The Long FAQ on Liberalism
A Critique of the Chicago School of Economics:
MILTON FRIEDMAN AND MONETARISM
In the decades following World War II, conservative economics
was in a sorry state. Keynesianism had conquered everything --
even Richard Nixon said, "We are all Keynesians now."
Much of the reason was because Keynesianism seemed to work. Under
Keynesian policies, nations were no longer suffering depressions;
and when recessions hit, these policies seemed to reduce them.
In those postwar years, the only real torchbearer for conservative
economics was Milton Friedman. Although he accepted Keynes' definition
of recessions, he rejected the cure. Government should butt out
of the business of changing the money supply, he argued. It should
keep the money supply steady, expanding it slightly each year
only to allow for the natural growth of the economy and a few
other basic factors. Market forces would cause inflation, unemployment
and production to adjust themselves automatically and efficiently
around this fixed amount of money. This policy he named monetarism.
But what about recessions, and the success of Keynesian policies
in cutting them short? Friedman responded with a point that was
historically true: that past economic slumps had not started by
people spontaneously hoarding money. Instead, these slumps were
caused when nations withdrew money from their money supply. Recall
that, prior to World War II, the world operated under a unified
gold standard, and international trade was paid in gold. Whenever
a nation ran up a huge trade deficit, it paid its bill out of
its gold reserves, thus causing a reduction in its domestic money
supply. This in turn caused the depressions that wracked so many
national economies. Friedman argued that if the money supply were
simply held steady, nations wouldn't suffer from depressions in
the first place, and would thus have no need to rely on deflation
or Keynesian policies to correct them.
Friedman then went on to make a more direct argument against Keynesian
policy. Such policy was unstable and harmful, he argued. History
showed that whenever the central bank expanded the money supply,
there were "long and variable lags" between implementation
and effect. Sometimes the economy would recover on its own before
the effects of extra money hit, which would only overheat the
economy and raise inflation. So in response, the central bank
might put on the brakes, but again, there would be no predicting
when the effects of this action would take place, possibly causing
a deeper recession than normal. The unpredictability of these
long and variable lags made the usefulness of active monetary
policy doubtful at best.
Friedman's arguments seemed compelling at the time. Yet today's
economists regard them as more clever than accurate. To prove
his points, Friedman had to devise a different definition of "money"
from what most economists use. Most economists define "money"
as cash in circulation and its close equivalents, like checking
accounts. Friedman, on the other hand, used "monetary aggregates,"
which included virtually everything in the financial sector, including
such hard-to-reach money as savings deposits, money market accounts,
and other financial instruments.
The problem with using this broader definition is that it blurs
the distinction between cause and effect. If history shows that
"monetary aggregates" always shrink when a recession
hits, this really doesn't say which causes which. Friedman suggested
that cause and effect ran in the following direction: the government
was responsible for shrinking his "monetary aggregates,"
which in turn caused recessions. An example best illustrates his
At the onset of the Great Depression, monetary aggregates took
a sharp plunge. This was accompanied by falling production and
soaring unemployment. Why did monetary aggregates fall? Friedman
blames the Federal Reserve. But the reason why is subtle, and,
to many of Friedman's critics, even misleading. For at no time
did the Federal Reserve actually pull money out of the economy.
Instead, what happened was that three bank runs caused over 10,000
bank failures. This was the age of the gold standard, when bank
deposits were based on fractional gold reserves. If everyone tried
to come in and exchange their dollars for gold at the same time,
there was no way a bank could do it; the majority of its customers
would be left standing with worthless banknotes. In a bank panic,
customers would race each other to the bank to be the first to
withdraw their gold; quite often this set off a chain reaction
with other banks as well. These bank panics produced so many worthless
banknotes that the money supply dropped by about a third, with
catastrophic results. In response, both banks and families began
hoarding even more cash.
Now, when Friedman accused the Fed of causing this monetary contraction,
a careful reading of his work reveals that he is simply blaming
it for doing nothing. That is, he argues the Fed should have stepped
in and injected enough money into the economy to sustain his monetary
aggregates at their previous level. But this is essentially an
activist monetary policy, just like Keynesianism. There might
be some minor conceptual or tactical quibbles here, but the basic
monetary philosophy is the same.
As for his charge that monetary policy has "long and variable
lags," it is true that earlier Keynesian governments had
a tendency to overdo it. But over time central banks have improved
both their monetary tools and the skill with which they use them,
so Friedman's objection is gradually becoming less relevant over
Friedman's "overcleverness" on this issue raises a
frequent objection about his work. Probably all scientists have political
biases they would like to see proven, but a persistent theme among
Friedman's critics is that he is unusually willing to cut corners
to prove his points. Paul Krugman writes: "I think it is
fair to say that up until the late 1960s Friedman and his followers,
while influential, were regarded by many of their colleagues as
faintly disreputable." (2) Edward Herman writes: "Friedman's
methodology in attempting to prove his models have set a new standard
in opportunism, manipulation, and the abuse of scientific method."
(3) Paul Diesing lists six tactics Friedman uses to support a
pet hypothesis called "Permanent Income" (or PI). These
"1. If raw or adjusted data are consistent with PI, he reports
them as confirmation of PI
Monetarism reached the peak of its popularity during the
1970s. In the 80s, however, it suffered a sudden reversal of fortune,
and today economists generally agree that "monetarism is
dead." Friedman stands virtually alone now among top economists
in his belief that it contains any merit.
2. If the fit with expectations is moderate, he exaggerates the
3. If particular data points or groups differ from the predicted
regression, he invents ad hoc explanations for the divergence
4. If a whole set of data disagree with predictions, adjust them
until they do agree
5. If no plausible adjustment suggests itself, reject the data
6. If data adjustment or rejection are not feasible, express puzzlement.
'I have not been able to construct any plausible explanation for
What happened? Monetarism was tried in Great Britain during the
80s, under Margaret Thatcher, and it proved to be a disaster.
For almost seven years, the Bank of England tried its best to
make it work. According to monetarist theory, the British economy
should have enjoyed low inflation and high stability. But in fact,
it went berserk. The economy sank into a deep recession, while
lead economic indicators zigged and zagged. Although inflation
came down, this was at the price of rising unemployment, which
soared from 5.4 to 11.8 percent. Between 1979 and 1984, manufacturing
output fell 10 percent, and manufacturing investment fell 30 percent.
(5) Eventually production recovered to a respectable 2.8 percent
growth, but it became clear that high unemployment was a permanent
feature of the British economy. Eventually, the Bank of England
came under overwhelming pressure to abandon monetarism, which
it did in 1986. The experiment was such a failure that not even
conservatives abroad wish to repeat it.
In step with Great Britain, the U.S. Federal Reserve announced
in 1979 that it, too, would follow a monetarist policy. Many people
blamed the double-digit inflation of the late 70s on Keynesian
theory, on too much expansion of the money supply trying to achieve
"full employment." Many critics thought that monetarism
would restore some responsibility and stability at the Fed. Chairman
Paul Volcker apparently agreed, and under the name of monetarism
contracted the money supply down to a steady level. This produced
a deep recession, but it did cure double-digit inflation.
In 1982, when inflation looked defeated, the Fed suddenly abandoned
monetarism and reverted to a Keynesian policy. In that summer
it sharply increased the money supply, and a few months later
the economy roared to life, in a recovery that would last seven
years. Milton Friedman was furious at the betrayal, but he got
little sympathy from his fellow economists, who were witnessing
a monetarist disaster unfold in Great Britain.
Why did the Fed abandon monetarism? Because it was never really
monetarist in the first place. Volcker's strategy to defeat double-digit inflation
had been classically Keynesian: reign in the money supply, and
accept a deep recession in the process. The "monetarist"
label was simply political cover, to mollify the Fed's growing
number of critics. Such criticism was not renewed after monetarism
failed in Britain, and Keynesian policies produced a seven-year
boom in the U.S. The contrasting experience of those two nations
was responsible for the demise of Friedman's theory.
Next Section: Milton Friedman and the
Natural Rate of Unemployment
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1. Except where otherwise noted, this essay is primarily based
on Paul Krugman, Peddling Prosperity (New York: W.W. Norton
& Company, 1994), pp. 34-40, 172-178.
2. Krugman, p. 40.
3. Edward Herman, Triumph of the Market (Boston: South
End Press, 1995), p. 36.
4. Paul Diesing, "Hypothesis Testing and Data Interpretation:
The Case of Milton Friedman," Research in the History
of Economic Thought and Methodology, vol. 3, pp. 61-69.
5. Peter Pugh and Chris Garratt, Introducing Keynes (Cambridge,
UK: Icon Books Ltd., 1994), p. 152.