After World War II, laissez-faire economists had a big intellectual
problem: the Great Depression. How could you argue for dismantling the post-WW
II social insurance states and returning to the small-government laissez-faire
of the past when that past contained the Great Depression? Some argued that the
real problem was that the laissez of the past had not been faire enough: that
everyone since Lord Salisbury and William McKinley had been too pinko and too
interventionist, and thus the Great Depression was in no way the fault of
believers in the free-market economy. This was not terribly convincing. So
advocates of a smaller government sector needed another, more convincing
It was provided by Milton Friedman.
Friedman proposed that with one minor, technocratic adjustment a largely
unregulated free-market would work just fine. That adjustment? The government
had to control the "money supply" and keep it growing at a steady, constant
rate--no matter what. Since money was what people used to pay for their
spending, a smoothly-growing money supply meant a smoothly-growing flow of
spending and, hence, no depressions, Great or otherwise. In Friedman's
Bradford de Long goes on to argue that Friedman's solution which depended on his assumptions that
1) a non-political central bank (i.e. the Fed Reserve) could assuring a smoothly growing money supply and
2) a tightly regulated banking industry
would avoid a depression 'Great or otherwise' this continuing the operation of a laissez faire like economy, has failed.
But look, Friedman's philosoohy wasn't exactly carried out the letter was it? It was the deregulation of the banking industry that caused the credit crisis in the first place. Banks gave out cheap loans which had short term low interest rates, and people simply used the option of refinance to renew their housing loans and got continous lower rates indefinitely. Banks sold the American Dream of owning a house on the cheap, and people bought homes way above their income levels just cos they could.
The banks then took these loans, repackaged them into securities and sold them to investment banks and other bodies willing to make a quick buck, who insured against the possibilities of the investments backfiring with the likes of AIG. Who were of course more than willing to extend the insurance due to the excellent ratings given for these securities from the likes of the S&P, Moody's, Fitch etc.
But fairy tales dont last long and pretty soon, the bottom dropped out of the houseing markets. Cos bubbles just dont keep growing. And that triggered the whole finacial tsunami that almost cripple the world economy and the ripples of which we feel all the way here on the coast of Sri Lanka.
But the deregulation of the banks aside, Friedman's idea of a non-political and independent Central Bank hasn't really helped proceedings. And just like the Great Depression, the Fed could be again posthumously accused of worsening the effect of this crisis which we are facing right now through its inability to ease up on monetary policy when the housing bubble was on its way to bursting.
Also, the Fed Reserve, effectively being the controller of the largest economy of the world, being essentiall a non political organization and therefore liable to more bias and adverse interests, is a bloody scary prospect.