Did Krugman Catch a Contradiction in Friedman's Great Depression Work?

Luis Pablo de la Horra

In this article published shortly after Milton Friedman’s death, Paul Krugman critically examines the figure of the Chicago School economist as an academic and disseminator of free market ideas. The article is quite long, so I do not intend to undertake a thorough analysis of Krugman’s take on Friedman. Yet there is one element in the article I would like to briefly address in the following lines.

What Caused the Great Depression?

Krugman accuses Friedman of intellectual dishonesty because of his seemingly contradictory analysis of the Great Depression. Friedman argued that the Great Depression was caused by the Federal Reserve not preventing the sharp drop in the money supply that took place during the period 1929-1933. In other words, the Fed turned a normal recession into a depression by failing to implement an expansionary monetary policy in the early 1930s.

And yet, when talking about the Great Depression in public forums, Friedman blamed government intervention for the worst economic crisis the US had experienced until then. Krugman sees a contradiction here:

By 1976 Friedman was telling readers of Newsweek that “the elementary truth is that the Great Depression was produced by government mismanagement,” a statement that his readers surely took to mean that the Depression wouldn’t have happened if only the government had kept out of the way  –  when in fact what Friedman and Schwartz claimed was that the government should have been more active, not less.

Either the Great Depression was caused by government intervention (let us not forget that the Fed is a semi-public corporation) or it was brought about by the passivity of the US monetary authorities to actively respond to the crisis. According to Krugman, both arguments cannot be sustained simultaneously.

Krugman believes that this contradiction stems from a conscious intellectual fraud. Because Friedman’s account of the Great Depression did not fit his public stance as a promoter of free markets and against government intervention, he dishonestly changed it to make it more appealing to his followers.

Not Quite

Krugman misses a very important point here. The Fed was created to prevent the recurrent bank panics that the country had suffered during the nineteenth century. Before its creation in 1913, no banking crisis had resulted in a recession comparable to that in the 1930s. In fact, as pointed out by Ben Bernanke,

Before the creation of the Federal Reserve, Friedman and Schwartz noted, bank panics were typically handled by banks themselves  –  for example, through urban consortiums of private banks called clearinghouses. If a run on one or more banks in a city began, the clearinghouse might declare a suspension of payments, meaning that, temporarily, deposits would not be convertible into cash […] Though not an entirely satisfactory solution  –  the suspension of payments for several weeks was a significant hardship for the public  –  the system of suspension of payments usually prevented local banking panics from spreading or persisting.

The Fed took over the role that clearinghouses had previously played in the monetary system. Yet it did not prevent the bank runs that took place between 1930 and 1931, which caused the money supply to fall by one-third. Friedman argued that, given that the Fed had been assigned with the duty of stopping bank runs, it was its responsibility to step up and provide liquidity to the banking system.

It is true that Friedman claimed that it was the refusal of the Fed to intervene that resulted in the Great Depression. However, the Fed was established by Congress to carry out certain tasks that were previously undertaken by the market. The failure of a government monopoly, and not of the market, explains the 1930s deep economic crisis.

In short, Friedman did not contradict himself: it was the creation of the Fed in the first place, and then its inability to do what the market would have done in its place (that is, had the Fed never been created) that caused, in his view, the Great Depression.

Reprinted from Medium.

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