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. (1)

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 argument:

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 time.

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 are: 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.

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.

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Endnotes:

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.