by From Richard Koo in current issue of RWER When Milton Friedman visited Japan in the 1950s and spoke to economist Kazushi Nagasu, he had strong things to say about the plight of his people: “I am a Jew…I do not think I need to tell you what kind of horrible deaths Jewish people had to face. The real drive behind my argument for free markets is the bloodied cries of Jewish people who perished under Hitler’s and Stalin’s regimes, and their message is that the best way to happiness is to have a mechanism that brings people together where states, races and political systems have no influence.”[1] Although many would agree with Friedman that the free market is the necessary mechanism, he is wrong on at least three counts. The first is his assumption that markets driven by a
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from Richard Koo in current issue of RWER
When Milton Friedman visited Japan in the 1950s and spoke to economist Kazushi Nagasu, he had strong things to say about the plight of his people: “I am a Jew…I do not think I need to tell you what kind of horrible deaths Jewish people had to face. The real drive behind my argument for free markets is the bloodied cries of Jewish people who perished under Hitler’s and Stalin’s regimes, and their message is that the best way to happiness is to have a mechanism that brings people together where states, races and political systems have no influence.”[1]
Although many would agree with Friedman that the free market is the necessary mechanism, he is wrong on at least three counts. The first is his assumption that markets driven by a profit-maximizing private sector can never go wrong. Every so often the private sector loses its head in a bubble, something observed most recently in the late-1990s dotcom bubble and the housing boom that followed a few years later. During a bubble, the private sector engages in a frenzy of speculation and ends up misallocating trillions of dollars of resources, something no government could ever hope to match. Markets work well when businesses and households have cool heads, but not when a bubble has formed.
Unfortunately, the pursued era is more conducive to the formation of asset bubbles than the golden era, when Friedman was formulating his theories. This is because a shortage of borrowers in the real sectors forces fund managers entrusted with the private sector’s excess savings to invest in existing assets such as stocks and real estate. With the low interest rates typical of the pursued era and central banks trying to hit their inflation targets with ever larger injections of liquidity, fund managers must take more risks to generate adequate returns.
When the bubble eventually bursts, the private sector comes to its senses and realizes it must work to restore its financial health by shifting its priorities from maximizing profits to minimizing debt. Even though that is the right thing to do at the individual level, when pursued collectively it causes the entire private sector to begin running a financial surplus and tip the economy into a devastating balance sheet recession.
This is where Friedman made his second mistake. He argued that monetary easing – whereby the central bank supplies liquidity and lowers interest rates – should be the primary remedy for recessions. This was the right answer when he was developing his theories in the 1950s and 1960s, as the US was in the golden era and businesses had ample domestic investment opportunities. But the effectiveness of monetary policy is drastically reduced once the economy enters the pursued phase, which is characterized by dwindling borrowers. The problem gets worse when the economy enters a balance sheet recession with its private sector minimizing debt. Monetary policy stops working because the absence of borrowers means funds supplied by the central bank to the financial sector have no way of entering the real economy even if interest rates are lowered to zero.
Friedman’s third mistake was to oppose fiscal stimulus based on a preference for small government. To him, fiscal stimulus represented big, intrusive government. But in a balance sheet recession, the government must use fiscal stimulus and serve as borrower and spender of last resort. There is no other way to keep the economy out of a deflationary spiral and give the private sector the income it needs to pay down debt and rebuild its balance sheet. The same applies when the economy is in a pursued phase with insufficient domestic investment opportunities.
Friedman’s overriding emphasis on the supremacy of markets, monetary policy, and small government allows no room for government to act as borrower of last resort. But it was the inability of Germany’s Brüning government – due in no small part to pressure from the Allied Command – to use fiscal stimulus to prevent the post-1929 economic collapse that allowed the country’s unemployment rate to reach 28 percent and paved the way for Adolf Hitler’s rise to power in 1933.
For better or for worse, Hitler implemented the speedy, sufficient and sustained fiscal stimulus needed to tackle the nation’s balance sheet recession – the construction of the autobahn expressway system was among the many public works projects undertaken by the Nazi government. By 1938, just five years later, Germany’s unemployment rate had fallen to 2% when the US unemployment was 19%.
This was viewed as a great success by people both inside and outside Germany. In contrast, the democracies of the United States, France and the UK continued to suffer from high unemployment as policymakers were unable to think outside the box of balanced budgets and small government. The failure of the French, UK and US governments to act as borrowers of last resort not only enhanced Hitler’s reputation, but also prevented them from presenting a credible deterrent to Germany’s rapidly expanding military.
To prevent the possibility of another Holocaust, it is essential that the public be taught what a balance sheet recession is and how to fight it with fiscal stimulus. People must also realize that neoliberal ideas that were relevant in the golden era are often counter-productive in the pursued era. Although pursued economies need to reform themselves along neoliberal lines at the micro-level to encourage more domestic investment, there is simply no room for neoliberalism at the macro level when the economy is in the pursued phase or is suffering from a balance sheet recession.
[1] Uchihashi, Katsuto (2009), Shinpan Akumu-no Saikuru: Neo-riberarizumu Junkan (“The cycle of nightmares: the recurrence of neoliberalism”), updated version, in Japanese, Bunshun Bunko, Japan, pp. 88-89.