Wednesday, April 27, 2011

On free markets and central banks

As we await Ben Bernanke's "historic" post-FOMC announcement press conference today, I think it's worth thinking about central banks. A stated belief in "free markets" is often a litmus test for classifying someone's economic thinking (and hiring that someone). But can you believe in central bank intervention and free markets at the same time? Milton Friedman is a perfect example that the answer is "yes." No one denies that Friedman was one of the most influential libertarian-leaning promoters of free markets in the 20th century, and yet, he was pragmatic about a currency controlled by a central bank and opposed a gold standard.

There are some economists today who argue that we should have "free banking" where the currency is controlled by the private banking system, as it was in the U.S. in much of the pre-Federal Reserve era. Market forces would control the supply of money. That's all well and good, but it's not the system we have in place today nor is it likely to be so.

In the meantime, our central bank controls the main levers of the money supply. Its job is to equilibrate supply with demand. Milton Friedman and Anna Schwartz "proved" that the Fed didn't do a good job of this during the Great Depression. Other economists have shown that Bernanke and the Fed also didn't do a good job of that during the crisis. Many economists have made the strong case that Friedman would have supported QE2, just as he advocated for similar policy in Japan in the 1990s. As the previous link shows, there is a strong conservative (ie: "free-market") case for QE2.

Milton Friedman was also not always and everywhere opposed to fiscal stimulus. He understood that government had to run deficits during recessions. The University of Chicago was preaching monetary and fiscal intervention long before Keynes.

In short, Milton Friedman believed in something called "aggregate demand." Just because you believe in aggregate demand doesn't mean you don't believe in free markets.

F. A. Hayek believed in a social safety net, and government taxation of negative externalities (both of which are held up as proper roles of government in Road to Serfdom). Both Friedman and Hayek preferred to be called "classical liberals," (as opposed to "conservatives") along the lines of Smith, Ricardo, Say, etc. Even Jean Baptiste Say, arguably the "founding father" of supply-side economics didn't believe his "law" held always and everywhere. If these three don't pass your "free market" litmus test, then your litmus test is broken.

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