Wanted: A Voice for Free Markets

The Wall Street Journal editorial page highlights an issue that I have been brooding on for awhile: the fact that in the current economic and political debate, we are really missing the voice of Milton Friedman, and more broadly, pragmatic defenders of free markets. Stephen Moore puts it perfectly when he says:

With each passing week that the assault against global capitalism continues in Washington, I become more nostalgic for one missing voice: Milton Friedman’s. No one could slice and dice the sophistry of government market interventions better than Milton, who died at the age of 94 in 2006. Imagine what the great economist would have to say about the U.S. Treasury owning and operating several car brands or managing the health-care industry. “Why not?” I can almost hear him ask cheerfully. “After all, they’ve done such a wonderful job delivering the mail.”

The number of voices calling Milton Friedman “wrong” or “misguided” or at the veryleast “reaching the end of his usefulness” has increased dramatically overthe past six months. Noami Klein’s Shock Doctrine is but Exhibit A.Sadly, she bears many similarities o the crazy homeless woman who berates me every day as I pass her en route to the subway. Further exhibits are a bit disheartening — witness this recent article from Brad DeLong arguing that Friedman’s principles are essentially right, but that they may have outlived their usefulness. This is a great read — DeLong is an excellent economist with a clear agenda. He is well-reasoned and logical But his conclusions are a bit scary:

DeLong’s summary of Friedman’s perspective:

Friedman adhered throughout his life to five basic principles:

1. Strongly anti-inflationary monetary policy.

2. A government that understood that it was the people’s agent and not a dispenser of favors and benefits.

3. A government that kept its nose out of people’s economic business.

4. A government that kept its nose out of people’s private lives.

5. An enthusiastic and optimistic belief in what free discussion and political democracy could do to convince peoples to adopt principles (1) through (4).

He goes on to argue, essentially, that (1) conservative governments have failed against many of these benchmarks and (2) that, regardless of Friedman’s principles, one must admit that the market economy does not produce outcomes which are the most “just” or “fair.” With respect to (1), of course he is right — no government has ever lived up to Friedman’s principles. When I own my own private island, I will run it entirely accordingly to principles of free markets, and it will be easy, because there will just be one family in residence. As soon as you add more than one family, it becaomes hard to run a government exactly to Friedman’s principles. ultimately, it is a matter of degree: Who is closerto Friedman’s principles? Conservatives (Reagan, Thatcher) or liberals (Carter, Blair)?

With respect to (2), I feel DeLong is on truly dangerous ground. He argues (emphasis added):

[T]he distribution of economic welfare produced by the market economy does not fit anyone’s conception of the just or the best. Rightly or wrongly, we have more confidence in the correctness and appropriateness of political decisions made by democratically-elected representatives than of decisions implicitly made as the unanticipated consequences of market processes. We also believe that government should play a powerful role in managing the market to avoid large depressions, redistributing income to produce higher social welfare, and preventing pointless industrial structuring produced by the fads and fashions that sweep the minds of financiers.

I flatly disagree with the bolded statement. In fact, if I were to summarize, I would make the exactly opposite statement:

“I have more confidence in  correctness and appropriateness the deceisions implicitly made by market processes than I do in the political decisions made by democratically-elected representatives. “

There, that sounds better.

If given 100 decisions to make, I believe appropriately designed markets would make a better decision than politicans probably 75+ times out of 100. Nothing is perfect.

Which brings me back to my main point — where is the reasoned voice supporting free markets, let alone Milton Friedman? Who can make the case for free trade, free labor markets, innovation-friendly property rights, and deep capital markets, all of which have advanced the human casuse so greatly over the past 500 years?

Mankiw vs. The Austrians on Interest Rates

An amusing retort by Robert Murphy, at the Mises Institute, arguing against Mankiw’s proposal favoring negative interest rates.

First, Mankiw’s proposal:

Let’s start with the basics: What is the best way for an economy to escape a recession?

Until recently, most economists relied on monetary policy. Recessions result from an insufficient demand for goods and services — and so, the thinking goes, our central bank can remedy this deficiency by cutting interest rates. Lower interest rates encourage households and businesses to borrow and spend. More spending means more demand for goods and services, which leads to greater employment for workers to meet that demand.

Assumption #1 that will anger Austrians everywhere — lower interest rates encourage consumption and borrowing, which is good for the economy.

How to do it though?

So why shouldn’t the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3 percent?

At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.

The problem with negative interest rates, however, is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less.

Unless, that is, we figure out a way to make holding money less attractive.

At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. (I will let the student remain anonymous. In case he ever wants to pursue a career as a central banker, having his name associated with this idea probably won’t help.)

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent

Ridiculous, you say?

If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.

This is all straight from Mankiw. Now, there is one majorly faulty assumption with this argument, as noted above. Mankiw is referring to the interest rate as a tool to regulate spending, as Murphy notes, but he fails to mention it’s role in regulating saving.

Perhaps the single biggest mistake in Mankiw’s worldview is his treatment of the interest rate as merely a brake or governor on “spending.” In this standard yet woefully simplistic approach, “the” interest rate serves to either stimulate or suppress how much money people spend today. So if businesses are laying people off, why, the answer is obvious: cut the interest rate to induce more spending, so businesses hire those workers back.

But in reality, interest rates coordinate production and consumption decisions over time. They do a lot more than simply regulate how much people spend in the present. In particular, certain sectors are much more sensitive to interest rates than others. For example, if interest rates fall, it’s not merely that consumers and businesses spend more, but that they spend more on particular items such as houses, cars, and factories. When interest rates fall, the share price of General Motors might rise, but not General Mills, because breakfast cereal is not a durable good (at least not in my household).

The key question which Mankiw and Murphy disagree on is this: is it better to postpone the pain associated with paying off your debts, deflating them over time with a weakened currency, or is it better to swallow the bitter pill today, in one massive, painful deflationary swallow? Get personal savings rates back to 10%, let the savers among us who have capital to lend charge egregious interest rates on this capital because there is simply none available.

Mankiw assumes (without telling the reader) that encouraging spending and smoothing consumption is a good thing, well worth the (quite hefty) costs. Murphy focuses on the costs, of which are there are many. For example, what would an extended bout of inflation do the dollar’s status as an international reserve currency? What might that cost us in terms of cost of future borrowing? Just one example.

I don’t know which is correct. But it’s always good to question assumptions.