3.3. Money Matters
Friedman’s interest in the role of money in the macro-economy was first sparked in 1948 when Arthur Burns at the NBER asked him to research the role of money in the business cycle. Thus began a thirty-year program of research with Anna Schwartz that would demonstrate that money matters — indeed that it matters a great deal — and that would further erode the perceived empirical importance of the Keynesian model.
By 1948, Keynesian economic theory ruled triumphant throughout the academies of the Western World. The classical quantity theory for the most part had been eliminated from textbook economics; and where it was mentioned it was treated as a curiosum. The conventional view throughout the economics profession was that money did not matter much, if at all. What really mattered was autonomous spending, notably in the form of private investment and government outlays. Fiscal policy was crucial; monetary policy was all but irrelevant in the sense that ‘you cannot push on a string.’
Only the University of Chicago, through the teachings of Henry Simons, Lloyd Mints, Frank Knight and Jacob Viner, had stood at all resolutely against this pervasive doctrine during the late 1930s and 1940s as Keynesian doctrine swept through the academy. Friedman was well-versed in the subtle version of the quantity theory expounded at Chicago, a version in which the quantity theory was connected and integrated with general price theory and became ‘a flexible and sensitive tool for interpreting movements in aggregate economic activity and for developing relevant policy prescriptions’ (Friedman, 1956, 3).
Systematically, over the period 1950-80, Friedman and his research associates would challenge the empirical relevance of the Keynesian model by demonstrating the empirical superiority of the quantity theory as expounded at Chicago. By the time that his research program was complete, and prior to the rational expectations revolution, almost all economists would recognize that money did matter, that what happened to the quantity of money had important effects on economic activity in the short run and on the price level in the long run (Friedman and Friedman, 1998, 228).
Before Keynes, the quantity theory of money had played an important role in classical economics. Using the behavioral equation MV = PY, classical theorists had argued that the income velocity of circulation of money, V, was a constant; that real income, Y, was unaffected by changes in the quantity of money (the so-called classical dichotomy); and therefore that changes in the supply of money, M, directly affected the price level, P. Keynes (1936) derided this naive textbook version of the quantity theory, arguing instead that V was not a constant but was highly variable and that it served as a cushion to prevent any change in the supply of money from exerting an impact on either real income or the level of prices.
In conjunction with his work at the NBER, Friedman established a Workshop in Money and Banking at the University of Chicago. The first product of this Workshop was a book: Studies in the Quantity Theory of Money (1956) which Friedman edited. In retrospect, this publication was the first major step in a counter-revolution that succeeded in restoring the quantity theory to academic respectability. There is no evidence that Friedman was aware at that time of the dimensions of the impending battle. His express intent in writing the introductory essay was simply to "set down a particular ‘model’ of a quantity theory in an attempt to convey the flavor of the (Chicago) oral tradition" (Friedman, 1956, 4). Of course, the impact of his essay would be much more dramatic than he and his colleagues at that time could possibly foresee.
Friedman’s introductory essay provided a subtle and sophisticated restatement of the quantity theory of money as a stable money-demand function (Breit and Ransom, 1998, 228). Unlike the classical economists, Friedman rejected the notion that V, the income velocity of circulation of money, was a constant. Instead, he modeled V as a stable function of several variables, since money was an asset, one way of holding wealth. Within this framework, he posited that V would respond to nominal monetary expansion in the short run by accentuating rather than by cushioning the impact of such expansion on nominal income. This restatement became recognized as the theoretical position of the Chicago School on monetary economics.
The four empirical studies in the book — dealing with inflationary and hyperinflationary experiences in Europe and the United States — provided support for the quantity theory in its restated form by demonstrating a striking regularity in economic responses to monetary changes. The most significant finding was that velocity was a stable function of permanent income. Since money is a luxury good, the demand for which rises as income increases, velocity would tend to decline over time as income rose. The monetary authority therefore must increase the stock of money to offset this decline in velocity, if it wished to maintain price stability (Breit and Ransom, 1998, 230).
These results met with skepticism from Keynesian economists who counter-claimed that the supply of money merely accommodated demand and did not impact independently on the macro-economy. It would take Friedman and his colleagues the better part of a decade of high-quality theoretical and empirical analysis to mount a persuasive case for the quantity theory.
One important component of this research program was the comparative test (Friedman and Meiselman, 1963) in which a simple version of the income-expenditure theory, C = a + kA was compared with a simple version of the quantity theory, C = b + vM. For the period 1897 to 1958, using annual data, and for a shorter period using quarterly data, the quantity theory performed better than the income-expenditure theory, implying that v was more stable than k, except for the period of the Great Depression.
More influential, ultimately, was the monumental book co-authored with Anna Schwartz, A Monetary History of the United States, 1867-1960 (Friedman and Schwartz, 1963). This monumental piece of empirical research offered substantial support for the restated quantity theory and sent shock waves through the economics profession by explaining the Great Depression in terms of the failure of the federal reserve to deploy effective open-market operations that would have prevented the banking crisis that brought about a significant decline in the supply of money (Breit and Ransom, 1998, 239).
Subsequent research by Friedman determined (1) that the impact of a fiscal deficit on nominal income was short lived whereas, after a lag, an increased rate of growth of the nominal money supply permanently augmented the rate of price inflation; (2) that the adjustment of nominal income to an increased rate of monetary growth occurred with a long and variable lag; (3) that in the long run additional monetary growth affected only the rate of inflation and exerted virtually no effect on the level or rate of growth of real output (Walters, 1987, 425).
So successful was Friedman’s empirical work in supporting the quantity theory that economists began to clamor for an explicit theory of the role of money in income determination, a theory capable of generating the propositions supported by the empirical investigations. In response Friedman published two strictly theoretical articles (Friedman, 1970, 1971) that sparked critical reviews from leading Keynesian scholars. The debate between the Keynesians and the quantity theorists would continue for another decade before the worldwide stagflation of the 1970s brought a close to decisive victory for Friedman’s position (Gorden 1978).
The restoration of the quantity theory undoubtedly weakened the reliance by governments on fiscal policy as a means of countering the business cycle. This alone was a major contribution to classical liberalism, weakening as it did the justification for government macro-economic intervention through fiscal policy. However, Friedman would fail to persuade the economics profession and the wider public that monetary policy also should be eschewed in favor of a non-discretionary rate of increase in the nominal money supply at the underlying rate of growth of productivity. This was unfortunate because governments that wished to use the inflation tax to evade the real debt implications of deficit-financing, now knew just how to go about their business. Although Friedman was very slow to recognize it, failure in this regard reflected more the pressures of public choice than any weakness in Friedman’s research on the long and variable lags in the relationship between changes in the nominal supply of money and changes in the behavior of nominal income.The Federal Reserve Board and its influential staff in the United States and central bank systems elsewhere would not easily be dislodged from playing an active role in monetary policy.
Failure was also, in part, the consequence of Friedman’s success in promoting free markets. Deregulation of the banking system made it difficult from the early 1980s onwards to determine just which M should be subjected to the non-discretionary rule. Perhaps most important, however, was Friedman’s neglect (typical of the Chicago School) of any detailed institutional analysis of the banking sector. In the absence of such an analytical framework, the call for non-discretionary policy too easily could be categorized as dogma rather than as science.
Fundamentally, of course, the case in favor of the non-discretionary rule collapsed during the 1980s once it became apparent that the demand for money was unstable in the wake of banking deregulations.
3.4. The Fallacy of the Phillips Curve
An important component of the Keynesian orthodoxy during the 1960s was the notion that there existed a stable negative relationship between the level of unemployment and the rate of price inflation. This relationship was characterized as the Phillips curve in recognition of the celebrated 1958 paper by A.W. Phillips that plotted unemployment rates against the rates of change of money wages and found a significant statistical relationship between the two variables.
Keynesian economists had focused on this apparent relationship to persuade government that there existed a permanent trade-off between price inflation and unemployment, allowing choices to be made between alternative rates of unemployment and alternative rates of price inflation. By accepting a modest increase in prices and wages, politicians, if they so wished, could lower the rate of unemployment in an economy.
Friedman had questioned the validity of the Phillips curve in the early 1960s, but without any significant intellectual impact. In his Presidential Address to the American Economic Association in December 1967 (Friedman, 1968), Friedman was able to raise the tone of this questioning, arguing convincingly that the concept of the stable Phillips curve was an illusion and that any trade-off that existed between the rate of inflation and the rate of unemployment was strictly temporary in nature. Once again, Friedman placed himself directly against the thrust of Keynesian doctrine deconstructing it from the perspective of Marshallian economics (De Vroey, 2001).
Keynes had rendered money non-neutral and had made fiscal policy potent in its effects on output by withdrawing one equation (the labor supply schedule) and one variable (money wages) from the classical model (Sargent, 1987, 6). The Keynesian model was thus short one equation and one variable by comparison with the classical model. To close that gap, the Keynesians had incorporated the Phillips curve as a structural relationship. In so doing, they mis-interpreted the true nature of labor market equilibrium.
Friedman in his 1967 Address re-asserted the classical assumption that markets clear and that agents’ decision rules are homogeneous of degree zero in prices. When agents confront inter-temporal choice problems, the relevant price vector includes not only current prices but also expectations about future prices. This the proponents of the stable Phillips curve had failed to recognize.
The trade-off between inflation and unemployment captured in the Phillips curve regression equations represented the outcomes of experiments that had induced forecast errors in private agents’ views about prices. If the experiment under review was a sustained and fully anticipated inflation, Friedman asserted, then there would exist no trade-off between inflation and unemployment. The Phillips curve would be vertical and the classical dichotomy would hold.
Friedman in his 1967 paper utilized a version of adaptive expectations to demonstrate that any trade-off between inflation and unemployment would be strictly temporary and would result solely from unanticipated changes in the inflation rate. The natural rate of unemployment, defined essentially in terms of the ‘normal equilibrium’ of Marshall rather than in the Walrasian terms of the subsequent rational expectations school (De Vroey, 2001, 130), was a function of real forces. If monetary expansion fools the workers temporarily so that they do not recognize that their real wage has been lowered, it might stimulate a temporary reduction in the level of unemployment below the ‘normal equilibrium (or natural rate). As soon as the money illusion dissipates, unemployment will drift back to the natural rate. To keep unemployment below the natural rate requires an ever-accelerating rate of inflation.
On the basis of this logic, Friedman predicted that the apparent Phillips curve trade-off evident in the data from the 1950s and 1960s would disappear once governments systematically attempted to exploit it. In the 1970s, the Phillips curve trade-off vanished from the data. Indeed, estimated Phillips curves became positive as rising rates of inflation began to coincide with rising rates of unemployment.
Once again Friedman’s positive economic analysis paved the way for a reduction in the extent of government economic intervention now through monetary policy. Economic events would ultimately invalidate the Phillips curve hypothesis. However, by directing the attention of economists to model mis-specification, Friedman hastened the process, further weakening the economic case for government intervention in the macro-economy.
3.5. The Reason of Rules
Friedman’s views on monetary policy were greatly influenced by Henry Simons’ teachings on the superiority of rules over discretionary policy (Breit and Ransom, 1998, 241). From the outset of his career, but with increased vigor following his empirical work on the quantity theory of money, not least his analysis of the Great Contraction (Friedman and Schwartz, 1963), Friedman argued in favor of committing macro-economic policy to a series of monetary and fiscal rules designed to reduce the degree of discretionary power available to government agents. It should be noted, however, that this argument was not based on any knowledge of public chocie. Rather, Friedman was concerned that central banks typically failed to predict the pattern of the business cycle and the distributed lags of monetary intervention, thus destabilizing the macro-economy.
Friedman’s advocacy of rules stemmed from recognition that monetary policy could not peg interest rates, could not generate full employment and could not stabilize cyclical fluctuations in income (Butler, 1985, 177). Yet, monetary policy had a considerable power for mischief, since it affected every part of the economy. Therefore, it deserved great respect. In particular, because changes in the supply of money exerted an impact on the macro-economy only with long and variable lags, the potential for destabilizing policy intervention was high even at the hands of a benevolent government.
At different times, Friedman advocated two comprehensive and simple plans for coordinating monetary and fiscal policies. In 1948, he advocated an automatic adjustment mechanism that would overcome the problem of the lag and that would be more likely to move the economy in the right direction than would discretionary monetary policy.
Friedman advocated (1) the imposition of 100 percent reserve requirements on the banks, making the supply of money equal to the monetary base and (2) a prohibition on government placing interest-bearing debt with the public. The Federal Reserve would be required to monetize all interest-bearing government debt, so government deficits would lead to increases in the monetary base, and government surpluses would lead to reductions in that base. Such a mechanism would act as an automatic stabilizer and would also assign a clear responsibility for growth in the money supply (and in inflation) to its primary determinant, the federal deficit (Sargent, 1987, 9).
If implemented, Friedman’s proposed rule would have eliminated much of the discretionary power that enabled governments to implement Keynesian macroeconomic policy. For that reason alone, it was doomed during the era of Keynesian hegemony. In addition, it implied the abolition of the central banking institutions that determine the course of monetary policy. Such powerful pillars of the economic establishment would not easily surrender their power and wealth by stepping down in favor of an automatic rules-based system.
By 1960, Friedman pragmatically recognized that central banks, open market operations and fractional reserve banking were here to stay, at least for the foreseeable future. In such circumstances, he advanced an alternative rules-based mechanism that was in some respects quite contradictory to his earlier, preferred ideal. Its essential element would be a legislated monetary rule designed to ensure the smooth and regular expansion of the quantity of money.
According to this mechanism, the Federal Reserve would be required by statute to follow a rule of increasing high-powered money by a constant k-percent per annum, where k was a small number designed to accommodate productivity growth in the economy. This rule would permanently limit the fiscal authorities’ access to the printing press to the stipulated k-percent increase and would force them to finance current deficits only by credibly promising future surpluses (Sargent, 1987, 9).
Cyclical movements in real income would not be avoided by this non-discretionary mechanism. However, the non-discretionary nature of the rule would prevent some of the wilder swings induced by inept and ill-timed monetary measures (Butler, 1985, 185).
So far, this advocacy has failed, not least because of public choice pressures combined with some skepticism as to the importance of high-powered money as the key monetary variable. Nevertheless, Friedman’s advocacy has not been in vain. Monetary authorities in the United States and elsewhere are now aware of the relationship between the quantity of money and the price level. Throughout the world, there is far more reliance on monetary restraint as the basis for price stability than was the case during the Keynesian era. Such monetary restraint has increased the political costs of fiscal expansion. Once again, a largely positive program of economic analysis has served well the cause of liberty.
4. On Liberty
Individuals are born with free wills, and, if they so choose, they are able to forge judgments that are conditioned neither by their particular circumstances nor by the environment in which they find themselves. Nevertheless, particular circumstances and environments influence judgments even though, ultimately, they do not shape them. Milton Friedman’s views on the nature and importance of liberty surely were influenced by his particular circumstances and environment.
Friedman is a second-generation central European immigrant and a Jew, characteristics that were not viewed favorably in the United States during the first half of the twentieth century; characteristics, indeed, that attracted hostile discrimination from public bodies and their agents, themselves protected from the discipline of the competitive market-place. Growing up in such circumstances demonstrated to Friedman in a very personal way the powerful and even-handed protection against prejudice provided by the capitalist system.
Much of Friedman’s scholarly career has been played out against the international backcloth of unequivocal political evil, in the form of totalitarian fascist nightmares epitomized by Adolf Hitler’s Third Reich and in the form of totalitarian socialist nightmares, epitomized by Josef Stalin’s USSR. The ‘days of the devils’ (Johnson, 1983) may now be largely over. However, their evil mark is printed indelibly on everything that Friedman writes and says and does.
Domestically in the United States, Friedman’s career has played out against a background of monotonic growth in the size of government and in the reach of its interventionist tentacles. Not for him has there been the privilege of nineteenth century British classical liberals who lived out their lives in environments that largely matched their philosophical beliefs. Circumstances and environments combine, in Friedman’s case, to demand an aggressive classical liberalism, designed to roll back tyranny as well as to preserve and to protect established liberties. That demand has called forth an unwavering supply.
Friedman outlines his special brand of classical liberalism very clearly in the introductory paragraphs of Capitalism and Freedom:
The free man will ask neither what his country can do for him nor what he can do for his country. He will ask rather "What can I and my compatriots do through government" to help us discharge our individual responsibilities, to achieve our several goals and purposes, and above all, to protect our freedom? And he will accompany this question with another: How can we keep the government we create from becoming a Frankenstein that will destroy the very freedom we establish it to protect? Freedom is a rare and delicate plant. Our minds tell us, and history confirms, that the great threat to freedom is the concentration of power. Government is necessary to preserve our freedom, it is an instrument through which we can exercise our freedom; yet by concentrating power in political hands, it is also a threat to freedom. (Friedman, 1962, 2)
In three important books — Capitalism and Freedom (Friedman, 1962), Free to Choose (Friedman and Friedman, 1979) and Tyranny of the Status Quo (Friedman and Friedman, 1983) — as well as in many other essays (see Leube, 1987 for a representative selection) and in numerous Newsweek columns — Friedman outlined a view of classical liberalism closely related to the philosophy of the young John Stuart Mill.
Friedman’s philosophy, like that of Mill, is one in which freedom is viewed as indivisible, with economic freedoms equally as important as political freedoms. Like Mill, Friedman also holds that government should be as decentralized as possible in order to allow alienated citizens to vote with their feet. Like Mill Friedman also holds that "the only purpose for which power can be rightfully exercised over any member of a civilized community against his will, is to prevent harm to others" (Mill, 1865, 6). It is a philosophy like that of Mill in which "[O]ver himself, over his own body and mind, the individual is sovereign" (Mill, 1865, 6).
This said, Friedman does not believe that most debates over economic policy are debates over value judgments (Friedman, 1967). Disagreements exist, for the most part because economists accept differing tentative hypotheses about the relationship between economic phenomena. Friedman maintains an optimistic perspective that most of these disagreements will disappear over time as competing hypotheses are subjected to empirical testing. He has qualified this optimism, however, with the passage of time recognizing, in the wake of the public choice revolution, that economists and policy-makers are not always driven by considerations of high moral purpose (Friedman, 1986).
In Friedman’s normative ideal, government should be strong and yet severely constrained. The major function of government is to protect the freedom of the people from outside and from inside intervention (i.e., to protect negative freedom in the sense most clearly defined by Isaiah Berlin, 1969). To achieve this objective, government must be empowered to provide an effective system of defense and to provide internally for the protection of property rights, the enforcement of private contracts and the maintenance of competitive markets. These powers, however, should not be unlimited. Government itself should remain strictly subject to the rule of law.
Unlike modern anarcho-capitalists, Friedman does not believe that private forces are capable of effectively providing these indispensable prerequisites of the free society. Nor is he comfortable with restricting government to the functions of the minimal (or night-watchman) state. Although he expresses a strong preference in favor of voluntary co-operation and private enterprise, he also recognizes that government upon occasion may enable individuals to accomplish jointly arrangements that would be more difficult or more expensive for them to accomplish severally (Friedman, 1962, 2). In particular, Friedman is sensitive to the problem of poverty and argues in Capitalism and Freedom (1962) in favor of a negative income tax to set a limit below which no family income could fall.
In contemplating such arrangements, however, Friedman unequivocally focuses on the harmful consequences of institutional arrangements that shield individuals from taking personal responsibility for their own decisions or that reflect paternalistic value judgments imposed by philosopher-kings on their fellow citizens. He is driven in this presumption by a recognition that the great advances in civilization have never come from centralized government, that centralized government can never duplicate the variety and diversity of individual action and that centralized government always substitutes uniform mediocrity for the variety that is essential for successful entrepreneurial innovation (Friedman, 1962, 4).
A basic human value that underpins Friedman’s philosophy is tolerance based on humility (Friedman, 1991). An individual has no right to coerce someone else, not only because of fundamental principles of classical liberalism, but also because no individual can be sure that he is right and the other person wrong. In this respect, Friedman sets himself aside from Utopian classical liberals such as Ludwig von Mises (Mises, 1963) who protect their arguments from empirical criticism on a priori grounds. Friedman rejects praxeology of the kind advanced by Mises on the ground that it converts a body of substantive conclusions into a religion.
Friedman argues that democracy is the appropriate form of government to foster political freedom. However, the prerequisite to democracy is a capitalist economy that separates economic from political power, allowing the one to offset the other (Breit and Ransom, 1998, 257). In this regard, Friedman fails to take full account of public choice arguments that there is a predictable tension between democracy and free markets in the absence of self-enforcing constitutional constraints on government authority.
Much of Friedman’s normative message is now commonplace in the debate over public policy. For example, several experimentations in the use of school vouchers are currently under way in the United States and many more are under consideration. The 1960′s Great Society programs that attempted to provide a welfare state from cradle to the grave are systematically, if slowly, being dismantled in favor of market-based alternatives. Affirmative-action policies that rely on bureaucratic controls rather than on competitive capitalism are increasingly the subject of criticism, even among those for whom those policies were ostensibly designed. Conscription in the military has given way to the market-based volunteer force. Fixed exchange rate regimes systematically have given way to flexible exchange rate regimes throughout the large majority of the Free World. In all these areas, Friedman’s once controversial ideas have begun to overwhelm the forces of mercantilism, mirroring the success of Adam Smith two centuries earlier.
It should not be forgotten, however, that Friedman’s success was bitterly fought and courageously achieved against powerful forces in a western world then dedicated to the elimination of individual freedom in favor of democratic socialism. Ranged against Friedman in this regard were eminent members of the economics profession (including Paul Samuelson, Kenneth Arrow, John Kenneth Galbraith, James Tobin, Robert Solow and Joan Robinson) who consistently demonstrated anti-free market prejudices combined with a high regard for big government and an easy willingness to sacrifice economic freedoms on the altar of Keynesian macroeconomic policies.
When intellectual battles are won and lost, the victor rarely receives his justly earned accolades. Those whose arguments have failed, and who seek continued academic respect, shift their positions and rely on myopia to protect them from the consequences of their earlier mistakes.
Rest assured, however, that those leopards who argued so confidently in the middle years of the twentieth century for the institutional arrangements of democratic socialism would not have changed their spots to the extent that they have in the absence of Friedman’s firm and convincing voice in defense of economic freedom, a voice that penetrated the citadels of coercion in the West as well as in the East, a voice that gave hope for a freer and more prosperous future during a dangerous half century for those who cherish freedom. Without that clear and convincing voice in favor of capitalism it is doubtful whether the public choice revolution would have made the inroads that it has into the widely held postwar mis-conception that government is the omniscient and impartial servant of the public good.
