide audience. Perhaps not wide enough though as there seems to be a wide gulf between the “managed capitalism” of today and Friedman’s ideal of truly free market capitalism. The strain of monetary policy that exists right now traces its roots directly back to his work, but something changed in that temporal transit. It is hard to judge contemporary “monetary” policy in terms of being “free to choose”.
In their famous book A Monetary History of The United States 1867-1960 Friedman and Schwartz make what amounts to the central observation of failure:
“During the five months when high-powered money rose by $330 million, currency held by the public increased by $720 million. The extra $390 million had to come from bank reserves. Since banks were unwilling and unable to draw down reserves relative to their deposits, the $390 million, amounting to 12 per cent of their total reserves in August 1931, could be freed for currency use only by a multiple contraction of deposits. The multiple worked out to roughly 14, so deposits fell by $5,727 million or by 15 per cent of their level in August 1931. It was the necessity of reducing deposits by $14 in order to make $1 available for the public to hold as currency that made the loss of confidence in banks so disastrous. Here was the famous multiple expansion process of the banking system in vicious reverse. That phenomenon, too, explains how seemingly minor measures had such major effects. The provision of $400 million of additional high-powered money to meet the currency drain without a decline in bank reserves could have prevented a decline of nearly $6 billion in deposits.”
Such asymmetric risks are an inherent flaw in fractional reserve systems. When the pyramid of fractioning out money expands too far, sudden changes in preferences for money – for whatever reason – are always a cause of calamity. The Federal Reserve was created specifically to prevent such mishaps by providing that “$400 million” on demand. The Depression was not a free market debacle; it was the central hand of bureaucracy injecting itself, through monopoly powers, into the central economic mechanism for exchange that precipitated the crisis. The markets demanded money and the central bureaucracy failed to deliver.
The source of this destruction was the changing preference of public deposit holders toward currency. In the decades leading up to the Great Depression, Americans had become comfortable with banking to the point that they were willing to use banks as savings vehicles. As such, they converted their physical currency into deposit liabilities. Under the traditional depository banking paradigm of the age, those deposits of real currency were lent out at a much larger proportion through the money multiplier. The limitation on that multiplication was the reserve requirement – how much currency a bank had to hold in its vault as a ratio of total deposit liabilities. This is how most people think of banking.
Before the FDIC, of course, bank failures often meant large losses for depositors. To get in front of bank failures meant logically converting deposits back into physical currency, and doing so before currency availability ran out. So the hinge upon which the entire Great Depression swung was the changing preference for physical currency over deposits. And the central criticism for the failure to respond to those changing preferences was the Fed’s inability (through bureaucratic neglect, struggles over turf, and, among other things, an incomplete philosophy of itself) to meet the need for physical currency. Monetary policy takes its name from this process.
In the wake of our first full-blown banking panic since the Great Depression, so much of monetary policy has been based on Friedman and Schwartz’s interpretations and intuitions. Academic scholars, most prominently Ben Bernanke, have advanced the cause of understanding, but have done so largely within the framework set forth by Friedman and Schwartz. Almost every part of the monetary response since the first appearance of crisis in August 2007 was based on observations first found in A Monetary History (LINK HERE).
Again, the Federal Reserve is tasked with ensuring money elasticity. In the context of the interpretations contained within A Monetary History elasticity is very straightforward. Monetary policy, in a crisis, needs to increase liquidity in the banking system so that any changes in preferences surrounding the pyramid of fractional lending do not cause the entire financial system to collapse. But what does the term “monetary” mean in the 21st century?
This is not at all straightforward. During the recent crisis there was no disruption in the public’s preference for bank deposits. There were no long lines at ATM’s as people desperately sought to convert bank deposits to physical cash. The public at large was relatively calm, even during the worst days of September and October 2008. Money, by its 1930’s definition, was not the problem. There was no “famous multiple expansion process of the banking system in vicious reverse”, at least not in the manner in which Friedman and Schwartz understood it. Physical currency or even access to ledger money, to go a step further, was never, and has never, been endangered through the whole of this seemingly unending financial crisis period.
The multiple expansion of “money” in the 21st century is rehypothecation and repos, all governed by equity capital. Money as it relates to “monetary” policy is not really money at all. The Federal Reserve does not speak of physical currency when it “stimulates”. “Monetary” policy focuses solely and unconditionally on debt. When the Federal Reserve and the FOMC act on monetary measures, they seek not to increase the supply of money but rather the supply of credit.
Maybe that does not seem much of a distinction, but it is, in my opinion, the most profound and misunderstood piece of the failure of the current “monetary” regime. Milton Friedman developed an understanding of the failure of physical currency as it related to fractional depository lending. Ben Bernanke and his contemporaries have yet to discover what actually constitutes bank reserves today and the means by which they are most vitally circulated.
The “money” at issue today is not physical currency nor are central banks seeking to counteract the public’s changing preferences toward deposits. When analyzing the malfunction of the banking system as it exists now, what we mean by “money” is financial collateral and equity capital. The former is the means to circulate “liquidity”, while the latter is the “reserve” base upon which the pyramid of investment banking credit rests. The changing preferences are not demands for liquidity by the general public, but in and amongst banks themselves. Central banks are not equipped to intentionally and directly increase the level of reserves in the banking system – the Fed cannot create equity capital or financial collateral. It can create dollar units and ledger money in an attempt to cajole the banking system into normalcy, but in that indirect process it actually distorts and upends markets intentionally. That is a big problem.
Observers and supporters of the Federal Reserve urge even more “monetary easing” to help re-ignite the economic animal spirits. Some of them have taken this occasion of remembrance over Milton Friedman’s life to point out his chief accomplishment was to observe that there are times when not enough money was available to the economy. These same people, mostly economists, abuse that observation to demand things like an increase in inflation or even targeting nominal GDP. They do not grasp, it seems, the very nature of what they are proposing. And invoking the name of Milton Friedman, ironically, demonstrates this blindspot or philosophical flaw.
The distinction between a shortage of actual, physical currency and a reduction in overall credit is immense. The calamity of the Great Depression was that consumers and businesses could not access an asset that they already owned free and clear. As that access was denied in greater and greater proportion, the desire to hold physical currency increased with it in a positive feedback loop. It was a self-perpetuating run of illiquidity that might have been solved with an infusion of real cash. The shortage of real money caused all sorts of real damage – with no options to obtain physical money, households and businesses had to resort to the sale of real goods right alongside financial assets, depressing the price of nearly everything. That was the kiss of actual deflation.
A decline in credit accumulation is not the same as deflation, far from it. We can see this distinction quite clearly as proponents of “stimulus” argue for a massive increase in borrowing with the “cost of money” so low. Interest rates currently residing at or near zero are being described as “free money”, most notably by Paul Krugman. The interest cost of money may be zero, but any additional debt still attaches future encumbrance. Perhaps that is not a consideration for the US government – as it sees no need to ever repay principal – but even under those terms there is still a future rollover event at some unknown interest rate. “Free money” advocates are intentionally encumbering future cash flows because they believe there will exist more flexibility and margin in the future than now.
Even if we accept that premise for the Federal government (which is fully arguable), the same is not true for individuals and all businesses. Large multinational firms operate on a debt rollover basis like the federal government, but businesses further down the size scale actually pay off debts, as do households. Installment and accrual loans require principal repayments. Outside the housing bubble and multinational corporations interest-only loans are atypical. If mortgage rates fell still closer to the “free money” level, would mortgage borrowings skyrocket? There is no indication that they would. Just recently, the 30-year average fixed mortgage has fallen below 3.5% and mortgage applications and originations have largely been unchanged to slightly lower. Even the Fed admitted as much when it floated its Discount Window-as-mortgage-funding-source trial balloon a few weeks back.
Several factors account for this lack of demand for nearly “free money”, but primary among them is this element of encumbrance. The interest cost is irrelevant because households simply cannot take on more debt after the nearly $4.5 trillion in mortgage debt that was added between 2003 and 2007 alone (in addition to the $500 billion in consumer credit). When stimulus advocates advocate increasing the money supply, they are not talking about money as it was understood by Milton Friedman and Anna Schwartz. They are talking about further encumbering households and businesses. There is a vast difference between accessing actual money that is owned free from future financial impediment to maintain or increase levels of economic activity and taking on new financial burdens to do the same. The former idea of money was real savings, created from real wealth in the exchange of labor for productive activities. The latter meaning of “money” is the creation of some form of reserves to be multiplied into new claims on future real savings and wealth.
Monetary policy in the modern sense of the word actually has little to do with money. Instead, it is always and everywhere about credit and debt. The reluctance of borrowers to access all this nearly “free money” is merely a realization by households and businesses that, as Milton Friedman’s 1975 book proclaimed, There’s No Such Thing As A Free Lunch. Cheap credit and debt may actually be more expensive than indicated by interest costs alone. Their reluctance is equally matched by the whole system of lenders that have come to finally appreciate this very idea. When the economy collapsed in the early 1930’s, real savings were wiped out in the blink of fractional reversal. In 2008, the economy simply woke up to the fact that there is a real limit to encumbrance. Over time, that is actually a positive trend.
Milton Friedman believed in freedom and free markets. Central banks believe in encumbrance and actively manipulating markets to achieve it. There is no money in monetary policy anymore.