I recently heard a radio interview with a prominent economist who was defending Federal Reserve Chairman Ben Bernanke’s moves to shore up the markets on Wall Street. Bernanke, the economist said with emphasis, had spent years studying the “mistakes” of the Fed during the Great Depression and was not going to repeat the “errors” that the Fed directors committed from 1930 to 1933.

The “errors” of which the economist spoke were outlined by the late Milton Friedman both in his 1963 A Monetary History of the United States (written with Anna Schwartz) and his popular Free to Choose (with Rose Friedman), published in 1979.

According to Friedman and his coauthors, the economic collapse that occurred in the United States from 1930 to 1933 came about because the Federal Reserve System failed to act in the face of bank failures and banking panics, leading to a massive contraction in the amount of money in circulation, which ultimately led to the calamity.

The anti-free market arguments

Friedman made his arguments as a means to counteract the common explanation of the Great Depression — that it was the result of the “internal contradictions” of capitalism. The typical explanation, popularized by John Kenneth Galbraith as well as the gaggle of Keynesians that proliferated in US universities, was that the capitalist system tends toward “underconsumption” or its evil twin, “overproduction.”

(Galbraith held that underconsumption occurred because the income “gap” between the wealthy and poor grew during the 1920s — another “natural” outcome of capitalism — while John Maynard Keynes and his followers held that private investment spending was volatile because of the “animal spirits” of investors. The system had a built-in, self-multiplying, downward spiral whenever private investors were unwilling to throw more money into the economy.)

Those who blamed the Great Depression on the “failures” of the free market were all too happy to come up with their own “solutions,” including attempts to cartelise the entire US economy or to force up wages via increased minimum-wage legislation or through the endorsement of expanding labor unions.

Some, like Galbraith, went further and advocated out-and-out socialism and central economic planning. The free-market system, they have argued, is too inherently unstable to be left to its own devices. (This is the same argument that Paul Krugman makes twice a week from his perch on the New York Times op-ed page.)

Friedman believed the monetary system was prone to failure

Thus, Friedman was seeking not only to explain why he believed the Great Depression occurred, but he also was trying to defend the free-market system, or at least was trying to defend most of the free market system. There was one portion of the system that was prone to failure, he argued, and that was the monetary system.

This alone is quite interesting, as Friedman was willing to buy into a government-run monetary system — “socialist” money — even as he tended to condemn other things socialist. However, he also was willing to admit that the fractional-reserve banking system (which he heartily endorsed) was subject to all of the instabilities one would expect when there exists a monetary system in which multiple claims are made on a single source.

Nonetheless, I do not wish to dwell on Friedman’s inconsistency. Instead, I wish to look specifically at his claim that the Great Depression could have been avoided had the Fed simply provided enough “liquidity” in the system. This is more than an esoteric exercise, as it seems that Bernanke has taken a page — or, perhaps, a number of pages — from Friedman’s playbook.

The Fed’s latest move — permitting reeling financial institutions to use near-worthless mortgage securities as collateral for about $200 billion in loans — is yet another example of Bernanke’s promise to “provide liquidity” at every step, as though the real crisis here is the lack of play money in the nation’s financial system. The problem here is that the original Friedman thesis was wrong, and that Bernanke’s glorified dropping of money from the Official Fed Helicopter is just as foolish.

The Smoot-Hawley Tariff Act

Murray Rothbard’s America’s Great Depression was first published, ironically, in 1963, but it tells a very different story than does Friedman. Rothbard’s book points out that the economic collapse from 1930 to 1933 did not happen because the Fed failed to provide “liquidity” to the system, but rather because the government intervened in an economic downturn and managed to turn a recession into an out-and-out calamity.

For example, Friedman notes (accurately) that there were more than 4,000 bank failures during this period. He somehow wants us to believe that had the Fed loaned enough money (via the printing press) to enough banks, that we would not have seen so many bank failures. However, he leaves out something that is very important: the passage of the Smoot-Hawley Tariff Act in 1930.

This infamous tariff, passed and signed by President Herbert Hoover despite the pleas of more than 1,000 economists who signed a letter urging him to veto the bill, not only made it nearly impossible to import consumer and capital goods from abroad, but also destroyed the export market for US farmers. Thus, a bill passed to raise production prices ultimately ended up reducing prices for agricultural products.

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