Krugman and Friedman – Part One

-By Thomas E. Brewton

New York Times columnist Paul Krugman, a proponent of socialistic state-planning, takes a shot at Nobel Prize-winning economist Milton Friedman.

My neighbor David Lane asked for reactions to Mr. Krugman’s essay, which appeared in the February 15, 2007, edition of “The New York Review of Books.” Mr. Krugman pays tribute to the late Milton Friedman, but disagrees with some aspects of his analysis of economic cause-and-effect.

Paul Krugman is a controversial apologist for rather far-left-liberal political and economic views. He is by training and former profession an economist himself. Before joining the Times as a columnist, he was held in high regard among academic economists. Today he is seen more as a propagandist whose economic predictions, usually damning Republic moves such as tax cuts, have often been notoriously wrong.

My reactions are based on detailed histories to be found in Benjamin M. Anderson’s “Economics and the Public Welfare,” Murray Rothbard’s “America’s Great Depression” and Allan H. Meltzer’s “A History of the Federal Reserve: Volume 1, 1913-1951.”

In this Part One, I will address only Mr. Krugman’s assertion at the outset of his essay. He wrote:

“And classical economics said that the answer to almost all problems was to let the forces of supply and demand do their job. But classical economics offered neither explanations nor solutions for the Great Depression.”

That is not factual.

What were the facts?

The liberal-Progressive-socialist party line was laid out by Stuart Chase, the economist who coined the name New Deal. In that version, the one to which Franklin Roosevelt continually reverted throughout the New Deal, the Depression was the result of greedy capitalists (economic royalists, in FDR’s terminology) who selfishly sucked up all the available money supply to continue building more and more unneeded manufacturing facilities. Neither Mr. Chase nor FDR offered an explanation, other than greed, for what motivated businessmen to such financially disastrous illogicality.

In Mr. Chase’s theory, capitalists figuratively were holding large moneybags and scooping all available money into them. This left insufficient purchasing power for the workers. When they stopped buying, the Depression started.

That thesis doesn’t hold water.

It’s true that farmers and businessmen over-expanded. But only a moment’s reflection should make clear that such action did not, and could not, suck all the credit out of the economy.

Whatever farmers and businesses borrowed from banks went to pay suppliers for seeds, fertilizer, and construction materials for new plants and raw materials for production. They had then to pay wages to farm hands and construction and production line workers. Funds borrowed by farmers and businesses obviously had to continue circulating in the same manner that prevails during normal business conditions.

What then did go wrong in 1929?

Contrary to Mr. Krugman’s assertion, the cause of, as well the remedy for, the Depression were very clearly understood at the time.

The cause, in short, was massive over expansion of the money supply by the Fed during the early 1920s. This imparted inflationary pressures and created a false expectation of future market demand. Farmers and businesses over-expanded and had to curtail output sharply when the temporary excess demand came to an end, after the Fed tightened the money supply in 1928.

World War I having ended in 1918, the Fed expanded the money supply at the urging of European central banks in order to finance their nations’ rebuilding of war-torn economies. A very large portion of the Fed’s money supply expansion went into floating European government bond issues in the New York market, the proceeds of which were used to finance Europeans’ imports from the United States.

The result was an early version of our 1990s dot.com boom and bust. Farmers bought extra land and machinery to supply a European market that was then producing very little of its own food. Machinery manufacturers invested in great expansion of productive capacity to meet European rebuilding demand.

Those expansions of output were far greater than our domestic market could support. As soon as European demand slackened, there was bound to be a recession in the United States, both in the farming (which then accounted for more than 50% of all employment) and in the manufacturing sectors.

Late in 1928 the Fed became alarmed at the degree to which excessive credit was spilling over into the stock market and speculative real estate investment (e.g. the early and abortive Florida land boom, which collapsed in 1925). The Fed began squeezing the money supply. Foreign government loan volume in New York fell off sharply.

Exports to Europe already had begun to decline. A major reason was the high level of United States tariffs (pushed to unprecedented heights in 1930 by the Smoot-Hawley Tariff Act), which made exporting difficult from Europe to the United States. If Europe could not export as its industries recovered, it could not repay loans that had been floated earlier in New York, nor could it continue importing large volumes of farm goods and manufactured products.

American farmers and manufacturers began to suffer, ushering us into the 1929 stock market crash.

Bottom line: had the Fed not created excess money supply to accommodate European central banks early in the 1920s, there would have been no Depression.

AND, contrary to Mr. Krugman’s assertion, there was a widely known and readily available remedy: let the economic cycle take its normal course.

Had we followed the successful course of the 1920-21 recession with little government intervention, workers would have been laid off until excess inventories were absorbed by the domestic market and costs of production had dropped to the point at which business could have rehired workers and increased production on a profitable basis.

The 1920-21 turn down, as severe at its outset as the 1930 Depression, lasted only a year. The roughly two-year dot.com recession that began at the end of President Clinton’s administration, though subject to many more government interventions than in 1920, is another example of fairly quick recover. Businesses laid off workers and liquidated inventory. Uneconomic dot.com businesses, financed often before they had any sales, let alone profits, were allowed go into bankruptcy.

Why in 1929 didn’t we follow the historical policy of non-intervention by the Federal government?

In a word: Hoover. President Hoover deserves all of the opprobrium heaped upon him by liberals, but not for the reason given in their textbooks. Writers who idolized Franklin Roosevelt have followed the New Deal script that aimed to discredit free-market capitalism and to extol the virtues of socialistic state-planning.

Far from being the old-style, laissez-faire conservative depicted by liberal historians, President Hoover was almost as much a state-planning activist as Franklin Roosevelt. Conservative economists, in fact, date the New Deal from 1930, two years before Mr. Roosevelt’s election in 1932.

In Mr. Hoover’s own words, in a 1932 campaign speech:

“No government in Washington has hitherto considered that it held so broad a responsibility for leadership in such times….For the first time in the history of depression, dividends, profits, and the cost of living have been reduced before wages suffered…They were maintained until the cost of living had decreased and the profits had practically vanished…”

Why, with the recent 1920-21 quick cure for recession still fresh in mind, would the President turn his back on tried-and-true policy and opt for large-scale Federal interventionism?

Mr. Hoover was a mining engineer by education and occupation. Before entering politics, he had made a fortune supervising the building of mines all over the world. He brought into government service the mindset of the early French social-engineers who orchestrated the first socialist regimes in France of the early 1800s. They too were professional engineers.

Their engineering mindset led to approaching economic and political situations from an idealized structural view point, rather than from a free-market view point. Unfortunately, in practice, no structural model works as planned, because it cannot allow for emotions and expectations of the millions of units comprising the marketplace. Only a free market setting prices can do that.

Immediately after World War I, Mr. Hoover had been immensely successful as the unpaid head of the emergency war relief measures in Europe. That catapulted him into President Harding’s cabinet as Secretary of Commerce in 1921. There he advocated what French socialists called rationalization of industry. Hoover believed that there was excessive and therefore destructive competition in American business. To counter that he urged stronger business trade associations that would, among other things effectively conspire to set prices.

During the 1920-21 recession, Hoover had publicly urged that the Federal government establish a bureau for economic planning to prevent unemployment. Fortunately, President Harding vetoed the idea.

Nonetheless the idea took root. Hoover and Franklin D. Roosevelt in 1922 organized the American Construction Council to advocate Federal and state funding for large public works projects. The plan was to smooth out the normal cyclical pattern of such construction work.

Another of Mr. Hoover’s state-planning concepts implemented during his administration was first manifested in the middle 1920s. He was strongly pro-union and preached the idea that high wage rates led to higher productivity of labor.

In reality, as we see today in the auto industry, the reverse is true. Business investment in more efficient machinery and better production techniques increases productivity, which permits management to pay higher wages.

Believing as he did, President Hoover in 1930 advocated higher wages to increase productivity as the way to end the Depression. Business profits were the only part of the mix that he regarded as dispensable.

All of these conceptions were part of the “new era” of permanent prosperity proclaimed by liberal-Progressive economists, exactly as they were to do again in the 1960s on the eve of President Johnson’s disastrous stagflation.

Such was the pattern of thinking that governed President Hoover’s reactions to the 1929 crash and the widening recession in 1930.

He began large public works projects and direct financing of private businesses. The only difference between his administration and the New Deal was the much larger scale of the latter operations.

In 1930, two years before FDR’s election, the giant Hoover Dam project was started in Nevada. In 1931 President Hoover established the Reconstruction Finance Corporation (RFC). Its purpose initially was to shore up small rural banks without sufficient liquidity to meet depositor runs because of too heavy a concentration in farm loans and insufficient diversification of other assets.

Parenthetically, after Franklin Roosevelt’s election in 1932, the RFC, greatly enlarged under Jesse Jones, was to become the banker for hundreds of private corporations that were never authorized by Congress. In what amounted to government-sponsored Enron-style off-balance-sheet dealing, the RFC lent money to individuals who used the funds to buy stock and capitalize those unauthorized corporations at President Roosevelt’s behest. None of it showed up in Federal budgets scrutinized by Congress.

What appealed to President Hoover’s engineering sense was an organized and planned economy, implemented by voluntary compliance and guided by central planning. Additionally, he favored higher inheritance taxes and regulations to eliminate stock market “speculation.” In other words, socialism.

To that end, President Hoover called heads of major corporations to Washington for repeated conferences in which he urged them not to lay off workers, to keep up wages and prices, and to continue to produce. If they did not do so voluntarily, he suggested, the government would be compelled to impose regulations to that effect. Businessmen were inclined to knuckle under, because they had seen Hoover, as Secretary of Commerce, force U. S. Steel to bow to labor union demands.

Economic reality called for the opposite of President Hoover’s policies.

In real life, artificially holding up wages forces businesses to lay off more workers than would be necessary in a free market. Maintaining prices of goods, rather than liquidating inventories at whatever price the market will bear, causes businesses to reduce production more than otherwise, because inventories can’t be sold at high prices.

Manufacturing businesses had high fixed costs for plant and equipment. No matter what the level of production, they had to keep paying interest on the debt that financed the plant and equipment. To avoid running out of cash during a sales downturn, they had no choice but to reduce labor costs, which were then about 70% of total costs.

Recessions end and workers are rehired only when there is a visible opportunity for businesses to increase production at a profit. That is impossible so long as warehouses are full of unsold inventories, and labor costs are too high. Remedying that requires liquidating inventories to pay off bank loans and cut loan interest payments, as well as laying off workers to cut labor costs.

President Hoover’s jawboning of business leaders flew straight into the face of economic reality. The result was to squeeze profit margins and thereby to forestall normal free-market recovery. When he left office after three years of the Depression, unemployed workers constituted 25% of the labor force, almost six times the level prevailing today.

____________
Thomas E. Brewton is a staff writer for the New Media Alliance, Inc. The New Media Alliance is a non-profit (501c3) national coalition of writers, journalists and grass-roots media outlets.

His weblog is THE VIEW FROM 1776 http://www.thomasbrewton.com/

Feel free to contact him with any comments or questions : EMAIL Thomas E. Brewton