It Was One Year Ago Today, Milton Friedman Taught The Band To Play


H/T on the graphic: The Winecommonsewer

How do we feel about the bailouts now? Tyler Cowen:

If another big negative shock comes the government’s liability position still could turn out to be much worse.  But if we stop and click pause and evaluate the policy today — the answer to my question is “yes, the bailouts were a good idea.”

Without the bailouts we would have had many more failed banks, very strong deflationary pressures, a stronger seize-up in credit markets than what we had, and a climate of sheer political and economic panic, leading to greater pressures for bad state interventions than what we now see.  Milton Friedman understood all this quite well, which is why argued bailouts would have been a good idea in the 1929-1931 period.

(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.)

If you are a libertarian, is not our current course more favorable for liberty than would have been a repeat of 1929-1931?  If not, I would be curious to hear your counterfactual version of how matters would have proceeded, without the financial bailouts.  Is it that you think the regional banks would have raised the financing to pick up the entire bag and keep the banking system afloat?  Or is it that natural market forces would have somehow avoided a wrenching surprise deflation?  Or do you think the authorities for some reason would have not nationalized the major banks?  Please let us know.

Maybe you think that the bailouts will have disastrous long-run consequences.  And maybe they will, I worry about this too.  But if anyone should know that modern politics can only stand so much short-run panic, it is libertarians and fans of Bryan Caplan’s book.  If we had not done the bailouts we did, we would, within a few months’ or weeks’ time have received a much worse and costlier bailout run by Congress and Nancy Pelosi.  How does that sound?

Megan McArdle:

Now that we have the benefit of hindsight, what should with think about the bailouts?  A large number of conservatives and libertarians are against them.  I think that a large number of liberals are too, though for different reasons.  Both dislike giving state money to companies, but the right worries about the tax burden and the corrupting influence of government on the market as much as the corrupting influence of companies on the government.  They are also, I think, more worried about moral hazard, while liberals worry more that the money spent on banks can’t be spent on other government programs.

All these concerns are correct.  The bailouts have probably substantially increased moral hazard, and perversely, arguably undermined the political will for regulation that might reign in that moral hazard.  Top investment bankers really do seem to have a worrying about of influence over Treasury and the Fed.  The tax burden is large, and should worry you whether you wish that money had been spent on food stamps, or returned to taxpayers.

That said, they were probably the best thing we could have done.


There are things about the bailouts that could have been done better; I think both Democrats and Republicans demanded too little from the large banks in return for its support.  But the basic strategy seems like the best option in a bad situation.  On the other hand, maybe this is an argument for liberals that we shouldn’t have done the bailout . . .

Matthew Yglesias:

I will admit to not being an expert on the thought of Milton Friedman, but I’ve been surprised by the overwhelming hostility exhibited by the institutional organs of American libertarianism—places like Cato and Reason magazine—to the bailout policies of Hank Paulson, Ben Bernanke, and Tim Geithner. Why surprised? Well, because my understanding of Freidman’s big contention about the Great Depression has always been that he was saying that instead of all this big government and New Deal and so forth, we should have just organized . . . massive bank bailouts. That given adequate bank bailouts, things never would have gotten so bad under Hoover, and FDR never would have come in the way he did, and post-war Keynesianism never would have gotten off the ground.


Of course libertarians are under no compulsion to agree with Friedman about everything, but given that he’s generally acknowledged to be one of their side’s intellectual giants this seems worth wrestling with to a much larger degree than I’ve seen. The ideological problem is clear enough—any form of heavy-handed state intervention into the economy serves to undermine the mythos of free market capitalism and thus legitimize social justice concerns and redistributive claims.

Nevertheless, the fact of the matter is that economic thinkers who the right is normally inclined to revere agree on the point that state intervention in the midst of financial panics is correct policy.

Karl Smith at Seeking Alpha:

There would have been a worse bailout – that’s the defense?

How about the fact that we stopped the second Great Depression. We prevented untold human suffering and a destabilization of governments in developing countries that could have lead to a vastly more dangerous world.

In my mind the entire point of macroeconomics was that when it happened again, when the forces that created the Great Depression materialized again, we would stop it.

It happened again and we stopped it. That’s success.

Arnold Kling:

The Financial Times reports,
“The US government, by contrast, is sitting on a paper profit of almost $11bn on its 34 per cent shareholding in Citigroup…

The government said it had earned an annualised return of 23 per cent from its $10bn investment in Goldman Sachs under Tarp. In June, Goldman returned the $10bn and later paid another $1.1bn to buy back warrants attached to Tarp aid. Morgan Stanley, American Express and other banks have done the same, leaving taxpayers with substantial profits.”

Pointer from Tyler Cowen, who says we should admit that the bailouts were a good idea.

Certainly, profits on the transactions would meet my test of whether the measures were addressing a liquidity crisis or just bailing out insolvent institutions. If AIG, Freddie, Fannie, and FHA all emerge solvent from this, then I absolutely have to shift my position in favor of the “insider” view that this was mostly a liquidity panic. I would probably be willing to make that concession even if AIG, Freddie, Fannie, and FHA together have negative net worth, as long as the deficit is under $100 billion for the four of them.


In the long run it would have been better to allow the entire financial system to burn to the ground then bail out the people who made these mistakes.

If you absolutely positively had to invest a trillion dollars in the financial system, it would have been better to summon solvent banking firms to NYC and hold Dutch auctions for their assets and liabilities. That is, who wants AIG plus a subsidy, and the subsidy increases (price drops) until the bank sells. No reward for failure. One could also have done a massive capital injection into the solvent banks at favorable enough rates that all would want to participate. One way to force the management to put their money where their mouths are is to require management to inject their own (outside) money into the new firms at some leverage ratio. Even if they have to borrow it against everything they have.

You could also try huge quantitative easing. If the federal reserve had done a trillion dollars worth of open market operations and driving real rates negative and injecting massive amounts of liquidity into the system, then I believe that market mechanisms could have been leveraged to restart lending if it failed.

Finally, how about investing in the publicly traded companies directly. Put substantial orders in to buy new equity in the 3000 largest publicly traded firms that can be sold at any time. Make these shares assets of the FDIC or assets deposited as seed capital for privatized social security accounts.

But here is my turnabout for advocates of the banking bailouts:

Have you also noticed that this hasn’t turned out to be much of a great recession? Though unemployment is sharply up, consumption and output have changed little, and we may have already reached the trough. One interpretation of this is that the package of stimulus and bailouts worked. But given what we know about how these were implemented, isn’t at least as likely that the panic wasn’t as bad as it was sold to us?

UPDATE: Julian Sanchez:

I’m not inclined to debate economic policy with Tyler and Megan, so I won’t presume to take a position on the ultimate wisdom of the approach that was taken, but this sounds an awful lot like the old debate trick I’ve previously referred to as the fiat shuffle. Just to refresh: The way the trick works is that, for the purposes of arguing the merits of a given policy, you assume away various real-world political barriers to the policy’s being enacted—in debate lingo, you get to “fiat” the policy and restrict the argument to whether this would be a good thing without fussing over whether you could get the votes in the House (or whatever) to do it. The shuffle comes when you assume the same political constraints back in again as part of an argument that the proposed policy would create pressure for other salutary reforms, or to dismiss alternatives as infeasible.

Now, this isn’t a clear case of fiat shuffle, because it’s easy to imagine that we might have had the political will to resist the bailouts, but that this would not have been sufficient to forestall still more aggressive intervention later assuming things would have gotten far worse. Still, despite a an initial defeat in the house, the bailout ultimately passed by a 3-to-2 margin there, and by an even more lopsided 3-to-1 vote in the Senate. Which is to say, the world in which we didn’t do the bailout is clearly a world with a pretty radically different political culture, presumably populated by legislators with a very different average worldview. When would the inhabitants of that world have given up their resistance to intervention, and how much more dramatic would the intervention have been when they did? Damned if I know, but projections based on the current composition and views of Congress probably don’t apply.

Megan McArdle responds:

I’m not totally sure that’s true.  If so many conservative and libertarian pundits hadn’t caved, I can imagine a world in which the Republicans continued their intransigence, and the Democrats (for understandable political reasons) refused to pass it without them.

But leaving this aside, we actually have some empirical evidence here.  In 1929, the federal government and the federal reserve took little action to bail out the banks.  In 1932, we elected FDR.

That was a long time ago.  But when you look at modern financial crises from Iceland to Argentina, what you see is that they have a tendency to produce some, well, radical changes in the political culture.  Moreover, those trends usually tend towards populism, redistribution, and state control of substantial segments of the economy.  So if we hadn’t had our Pelosis now, we’d have had them by 2012.  To a first approximation, I’d say that the bailouts are the reason that we won’t have a single-payer health system or actual national automakers any time soon.

UPDATE #2: David Henderson

Tyler Cowen

Megan McArdle

UPDATE #3: Steve Verdon

1 Comment

Filed under Economics, The Crisis

One response to “It Was One Year Ago Today, Milton Friedman Taught The Band To Play

  1. Pingback: What We’ve Built Today « Around The Sphere

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