Nov 252013

For those who were surprised by Milton Friedman’s advocacy of Quantitative Easing, here is another extract from his 1999 interview:

I think the Austrian business-cycle theory has done the world a great deal of harm. If you go back to the 1930s, which is the key point, here you had the Austrians sitting in London, Hayek and Lionel Robbins, and saying you just have to let the bottom drop out of the world. You’ve got to let it cure itself. You can’t do anything about it. You will only make it worse. You have Rothbard saying it was a great mistake not to let the whole banking system collapse. I think by encouraging that kind of do-nothing policy both in Britain and in the United States, they did harm.

In his 2012 GWU lectures, Ben Bernanke calls this the liquidationist theory,

which posited that the 1920s had been too good a time: the economy had expanded too fast; there had been too much growth; too much credit had been extended; stock process had gone too high. What you need when you have a period of excess is a period of deflation, a period when the excesses are squeezed out (Lecture 1, at 50:25, or p. 20).

By espousing the theory (named after Treasury Secretary Andrew Mellon’s recipe: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate”), the Fed failed to combat the Great Depression: on the monetary policy front, by raising rather than lowering interest rates, with the aim of preserving the Gold Standard; and on the financial stability front, by letting widespread bank failures.

Clear, conclusive evidence, you would think. But no: come 2008, liquidationists were at it again. Being ‘Austrian’ became a fashionable pose and ‘Purge the system!’ a cool slogan. Here is one of the Austrian champions, Ron Paul, debating Paul Krugman. It is April 2012 – surely enough time to reconsider, you would think. Nope. Krugman tries to put some sense into it, to no avail:

Bayesian updating is a tug of war between confirmative and disconfirmative evidence. The higher the prior, the stronger the evidence required to disconfirm it. But when the prior is so high as to border on Faith, no evidence is strong enough. It is the same with Eugene Fama and the Efficient Market Theory. It is not a healthy attitude. As Keynes did not say: “When the facts change, I change my mind. What do you do sir?”

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