AGE OF ANTI-FRIEDMAN
Does the free market have a death wish?

�Laissez-faire capitalism failed us. ... We need a more active and intelligent government to keep our model of a capitalist economy from running off the rails.�
�Richard Posner, A Failure of Capitalism (2009)

The return of depression economics has brought back the old Keynesian (and Marxist) canard that laissez-faire capitalism in inherently unstable, that markets suffer from some sort of neurosis that leads inevitably to irrational behavior and self-destruction. How else to explain why the entire private banking system suddenly collapsed into insolvency in late 2008 and required massive federal intervention?

Keynes warned that the invisible hand of the market is far from benign, and the Great Depression proved that capitalism could be engulfed in a �chronic condition of sub-normal activity� for years. Nobel laureate Paul Samuelson best summarized the Keynesian view, known as the financial instability hypothesis, that the market is crisis-prone and has no �automatic mechanism� to achieve sustainable growth and full employment. 

For Samuelson and other Keynesians, the market economy is great in delivering the goods in the long run, but in the short run, it is full of wild uncertainty and �animal spirits� (Keynes� term). According to Samuelson, capitalism is like a car that occasionally runs recklessly at high unsustainable speeds and other times runs off the road and crashes. �The private economy is not unlike a machine without an effective steering wheel or governor.� Who can provide this governor? The federal government. The consensus view is that World War II and massive deficit spending got us out of the Depression, and saved capitalism from itself. 

Chicago economist Milton Friedman countered the conventional wisdom by demonstrating with meticulous research that the federal government was itself a destabilizing influence. The Federal Reserve, in particular, turned the 1929 stock market crash into a full-blown depression by acting �ineptly� and refusing to act as a lender of last resort (allowing the money supply to fall by a third). As he concluded in Capitalism and Freedom (1962), �The fact is that the Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy.� 

The Age of Friedman, as Harvard economist Andrei Shleifer calls it, ushered in an age of supply-side economics (tax cuts, deregulation, anti-inflation, less government) that began with Thatcher and Reagan and continued through the Clinton era and into the beginning of the 21st century. As Professor Shleifer concludes, �In the Age of Milton Friedman (1980-2005), the world economy expanded greatly, the quality of life improved sharply for billions of people, and dire poverty was substantially scaled back. All this while the world embraced free-market reforms.� 

But it was too good to last. The financial crisis hit from 2007 to �09, and suddenly the Keynesians and Marxists were quick to place blame: The financial capitalists did it to themselves. They ran the economic car off the road again. As George Akerlof (Berkeley) and Robert Shiller (Yale) declare in Animal Spirits, �Without intervention by the government, the economy will suffer massive swings in employment. And financial markets will, from time to time, fall into chaos.�

It is now the Age of Anti-Friedman. 

Such an interpretation to be expected from modern-day Keynesians and Marxists. But when a highly respected Chicago economist, Richard A. Posner, takes this tact, I take notice. Posner is a doyen of the market-oriented law-and-economics movement, a federal appellate judge and University of Chicago law professor who learned his economics at the feet of Milton Friedman and George Stigler. 

Yet Judge Posner has apparently switched sides in his new book, A Failure of Capitalism. He declares, �Some conservatives believe that the depression is the result of unwise government policies. I believe it is a market failure.� Somehow he�s convinced that �laissez-faire capitalism� brought about the financial crisis of 2008, such as Citibank�s adoption of excessive leverage. He even goes so far to blame bad government policies, such as the Fed�s notorious easy credit in 2003, on the free market because �conservative� officials were in charge of the Fed and promoted an ideology of deregulation and less government involvement. 

Moreover, he adopts a Keynesian interpretation of the Great Depression in the United States, Germany and Japan in the 1930s � military expenditures through deficit spending got them out of the Great Depression. He ignores monetary policy and makes virtually no reference to Milton Friedman, who is not even cited in the back of the book as a recommended author. But Keynes, Krugman and Shiller are. 

Judge Posner makes a fleeting reference to the Austrian school, but apparently he is unaware that the Austrian economists (Ludwig von Mises, Friedrich Hayek and Murray Rothbard) and their followers who have repeatedly warned that the government�s easy-money policies and unsound banking regulations create an unsustainable boom in capitalism that inevitably leads to a catastrophe and depression.

Judge Posner�s solutions are equally perverse: raising taxes on the wealthy (�we are an undertaxed nation� � oh, please), capping executive pay, and regulating credit-card use. President Obama would be pleased. 

The problem with Posner�s thesis is that the federal government may have once again been the one that steered the capitalist economy off the cliff. As in the Great Depression, there is plenty of evidence that the government acted perversely prior to the financial chaos of 2008 � in housing policy (Community Reinvestment Act, Freddie and Fannie Mae), accounting rules (market-to-market) and monetary policy (easy money). Judge Posner addresses these concerns, but remains unconvinced that such actions could lead to outright insolvency. 

So capitalism takes the fall. Yes, admittedly, business entrepreneurs and Wall Street came up with creative investment strategies and new tools of risk avoidance and leverage (such as mortgage securitization, collateralized debt obligations and credit default swaps) during the boom years, but the important question is this: What made the market go crazy beyond the normal fluctuations and standard models of microeconomic creative destruction? What causes a �cluster of business errors� all at the same time? The Austrian school offers one answer: Only bad policy can cause systematically bad business decisions. Only government intervention has the clout to create an unsustainable boom on a scale that inevitably leads to a macroeconomic disaster and Great Depression. 

Who is right? The best way to find out is to use a technique long advocated by the economics profession: test the hypotheses with the evidence from history. I propose this challenge to Judge Posner and all Keynesians: show me a case study of an economic crisis in free-enterprise capitalism where government policy was relatively stable and benign, and I�ll accept the financial instability hypothesis. As far as I�m aware, in every case of economic catastrophe, government was a principal suspect. The crises of 1837, 1873, 1893, 1929, 1973 and 2008, just to name a few, all involved perverse government policies.