Milton Friedman's Bubbles
Jude Wanniski
September 30, 1998


Memo To:Professor Milton Friedman
From: Jude Wanniski
Re: “Bubble Trouble”

It is my experience in studying economic history that when wise men blame dramatic fluctuations in the stock market on “bubbles” they don’t know what really happened. John Kenneth Galbraith did not know why the stock market crashed in 1929, so he said it was a bubble. In other words, the market free market was irrational. Now I read in National Review that you believe in “bubbles” left, right and center. I’d never before seen you take the position so explicitly that the Wall Street Crash of 1929 was the result of an inefficient market blowing bubbles, but now you have joined Galbraith and the other bubble theorists. You are ascribe the decline of the Japanese stock market in 1990 to the breaking of a bubble, which means to me that you believe the market should not be free to place value on financial assets, because the market is not efficient. It is dumb. You go on, in the NR interview, to insist that the market declines here in the past few months have been the result of rational air coming out of irrational bubbles. Here is how it came across in NR:

NR: Have the recent troubles in the stock markets been noise?
Friedman: I have believed for some time that the stock market was in a bubble, and that bubble just burst. And it’s a good thing to have bubbles burst, because you cannot sustain a bubble indefinitely. And if the bubble goes too far, the bursting has very serious consequences. The best example of that is Japan, where the bubble went too far in the late 1980s, and when it burst in 1990 Japan took action which led to, by now, eight years of seriously depressed conditions.
NR: What accounted for our bubble.
Friedman: A tendency for people to extrapolate the past too far. What accounted for the tulip bubble in the Netherlands some centuries back? What accounted for the Florida land bubble, the Japanese bubble?  Bubbles occur because there is a mass psychology that develops and tends to project what’s going on and thinks it will always continue to go on.
NR: Some commentators say all this might slow the worldwide turn to free markets. Is that a threat?
Friedman: Yes, there’s a real threat, not in the United States but in other countries around the world. What’s happening is not attributable to free markets but in almost all cases to the absence of a free market.

Now, now, professor. In the first instance, you insist that market advances and declines have been the result of irrational behavior -- bubbles forming and bursting. You then insist that if there were a free market, these things would not be happening. If the free market is irrational, it has to be brought to heel. There is no other conclusion if you are interested in protecting the masses of people from the anguish of free markets and its bubbles.

No, sir. With all due respect, there has always been a flaw in your monetarist theory, the same flaw that underlies all the other theories in the consumer-driven demand model. When you could not explain the Crash of 1929 within the monetarist framework, the only way your framework could continue to have value is if the free market broke down because that masses of people who comprise the market became irrational -- and bid equity prices up beyond their “true” value.

The flaw is that you never seem to consider the possibility that markets can rise or fall sharply because of changes of tax or tariff policy, or that our equity market several times in our history may have fallen sharply because of economic contractions in Europe. When you and your students look only at the single variable of "money supply," it is no wonder you can't square abnormal market activity with your two-dimensional monetarist theory. The Crash of 1929 was not due to any mistakes of the Federal Reserve, which comported itself in that period well within the framework of the role it was given in the 1913 Act. Nor could the Fed do anything in 1931-33 to prevent the "Great Contraction" from unfolding, because it was not the result of a monetary scarcity and could not be offset by monetary excess. Banks failed because the country needed far fewer banks and far less money because of the Hoover tariff and tax increases, followed by the Roosevelt tax increases. If there was any error of monetary policy, it was in FDR's decision to devalue the dollar against gold to $35 from $20.67. All that did was raise nominal prices. The Depression continued and got even worse in terms of output and employment.

In other words, your comment in NR that all recessions can be ended by printing money is not correct. Only those caused by a scarcity of money can be alleviated by the printing of money, which is the problem we have in the United States today — as evidenced by the sharp decline in the gold price over the past 20 months. You did, after all, err 25 years ago when you said gold no longer had a monetary function, but had become a commodity no better than "pork bellies." We may have left the gold standard, but the private markets of the world retained it as the best single signal of monetary error — inflation and deflation — by all central banks. We do not need to go back to an old-fashioned gold standard, given the fact that we have a modern banking system that effectively replaces most of the gold functions — including that of a medium of exchange. Alan Greenspan was quite correct in recent congressional testimony when he said we could stimulate the gold standard and thereby make use of its most important remaining attributes.