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“The Federal Reserve definitely caused the Great Depression by contracting the amount of money in circulation by one-third from 1929 to 1933.” — Milton Friedman, Nobel Prize winning economist, January 1996 in a National Public Radio interview

“…One unsolved economic problem of the day is how to get rid of the Federal Reserve…”

– Milton Friedman

Region: In a Region interview with your friend and former colleague George Stigler, we posed a question about the quality of the Fed’s economic research efforts. Stigler said, “I don’t feel very confident commenting about that. I’ve been told by Milton Friedman that one of the perversities of history is that when the quality of the Washington staff is high, policy is pretty poor, and in the years when policy has been very good, the staff has been low quality. Now if you want to explore that, you’ll have to interview him.” Did George Stigler understand you correctly?

Friedman: I probably said some such thing in my discussions with George, but I’ve not made a systematic study. I believe that it was based on one major phenomenon that stuck in my mind. In my special field of interest of money, there is no doubt that a large fraction of all of the economists who work more or less full time on monetary research are employed by the Federal Reserve. Many of them have made important contributions to monetary analysis and theory going back to the 1920s, when Winfield Reiffler, Walter Stewart and Emmanuel Goldenweiser were all contributing to understanding monetary institutions. I have no doubt that the Federal Reserve has made a positive contribution to monetary research, which I suppose I ought to set off on the account as a credit against a terribly poor policy performance. If I were to make up a balance sheet for the Federal Reserve, I could name many credit items on the research side, very few on the policy side.

The interesting thing to me has always been that the most important contributions to understanding of monetary theory and monetary institutions have not come from Washington during the decades in which I’ve been active. The Federal Reserve Bank of St. Louis in the 1950s, ’60s and ’70s was by far and away the pre-eminent producer of significant monetary research within the System. More recently, several other regional banks, including your own, have joined them and have made important contributions. Certainly the Minneapolis bank, with the contribution of its personnel to the development of rational expectations, has been an important contributor to monetary theory. All of the regional banks publish bulletins—required by law I guess. Some hardly ever publish material of general interest to students of monetary theory and policy, but most do, even if only occasionally. It would be invidious for me to mention names without a more careful study—though offhand, I can recollect such articles in the bulletins of four regional banks other than St. Louis and Minneapolis.

Region: In your early writings, you argued that deposit insurance was a worthwhile development. Here at the Minneapolis Federal Reserve we’ve taken the position that deposit insurance, now at virtually 100 percent, has a perverse effect and should be reformed in a way that would bring more market discipline. Where do you stand on the question of deposit insurance?

Friedman: Circumstances alter cases and I believe that both views are correct. Anna Schwartz and I in our Monetary History were discussing the situation after the financial collapse of the 1930s. We said then and believed then, and I still do, that the Federal Reserve had failed to do what it was originally set up to do. It had permitted a collapse of the monetary system, it had permitted perfectly sound banks to fail by the thousands because of liquidity problems, although it had been set up in 1913 with the objective of preventing that kind of a situation. And we argued in the book that since the Fed had failed and showed no sign that it was not going to continue to fail in pursuing its function, something else was needed to perform the function for which it had originally been established and that the Federal Deposit Insurance Corporation would serve that function. Interestingly enough, it did for some 40 years. From 1934 to the early ’70s, there were very few bank failures. And there were essentially no runs on banks because of liquidity problems. So it did serve a useful function for 40 years.

In my opinion, what destroyed the usefulness of deposit insurance was the inflation of the 1970s for which the Federal Reserve has to bear major responsibility. That inflation had the effect of destroying the net worth of financial enterprises, particularly the savings and loan institutions, which were borrowing short and lending long. They had mortgages and the like outstanding at fixed relatively low rates of interest. When the cumulative inflation of the 1970s inevitably led to a rise in the interest rates they had to pay, the result was to wipe out the net worth of the proprietors of those enterprises. Once the net worth of the enterprises was destroyed, deposit insurance did have a very perverse influence. In order for deposit insurance to work, there has to be some private personal incentive for safe banking. That incentive was provided by the net worth of the proprietors of financial institutions. Eliminate that net worth and deposit insurance created a win-win position for proprietors of those enterprises to engage in risky activities.

Region: In your new book, Money Mischief, you discuss monetary union. What are your thoughts on Europe’s plan for one currency?

Friedman: I believe it will not come to an achievement in my lifetime. It may in yours, but I’m not sure that’s true either.

Region: Why is that?

Friedman: Because I do not believe that at the moment, a single European currency is either feasible or desirable. Let me restate that. It would be highly desirable if Europe could have a common money, a single unified money, just as it’s desirable for the United States that we have a single unified currency. But in order for that to be possible or desirable, you have to have a unified currency over an area in which people and goods move relatively freely, and in which there is enough homogeneity of interest so that severe political strains are not raised by divergent developments in different parts of the area.

Let me illustrate. In the United States, right now you have much more severe economic problems in New England, in the Northeast in general, than you have elsewhere. If the Northeast were a separate country with a different language from the rest of the country, with a supposedly national government, it would be very tempted to resort to devaluation. What prevents it from doing that now is that we are a nation with one language, one political structure, a recognition that one region or another may have difficulties relative to other regions. Some years ago it was the South that had this problem.

Now come to Europe. Will there be as much tolerance for that kind of an adjustment as between France, on the one hand let’s say, Germany, Italy, Spain, Sweden, and so forth? I’m very dubious that those preconditions for a successful unified currency exist on the European continent. That’s looking at the ultimate.

Now consider the process you have to go through to get to a unified currency. In order to have a truly unified currency, not a collection of separate national currencies joined by temporarily fixed exchange rates like the European Monetary System or the International Monetary Fund was in its earlier days - in order to have a truly unified currency, you either need to have no central bank, as with a commodity currency like a gold standard for example, or you need to have at most one true central bank: one authority that can issue money. In the United States that authority is the Federal Open Market Committee of the Federal Reserve System. It’s one. The Federal Reserve Bank of Minneapolis issues currency notes on which the bank’s name appears, but you can’t decide how much to issue. That decision is made in Washington by the Federal Open Market Committee.

In order to have a comparable situation in Europe, you have to eliminate the Bank of France, the Bank of Italy, the Deutsche Bundesbank, the Bank of England and so forth. You have to have one true central bank with full authority. The plans that are being made call for such a central bank, but it’s a long cry from calling for it and having it. After all, the Treaty of Rome, which I believe was signed in 1957, called for eliminating all customs and tariff barriers among the Common Market nations. They still have not all been eliminated some 35 years later. So to call for something is one thing, to do it is a very different thing. And even the central bank that’s called for is going to be run by essentially a committee of representatives from France, from Germany, from England, and so on. I cannot see that kind of institution as having the same ability to withstand political pressures internally in these various areas that the Federal Reserve’s Federal Open Market Committee has.

Region: The New School of Classical Economics (among others, Sargent, Wallace, Prescott, Lucas) argues that the best way to study economics is within the general equilibrium models. They stress the importance of the institution’s arrangements: the rules of the game. What is your view on this approach?

Friedman: I believe that the approach has much to offer us, but I also believe that its proponents, like all proponents of fresh approaches, tend to carry a good thing too far. I would say it has had too much influence up to date. It has made a real contribution, but it is by no means the only, or necessarily even the most useful, approach.

Region: If you were advising the Federal Reserve, what would you say are the unsolved economic problems of the day?

Friedman: One unsolved economic problem of the day is how to get rid of the Federal Reserve.