Milton Friedman: The Great Conservative Partisan
Milton Friedman died on November 16, 2006 at the age of 94. Without doubt, Friedman was one of the most influential (perhaps the most influential) economists of the second half of the twentieth century. Not only did he contribute to reviving belief in the economic efficacy of the market system, he also had a profound political impact by linking capitalism with freedom.
Friedmanâ€™s treatment of capitalism and freedom colored understandings so that many among Americaâ€™s elite now see a simplistic identity between the two. However, the reality is a complicated tango whereby free markets promote certain dimensions of freedom but can also bruise others â€“ including democracy, meritocracy, and equality of opportunity. To paraphrase George Orwell, in market systems we are all free but some are (a lot) freer than others.
In 1976 Friedman was awarded the Nobel Prize in economics for his contributions to scientific economics. These contributions are marked by two characteristics. First, they are imbued with an underlying conservative partisanship characterized by profound animus to government. Second, Friedman achieved public standing through his macroeconomic work, much of which has been discredited. In a sense, Friedman is the economist who lost the battle but ended up winning the war, convincing society to adopt his view of the world.
One of Friedmanâ€™s most widely recognized contributions is monetarism, which recommends that central banks target money supply growth. Monetarism flourished in the late 1960s and 1970s and was briefly adopted by central banks as a policy framework in the late 1970s and early 1980s. That experiment produced devastating interest rate volatility, prompting central banks to revert to their traditional practice of targeting interest rates.
Monetarism was supported by Friedmanâ€™s joint work with Anna Schwartz in which they argued that the Federal Reserve caused the Great Depression through mistaken monetary tightening. This was Friedmanâ€™s first major salvo in his crusade against government, implicitly blaming government for the Depression. Friedmanâ€™s claim has always smacked of the tail wagging the dog since the Fedâ€™s tightening was modest and brief, suggesting an underlying instability of the 1929 economy. The 1929 stock market was characterized by feverish speculation, and the Fed would indeed have done better to provide easy liquidity when investors rushed to exit. However, that also proves the dangerous instability of financial markets and makes the case for an active government regulatory presence, the very opposite of Friedmanâ€™s philosophical perspective.
At the theoretical level, monetarism asserts that central banks control the money supply and should aim for steady money supply growth. Friedman even recommended replacing the Fed with a computer that would mechanically manage the money supply regardless of the economyâ€™s state. Furthermore, he suggested the Fed aim for a zero nominal interest rate. If the equilibrium real interest rate is three percent, that policy implies steady deflation of three percent.
These monetarist propositions reflect a flawed understanding of money. Money is a form of credit - an IOU. If central banks try to control the narrow money supply, the private sector just moves to create other forms of credit. That is why the Fed was unsuccessful in targeting the money supply, and why predicating economic policy on the relationship between the money supply and economic activity is a will oâ€™ the wisp. With regard to deflation, Japanâ€™s recent experience has confirmed the lessons of the Great Depression. In a credit-money economy generalized deflation is catastrophic and should be avoided.
Monetarismâ€™s most famous aphorism is that â€œinflation is always and everywhere a monetary phenomenon.â€ This saying reflects Friedmanâ€™s polemical powers, capturing for monetarists what all sensible economists already knew. Inflation is about rising prices, and prices are intrinsically a monetary phenomenon since they are denominated in money terms.
Sustained inflation requires that the money supply grow in order to finance transacting at higher prices. For Friedman, this made villainous central banks the exclusive cause of inflation because of his belief that they control the money supply. However, the reality is that the private sector can also inflate the money supply through its own credit creation activities. Additionally, central banks (viz. the Bernanke Fed) may be compelled to temporarily accommodate inflationary private sector pressures to avoid triggering costly recessions. The implication is that inflation can have different causes, something Friedman denied. Sometimes inflation is caused by excessively easy monetary policy or large budget deficits financed by central banks. Other times it is due to private sector forces, including speculative booms and conflicts over income distribution.
Monetarism asserts that monetary policy is all-powerful. Subsequently, Friedman changed his view and argued that monetary policy had no long-run real economic impacts. Friedman cleverly termed his later theory the natural rate of unemployment, thereby enlisting nature on his side.
His new theory supported an extreme conservative policy agenda that still lives. According to the theory, the minimum wage increases unemployment by driving up wages, and should therefore be done away with. The same holds for unions. No consideration is given to the possibility that these institutions create an income distribution that promotes mass consumption and full employment. Finally, since central banks supposedly have no long run effect on unemployment and wages, they are not responsible for labor market outcomes. Natural rate theory thereby allows the Fed and European Central Bank to take full employment policy off the table while protecting them from charges that their policies may contribute to wage suppression.
Close inspection reveals natural rate theory to be akin to a religious doctrine. This is because it is not possible to conceive of a test that can falsify the theory. When predictions of the natural rate turn out wrong (as they repeatedly have), proponents just assert that the natural rate has changed. That has led to the most recent incarnation of the theory in which the natural rate is basically the trend rate of unemployment. Whatever trend is observed is natural â€“ case closed.
Since natural rate theory cannot be tested, a sensible thing would be to examine its assumptions for plausibility and reasonableness. However, Friedmanâ€™s early work on economic methodology blocks this route by asserting that realism and plausibility of assumptions have no place in economics. With most economists blindly accepting this position, the result is a church in which entry is conditional on accepting particular assumptions about the working of markets.
The theory of consumption is another area in which Friedman contributed. His permanent income theory of consumption sensibly argues that household consumption and saving decisions are made on the basis of householdsâ€™ assessments of their long term sustainable income, and not just on the basis of todayâ€™s income. However, Friedman also asserted that all households save the same proportion of their sustainable income. This proposition is manifestly false, as shown by the behavior of the super-paid. It also has clear conservative implications. Since all save the same proportion, transferring income from higher paid to lower paid households generates no economic stimulus. Progressive taxes can still be justified on ethical grounds, but not on economic stimulus grounds.
Lastly, Friedman was an early proponent of flexible exchange rates. Whereas the argument that flexible exchange rates facilitate macroeconomic adjustment has worn well, Friedmanâ€™s arguments against the dangers of destabilizing speculation have not. In line with his ideological predisposition for markets and against government intervention, Friedman ruled out destabilizing speculation. His argument was there exists a fundamental equilibrium price, and if prices depart from this speculators see a profit opportunity and drive prices back. However, experience has shown that exchange rates and asset markets are prone to speculative bubbles, and it has been extremely difficult to find a relation between exchange rates and fundamentals â€“ whatever they are.
While such findings do not support fixed exchange rates, they do support a case for sensible exchange rate management by well-informed officials who can do a better job than speculative casino markets. Yet, the triumph of Friedmanâ€™s anti-government economics means that this sensible policy approach has been ignored by U.S. policymakers.
In sum, Milton Friedmanâ€™s political economy helped provide a corrective to the excessive disregard of markets and the price system engendered by the Great Depression, and his advocacy of the power of economic incentives abides. However, Friedman was not a lone defender of markets. Keynes, himself, always held an enormous regard for the market system â€“ what he termed the Manchester System. Leading American and British Keynesians also shared that regard. However, whereas these Keynesian economists understood the limits of the market and the importance of government in making capitalism work for ordinary people, Friedman did not. By all accounts, Milton Friedman was a considerate and compassionate person, and he was a revered teacher. However, his fame rests on his ideas, and those ideas suffer from an excess of conservative partisanship.