Attaching the crisis blame: what would Friedman do?
May 4, 2009
By Caroline Baum
What would economist Milton Friedman say? Everywhere you turn, billboards are advertising the failure of capitalism. Not literally, of course, but the equivalent.
The view that the financial crisis is a market failure is cropping up in the most unlikely places, including that bastion of free market capitalism, Chicago.
The latest convert to the cause is Richard Posner, a judge on the US Court of Appeals for the Seventh Circuit, and the author of a new book: A Failure of Capitalism: The Crisis of '08 and the Descent into Depression.
Posner makes two points: one, banking is inherently risky and was made riskier by deregulation; and two, the Federal Reserve kept short-term rates too low for too long, sparking a property bubble whose undoing proved nearly fatal to the banks.
Let's start with the claim that deregulation was to blame.
"It's exactly the opposite," said Sam Peltzman, professor emeritus at Chicago's Booth School of Business, when I asked him what Friedman, his former professor and colleague, would have said.
"Regulation was there to make the banking industry safe. It conduced to do just the opposite." Financial institutions respond to regulation in ways that offset the original intent, according to Peltzman.
When regulators increased capital requirements, banks took greater risk with their capital, Peltzman said.
When the Basel Accord sought to align capital requirements with risk, banks took risk off their balance sheet, creating structured investment vehicles to house the wayward assets, he said. "That made it worse."
Regulation didn't prevent the savings and loan industry from getting into trouble in the 1980s. Nor did it prevent large banks from lending to Asia a decade later. Regulation was unlikely to prevent the next crisis either, Peltzman said.
Michael Bordo, a professor of economics at Rutgers University in New Brunswick, New Jersey, said Friedman would have said that Posner's contention that the Fed's erring on the side of low interest rates constituted a failure of capitalism was total nonsense. "It was not a failure of capitalism; it was a failure of the central bank," Bordo said.
The odds that the Federal Open Market Committee will be able to select the overnight interest rate that keeps the US economy growing at its potential in perpetuity are next to nil.
No one should be surprised to learn that Friedman would have disapproved of the bailouts. Friedman's view was that no one is too big to fail, that bankruptcy is a way of reallocating resources, according to Bordo.
I asked Posner why the Fed's errors constitute a failure of capitalism.
He said the central bank was part of the capitalist structure, along with property rights and a judicial system to enforce them. To the extent that the Fed mismanaged the money supply (or interest rates) and failed to assure a reasonable degree of economic stability, it had to be regarded as a failure of capitalism.
Friedman wouldn't agree that it was a failure of capitalism, said Anna Schwartz, Friedman's co-author on A Monetary History of the United States, 1867-1960. "It was a failure of government."
The Fed conducted very easy monetary policy, which permitted the asset price boom, she said last week.
"It had nothing to do with capitalism failing. It had to do with the policies and institutions that conducted them."
Caroline Baum is a Bloomberg columnist. The views expressed are her own
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