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October 21, 2010

Lessons from Milton Friedman: The Failure of the Federal Reserve

In these troubling economic times, established economic principles always have insight into the problems we have and the possible solutions. Milton Friedman discovered that the during the Great Depression the Federal Reserve sat idly by while banks failed one after another. He believed that the banking system could have been aided had the Fed come in and purchased long term Treasury bonds, thus providing the banking system with the liquidity it needed.

Today, this theory is commonly accepted by many economists, including (for the most part) the Federal Reserve chairman. So how could this lead to another failure?

Just as the Federal Reserve could fail by not doing enough, the Fed is currently failing us by doing too much. To date, the Fed has provided $2 trillion in aid by buying a combination of toxic assets and Treasury bonds from the banking system in exchange for cash (liquidity). Unfortunately, this has not sparked increased credit as the consumer is still foreclosing on their homes and deleveraging.

What this has done is pushed $2 trillion of cash into the market, and it has failed to focus on the problem, which is debt.

The Federal Reserve's carpet bombing technique is overlooking the focused areas of our economy that nearly brought the system down. Foreclosures are still high and may continue to rise. There's further evidence that some people are pushing away from the mortgages, but still spending on consumer items. Unemployment is increasing and employers are reluctant to create jobs. Finally, consumers and businesses have too much debt on their balance sheets and they are not making creative efforts to write their debts down (not to mention our federal government).

Instead of printing money, the Federal Reserve should focus strictly on debt reduction. Creative measures need to be developed to allow the system to deleverage and write down principle from debt. Bankruptcies need to be sped up so companies can shed debt quickly (or liquidate) and get back to operating.

I believe the monetary lesson from this recession will be you can ignore the problem (Great Depression) or overlook it. Let's hope the Federal Reserve gets its focus soon.

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