How David Slew Goliath

A few weeks ago I attended the annual American Economic Association meetings, where two famous economists were honored: the diminutive Milton Friedman and the tall John Kenneth Galbraith. Both these titans in economics had died in the past year following exceptionally long and influential careers.

Yet there was a stark contrast in the two sessions. The Friedman room was expansive and held more than a thousand enthusiasts, while Galbraith’s session attracted no more than 50 people. Some of the difference can be explained by the fact that the AEA meetings were held in Chicago, where Friedman taught for 30 years, and because two of the speakers were Nobel laureates, Gary Becker and Bob Lucas.

However, there is little doubt that if these two economists were honored 50 years ago at an AEA meeting, their fortunes would have been reversed. In the late 1950s, Friedman was a relatively unknown professor at Chicago who was regarded as a “reactionary” monetarist devoted to extreme laissez faire. Galbraith was hailed as the “progressive” Keynesian from Harvard who eloquently understood “American Capitalism,” and articulated the “countervailing powers” of Big Business, Big Labor, and Big Government. In 1958, his bestseller, “The Affluent Society,” made a convincing case for redistributing wealth and progressive taxation as the only legitimate solution to the widening gap between “private opulence” and “public squalor.” Galbraith went on to become a member of the “new economics” team of the Kennedy Administration and ambassador to India. In 1967, Galbraith completed his trilogy with “The New Industrial State” at time when America’s financial institutions were flexing their muscles around the globe. Galbraith reflected this hubris: The “technostructure” of big business could control markets and manipulate consumers through planning and advertising, and was no longer beholden to shareholders, consumer sovereignty, or supply and demand. The Sixties were the high tide of Keynesian economics and fine-tuning the economy.

But a series of unpredicted crisis and trends in the late 1960s and early 1970s opened the door for Milton Friedman and the growing band of free-market economists. The West suffered a sharp rise in inflation and economic crises, and American manufacturing lost its dominance in the world economy. It was time for a counter-revolution to the Keynesian-Galbraithian monolith.

At Chicago Friedman’s rigorous analysis of the business cycle and free-market solutions started paying dividends. His mammoth “Monetary History of the United States,” published in 1963 and co-authored with Anna J. Schwartz, gradually convinced the economics profession that the Great Depression was not a result of “bad” distribution of income, “bad” corporate structure, and a “bad” banking system, as emphasized by Galbraith in his book “The Great Crash,” but largely because of “bad” government policy by the Federal Reserve, which allowed the money supply to collapse by more than one third. Friedman’s achievement was a triumph of empirical economics that Galbraith could never match.

Friedman and other market economists also countered Galbraith’s “social imbalance” thesis in “The Affluent Society.” The Keynesian “tax and spend” solution had failed miserably to redress the gap between private affluence and public poverty because government often lacks the market incentives to cut costs and meet the needs of its customers, the taxpayers, in an efficient way. In his 1962 book, “Capitalism and Freedom,” Friedman argued that the solution to this social dilemma was to expand the market (supply side economics) and apply market principles to public enterprise where feasible. This led to the privatization movement around the world, where country after country systematically denationalized, deregulated, and privatized public enterprises and services, especially after the collapse of the Soviet centralized planning model in the early 1990s.

Unfortunately, Galbraith seemed to be oblivious to these dramatic changes. In the 40th anniversary edition of “The Affluent Society,” Galbraith had a chance to revise his thesis in light of the worldwide movement toward freer markets. Yet the privatization solution completely eluded Galbraith’s mind. He chose not to even mention it.

In sum, one gets the impression that Friedman and other the free-market schools are today’s “progressives,” offer new bold solutions to public issues in education, welfare, and fiscal policy, while Galbraith and the old-style Keynesians are the “reactionaries,” unwilling to entertain the new market solutions to public problems. Over the past 30 years, Friedman’s star has risen while Galbraith’s has fallen. Well did George Stigler conclude, “All great economists are tall. There are two exceptions: John Kenneth Galbraith and Milton Friedman.”


Mark Skousen
for The Daily Reckoning
January 30, 2007

Editor’s Note: Dr. Mark Skousen is is a professional economist, financial advisor, university professor and author of more than 20 books. Dr. Skousen has taught economics and finance at Columbia Business School, Barnard College at Columbia University and Rollins College in Winter Park, Florida. He has appeared on ABC News, CNBC Power Lunch, CNN, Fox News, and C-SPAN Book TV.

He is the author of the new book, “The Big Three in Economics: Adam Smith, Karl Marx, and John Maynard Keynes” (M. E. Sharpe Publishers, 2007). To purchase your copy, see here:

The Big Three in Economics

Rerun the tape!

No, we’re not talking about the War in Iraq; we know how that show goes.

We’re talking about the financial show. Each new twist is just a bit more absurd than the one that went before.

The plot, as we recall it, runs like this: The tech bubble blows up…the economy and the stock market tank; 9/11 comes along…the feds panic; the Bush Administration takes a modest, fraudulent surplus…and turns it into a massive budget deficit; taxes are cut…spending increases. In the span of 18 months, a total of about $1.5 trillion is added to the economy.

Desperately worried that it has a Japan-like deflationary slump coming up (a fear to which we happily contributed, albeit in a small way, in our first book, “Financial Reckoning Day”) the Federal Reserve swings into action, too. It is the Ides of March every day at the Fed. Slash; cut…rates go down to a nominal 1% – or about 2% below the rate of consumer price inflation.

Then, three years later, while rates are being ‘normalized’, the Fed continues to worry…this time about a slump in residential housing. Even though rates are increased, the Fed boosts liquidity by allowing the money supply to expand at a 10% rate – about three times faster than GDP growth. And Adrian Van Eck estimates that another $1 trillion of new money will be added to M3 in 2007.

This tide of liquidity, by the way, doesn’t stop at the U.S. border. Instead, it washes all over the world. Foreign countries need to keep their own currencies from rising against the dollar; they, too, find they have to turn on the taps just to stay even. In Europe, for example, M3 is now rising at 9.7% per year – about the same as the United States – its fastest rate in 17 years.

Where is all this new money going? Into consumer prices? Nope…not yet.

Banks, investment companies, and large speculators control the flow of this new loot. It never reaches the working man, except in the form of additional debt. So, it does not seem to lift prices of Huggies and cola. Instead, it floats up the prices of financial assets. Art…derivatives…swaps…you name it.

As things rise in price, the intermediaries are able to get even more leverage out of them. Trade ’em, refinance ’em, repackage ’em, sell ’em, restructure ’em, hedge ’em; the whole economy has become a dervish – with each whirling, swirling, twirling financial instrument throwing off fees, commissions, and spreads for the shrewd operators who manipulate ’em.

It’s almost too much for us to keep up with.

The head of the European Central Bank elaborates.

“There is now such creativity of new and very sophisticated financial instruments…that we don’t know fully where the risks are located,” said Jean Claude Trichet. “We are trying to understand what is going on – but it is a big, big challenge.”

Mr. Trichet was speaking to the illustrious group gathered in Davos, Switzerland. The Financial Times describes the debate in which he played a role:

“Many investment bankers and some regulators and economists argued at last week’s World Economic Forum in Davos that the growth of the $450,000 billion…derivatives sector had helped reduce market volatility and made the system more resilient to shocks by spreading credit risk. But other officials fear these instruments may be raising leverage and risk-taking to dangerous levels and keeping the cost of borrowing artificially low, potentially increasing the chance of financial crises.”

More news:


Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis…

“Gold has really been on a strange trading trip, given that the dollar had held the hammer, and oil prices were falling. Now, oil prices are recovering. Let’s hope this lights a fire under gold to move it even higher, eh?”

For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig


And more views:

*** Here at the Daily Reckoning we have our opinion: The more a financial innovation proves successful, the more successful investors will find ways to make it fatal.

Norman Angell’s book, published at the beginning of the 20th century, argued persuasively that new innovations in politics and markets of the period made war unthinkable. People stopped thinking about it. They stopped worrying. They stopped taking precautions. Never had people been more optimistic and more complacent than they were – right up until WWI began in August of 1914. Then, all the innovations that so delighted Angell – industrialization, technological improvements, nationalization – became the exact same innovations that made it the bloodiest and most expensive war in history.

Coincidentally, that was also when U.S. property prices reached their last epic high. In real terms, they went down in WWI and kept going down for 70 years or more. Only in the last 10 years have they gone back up – returning to their 1914 high only in 2005.

And now, a whole new round of innovations are supposed to make market crashes and depressions obsolete. Perhaps it is true. But we wouldn’t bet on it.

The credit bubble has now been expanding at an extraordinary rate for so long that people have begun to take it for granted. But residential property in the United States is taking a breather, maybe even going down a little. U.S. stocks are taking it easy – flat since the beginning of the year. Oil seems stable around $55. Gold is marking time at $640. Bond yields have been rising for the last two months. Where’s all the money going? Or is this great liquidity bubble finally beginning to lose air?

If not yet…when? We wish we knew. Mr. Trichet warns that investors should prepare for a ‘repricing’ of financial assets. We doubt he knows any more than we do…but we don’t doubt he is right.

*** Our buddy James Kunstler weighs in on last week’s state of the union:

“It was a speech that any county planning board chairman might have made, which is to say a lame defense of the status quo. Missing is the comprehension of a crisis that is gathering like a hurricane unseen from the shore but visible to anyone with rudimentary radar. This president will use every last corn kernel and every last wood chip to keep 260 million cars and trucks running. Better prepare to cut down on the Cheez Doodles, America. He wants to reduce gasoline usage by 20 percent over the next ten years.

“Guess what: circumstances will probably do that for us involuntarily, because the sheer amount of petroleum available to the United States is certain to decline substantially by then, whether we like it or not. Real leadership would recognize this and propose making other arrangements, like getting the trains running again or ending incentives for suburban sprawl. A big tax deduction on health insurance would work for me, but what about the millions struggling to get by on Wal-Mart global-labor-arbitrage wages with no health insurance benefits? They’re just f#%*@*.”

*** “Number of vacant homes for sale surges 34%,” says a headline.

“We gave up,” reports a friend from Florida. “We had our house on the market. We tried to sell it ourselves. Then, we put it with a realtor. But there were nearly a dozen other places for sale on the same block. Almost all of them were empty. We just figured that this was not the time to sell. So we put our house up for rent. It’s not ideal, because now we have to manage rental property, which we don’t want to do. But it’s better than losing money. Of course, right now…it’s still empty. We haven’t found a renter yet.”

Many homeowners have already lost money; they just don’t know or don’t want to admit it. They presume that by taking a property off the market, they are avoiding a loss.

‘Cut your losses,’ is an old-time rule in the stock market. You thought a stock would go up…and it didn’t. This tells you that you’re wrong. You should realize that you don’t know what you’re doing; sell the position, and ‘let your winnings run.’

But the idea of ever-rising house prices is so deeply rooted that people cannot believe they’ve made a mistake. They cannot believe that their theory is wrong. They cannot believe that there is something going on which they just don’t understand. Instead, they merely assume that their timing was off.

“I was a little late,” they say.

And they think that if they hold onto the position, the time will come when it will be a good investment again.

Yet, if it is true that housing follows very long patterns – with a cycle as long as 120 years – they might wait a long, long time before they get their money back.

The Daily Reckoning