Welcome to the new version of European Tribune. It's just a new layout, so everything should work as before - please report bugs here.

The Legacy of Milton Friedman

by Drew J Jones Fri Nov 17th, 2006 at 02:48:13 PM EST

For bruno-ken and Miguel....

There are really only four major figures worth speaking of in my field: Adam Smith, David Ricardo, John Maynard Keynes, and Milton Friedman.  The first three are long gone -- the youngest of them having died in 1946.  Three days ago, Friedman finally passed, and, as I said in yesterday's open thread, with his death the era of giants in economics comes to a close.  Most people are familiar with his libertarian political views, but I thought I'd throw a diary together on his contributions to economic theory.

Friedman was, of course, the founder and leader of the Chicago School of thought, perhaps better known as Monetarism.  More than anyone, Friedman resurrected the idea of real variables -- as opposed to nominal variables -- only changing permanently because of changes in other real variables, thus helping to lay the foundation for modern Neoclassicalist economic thought.  Perhaps his greatest achievement, in particular, came in the form of his brilliant dismantling of what is known as the Phillips Curve.  And that is where I will begin.


I. An Army of One

As I've said many times of Keynes, the Average Joe one meets on the street has no idea how much Keynes's ideas have influenced his life.  It is, quite literally, impossible for me to pick up a newspaper or even discuss current economic events without seeing his fingerprints.  The same can be said, albeit to a lesser extent, of Milton Friedman.  But, anyway, back in 1958, New Zealand-born economist AW Philllips published an academic paper titled "The relationship between unemployment and the rate of change of money wages in the UK 1861-1957" in the journal Economica.  This would later be transferred to show a relationship between inflation and the unemployment rate, as you can see in the graph above.

Many prominent Keynesians, including Nobel Laureates Paul Samuelson and Robert Solow, along with many (if not most) economists, took this apparent relationship to imply that governments could choose an acceptable balance between inflation and unemployment.  With a bit higher inflation, it appeared we could push the unemployment rate well below the levels we were historically accustomed to.  This quickly became the accepted norm.

Milton Friedman saw the flaw in this idea, arguing that the seemingly-permanent relationship the Phillips Curve described was an illusion -- that there was, in fact, no tradeoff between inflation and unemployment in the long run.  Instead, Friedman predicted, businesses' inflation expectations would change, prices would be set higher to avoid shortages, and the curve would shift out, requiring that government pump even more cash into the system to get the same result.  It would, Friedman said, turn into a vicious cycle, eventually ending in both rising unemployment as well as rising inflation.

That was in 1968.  By 1976, Friedman had become the most famous economist on the planet.

This is not to say that Keynesianism was completely wrong.  In truth, the 1973 oil shock, when plugged into the old IS-LM model that John Hicks developed after Keynes wrote The General Theory, will, in fact, yield an outcome of stagflation.  Whether one was more to blame than the other is anybody's guess, -- everybody agrees, however, that Nixon was an idiot -- but both problems fed each other to deal a severe blow to western economies at the time.  Regardless of the faults, or lack thereof, of Keynesians in the '60s and '70s, Friedman's Monetarist "counterrevolution" took hold and dominated economic thought until the mid-1980s, after which New Keynesianism would begin to rise, but that's another diary.

At the same time Friedman dismantled the Phillips Curve, he developed the Natural Rate (of Unemployment) theory, also known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU).  This theory stated that unemployment, for various reasons, could never fall below a certain floor and remain sustainable because of the pressure on wages that would be associated with such a tight labor market.  If workers' real wage increases are set well above increases in their marginal product, it will result simply in a market-based redistribution rather than a real increase in national welfare, and inflationary pressures will eventually begin to hit the market, thus pushing up interest rates and slowing the economy.

II. The Long Run Does Matter

In 1957, at the height of the Keynesian Consensus, Friedman developed an important theory of household behavior called the Permanent Income Hypothesis (PIH).  Keynesians had traditionally taken a very specific understanding of consumption's relation to income -- that consumption would increase with income, but that it was subject to diminishing returns.  (As income rises, the proportion of real income growth which is dedicated to the consumption of goods and services declines.)  Meaning,

c'(y) > 0, and c''(y) < 0,

where c = consumption and y = income.

The PIH stated, however, that individuals made decisions based on expected income over their entire life-cycle, and that they would smooth consumption out over that life-cycle so as to maximize utility given the household's (or individual's) time preference.  Friedman's theory introduced, as the Wiki article notes, assets into the consumption function, and adjusts future consumption and income into its present-day value, so that

c(t)+(c(t+1)÷(1+r)) = A(t)+y(t)+(y(t+1)÷(1+r))

in a two-period model, assuming I haven't completely fucked up the math by forgetting the model, which is admittedly quite an assumption at times.  (If so, of course blame me.)  Here, t denotes period one, t+1 denotes period two, and r denotes the interest rate (dividing by (1+r) being the adjustment of future consumption and income to present value).  A(t), obviously, represents assets.

His success would give rise to many other big names of the last thirty years -- most notably Robert Lucas, who developed the theory of Rational Expectations (RATEX), which attempts to lay out a basic framework explaining how decisions in the present are influenced by expectations of the future.  Lucas's theory is an extension of the PIH, whereby changes in expectations, and thus behavior, arise from random disturbances.  Later papers would also introduce the impact (say) on happiness from households' children and grandchildren into utility functions, furthering the focus on how we make decisions about the future.  The Monetarists, and Neoclassicalists in general, were obviously more concerned with mathematics than the Keynesians have traditionally been.  This, too, is partly a product of Friedman, who, also being a statistician, insisted on models to predict outcomes.

III. The Depression

In 1963, Friedman coauthored, with Anna J. Schwartz, A Monetary History of the United States, 1867-1960, the Bible of Monetarism.  The book sought to examine the relationship between economic activity and the money supply.  His work in this book, as well as academic papers, would help to focus attention on measures of the money supply ("monetary aggregates") used by the Fed -- M1, M2 and M3.  In particular, Monetarists point to the contraction of M1 from 1931 to 1933 as the cause of the Great Depression.  The Depression was thus, in his view, the result of missed opportunities at the Fed to stabilize the economy.  The book was so successful that current Fed chairman Ben Bernanke (then a governor under Alan Greenspan) remarked in 2002, at a celebration of Friedman's 90th birthday, "Regarding the Great Depression. You're right, we did it. We're very sorry."

Believing that significant changes in the money supply would result in undesirable consequences, Friedman became an advocate of central banks attempting to maintain a steady rate of inflation.  Today, Britons and Europeans know this as an inflation target.

Love him or hate him, -- and, in my experience, there are usually few in between -- Friedman's impact is undeniable.  On the whole, I consider his contributions to have been positive.  As I've said, this was a giant of a social thinker -- and one who was far too modest to ever admit to it.  I'll guarantee that not one student of economics has taken a class in the last couple of days without entering a discussion of Friedman's work.  No doubt more than a few fierce debates have been held.  I maintain my belief that he was, at heart, a Keynesian (and he was hated by many Austrians and some Neoclassicalists for it), but that he added to the brilliant ideas we were lucky enough to receive from Keynes and, in many ways, forced Keynesians to get their act together.

Rare is the occasion that someone as talented, decent and, frankly, inspiring as Friedman comes along.  I hope we're fortunate enough to enjoy the work of many more scholars like him.  Too few have been able to see the big picture.  Friedman was, without question, the greatest of those few in recent history.

Display:
Not my best work, but hopefully it makes some key points.

Be nice to America. Or we'll bring democracy to your country.
by Drew J Jones (pedobear@pennstatefootball.com) on Fri Nov 17th, 2006 at 02:54:58 PM EST
More than any other person, Friedman is the cause of the great shift to the right, and the assault on working people, that has taken place everywhere in the West over the past 35 years.

High unemployment in Europe is a direct consequence of European central banks dogmatically sticking to Friedman's anti-inflation mania, keeping interest rates high even as unemployment soared.

The US economy has been successful only when it departed from Friedman's dogmas, either by running big deficits in the Reagan years or pushing interest rates downward in the Clinton years.

Friedman's belief that unemployment is voluntary is the economic basis of Thatcherism.

by tyronen on Fri Nov 17th, 2006 at 05:08:25 PM EST
You're, of course, welcome to your opinion.  I'm simply here to tell you that you don't know what you're talking about, and you've clearly read none of my comments from last night.

Interest rates were "pushed downward" during the Clinton years because of the fact that inflation was low.  Productivity growth was strong, which helped to keep prices down.  Central banks raise and lower interest rates in response to inflation and inflation expectations.  Unemployment soared during the early-1980s, because inflation has reached a hideous level and needed to be purged with contraction.  (The US got it roughly correct.  The UK, as I read it, completely screwed it up.)  The deficits were practically inevitable -- although I, in no way, mean that to excuse Reagan's behavior.  Tax receipts always fall dramatically during a recession.

Friedman's work may have provided a basis for Thatcherist nonsense, but Thatcher, quite frankly, had all of the economic knowledge of a rock and wouldn't have understood Friedman if she had spent her entire life studying him.  She botched the entire job, which is why I gave Reagan some credit last night relative to her.  It did not help that Britain had a central bank that lacked independence until, if I'm not mistaken, 1997.  That is a direct result of a stupid politician operating with what was then a poorly designed institution.

What the US economy demonstrated in the 1980s was that Friedman was partly right and partly wrong.  And, as I've said, he actually had the decency to admit that he was wrong -- that, after the inflation had been purged, the Keynesian stimulus worked as expected, which leads us to the microeconomic foundations of the short-run Phillips Curve, but that's, again, another diary.

Be nice to America. Or we'll bring democracy to your country.

by Drew J Jones (pedobear@pennstatefootball.com) on Fri Nov 17th, 2006 at 05:34:17 PM EST
[ Parent ]
No, I hadn't read your comments last night, but that doesn't really change any of my points.

The NAIRU is right-wing fiction, a canard central banks use to keep unemployment high and wages low.  

For years, economists claimed the American NAIRU was 6 percent.  In the 1990s, the Fed decided to buck the wisdom and not raise rates when unemployment dipped below that level.  Everyone screamed that inflation would accelerate...didn't happen.  Unemployment dropped below 6, then below 5, then below 4, finally bottoming out at 3.8.  Inflation remained low.

In Canada (where I lived in the 1980s and 1990s), the central bank began hiking rates in 1989, pushing unemployment to double-digit levels in order to crush inflation (which was only 5 percent to begin with).  It took a decade for jobs to recover, and wages never did.  

Friedman is one of the founders of the belief, now standard among economists, that governments can do little to create jobs, that wealth redistribution will always hurt wealth creation, that nearly all regulations and taxes are Bad Things.  

Friedman's disciples claim that to lower the NAIRU, countries like France and Germany must cut unemployment insurance, emasculate unions, dismantle regulations, and in general adopt all the bad features of the US economy and none of the good.  See how well that works.

by tyronen on Fri Nov 17th, 2006 at 07:31:50 PM EST
[ Parent ]
I have nothing to say about the NAIRU idea in particular, but in judging Friedman and others, it's important to remember that sound ideas can be used to support unsound policies. Sometimes the idea itself is perverted, and sometimes the idea is part of a system of thought that is unsound for other reasons. A special instance of the latter would be taking a sound abstract relationship and deriving a false conclusion by applying it to a false premise. Garbage facts produce garbage policy.

Words and ideas I offer here may be used freely and without attribution.
by technopolitical on Sat Nov 18th, 2006 at 02:22:40 AM EST
[ Parent ]
The NAIRU is as close to an undeniable fact of life as you'll ever find in social sciences.  Examine Britain for the last few years, or the US over the last few months.  Which economists claimed it was 6%?  Economists, first of all, don't believe there is one set-in-stone NAIRU, so this talk of 6% goes out the window.  NAIRU, like potential output, depends on a number of factors -- the most important being productivity growth and inflation (which are related) -- and can change.

The Fed didn't raise rates, because it didn't need to given low inflation.  Read any of the three billion news stories from that period on productivity growth -- this is, allegedly, Greenspan's finest moment -- allowing the Fed to stop raising.  Do you think 2000 was the first time we ever experienced unemployment rates below 6%?  Hardly.  Even at the low point of the 2001-2003 crash, the unemployment rate never exceeded 6.2%.  Where you come up withh this idea, I don't know.

Friedman is one of the founders of the belief, now standard among economists, that governments can do little to create jobs

Friedman believes no such thing.  (And, no, the idea of this being the standard view among economists is truly laughable.  Not even the Neoclassicalists believe that.)  He knows, and has admitted, that -- again, to take this example -- the Reagan boom was largely the result of a massive Keynesian stimulus following the inflation purge.  Friedman has was also, for example, the guy who pushed the idea of negative income taxes, -- in the US we call it the Earned-Income Tax Credit -- which, as you well know, is a (from what I know highly successful) form of redistribution.

Again, your comment is more focused on your settled prejudices than on what Friedman actually stood for.

Be nice to America. Or we'll bring democracy to your country.

by Drew J Jones (pedobear@pennstatefootball.com) on Sat Nov 18th, 2006 at 04:45:51 AM EST
[ Parent ]
This is not to say that Keynesianism was completely wrong.  In truth, the 1973 oil shock, when plugged into the old IS-LM model that John Hicks developed after Keynes wrote The General Theory, will, in fact, yield an outcome of stagflation.

I would like to see that in detail. Can you do it here, or do you have references?

Those whom the Gods wish to destroy They first make mad. -- Euripides

by Migeru (migeru at eurotrib dot com) on Fri Nov 17th, 2006 at 05:49:21 PM EST
If I hadn't just polished off a bunch of beer, I'd write it out, but, alas, that shall have to wait for tomorrow or Sunday.  I actually ran the figures myself a couple of years ago as a undergrad.  A reference would be easier.  I should remember that.... ;)

Be nice to America. Or we'll bring democracy to your country.
by Drew J Jones (pedobear@pennstatefootball.com) on Fri Nov 17th, 2006 at 05:56:13 PM EST
[ Parent ]
Listening to Drew spout his recently learned dogma is like listening to a divinity student parroting back bits of religious teachings.

What would happen to them if they discovered that their gods were actually just ordinary men?

Drew, you will probably get an excellent education in conventional economic thinking, go out into the business world and make a lot of money telling people what they want to hear, but you will be totally unprepared to deal with a planet where raw material shortages completely negate all the premises of capitalism. So I suggest you save as much as possible early in your career. It's hard to predict when the bubble will burst.

Friedman was a first class idiot. That fact that he may have done some theoretical work early in his career that enabled some to make lots of money does not change the fact that most of his time was spent selling snake oil. The "Nobel" prize in economics is a joke. It trades on the Nobel name but is like the Oscars. Self congratulation by a bunch of industry insiders to themselves. It is sponsored by a bank which is trying to improve the reputation of economics. This won't work, putting lipstick on a pig still doesn't make it a testable science.

Policies not Politics
---- Daily Landscape

by rdf (robert.feinman@gmail.com) on Fri Nov 17th, 2006 at 05:49:31 PM EST
The personal attack on Drew isn't warranted, even if you think he's wrong.
by Colman (colman at eurotrib.com) on Fri Nov 17th, 2006 at 06:01:21 PM EST
[ Parent ]
My short-term memory is admittedly shot to hell, having smoked a lot of dope when I was younger, but the only thing in that diary that is "recently learned" is the reference to Friedman dying -- recent learned because of the fact that it, you know, recently happened.

I know you have an incredibly difficult time actually addressing the main points of what I say, Bobby, and I suppose it's your prerogative to behave as though you were a four-year-old in your responses, but, quite frankly, I really don't give a shit about your opinion of me.  If you want to grow into a bitter old man talking down to the rest of the world, good on you.  I find it pathetic, but it's your life, so onward, Christian Soldier.

Be nice to America. Or we'll bring democracy to your country.

by Drew J Jones (pedobear@pennstatefootball.com) on Fri Nov 17th, 2006 at 06:08:37 PM EST
[ Parent ]
Bad Drew: no personal attacks, even if he started it.
by Colman (colman at eurotrib.com) on Fri Nov 17th, 2006 at 06:17:40 PM EST
[ Parent ]
I know.  You're right.  Regretted posting it as soon as I hit the button.  I apologize.

Be nice to America. Or we'll bring democracy to your country.
by Drew J Jones (pedobear@pennstatefootball.com) on Fri Nov 17th, 2006 at 06:19:09 PM EST
[ Parent ]
you're both academics....?
by Nomad on Fri Nov 17th, 2006 at 07:39:57 PM EST
[ Parent ]
The "Nobel" prize in economics is a joke.

Indeed. Even the common name is a bit fraudulent. The "Nobel Prize" in economics is actually the "Nobel Memorial Prize", and was first awarded in 1969.

Words and ideas I offer here may be used freely and without attribution.

by technopolitical on Sat Nov 18th, 2006 at 02:33:26 AM EST
[ Parent ]
I believe it was instituted in a bit of tit-for-tat. The Nobel commitee was interested in being allowed to break the will a bit and invest money in stocks, not only bonds. They made a deal with politicians interested in a price that would encourage their brand of social engineering (this is Sweden, 1968).

Voilà!

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se

by A swedish kind of death on Sat Nov 18th, 2006 at 01:18:58 PM EST
[ Parent ]
Apparently I'm not the only one who has noticed that the neo-con, libertarian conventional wisdom is not all it's cracked up to be:

From the editorial director of CBSnews.com

Good Riddance To The Gingrichites

(I know the true libertarians always claim that their ideals were subverted by the evil, greedy politicians in power, but this is just part of their fantasy world, that some new savior will do it right.)

Policies not Politics
---- Daily Landscape

by rdf (robert.feinman@gmail.com) on Fri Nov 17th, 2006 at 06:27:04 PM EST
A(t), obviously, represents assets.

;)

A great diary, Drew.  I'm gonna read my Kenyes...

The Monetarists, and Neoclassicalists in general, were obviously more concerned with mathematics than the Keynesians have traditionally been.  This, too, is partly a product of Friedman, who, also being a statistician, insisted on models to predict outcomes.

Statistics!  But which statistics, and over how long a time period--and through how many revolutions?  Short term thinking...comes to mind...great essay!

Re: The Great Depression.  I can't remember the details, but R. Buckminster Fuller persuaded me that the banks ran out of money, the govt. had to take over, all money was sourced from the state, the state took control, businesses had to invest in R&D, make what was needed, rein in the capitalists, all was hunky-dory (boom!  Economic growth!) until after the war, when the co.s decided that it was time to make profits, forgetting how without the govt. they wouldn't exist...have I got that all wrong?

(I's an ignoramus of these matters, Drew, so be kind!)

Okay, overall, I think the application of mathematics to economics is fine, as long as economics is serious about its mathematics.  X = Y (and variations thereof) is fine, as long as X and Y are clearly defined...or somesuch.  "People over time will trend towards..." is fine, great for actuarial tables, but how does lived history fit in?  But yay!  I will read Keynes...  I'm a convert...the original texts, yay!  And Adam Smith, but it seems, from what I understand (oh so little!) that he is useful for other times, but not these.

A (n other!) diary on Keynes, Drew.  (n other being Miguel's.)  A luvverly PhD-in-progress disseminated to this part of the wider public!

Keeping us healthy, wealthy, and wise....is the goal, no?

Don't fight forces, use them R. Buckminster Fuller.

by rg (leopold dot lepster at google mail dot com) on Fri Nov 17th, 2006 at 08:34:31 PM EST
A (n other!) diary on Keynes, Drew.

Should read

A (n other!) diary on Keynes, please, Drew!

Don't fight forces, use them R. Buckminster Fuller.

by rg (leopold dot lepster at google mail dot com) on Fri Nov 17th, 2006 at 09:26:21 PM EST
[ Parent ]
This is an outstanding diary, Drew.  Thank you for your time and effort to prepare this.  I don't like to pull any one comment out, but I will,
The Depression was thus, in his view, the result of missed opportunities at the Fed to stabilize the economy.  The book was so successful that current Fed chairman Ben Bernanke (then a governor under Alan Greenspan) remarked in 2002, at a celebration of Friedman's 90th birthday, "Regarding the Great Depression. You're right, we did it. We're very sorry."
The world is complex, with many factors not included in Friedman's models--ah, the impact of exogenous variables.  But clearly his theory has provided tools that allow the economic side of our lives to be better managed, by those countries that choose to do so.  We no longer need to suffer the periods of horrible depression or out of control inflation that previous generations lived with.  And Milton deserves some credit for that.  

I don't agree with some of the above comments on your diary.  Different countries may choose different views on wealth distribution, yet still benefit from the insights of Prof Friedman.  They can maximize overall economic benefit within their social views of wealth distribution, by applying Milton's concepts.  Friedman's views will help the more socialized views of some European systems to maximize their potential within their chosen economic/political framework; just as in countries with a more traditional capitalistic views, Friedman's work has been of enormous benefit.

I would argue that the application of some of Friedman's principles by the Fed in the US will prevent the recession postulated by some (ahem,,,,).  And from my perspective, thank you Milton.

by wchurchill on Sat Nov 18th, 2006 at 01:15:01 AM EST
He may have been "talented, decent and, frankly, inspiring" and in that light I applaud him as a human being.

But like virtually all of the other Nobel Memorial  Prize winning Economists he won his because his conclusions were consistent with maintenance of the catastrophically unfair and unsustainable global monetary and capital markets we take for granted as a "given".

The fact of the matter is - IMHO - that any interest-rate set in excess of the shared costs of administration and defaults is BY DEFINITION inflationary being unsupported by any "Economic Value" or "Money's Worth".

If I am wrong, would somebody please explain in what respect?

Deficit-based Money is not "Value" - it is a "Claim over Value" (IOU) issued by Banks based upon a "Fractional Reserve" aka fresh air - and bears the same relation to Value as anti-Matter does to Matter.

The outcome is that "monetarism" is totally and utterly baseless.

The axiomatic assumptions underpinning virtually all schools of Economics, and particularly Friedmans' - certainly suit those who run and profit from the system (ie print the Money and use some of their profits to finance Nobel Memorial prizes) but to use technical jargon Friedman's assumptions were, and remain, complete and utter bollocks.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sat Nov 18th, 2006 at 05:00:07 AM EST
I am not really sure what the importance of his work is. If stagflation can be explained by Keynesian economics, why is Friedman still honoured with dismantling it?

And what is the significance of his theories? Sorry if this is stupid question, I am neither an economist nor a mathematician.

by Trond Ove on Sat Nov 18th, 2006 at 10:13:21 AM EST
The dominant Keynesian model could predict stagflation given a supply shock in the oil market, but there was more going on in the '70s than that.  It could not have predicted the bad outcomes resulting from policy based on the strict belief in the Phillips Curve relationship being permanent.  According to IS-LM, the answer to contraction in real GDP was to pump up the economy using the Fed, fiscal policy or both.  What Friedman discovered was that this was only a temporary relationship -- an illusion -- that would eventually fall apart and yield rising unemployment as well as rising inflation, which many Keynesians would not have predicted at the time.

Be nice to America. Or we'll bring democracy to your country.
by Drew J Jones (pedobear@pennstatefootball.com) on Sat Nov 18th, 2006 at 12:46:23 PM EST
[ Parent ]


Display:
Go to: [ European Tribune Homepage : Top of page : Top of comments ]