Milton Friedman’s economic legacy
Given the mistakes of central bankers, economists should look again at Friedman’s ideas, not least his warning that mathematical models were little more than an exercise in statistical tautology.
Milton Friedman died in 2006. Jennifer Burns, a historian at Stanford University has published a full biography of him, Milton Friedman, the Last Conservative. It is a huge scholarly achievement. In many respects it is a work of intellectual archaeology in 20th century economics. Moreover, a work of archaeology that merits interrogation by contemporary economists, as an aide to better understanding modern economic issues. These include the methodology of economics, the role of consumption in the economy and the big questions in monetary economics and the conduct of monetary policy and macroeconomic management more broadly.
This article focuses narrowly on the economic legacy of Milton Friedman’s ideas, drawing on Jennifer Burns' full biography. Her book explores his family, professional life and political activity, which I reviewed in an article for Financial World that will be available online after 1 May 2024.
Mathematician and statistician
Milton Friedman began his studies in economics by focusing on mathematics and statistics. This was because when he began his undergraduate studies at Rutgers University, he was acutely alert to the fact that he would have to learn a living on graduation and expected to become an actuary. Throughout his post graduate work, he retained his interest in statistics and mathematical techniques given his expectation that he would earn his living from them. This meant that from the start of his academic career Friedman was perceived very much as a modern mathematical economist. This was reflected in the Economist describing Friedman as an economist’s economist in the 1950s.
Freidman was a critic of the overuse of complex maths in economics
Yet at the time in the middle of the 20th century when academic economics took off on its journey into highly mathematicised quantitative analysis, often explicitly replicating the practice of theoretical physics, Friedman was a critic of the overuse of mathematical modelling in economics. During the Second World War Friedman was seconded from academia for war related work in Washington DC. As well as working at the Treasury Department on role of taxation in wartime finance, he worked at the Statistical Research Group (SRG). Among the projects he worked on was the testing of new alloy turbine blades in an endeavour to manufacture planes that could fly higher and faster. Friedman’s job was to improve the statistical testing to help researchers improve their research. He used a pioneering large-scale computer built by IBM at Harvard. Harvard’s Mark1 to identify multiple regressions that predict the strength of untested alloys. The equations matched all the data that Friedman had collected to identify what should be alloys of unprecedented strength. When the new alloys were tested in a laboratory at MIT both failed. Friedman found that his calculations could not map what happened in the physical world.
Maynard Keynes shared Freidman’s scepticism about the simplistic use of regression analysis: equation models as little more than statistical tautology
For Friedman the challenge of using simultaneous equations to analyse alloys had implications for economists trying to use similar mathematical techniques to construct general equilibrium models. This made Freidman very cautious about readily accepting the predictive power of regression analysis. Friedman laid out his scepticism about the efficacy and use of large fifty equation economic models in an article in Review Business Cycles in the United States of America, 1919-32 by J Tinbergen published in the American Economic Review 30 September 1940. Friedman considered a fifty-equation model as little more than a tautology, arguing that the equations used in the regression analysis only yielded correlations as ‘simply tautological reformulations of selected economic data’. Jennifer Burns points out that Lord Keynes reviewed the same book the previous year and concluded by asking whether statistical methods could be useful in applied economics.
Friedman set out an extended critique of the growing role of mathematical modelling or what he called the ‘taxonomic approach’ in economics. This was in a review of Oscar Lange ‘s book Price Flexibility and employment. The gravamen of Friedman’s complaint is that econometric models provide ‘formal models of imaginary worlds, not generalisations about the real world’. Moreover, Lange had constructed his arguments and conclusions in a manner that meant that they were not ‘susceptible of empirical contradiction’. Friedman argued that the test of a theory was ‘not conformity to the canons of formal logic but the ability to deduce facts that have not yet been observed, that are capable of being contradicted by observation, and that subsequent observation does not contradict’.
The key to Friedman’s methodology – testable propositions that can be empirically investigated
In his book Essays in Positive Economics published in 1953 Friedman brought together his thoughts on economic methods. Drawing on Neville Keynes’s distinction between positive and normative propositions he set out an agenda based around simplified propositions that could be tested against events. The work of economics is in this taxonomy to describe and identify the workings of the world as it is rather than being an exercise in describing the world that we would like to see. In Friedman’s mind economics is an exercise in observation and understanding rather than a statement of ideological intent. It is moreover an exercise in empirical understanding that stands ready to be contradicted.
The misuse of mathematical techniques in a subject that has gone backwards over 30 years
Friedman’s thinking about the methodology and purpose of economics remains relevant today. If anything, it may carry greater importance. The combination of the over mathematisation of economics and the deployment of econometric modelling as part of the pursuit of active ideological political agendas mean that it is more pertinent. Paul Romer illustrated this in the powerful indictment that he made of modern academic practice in a lecture he gave at New York University Stern School The Trouble With Economics in 2016 when he was Chief Economist at the World Bank. In his view ‘For more than three decades, macroeconomics has gone backwards. The treatment of identification now is no more credible than in the early 1970s but escapes challenge because it is so much more opaque’. Romer argued that too much economic analysis was constructed around mathematical models with equations remote from descriptions of the real world that too often yielded results that were neatly consistent with their authors ideological or policy preferences.
Understanding and thinking about consumption
Consumption accounts for around three fifths or two thirds of expenditure in the national accounts of advanced economies, such as the UK and the USA. Understanding the motivations and behaviour of consumers and households is critical for getting a realistic purchase on the behaviour of economic agents. The study of consumption became a central part of economic analysis following the publication of Maynard Keynes’s General Theory of Employment, Interest and Money in 1936.
Keynes assumed that consumption rose as peoples’ incomes rose but not by as much as the increase in income. The consumption function was assumed to be stable and predictable. In Keynes’s formulation consumption rises as income increases but the rate of change of increase is slower. This slower rate of increased consumer spending as income rises resulted in a problem of hoarding, over saving and under consumption and an economy with a tendency to settle at an equilibrium that was below the level of demand necessary to ensure full employment.
Home Economics and the empirical demolition of the Keynesian consumption function
Milton Friedman had an unusual and highly personal opportunity to research the behaviour of consumption in the 1940s and 1950s that arose from his wife Rose’s work as an economist in Washington DC in the 1940s. After losing a baby in childbirth Mrs Friedman returned to work as an assistant to Dorothy Brady, the head of the US Department of Agriculture’s Bureau of Human Nutrition and Home Economics. Mrs Rose Friedman and Dorothy Brady worked on one of the areas of economics that were central to assessing the Keynesian revolution. The data they worked on from the study of Consumer Purchases and other studies of household budgets suggested a more complex pattern of behaviour than the elegant algebraic formulation of the consumption function on page 96 of the General Theory. This more prosaic picture of household spending behaviour cohered with a major study by Simon Kuznets the pioneer of national accounting in the US that found that consumption ratios were stable with spending rising as income rises. This disjunction between Kuznets empirical analysis of spending and one of the central propositions in the General Theory became known as the ‘Kuznets paradox’.
The collaboration between Rose Friedman and Dorothy Brady resulted in a paper Savings and the Income Distribution. This paper found decisions on consumption and saving were not predicted by the absolute income the household received but its relative income. The level of income alone was not a predictor of spending on its own. The character of the community that a household lived in also influenced its pattern of spending and saving. The norms of behaviour in different communities also influenced spending and saving with different patterns of behaviour in rural and urban communities. The work done by women researchers at the Home Economics Bureau was considered something of a backwater. Yet with other work done by a friend of Dorothy Brady, Margaret Reid on the spending of farmers whose spending reflected the dynamics of weather, prices and the need to purchase new machinery that made spending on consumption swing significantly from year to year, had profound implications for Lord Keynes’s formulation of the consumption function. Reid found farmers based their spending and savings on a forecast of average income over several years. These findings laid the basis for Milton Friedman’s work on the consumption function in the 1950s.
In 1957 Friedman published A Theory of the Consumption Function. Drawing on the work of Brady, Reid, Rose Friedman and Simon Kuznets with whom he had worked on the dynamics involved in the earnings of doctors and dentists. Friedman developed the concept of the permanent income hypothesis. People knew from their experience that they had permanent income and transient income. They tended to save transient income that enabled them to have savings to draw on and maintain consumption spending when income returned to its permanent level. This meant that economies were more stable than the analysis implied by Keynes’s General Theory that informed the post-war Keynesian policy consensus.
Replacing the Keynesian formulation of the consumption function with a permanent income hypothesis removed a fundamental proposition informing the secular stagnation thesis, higher income did not lead to higher savings, the permanent income hypothesis was neutral. The need to stabilise the business cycle given that economic cycles came with active policy was reduced given that business cycles came and went, and people made decisions about their spending and saving on long-term expectations about their income.
Friedman’s formulation of the permanent income hypothesis represented a fundamental assault on the Keynesian analysis and its policy implications. It remains relevant today as an analytical device. Not least in challenging the proposition that a temporary or permanent income increase in income inequality will lead to a secular stagnation resulting from a higher saving ratio among rich households that will not spend their higher and rising incomes. It is of great relevance in the way that we should consider changes in the value of asset prices and the wealth effects that arise from them. If Alan Greenspan and his colleagues at the Federal Reserve Board had paid attention to the concept in 1987 an unnecessary and damaging loosening of monetary conditions following the fall in equity prices in October 1987 would not have happened. A sharp procyclical monetary stimulus at the end of a long period of economic expansion would not have ignited an inflation problem that had to be corrected involving a recession at the start of the 1990s.
Labour market institutions
In his presidential address to the American Economic Association in 1967 Milton Friedman put on a display of intellectual pyrotechnics that still merit attention today.
First Friedman demolished the notion that there was a reliable long-term trade-off between inflation and unemployment, enabling policy makers to opt for a given level of inflation for a chosen level of unemployment. He demonstrated that the Phillips Curve and the relationship between inflation and unemployment was in the long term unstable.
Second Friedman borrowed a proposition about the normal rate of interest from the 19th century Swedish economist Knut Wicksell, what Wicksell called the natural rate of interest. Wicksell argued that there was a natural rate of interest generated by money and capital markets, but monetary authorities and central banks can through policy action drive interest rates below the ‘natural’ rate of interest and create inflation. He reformulated this notion of a natural rate of interest into a natural rate of unemployment.
Natural rate of unemployment and labour market institutions
This natural rate of unemployment is determined by labour market institutions. These include trade unions and the extent that they enjoy the wage bargaining power to impose a trade union wage mark-up, which influences the demand for labour, along with non wage employment costs arising from regulation that work to influence the demand for labour. Taxes and payroll social security taxes also influence employer demand and the supply of labour by workers. The natural rate of unemployment emerges from the working out of these influences on the demand and supply of labour. The natural rate of unemployment is not in any way permanent, fixed or immutable. It can be changed by modifications to trade union behaviour reflecting for example changes in the structure of trade union law, changes in the replacement ratio of social security benefits to average earnings and the active enforcement of benefit conditionality and the extent that the state supports unemployed workers in their job search through active labour market programmes.
Britain in the 1980s and Germany in the 2000s offer examples of the way in which labour market institutions can become more flexible thereby reducing the natural rate of unemployment. At the time of Milton Friedman’s presidential speech both the American and British labour markets were going through a series of protracted changes that raised the natural rate of unemployment. When policy makers responded to the higher rate of unemployment by trying to use macroeconomic demand management policies, unemployment did not fall much, but inflation rose. So that over each successive economic cycle at every peak and trough unemployment and inflation were both higher. This process was to destroy political confidence in the neo-Keynesian consensus in the mid-1970s, until it was abandoned in both Britain and America. Milton Friedman carried out the academic demolition work in 1967. With a time lag of around a decade politicians and policy makers eventually followed Friedman’s intellectual lead.
The Quantity of Money, the failings of the Federal Reserve and Monetary Policy
Milton Friedman is best remembered as a monetarist economist. He and his close collaborator Anna Schwartz, an economist based at the National Bureau of Economic Research revived interest in the role of money in the economy and the quantity theory of money in the 1960s. It was a remarkable intellectual achievement to rehabilitate an idea and an approach to economics that had been declared dead by the academic economic community and the international policy making elite based in Washington DC.
The intellectual victory of Lord Keynes’s General Theory and the construction of the neo-Keynesian synthesis by various academic acolytes was complete by the 1950s. Economists such as Sir John Hicks – the IS/LM curves in 1937 in ‘Mr Keyes and the Classics’, Franco Modigliani ‘s Liquidity preference and the theory of interest and money in 1944; Alvin Hansen’s clarification on nominal wage rigidity in Monetary Theory and Fiscal Policy in 1949, and Paul Samuelson the author of the term neo-classical in synthesis in his book Economics in 1955 had created a consensus where the role of money in the economy was passive and interest in it was akin to antiquarian inquiry.
In America in the post-war years the Truman administration swiftly legislated the Keynesian consensus into institutional form. The Employment Act 1946 made the purpose of economic policy maximum employment, production and purchasing power and made the federal government responsible for it. It also set up the Council of Economic Advisers to advise the president and the Joint Economic Committee of Congress to review economic policy. As Jennifer Burns puts it ‘The federal government was now committed by statute and bureaucracy to Keynesian demand management. And economists had been given a permanent berth in government at its highest level’.
In terms of official statements of the international economic consensus on the role of money in the economy, the British Radcliffe inquiry Report of the Committee on the Working of the Monetary System, published in 1959, provided what could be described as the locus classicus of official thinking at the time. Its central observation was that money was of little importance and the central issues related to wider liquidity in the economy. Its conclusions were accepted by the British Treasury.
So when Milton Friedman as one of the ablest economists of his generation embarked on the study of the quantity of money, to most economists in teaching in universities or working in finance ministries or central banks, his interest in the Fisher Equation, must have appeared ‘recondite’ to generous and polite economist colleagues or and quixotic and irrelevant, if they were minded to be more disputatious.
It probably was not an accident that his collaborator was an outstandingly able woman economist, who as Jennifer Burns explains had in professional terms, such as those critical things like getting her PhD accepted and published and obtaining satisfactory employment in terms of salary and security, while bringing up four children, had for all practical purposes lost her way. More than that she had been badly treated by her employers, not least by Arthur Burns the close friend and mentor of Milton Freidman. Schwartz had written a book published in two volumes The Growth and Fluctuation of the British Economy 1790-1850 with Walt Rostow, which because of its joint authorship, Burns would not allow to form part of her doctoral thesis. Jennifer Burns explains that Arthur Burns had a high regard for Schwartz’s intellect and scholarship and kept her on at the NBER. Indeed, for his purposes it was handy that she did not have a doctorate. It effectively stopped her from getting a university teaching job and leaving the NBER.
Friedman chose on his appointment at Chicago as a professor to teach both the Money and Banking and Economic Theory courses. This involved him in declining the offer of teaching a course in mathematical economics. The interesting thing, apart from money being unfashionable, was that Freidman had no expertise in monetary economics, while he was outstandingly well equipped to teach the mathematical economics course. Friedman was encouraged to take an interest in money by his former Rutgers University teacher Arthur Burns who had become Director of the NBER in 1946. Burns encouraged Friedman to look at the role of money in the business cycle and connected him to Anna Schwartz who worked at the NBER. Schwartz provided Friedman with a reading list that enabled him to immerse himself in monetary history. As Jennifer Burns notes, this approach involved months reading around the history of the subject before framing a proposition that he then tested against the facts that could be established.
The exercise in summertime reading in 1948 crystalised a substantive critique of the US central bank in Friedman’s judgement that was to colour much of his thinking on money. He wrote to his head of department at Chicago University that ‘By and on the large the Federal Reserve System has probably been a destabilising influence during its life and that we might very well have been better off if we had never had it.’
In his interest in money Friedman was able to draw on a tradition of monetary economics at Chicago. Some of his own professors who had taught him had contributed to it and thought a great deal about the role of money, not least in the great depression when the Chicago plan had criticised the Federal Reserve. In an article Friedman published in 1948 A Monetary and Fiscal Framework for Stability the influence of that work was clear not least the case for stable monetary rules, which would later from part of the monetarist policy tools that Friedman would be best known for.
For over a decade Friedman and Schwartz worked on their great book A Monetary History of the United States, 1867-1960. They presented a huge amount of data on the history of the US economy, but as Jennifer Burns says, ‘but beyond piling up facts, they also advanced a theory of how money worked in the economy’. At the heart of the book was an allegation that the Federal Reserve was principally responsible for the Great Depression, as a result of contracting the money supply by 33 per cent. It located this failure in the personalities that ran the Federal Reserve at the time. The central problem was the leadership of the central bank. A capable experienced central banker with a practical understanding of what needed to be done in a liquidity crisis Benjamin Strong died and was replaced by George Harrison a cautious, conciliatory bureaucrat who sought consensus. The result was official inactivity when action was needed to prevent monetary contraction from collapsing both the banking system and the economy.
As Jennifer Burns comments there was nothing new in the Monetary History of the United States, 1867-1960 that had not already been set out by Friedman in other publications such as Studies in the Quantity Theory of Money that came out of his Chicago University workshop published in 1956 and the A programme for Monetary Stability published in 1960. Friedman had also set out astringent criticism of the Federal Reserve and his broader thinking on monetary policy in various testimonies to Congress. In evidence to the Joint Economic Committee of Congress in 1959 Friedman presented his central piece of guidance for monetary policy: a rule limiting the annual growth of the increase in the economy’s money supply. He said, ‘This can best be done by assigning the monetary authorities the task of keeping the stock of money growing at a regular and steady rate, month in and month out’. Friedman suggested the rate of growth of money should be around 4 per cent a year. While most of the ideas that we associate with Freidman and monetarism were in circulation before the publication of the great work with Anna Schwartz in 1963, it was the publication of their book that transformed interest in them. The American Historical Review said it was ‘one of the most important books of our time’. The scale of the book – 860 pages and the intellectual audacity of its arguments and examples compelled attention.
Milton Friedman’s monetarism
What are the central propositions of Milton Friedman’s monetarist analysis? They can be briskly summarised. Money is important and cannot be ignored. Money plays a central role in most business cycles. Inflation is essentially a monetary phenomenon. The concept of the neutrality of money. This idea is that while an increase in the quantity of money may increase the price level it does not change the real economy and real economic welfare. Long-term economic growth and increases in economic welfare are determined by real things such as the evolution in the stock of physical and human capital and innovation and technical progress. There are long and variable lags in monetary policy and the impact of changes in monetary conditions on the economy. These lags mean that active attempts to manage the economy can lead to pro rather than counter cyclical policies. Hence the preference for a rule that sets the money supply to growth in line with the productive capacity of the economy at around 3 to 4 per cent.
The Nixon-Burns inflation disaster 1969 to 1976
The 1970s were a decade when long standing fractures in the Keynesian policy paradigm created problems that would probably have provoked a collapse in the Keynesian consensus. These problems were further aggravated by shocks that started in the late 1960s. They included the costs of the Vietnam war and the pressures it created for the financing of the US balance of payments, the collapse of the Bretton Woods fixed parity regime, trade union militancy across advanced economies after 1968, a synchronised economic expansion across advanced economies that contributed to a boom in international commodity prices and finally the quadrupling of oil prices in November 1973. By 1975 America and other advanced economies, such as Britain and France experienced high and unstable inflation accompanied by stagnant growth in output and rising unemployment. By the end of the 1970s the post-war Keynesian economic consensus was over.
In America the Nixon administration and the Federal Reserve made egregious policy mistakes that expedited the economic crisis. Milton Friedman was well connected with the Nixon administration and there were several Chicago colleagues serving in it, not least George Schultz who served variously as Labour Secretary, Director of the Office of Management and Budget and Treasury Secretary. The most significant of his connections was with his old professor, teacher, mentor and friend Arthur Burns who initially served as economic counsellor to President Nixon before President Nixon appointed him as Chairman of the Federal Reserve Board.
From Milton Friedman’s perspective everything that could go wrong, did go wrong. And arguably worse every policy that could be mistakenly chosen and would make things worse was selected. The heart of the administration’s economic policy mistakes was President Nixon’s belief that he would have been elected President in 1960 if the economy and been performing better and interest rates had been lower. For that he blamed the Federal Reserve and was determined it would never happen again. From the start President Nixon wanted a prosperous expanding economy with low unemployment to coincide with the mid-term Congressional elections in 1970.That meant a compliant Federal Reserve Board with a chair who would ensure monetary conditions were appropriately loose at the right time to fit with the Republican administration’s electoral cycle. The story of the US economy during the Nixon administration is well told in Nixon Economy Booms, Busts and Votes by Allen Matusow.
Arthur Burns was under constant pressure to deliver strong growth and high employment. To square the circle of high growth and inflation control, Burns proposed a prices and incomes policy. Friedman and Burns were very close friends. As Jennifer Burns explains, to Friedman, Burns was a teacher, mentor and father figure. They were Republicans, but as Jennifer Burns notes despite much in common they approached economics from a different analytical perspective. Burns was an institutional economist, who took a cost push approach to inflation and was much more attracted to price controls. Despite being a close friend of Friedman he had avoided commenting on A Monetary History of the United States. In short, he was not a monetarist. The freeze on prices and incomes devised by the Treasury Secretary John Connally called the New Economic Plan, was an anathema to Friedman. The result of loose monetary policy in 1972, with the price level protected by the controls of the New Economic Plan was inflation rising from around 5 percent in 1970 to a peak of over 10 per cent in 1975. While the rate of unemployment rose from around 4 per cent in 1970 to 8 per cent at the end of 1975. It was the classic stagflation that vindicated Friedman trenchant criticism of the Nixon administration’s resort to price controls and the Federal Reserve Board’s failure to control the money supply.
The close and happy relationship between Arthur Burns and Milton Freidman did not survive Burns persuading President Nixon to use prices and incomes policy. Having been opposed to price controls since his wartime stint at the US Treasury Department in the 1940s a return to the policies of the Office of Price Administration was repugnant to Freidman. His brother-in-law Aaron Director, also a wartime Treasury official, had set out their defects in a Treasury Department memo. At the heart of Director’s criticism was his view that price controls struck at the symptom and not the cause. Director memorably made the point that ‘inflation is essentially a monetary phenomenon.’ In the 1960s at a speech to Chicago University alumni in Michigan, Friedman drawing on a Chicago colleague Phillip Cagan’s research pointed out that even in the German Weimar hyperinflation in the early 1920s the economy performed well because price signals were not impeded by artificial and distorting controls.
Paul Volcker’s practical monetarism
If the Nixon administration created an inflation problem that was aggravated by the distortion of wage and price freezes, President Carter appointed Paul Volcker as Chairman of the Federal Reserve Board, who applied practical monetarism that effectively carried out a policy of disinflation between 1979 and 1982. Friedman and Volker did not get on. During the collapse of the Bretton Woods system Volcker was opposed to Freidman’s support for floating exchange rates. Volcker was certainly no Friedmanite monetary disciple. Yet by setting targets for the money supply to be achieved by targets for the supply of nonborrowed reserves to the Federal Funds Market in October 1979, and giving priority to controlling the money supply over targeting interest rates, it was a close approximation to a monetarist approach.
Not quite what Freidman had in mind
Friedman was broadly supportive of the new direction of travel and cautiously welcomed the October 1979 announcement in his regular column in Newsweek. Volcker’s ‘practical monetarism’ involved erratic trends in the growth of the money supply. Big swings in the money supply had never been part of the Friedman mantra. His commitment was to a gradual policy where inflation would be surely and steadily squeezed as economic agents realised the central bank would control the money supply and inflation. Expectations were an important part of the process. The swings in the reported measures of the money supply were reflecting the ending of Regulation Q that placed a ceiling on interest rates paid on retail bank deposits. This made Friedman critical of the conduct of policy. While Volcker gave priority to meeting the Fed’s money supply targets rather than stabilising interest rates at a given policy rate, which Friedman agreed with, Volcker still set a target for the Federal Funds Rate that Friedman disagreed with. While Volcker targeted the supply of nonborrowed reserves to the banking system as a form of money base control, the target was in practice a lagging target based on a historic fourteen-day maintenance period, which Friedman disagreed with, arguing for contemporaneous reserve targeting.
A world and financial institutions that had changed
Deregulation and institutional change transformed previously stable monetary relationships. Not least high nominal interest rates. For years savers had suffered from negative real interest rates, by 1981 there were positive real interests, rates that increased the demand for money. The result was that instead of the chosen monetary aggregate M1 falling in line with policy and then resulting in a fall in inflation, there was a monetary squeeze by 1982 where everything was falling – output, employment and inflation, everything except the Fed’s monetary target M1. In the autumn of 1982 Volcker announced that the Fed would return to interest rate targeting. Volcker had got inflation down and the Fed then kept it down for almost two generations. Moreover, in 1982 there was a recovery in output that was the start of a period of expansion that lasted six years.
Jennifer Burns makes the point that the economy that Friedman and Schwartz’s book A Monetary History of the United States, 1867 -1960 described so well had changed by 1980. The Carter administration’s agenda of financial deregulation and the ending of controls such as Regulation Q had fundamentally changed the financial system that the Federal Reserve had presided over in the fifty years between the 1930s and the 1980s.
Now it would be possible to say that the time had come long ago to put their great book back on the library shelf and just leave it there. In many respects that was what the central banking and policy making establishment and the academic economic community did after 1982. Monetary targets and intermediate indicators were abandoned. Central banks used interest rates as their policy instrument working on the demand for money and credit rather than seeking direct controls that influenced the supply of money. Policy makers turned to targeting inflation with central banks taking a wholly discretionary approach to achieving an inflation target without any intermediate targets. In the process they buttressed inflation targets with official forecasts for inflation to overcome the lagging character of inflation, the principal defect.
A world of models and no money
These models were framed around the principals of Dynamic Stochastic General Equilibrium (DSGE) models. Policy was framed in relation to the productive capacity of the economy and the notion of the output gap – how far above or below output is in relation to capacity. It was a Keynesian approach to economic modelling worthy of the intellectual legacy post-war neo-Keynesian consensus. There was no banking sector and no role for money in the modelling. The intellectual leadership for this New Keynesian approach came from economists, such as Michael Woodford laid out in articles like Doing Without Money Controlling Inflation in a Post-Monetary World published by the NBER in 1997. Market liberal economists in the so-called freshwater university departments focused on rational expectations and market efficiency. In this iteration of market liberalism, economic agents were so rational, so well informed, and expectations were so powerful that efficient markets could be relied on to operate without guidance and rules of the sort that Anna Schwartz and Milton Freidman occupied themselves with. Jennifer Burns illustrated this by referring to a spat between Friedman and Eugene Fama a professor at Chicago University Business school, who argued that markets were so efficient there was no need for rules to regulate bank deposits.
But things have gone wrong in 21 century, one thing after another
Since Friedman’s death in 2006 there have been two major macro-economic crises. The first between 2008 and 2009 was a banking and financial crisis provoked by the internationally loose monetary conditions ahead of 2007, led by the Federal Reserve. Followed by a collapse of credit and banks between 2008 and 2009, resulting in the Great Recession. The second has been the failure of central banks to control inflation between 2021 and 2023. The first demonstrated that wholly efficient self-correcting efficient financial markets in need of no regulation or guidance was the kind of unrealistic assumption that Friedman had criticised in his book Essays in Positive Economics in 1953. The second, the inflation crisis since 2021 has demonstrated the deficiency of the inflation targeting monetary policy regime of central banks that take no account of money.
Since Friedman’s death, following the Great Recession 2008-09, advanced economies have grown very slowly and the secular decline in the rate of productivity growth and overall economic growth since 1960 has become more pronounced. As interest rates fell towards zero – the zero-rate boundary – central banks turned to unorthodox monetary instruments, such as quantitative easing, credit easing and forward guidance to make monetary conditions stimulative when monetary policy had lost all traction as a source of stimulus. They were trying to put int policy the flesh of Milton Freidman’s musing about what policy makers should do in the event of a sustained deflation and his belief that the Federal Reserve had an obligation to act in a crisis. The first significant Federal Reserve official to explore these ideas before the crisis took its early stages in 2007 was Dr Ben Bernanke and earned the sobriquet ‘helicopter Ben’ for his intellectual efforts.
Given the problems of inflation targets, central bank economic models the big questions that Friedman explored should be back on the table
Given the problems central banks have had with inflation targeting, many of the questions and propositions that Milton Friedman put on the table should be re-explored. Among the issues should be the question of gradualism versus short sharp shock disinflation when there is an inflationary problem, the role of policy rules versus discretion and the part that a pre-announced policy has in guiding expectations. A big question that ought to be examined is the extent that policy makers should develop instruments that directly influence the supply of money rather than the demand for money. The UK in 1980 published a Green Paper on Monetary Control Cmnd.7858. It was supposed to be a proper discussion of money base control, but was instead an exercise in intellectual obfuscation. HM Treasury sidestepped the central issues involved.
Jennifer Burns draws attention to written evidence that Friedman gave to the House of Commons Treasury Select Committee ‘I could hardly believe my eyes. Only a Rip Van Winkle, who had not read any of the flood of literature during the past decade and more on the money supply process, could have written it’. She points out that in his memoirs The View from No 11 Nigel Lawson explained that he was attracted to money base control, given the problems the Government had in 1980 with monetary policy, but considered it impractical given the implacable opposition of the Bank of England to implementing it. At the time the principal economist involved in working on these issues took the view that in institutional terms a move to money base control would be a significant upheaval and should not be undertaken unless there was another future episode of inflation and monetary disorder that would merit a radical reform of the UK’s monetary institutions. There have arguably been four such episodes: inflation of over 10 per cent at the end of Lawson boom in 1990; the ERM debacle in 1992; the asset price bubbles ahead of the credit and banking crises 2007-09; and the inflation between 2021 and 2023. These invite the radical institutional interrogation that the British Treasury official speculated about in 1980.
Jennifer Burns’s book is a resource for exploring these questions
For anyone interested in these issues, Jennifer Burns biography of Milton Friedman, provides a marvellous resource to draw on Friedman’s work and the ideas of his circle of colleagues, friends and relatives. One of the interesting things about Friedman’s thinking is that while much of it was presented in ex-cathedra books and articles, such as Essays in Positive Economics, Studies in the Quantity Theory of Money and the Monetary History of the United States, 1867-1960, many of his ideas had their most powerful expression in Congressional testimony, speeches and Newsweek articles, such as his ideas on rules for steady monetary growth, the power of anticipated inflation in changing the expectations of economic agents about things such as wages and why government deficits do not cause inflation. Jennifer Burns’s book draws on these and makes them available in an accessible way.
The last word in this article exploring Jennifer Burns’s life of Milton Freidman should go to Anna Schwartz, his collaborator in their great study of American monetary history. Unlike Freidman she lived to see the 2008-09 credit and banking crises. She died in 2012 at the age of 96. She opposed the decisions of policy makers to bail out the banks and the policy of continuous very low interest rates after the crisis. In many respects she was better equipped to understand the dynamics of the bank failures that started in 2008 than most policy makers. Schwartz understood that banks and financial markets had radically changed. Securitisation, disintermediation and a financial environment where banks made extensive use of derivative products and the move to ‘marked to market’ accounting conventions had driven a coach and horses through the central bank lender of last resort function. In its classical formulation by Walter Bagehot in Lombard Street, the job of a central bank is to lend readily to an illiquid, but solvent bank, but not to an insolvent bank. In a regional federal reserve bank seminar, looking at the response of central banks and policy makers to the 1998 Asian crises, several years after the event, Schwartz said that in a similar future crisis, it would be difficult for the Federal Reserve to stabilise the banking system, by rescuing the banks involved, because as she put it, the Fed does not have a mandate to take a ‘margin call,’ with taxpayers money for a bank that is insolvent.
Warwick Lightfoot
13 April 2024
Warwick Lightfoot is an economist who served as Special Adviser to the Chancellor of the Exchequer between 1989 and 1992.