David R. Henderson  

Tyler Cowen on Pretense

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On his blog today, Tyler Cowen, who does not usually use harsh language, does use it when referring to libertarians. He writes:

By the way, some libertarians like to pretend that Milton Friedman blames the Fed for "contracting" the money supply by one-third in that period but in reality Friedman blames the Fed for having let the money supply fall by one-third and not having run a bank bailout.

He's correct that Friedman wanted the Fed to increase the money supply. I don't think I'm pretending when I say that I don't think Friedman advocated bailing out banks during the Depression. As I think Friedman would have, last fall I advocated an increase in the money supply while opposing a bailout. Those two, contra Cowen, are separable.

But here's the bigger question for those of you who, like me, read Tyler Cowen's blog regularly: do you recall his ever accusing left-wing statists of pretense? I can't find an instance of it. If I'm right, what explains his asymmetric treatment?

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COMMENTS (30 to date)
RL writes:

"If I'm right, what explains his asymmetric treatment?"

He knows us better?


Bruce Bartlett writes:

There's no way the Fed could have expanded the money supply in the early 1930s without bailing out the banks. How do you think the money supply declined in the first place? It's because banks failed and their deposits disappeared. To keep those deposits from disappearing in an era before deposit insurance would have required keeping bankrupt banks afloat.

One of Ben Bernanke's most important academic articles showed that when the Fed tried to expand the money supply it couldn't do so because the closure of so many banks closed off the mechanism by which money would be injected into the economy.

Saying that you are for expanding the money supply but against bailing out the banks is incoherent.

ThomasL writes:

Why are people in love with a money supply which can only move one direction (up), regardless of the actual demand for money?

Tony writes:

Paints Robert Reich as an amateur here (fallacy directed at a professional economist isn't softer than pretend directed towards pundits, is it?):


As for assymetry, he probably expects more from your side and doesn't have the burden of signaling his libertarian bona fides.

ThomasL writes:

I'll expand that a little. Earlier I heard someone arguing (I forget the blogger, unfortunately) that the Fed, in fact, had to expand the money supply radically in late '08 because of increased demand for money. The argument being that, like any good, when more was demanded more would (in context, the argument was "should") be supplied.

That never made sense to me on the face; people were demanding money as a store of value. If you look at it so simplistically as to say, "Look, people want money, and they don't have as much as they want, so let's print them more so they'll be satisfied," I suppose it fits. However, you've really killed the whole point by then. They wanted the money _because_ of the value it represented, not to paper their walls. If you destroy the value, you destroy the reason. That is one way to slake demand alright.

Ben writes:

If he rarely accuses anyone of pretense, it may imply nothing (it had to happen to one group first)

Bill Woolsey writes:

I am shocked by the confusion in Bruce Barlett's comment. It seems to be yet another example of what Leland Yeager called "money and credit, still confused."

The quantity of money includes currency and a variety of bank deposits. Even if deposits fell to zero, the Fed could increase the quantity of currency enough to increase the total quantity of money. For example, suppose that the quantity of currency was $800 billion and the quantity of deposits was $1600 billion. The total money supply would be $2.4 trilion. Suppose the Fed wanted the quantity of money to be $3 trillion. Deposits could fall to zero, and the Fed could create $3 trillion worth of currency. The money supply would then be $3 trillion, with no bank deposits.

Of course, not all the banks failed during the Great Depression. Those that didn't fail didn't even increase their reserve deposit ratio to 100%. The money multiplier didn't fall to 1. And even if they had kept 100% reserves, then the Fed would just need to incease reserves enough to get the quantity of money to the desired level.

Given the actual money multiplier and currency deposit ratio during the Depression, there was always sufficient outstanding government debt for the Fed to use open market operations and raise base money enough to keep the M1 measure of the money supply on its pre-Depression growth path. (Of course, there may have been gold outflows if they had tried, which points to the real problem.)

Still further, increasing the quantity of currency in response to an increase in the demand to hold currency, because people have less trust in banks and want to hold currency rather than deposits is not a "bail out" of the banks.

Failure to meet that demand for currency results in a shortage of currency and broader measures of money, a decrease in nominal expenditure, real output, and prices. The last two things, falling output and prices, hurt bank debtors and can cause banks to fail.

However, if some banks were already going to fail, say small unit banks in midwest communities where drought had devastated the farmers who owed the them money, increasing the quantity of currency to match an increase in the demand for currency would hardly help.

Bernanke's theory explains how widespread bank failures could cause a decrease in real output even if prices and wages were perfectly flexible so the real volume of expenditures were not impacted by the reduction in nominal expenditures and the nominal quantity of money. Bernanke developed a theory of how bank failures could reduce real output in the context of a new classical model based on continuous market clearing. (That was the style when he was writing.)

The implication of Bernanke's argument is that even if the Fed expanded the quantity of money enough to maintain nominal expenditure in the economy, the failure of banks could disrupt production. The decrease in the supply of output would result in shortages of goods and inflation. So, bank failures would lead to stagflation.

If Bartlett and Cowen want to appeal to Bernanke to defend Bernanke... well, I guess that is natural. What does that have to do with Milton Friedman?

bill woolsey writes:


The quantity of money can decrease. Why do you say that it can only increase?

Bob Murphy writes:


You raise an interesting point. I know that Friedman talked about Canada not having bank failures because they allowed branch banking (which many US states prohibited). I hadn't remembered Friedman explicitly calling for a bailout of banks, but it didn't occur to me that Cowen could be mistaken on such a central point of his accusation.

Either way, my theory of motivation is that Tyler knew a bunch of knee-jerk libertarians were going to go nuts over his post, and so he was pre-emptively hitting back. He was right.

Tyler Cowen writes:

David, try my pieces on Naomi Klein or *The End of Poverty* or my periodic tangles with Paul Krugman or my calling various Democratic health care notions the new voodoo economics or any number of other posts, including but not restricted to those on the stimulus. How about my saying that G.A. Cohen was "wrong about everything"? Or the Robert Reich post cited above or my post "Imagining the Button." I could go on. I believe you are noticing one kind of criticisms much more than the other.

frankcross writes:

It's not really so hard to go to the site and do a search for the word "pretense." For which you get a variety of results, including criticisms of liberals.

ThomasL writes:

bill woolsey writes:


The quantity of money can decrease. Why do you say that it can only increase?

Excuse me, I didn't mean to imply that it couldn't shrink at all, only that it rarely shrank, and things were almost always done to prevent that from happening in great degrees or for more than brief periods.

So that isn’t entirely without support, check out this graph of M2: http://research.stlouisfed.org/fred2/series/M2NS?cid=29

I’d compliment anyone who could point to deep or prolonged downward trends. I don’t think that is an accident; there is evidence to suggest that the Fed is not happy with the implications of a contracting money supply.

I want to clarify, re: my longer comment, that I acknowledge some entity might stand to gain by the system so long as the increase in the money supply disproportionately fell to them. However, I don't understand why that would be perceived as a general social good, or a generally wise plan.

Don the libertarian Democrat writes:

It is very hard to determine what Milton Friedman would have said. In "A Program For Monetary Stability" ( PFMS ), he says that Deposit Insurance has made a Liquidity Crisis based on banks runs almost inconceivable ( pp. 37-38 ). I take him to be saying that even though the limit is $10,000, the govt basically is committed to stopping any run ( p.21 ). I use this reasoning for the argument to save Lehman. It was going to start a Collateral Run, which could lead to a Debt-Deflationary Spiral.

He also makes it plain on page 18 that allowing a large number of banks to fail was a disaster. The question of sound collateral is addressed by Schwartz, and MF might have agreed with her that:

"But the Fed just sat by and did nothing, so bank after bank failed. And that only motivated depositors to withdraw funds from banks that were not in distress," deepening the crisis and causing still more failures.

But "that's not what's going on in the market now," Ms. Schwartz says. Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value."

The question is really whether or not you believe that letting Lehman fail was going to lead to a panic, and so you had to rely on dubious collateral to stop this panic. The same call applies to AIG.

I would have saved Lehman, basing my view on this quote from Bagehot that AS & MF quote on p. 395 of "A Monetary History...:

The way in which the panic of 1825 was stopped by
advancing money has been described in so broad and
graphic a way that the passage has become classical. “We lent it,” said Mr. Harman [one of the Bank’s more senior directors] on behalf of the Bank of England, “by every possible means and in modes we have never adopted before; we took in stock on security, we purchased Exchequer bills,
we made advances on Exchequer bills, we not only discountedoutright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we
were not on some occasions over-nice [to the borrowers].”

Here's a post that seems to agree with me:


Niko writes:

Thomas is correct in that the Fed does make it a policy to not allow the money supply to contract as a rule.

Even though the US has had something like six deflationary periods since the beginning of the 20th century with only two correlating with a recession, Alan Greenspan was absolutely horrified at the idea of deflation.

Maybe I read that on this blog, actually.

Megan McArdle writes:

Bill Woolsey, Treasury prints currency, no? And without a more expansionary fiscal policy, I don't see how you could have put billions and billions of new dollars into peoples' hands.

Since the Fed did not have the authority to take the US off the gold standard, it seems to me that Bruce Bartlett is right.

Bill Woolsey writes:


The Treasury operates the Bureau of Printing and Engraving. It prints currency at the request of the Fed which pays a printing fee. The Treasury's role is of no more significance than the role of Kinkos in determining the number of copies of a flyer.

If the Fed is going to make open market purchases in government bonds, then the limit is the outstanding national debt. That depends on past fiscal policy, not current fiscal policy. If the national debt is all held by the Fed, then further expansion by open market operations in government bonds requires the Fed to start purchasing other sorts of assets.... or.... that is when deficit spending is necessary. The government must run deficits to create government bonds for the Fed to buy. (My preference is for the Fed to buy other asets.)

If all banks were literally closed, the Fed would need to order currency from the Treasury and purchase outstanding government bonds with the it. If there are no banks, there are no payments anywhere by wire or check, and all payments are with currency. (Big sacks of it, I suppose.)

Of course, not all the banks had failed in the Great Depression. A more realistic scenario, would be for the Fed to purchase government bonds by wiring funds to the sellers' banks, but with no one trusting banks, those sellers would withdraw the received funds in the form of currency. The Fed would pay for the bonds in the usual way, crediting the reserve balances of the banks of the bond sellers, but the banks would withdraw currency from their reserve balances at the Fed to pay it out to the bond sellers. The Fed would have the currency printed as necessary.

It is possible that the Fed was unable to increase the money supply enough during the thirties because of gold reserve requirements. If those were ignored, the requirement to maintain redeemability could also have been a contraint. In reality, the Fed wasn't always pushing on that constraint and complaining. Which is what it should have been doing.

The U.S. did leave the gold standard for a time, and then returned at a higher price. The economy recovered strongly during that period.

While I would be glad to discuss the role of the gold standard in the Depression, this is not the same thing as saying that the Fed was unable to expand the money supply because all (or many) banks had failed.

Increasing the money supply (or keeping it from falling) is not the same thing as bailing out the banks.

And while I realize that the Great Depression has been brought into this discussion, the context was the current situation--did the Fed need to bail out the investment banks on Wall Street? (And Citibank too.) And there is no gold standard now to keep the Fed from increasing the quantity of money as much as it sees fit. There are about $5 trillion in outstanding goverment debt.

My view is that the Fed should increase the quantity of base money however much necessary to keep nominal expenditures on a 3% growth path. FDIC should reorganize failed banks as fast as it can. But the notion that the Fed cannot expand the money supply if some (or even all) banks fail is false.

Megan McArdle writes:

But the money supply is in some sense just a proxy for the credit markets. An increase in the physical amount of currency does not help you if everyone takes it home and sticks it under their mattress because they're afraid of the banks failing. You've increased the amount of currency in circulation, but the velocity is still falling. Demand deposits and currency are only substitutable when there is faith in the banks.

You seem to be saying that a world with no banking system and an equally sized m1 composed entirely of currency would be no different from a world with a mix of currency and demand deposits. This seems ludicrous to me, but perhaps I do not understand.

Jeffrey Rogers Hummel writes:

Bill Woolsey's comments do an excellent job of defending David's important point about the crucial but often overlooked difference between what Milton Friedman would have had the Fed do during the Great Depression and what Ben Bernanke has actually done during the current recession. I posted about the same point over at Liberty and Power. As I stated there: "Milton Friedman's research on the Great Depression, which emphasized the demand-side impact of the bank panics, is quite different from Ben Bernanke's, which emphasized the supply-side impact. This difference implies significantly different policies: a general increase in liquidity in the case of Friedman versus targeted (and until last October, sterilized) bailouts in the case of Bernanke." Bernanke's subsequent doubling of the monetary base to $1.7 trillion could have easily been accomplished with traditional open market operations, making hardly a dent in the Treasury's outstanding debt of nearly $7 trillion while avoiding any loans whatsoever to specific depositories, investment banks, or other financial institutions.

Bill Woolsey writes:


I don't think that the quantity of money is a proxy for credit markets. As Yeager said, "Money and Credit, Still Confused."

Money can exist even if no one lends it. And the quantity of money can impact nominal expenditure even if total lending and borrowing decrease.

I agree that if the quantity of currency rises and people just put it under their mattresses that this does no good. This is called the liquidity trap, though it is usually both currency and deposits that are supposedly held rather than spent.

The point of increasing the quantity of money, whether it is made up of currency alone or both currency and deposits, is for people to spend the money on goods services. This could be households going out to eat at restaurants or restaurant owners taking the profits earned from those sales and purchasing new stoves.

If people take the extra money and lend it to someone else who spends it, that is fine. But spending it directly on goods and services works without an intermediate step of lending it to someone who spends it.

(I certainly hope you aren't laboring under the confusion that as long as people leave their money in the bank that this means that there can be no problem and that it is only hoarding physical currency that is at issue. The issue is the quantity of money of all sorts and the demand to hold it.)

I am not sure about the terminology of "but velocity is still falling." If velocity falls, then maintaining nominal expenditure requires an increase in the quantity of money. If increases in the quantity of money cause velocity to fall more, then that is just another way of stating there is a liquidiy trap. People are taking the new money and just holding on to it. It doesn't matter whether it is currency or deposits or some mixture.

But none of this is relevant as to whether or not the Fed can increase the quantity of money without there being banks. It can. And if increases in the quantity of currency created through open market purchases result in matching increases in the demand to hold currency, then the increase in the quantity of currency will not impact spending. But that doesn't make it impossible, just ineffective. (While I am generally skeptical about the liquidity trap, I do think buying zero interest T-bills is ineffective and that in such a circumstance, the Fed must buy assets that don't have zero yields.)

Finally, I have never said that banks are useless or unimportant. In particular, I don't think that a world where all money is currency is the same as one where money is made up of a combination of currency and transactions deposits. But banks are not necessary for the Fed to increase the quantity of money or for increases in the quantity of money to increase nominal expenditure.

I think having all banks close would be a disaster. I don't want to use currency for all payments. Further, I think credit markets are valuable and useful, they shift funds from lower to higher valued uses.

But I don't think there was any danger of all the banks closing during the last two years. The disruption would involve reorganizing insolvent commercial banks and thrifts, and having the reorganized institutions expand both their FDIC insured deposits and lending to meet the credit demands that had been met by the failed shadow banks that had been run by investment banks and Citibank's off balance sheet operations. Protecting insured deposits from loss at commercial banks and thrifts might have cost the Treasury hundreds of billions, but the notion that making sure the stockholders of Citibank, Bear Sterns, and Goldman must keep a little something or else nominal expenditure must collapse is an error.

Don the libertarian Democrat writes:

This was an excellent discussion. From Hetzel's paper:


"The failure of Lehman Brothers on September 15, 2008, created uncertainty in financial
markets. Hetzel (2009a) argues that the primary shock arose from a discrete increase in risk due to the sudden reversal of the prevailing assumption in financial markets that the debt of large financial institutions was insured against default by the financial safety net( NB DON ). A clear, consistent government policy about the extent of the financial safety net would likely have avoided the uncertainty arising from market counterparties suddenly having to learn which institutions held the debt of investment banks and then having to evaluate the solvency of these institutions. Nevertheless, the turmoil in
financial markets and the losses incurred by banks would likely have been manageable without the emergence of worldwide recession."

I agree with this this. Now, here:

"The alternative road lies with the extension of the policy changes taken in the Volcker-Greenspan era. In this spirit, the FOMC should be willing to
move the funds rate up and down to whatever extent necessary to respond to changes in rates of resource utilization. The issue then is credibility. "

That Credibility didn't exist. The expectations of the market matters. The point about the RFC and the bailouts is interesting, but we've done other things than just an RFC. My view follows the Chicago Plan of 1933. But the point about Friedman's view is well taken.

I don't think I'm pretending when I say that I don't think Friedman advocated bailing out banks during the Depression. As I think Friedman would have, last fall I advocated an increase in the money supply while opposing a bailout. Those two, contra Cowen, are separable.

David, you're right. Tyler is confused when he suggests that "lender of last resort", which Friedman retrospectively favored as a means to prevent shrinkage of the money stock during 1929-32, is a bailout policy. Classical LOLR policy does not require -- indeed prohibits -- Bernanke's bailouts, i.e. loans to insolvent banks and loans to non-banks.

Bruce Bartlett comments above:

There's no way the Fed could have expanded the money supply in the early 1930s without bailing out the banks.

Simply not true. Money supply = bank deposits + currency held by the public. When banks holding 11% of the deposits disappear, it's easy enough to use open market operations to expand reserves and thereby deposits at the banks holding the other 89%, and to expand currency.

One of Ben Bernanke's most important academic articles showed that when the Fed tried to expand the money supply it couldn't do so because the closure of so many banks closed off the mechanism by which money would be injected into the economy.

I don't recall Bernanke providing any such demonstration of a false proposition. I do recall Bernanke's AER article pointing out that the public's withdrawal of bank deposits reduced the amount of real intermediation that the banking system could provide, a problem that would not be solved by injecting currency to restore M.

Saying that you are for expanding the money supply but against bailing out the banks is incoherent.

On the contrary, by textbook money-and-banking logic, it is perfectly coherent. To repeat, when banks holding 11% of the deposits disappear, it's easy enough to use open market operations to expand deposits at the banks holding the other 89%, and to expand currency. No bailouts are required.

123 writes:

Cowen is wrong. Friedman did not approve bank bailouts. He might have approved a partial conversion of bonds to equity to restore the banks without liquidation, but this is not a bailout, but a purely private sector operation.

Don the libertarian Democrat writes:

123 Some of us agree with the Economics of Contempt that these large banks could not be liquidated by the FDIC:


It then depends on what the consequences of bankruptcy would be. I would argue that Lehman showed that was a bad road to follow.

Bill Woolsey writes:


I went to the post you cited. Laws can be changed. They passed new legislation for the TARP bailout. I think Zingale was right about the need for expedited bankruptcy for financial firms.

One of the problems in this discussion is confusion between investment banks and commercial banks. While commercial banks (and thrifts) are heavily invested in home loans and mortgage backed securities, Citibank and the stand alone investment banks were even worse.

"Bankers" on Wall Street have nothing to do with deposits and the only loans they originate are corporate bond issues. But they developed the "shadow banking system" by funding securitized loans with asset backed commercial paper.

"Liquidating" the commercial banks and thrifts is hardly what FDIC needed to do. Reorganizing them is what it could have done, (and does.)

I think the "policy" should have been to let the investment banks and Citibank fail. And make it clear that other commerical banks and thrifts would be reorganized as fast as possible, with the reorganized banks allowed to rapidly expand because of increased demand to hold FDIC insured deposits. The commercial banks and thrifts would have to learn to again hold the loans they originate on their balance sheet rather than sell them, and fund them with FDIC insured deposits. Of course, the banks would need more capital, but the shift from securitzition to traditional lending means more profit from traditional lending. I think temporarily loosening capital restrictions would have been a good idea. Dangerous, but the least bad option. Having the taxpayer buy shares in banks in order to allow banks to meet capital requirements aimed at protecting taxpayers from loss is _insane!_

The Fed's job in all of this would be to raise base money however much necessary to make sure that all of this occurs in the context of nominal income continuing on its 5% growth path. (I prefer a zero inflation 3% growth path, but I don't think last fall was the time to implement disinflation.)

Yes, the shadow banking system goes away. No effort is made to jump start securitization, asset backed commerical paper or any of the rest. Yes, the capital requirements do imply that in the long run, there is less intermediation. People holding FDIC insured depostis earn less than they earned from mutual funds invested in asset backed commercial paper, funding some pool of securitized loans. Those getting loans would pay more when the originators hold them rather than sell them (and having them funded by asset backed commercial paper funded by money market mutal funds.) The margin between the interest rates on loans and deposits is bigger. Banks make more profit attracting more capital.

But, of course, that means that Wall Street takes big losses. They should.

Also, when FDIC reorganizes failed commerical banks and thrifts, the previous stock holders are wiped out. The new stockholders are attracted because of the future profits in traditional banking that exists because they are no longer competing with a model where the intermedation is occuring through wall street-- a scheme that operated with less capital and so had a competitive advantage before.

I have no problem with other bank creditors sharing the loss with stockholders. I think that is a good idea. Still, what is really involved is how much money FDIC contributes to the reorganization and which creditors other than insured depositors are covered. With enough contribution from FDIC, all can be protected from loss. But that costs taxpayers more.

The Fed could increase base money enough for all of this change to occur in the context of growing nominal income. I put no credence in the notion that real credit shortfalls would create production bottlenecks. (That would be a firm having buyers but unable to find credit to bring the goods to market.) I do think there would be sectoral shifts, so spending would rise in some sectors of the economy while shrinking in other sectors. Credit shifts funds from some to others. That shifts spending to somewhere new from where it would have been. Less credit, and a different pattern of expenditure. That sort of thing leads to stagflation in the context of stable growth of nominal income. But as the traditional banking system expands to make up for the shortfall in real credit, those sectoral shifts would moderate. And, of course, resources can be reallocated so that production matches the new pattern of demand. Real output recovers and inflation again falls.

Bailing out Wall Street and rebuilding the house of cards means none of that would happen. Everyone would regain confidence and hold mutual funds investing in asset backed commercial paper funding securitized loans. The demand for FDIC insured deposits would be less, nominal income wouldn't fall. Everything would be great..


Lee Kelly writes:

Or it did work. Bernanke saved his friends on Wall Street and did his friends in government a favour. In fact, Bernanke is now so popular among those in power that he has been selected for another term. If Bernanke's goal was to help his friends and keep his job, then everything you mention surely did work.

... at least so far.

Jacob Oost writes:

Here's a simple way to expand the money supply: print whatever money you want, then use that cash instead of checks for government expenditures.

F'instance, say you want the money supply to grow by $100 billion in a given year. You figure payroll for all government-employed humanities majors that year is $120 billion. Give $20 in checks, and $100 billion in cash. Instant growth of money supply.

Of course, this is actual currency, not privately held credit. And using this method, you need not coerce banks to accept your money nor rely on whatever the demand for money might be at the time. You just inflate by fiat.

I'm not saying I endorse it necessarily, but I want to point out that you can grow the money supply without going through the banks to do it.

Also, correct me if I'm wrong, but wasn't Friedman's argument that interest rates should have been kept down via a fixed money rule so that the contraction would never happen in the first place (in theory)?

123 writes:


you say that the "policy" should have been to let the investment banks and Citibank fail. This is wrong, because they have a much higher value as going concern, instead of TARP we just needed to force the partial conversion of bondholders to equity. Disorderly failure of Lehman was a huge mistake.

123 writes:


After Bear Stearns it was clear that a new law was urgently needed. Unfortunately only the Freddie and Fannie conservatorship law was passed.

Vangel writes:

Shouldn't Friedman have blamed the Fed for increasing the money supply so much during the second half of the 1920s? As Rotbard argued, the malinvestment crisis began long before the market crashed in 1929.

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