Uneasy Money

I recently came across this excerpt from a longer interview of Milton Friedman conducted by Brian Lamb on Cspan in 1994. In this excerpt Lamb asks Friedman what he thinks of the Fed, and Friedman, barely able to contain his ideological fervor, quickly rattles off his version of the history of the Fed, blaming the Fed, at least by implication, for all the bad monetary and macroeconomic events that happened between 1914, when the Fed came into existence, and the1970s.

Here’s a rough summary of Friedman’s tirade:

I have long been in favor of abolishing [the Fed]. There is no institution in the United States that has such a high public standing and such a poor record of performance. . . . The Federal Reserve began operations in 1914 and presided over a doubling of prices during World War I. It produced a major collapse in 1921. It had a good period from about 1922 to 1928. It took actions in 1928 and 1929 that led to a major recession in 1929 and 1930, and it converted that recession by its actions into the Great Depression. The major villain in the Great Depression in my opinion was unquestionably the Federal Reserve System. Since that time, it presided over a doubling of price in World War II. It financed the inflation of the 1970s. On the whole it has a very poor record. It’s done far more harm than good.

Let’s go through Friedman’s complaints one at a time.

World War I inflation.

Friedman blames World War I inflation on the Fed. Friedman, as I have shown in many previous posts, had a very shaky understanding of how the gold standard worked. His remark about the Fed’s “presiding over a doubling of prices” during World War I is likely yet another example of Friedman’s incomprehension, though his use of the weasel words “presided over” rather than the straightforward “caused” does suggest that Friedman was merely trying to insinuate that the Fed was blameworthy when he actually understood that the Fed had almost no control over inflation in World War I, the US remaining formally on the gold standard until April 6, 1917, when the US declared war on Germany and entered World War I, formally suspending the convertibility of the dollar into gold.

As long as the US remained on a gold standard, the value of the dollar was determined by the value of gold. The US was importing lots of gold during the first two and a half years of the World War I as the belligerents used their gold reserves and demonetized their gold coins to finance imports of war material from the US. The massive demonetization of gold caused gold to depreciate on world markets. Another neutral country, Sweden, actually left the gold standard during World War I to avoid the inevitable inflation associated with the wartime depreciation of gold. So it was either ignorant or disingenuous for Friedman to attribute the World War I inflation to the actions of the Federal Reserve. No country could have remained on the gold standard during World War I without accepting inflation, and the Federal Reserve had no legal authority to abrogate or suspend the legal convertibility of the dollar into a fixed weight of gold.

The Post-War Collapse of 1921

Friedman correctly blames the 1921 collapse to the Fed. However, after a rapid wartime and postwar inflation, the US was trying to recreate a gold standard while holding 40% of the world’s gold reserves. The Fed therefore took steps to stabilize the value of gold, which meant raising interest rates, thereby inducing a further inflow of gold into the US to stop the real value of gold from falling in international markets. The problem was that the Fed went overboard, causing a really, and probably unnecessarily, steep deflation.

The Great Depression

Friedman is right that the Fed helped cause the Great Depression by its actions in 1928 and 1929, raising interest rates to try to quell rapidly rising stock prices. But the concerns about rising stock-market prices were probably misplaced, and the Fed’s raising of interest rates caused an inflow of gold into the US just when a gold outflow from the US was needed to accommodate the rising demand for gold on the part of the Bank of France and other central banks rejoining the gold standard and accumulating gold reserves. It was the sudden tightening of the world gold market, with the US and France and other countries rejoining the gold standard simultaneously trying to increase their gold holdings, that caused the value of gold to rise (and nominal prices to fall) in 1929 starting the Great Depression. Friedman totally ignored the international context in which the Fed was operating, failing to see that the US price level under the newly established gold standard, being determined by the international value of gold, was beyond the control of the Fed.

World War II Inflation

As with World War I, Friedman blamed the Fed for “presiding over” a doubling of prices in World War II. But unlike World War I, when rising US prices reflected a falling real value of gold caused by events outside the US and beyond the control of the Fed, in World War II rising US prices reflected the falling value of an inconvertible US dollar caused by Fed “money printing” at the behest of the President and the Treasury. But why did Friedman consider Fed money printing in World War II to have been a blameworthy act on the part of the Fed? The US was then engaged in a total war against the Axis powers. Under those circumstances, was the primary duty of the Fed to keep prices stable or to use its control over “printing press” to ensure that the US government had sufficient funds to win the war against Nazi totalitarianism and allied fascist forces, thereby preserving American liberties and values even more fundamental than keeping inflation low and enabling creditors to extract what was owed to them by their debtors in dollars of undiminished real purchasing power.

Now it’s true that many of Friedman’s libertarian allies were appalled by US participation in World War II, but Friedman, to his credit, did not share their disapproval of US participation in World War II. But, given his support for World War II, Friedman should have at least acknowledged the obvious role of inflationary finance in emergency war financing, a role which, as Earl Thompson and I and others have argued, rationalizes the historic legal monopoly on money printing maintained by almost all sovereign states. To condemn the Fed for inflationary policies during World War II without recognizing the critical role of the “printing press” in war finance was a remarkably uninformed and biased judgment on Friedman’s part.

1970s Inflation

The Fed certainly had a major role in inflation during the 1970s, which as early as 1966 was already starting to creep up from 1-2% rates that had prevailed from 1953 to 1965. The rise in inflation was again triggered by war-related expenditures, owing to the growing combat role of the US in Vietnam starting in 1965. The Fed’s role in rising inflation in the late 1960s and early 1970s was hardly the Fed’s finest hour, but again, it is unrealistic to expect a public institution like the Fed to withhold the financing necessary to support a military action undertaken by the national government. Certainly, the role of Arthur Burns, appointed by Nixon in 1970 to become Fed Chairman in encouraging Nixon to impose wage-and-price controls as an anti-inflationary measure was one of the most disreputable chapters in the Fed’s history, and the cluelessness of Carter’s first Fed Chairman, G. William Miller, appointed to succeed Burns, is almost legendary, but given the huge oil-price increases of 1973-74 and 1978-79, a policy of accommodating those supply-side shocks by allowing a temporary increase in inflation was probably optimal. So, given the difficult circumstances under which the Fed was operating, the increased inflation of the 1970s was not entirely undesirable.

But although Friedman was often sensitive to the subtleties and nuances of policy making when rendering scholarly historical and empirical judgments, he rarely allowed subtleties and nuances to encroach on his denunciations when he was operating in full rabble-rousing mode.