Financial Crises: a Friedman-inspired solution

Guest Post by Robert Leeson (contact: rleeson at

Relentlessly printing and spending money may, with time, realign the self-interest of financial intermediaries with the social objective of lubricating our economic system. But by then we will be dancing with other demons: accelerating inflation and ballooning deficits. We must, therefore, attack financial instability at source by increasing the incentive to save and securing the channels by which savings are transformed into capital.

Milton Friedman’s correspondence (which I am currently editing for publication) contains numerous references to the benefits of a consumed income tax relative to the existing tax on income. Friedman also favored restricting banks to deposit taking (and obliging banks to hold 100 percent of those deposits in liquid assets).

Combining these two proposals produces a variety of structural reform possibilities – all of which would disburden capitalism of many finance-induced crises.

Currently, the Federal Reserve influences interest rates (and thus, they hope, the economy) by buying and selling financial instruments (usually Treasury securities). The Fed could also create and sell new savings-into-capital instruments to initiate an investment-led recovery.

A pre-tax savings vehicle could add to our capital stock on a dollar-for-dollar basis. These pre-tax dollars could be deposited with the Fed both through the withholding tax system and through supplementary contributions. These deposits should be inflation-protected and accessible to the saver at any time as income (minus provisional tax, which could be a declining function of the length of the deposit, tailing off to zero at, say, age 65).

If the average contributor saved 20 cents of income tax on every dollar deposited with the Fed, and the total tax cost was 2 percent of national income (the size of the proposed stimulus package) this would produce a capital fund of 10 percent of national income (a five-fold bang per buck).

The Fed could then auction these funds directly to financial intermediaries on a contractual sector-specific basis (every dollar borrowed must either be lent to the designated sector, or returned). The Fed could also invite auction applications from companies seeking investment funds directly – again on a contractual basis (every dollar borrowed must be spent on the nominated investment project, or returned).

Financial intermediaries are currently regulated and so the additional monitoring cost would be small. Auction applications from companies seeking direct investment funds should be approved and audited by an independent regulatory body (a relatively minor additional cost). Individual projects must be funded transparently free from political or lobbying pressure, although the proportion of funds allocated to specific categories (infrastructure, residential home ownership etc) could be determined either by the Fed or by Congress.

The spread between the cost of these funds (the inflation rate) and the return (the interest rate charged) would generate a surplus which could either fund future investment projects or partly offset the initial tax cost of the savings vehicle.

When the current crisis ends and the negative externalities (spill over costs) imposed by the financial sector subsides, we can choose between two budget-balancing alternatives. First, we could pay for the pre-tax savings by increasing the tax on consumption (sales taxes). Alternatively, we could design an expenditure tax to replace (or supplement) all existing taxes (except “sin” taxes on tobacco, gambling, alcohol, petrol etc).

Under a consumed income system, provisional tax would continue to be levied, but tax returns would consist of two items (income and Fed deposits) with the difference between the two (expenditure) as the taxable residual. The tax rate should probably be progressive: spending, say, $20,000 per year would attract no tax, whilst spending above, say, $150,000 a year, would be taxed at the highest marginal rate.

In addition to replacing complexity with simplicity, such a system serves two masters: balancing the budget and increasing national savings (a consumed income tax should be revenue-neutral with respect to the taxes it replaces). The increase in national savings should increase capital per worker, boost productivity and wages, thus allowing both savings and consumption to rise (a virtuous rather than a vicious spiral).

The Fed would also acquire an addition policy lever. In any funding round, if the demand for these deposits outstripped the supply, and a further investment stimulus was deemed to be appropriate, other financial instruments (such as Treasury bonds) could be sold to finance the shortfall. Likewise, variations in marginal tax rates could increase the price of current relative to future consumption and thus provide an incentive to increase deposits. Alternatively, if no further stimulus was deemed appropriate, only those brokers or companies offering to pay a higher interest rate would be funded (which should generate a larger surplus).

There are no perfect economic systems and the business cycle cannot be completely eliminated. We must also think carefully about the tax treatment offered to existing assets that are sold and deposited with the Fed. But we can definitely supplement a crisis-inducing financial system with an uninterruptible flow between savings and capital. In the process, all “systemic” institutions (those whose failure would threaten the stability of our financial system) would be effectively relocated into the non-systemic category.

Ironically, under capitalism, labor has increasingly escaped exploitation (slavery, child labor, unsafe working conditions etc), but capital and credit can still be crunched by intermediaries. Increased regulation will change the products but not the incentives of the regulation-avoidance industry; and no doubt, post-tax dollars will continue to feed that sector. But our economic system would be more stable if we can design vehicles that directly channel savings into socially productive capital and thus bypass the tangled intermediation web.


Robert Leeson is a visiting fellow at the Hoover Institution and adjunct professor of economics at Notre Dame Australia Universities. He is the co-editor (with Charles Palm) of The Collected Writings of Milton Friedman (Palgrave Macmillan, forthcoming).

1 thought on “Financial Crises: a Friedman-inspired solution”

  1. I look forward to further insights into Prof Friedman’s inner reasonings. I heard him speak in person once, circa 1981, and he was adamant that economic freedom was an absolute pre-condition for political freedom. He also said that the Fed should be abolished and “replaced with a computer.” And he wanted to reduce most regulation to maintaining rules that enabled fair settlement of private contracts. He had a greater knowledge of contract law than the average economics professor.

    There would be intense interest in the release. Perhaps, it could be expedited by seeking out Foundation – many choices – assistance. You would be surprised what the work of a database researcher could provide.

    Good luck in the project.

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