Where Friedman Went Wrong

By: Antal E. Fekete | Thu, Nov 30, 2006
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What the Obituaries Don't Say

I was in Chicago on November 17, 2006, to address the 2007 MBA class of the University of Chicago Graduate School of Business. I had a prepared address on Milton Friedman's monetary theories concerning the adjustment mechanism of foreign trade under the floating exchange rate system. Before I could deliver it the announcement came that Milton Friedman died the previous day in San Francisco at the age of 94. Newspapers carried long obituaries calling him the man "who changed economics, policy, and markets", and the man "who made free markets popular again". My address was sharply critical of the Nobel laureate Chicago economist. It would have been a dissonant chord in the cacophony of eulogies, so I decided not to deliver it and, instead, I delivered an extempore address. However, I did not tear up my script. I realized that a dollar crisis was brewing. Friedman has sowed the wind and the world is going the reap the whirlwind. Soon. When it does, I may want to publish my critique of Friedman's monetary theories.

Here it is.

Keynes and Friedman

Graduating Class, honored guests, Ladies and Gentlemen:

You may call me reckless for daring to come here, the shrine of monetarism, to preach the anti-monetarist gospel. I must confess that I do it with some diffidence Yet I do it because I have to.

Along with John Maynard Keynes (1883-1947), Milton Friedman was the enfant terrible of twentieth-century economics. Thirty-five years apart, the two of them were the great wreckers of the gold standard. George Schultz, a friend of Friedman's who served in the Nixon administration, says that in 1968 Friedman wrote a letter to president-elect Nixon suggesting that upon inauguration he should unilaterally take the United States off the gold standard (whatever was left of it after president F. D. Roosevelt had wrecked it thirty-five years earlier, in 1933, on advice from Keynes).

In 1933 Keynes had set out to persuade Roosevelt to default on the domestic gold obligations of the United States. He prevailed. In 1968 Friedman set out to persuade Nixon to default on the international gold obligations of the United States. He did not prevail. Not immediately, anyway. Thus the credit for dealing the coup de grâce to the gold standard temporarily eluded him.

Demonetization of gold was not the only option available to Nixon. He could have also devalued the dollar in terms of gold. As is known, Mises was in favor of the latter. A new official gold price of $70 per oz, amounting to a 50 percent devaluation, was the figure being bandied about.

Friedman's unsolicited advice to Nixon tells us something about the character of the man. Rather than initiating a high-level debate among monetary economists on the disastrous monetary policies of the US government after 1933 that had 35 years later led to the 1968 crisis, Friedman preferred to work behind the scenes on plunging the nation headlong into irredeemable currency. He wanted to make the dollar an out-and-out fiat money, the worst type of currency known to man.

Friedman of course knew that people would be hooked on fiat money once it was inflicted on them. Here is a quotation from monetary scientist Walter E. Spahr [1] who served as the Head of Department of Economics at New York University from 1927 to 1956.

"The majority, when given a taste of it, embrace irredeemable currency. The arguments offered in its defense are many and various, and constitute a sad commentary on human intelligence and character. The dilemma whether to give it up or not is much like that of the drug addict whether to give up dope. Even if he wanted to heed the advice of his understanding and experienced physician, more often than not he will stick with the dope. The run-of-the-mill speeches and articles on 'inflation' in this country provide a typical example of the majority reaction: they either evade the issue in ignoring that inflation is caused by fiat money, or they distort pertinent evidence, or they preach virtue where there is none, or they utilize currently popular platitudes, or they treat superficiality as though it should be accepted as wisdom. Rarely does one see a statement that an irredeemable currency is preferable accompanied by an attempt to give reasons for such an untenable belief."

Well, Friedman's is precisely such a statement.

"A nation in due course pays severely for the use of irredeemable currency. The United States is in a position analogous to that of a drug addict administering a law liked by all other fellow drug addicts."

Unfortunately, in this case, the 'understanding' and 'experienced' physician, Friedman, urges the addict to carry on with his 'substance abuse'.

Irredeemable currency is a massive fraud

The following quotation is also from Walter E. Spahr [2].

"Irredeemable currency means either fiscal or moral bankruptcy, or both. We are morally bankrupt now in so far as our monetary system is concerned. Both the U.S. government and the Federal Reserve have demonstrated that they wish to be free of pressure that people may put on them if our currency were redeemable. They are satisfied to hide behind irredeemable I.O.U.'s. Although a private citizen can expect imprisonment if he issues irredeemable bills of credit, our government and Federal Reserve banks have adopted as defensible a standard of morality that is not tolerated among honest people. This tantamount to exercising power arbitrarily while refusing to accept the corresponding responsibility."

It is unfortunate indeed that Friedman has never addressed the question of morality in issuing obligations that one has neither the means nor the intention to meet as is demonstrated in the check-kiting scheme between the U.S. Treasury and the Federal Reserve Open Market Committee.

"A nation is in serious trouble when that state of affairs exists. The federal spending orgy since 1933, the depreciation in the purchasing power of our dollar, the mounting federal debt, the centralization of power in Washington, D.C., the steady march into the Death Valley of socialism, these are some of the manifestations of what tends to happen when a government steals the people's purse, having drugged them with the poison of irredeemable bills of credit."

Although this was written in 1958, what has happened since has surpassed the worse fears of the author. One feels like asking Friedman directly how he would answer Spahr's fear.

"Irredeemable currency is a massive fraud on the people. It is the chief and common means by which governments put shackles on free men."

In spite of all his free-market rhetoric, this point was lost on Friedman.

"A government loses its moral standing among men of integrity when it employs irredeemable I.O.U.'s. Irredeemable currencies are monuments to the dishonor of governments."

And, as one might add, to the dishonor of advisors who urge the government to carry on the abuse of power usurped in defiance of the Constitution.

"Irredeemable currency tends to expand and grow, and to carry the abusers to their destruction. It is a potent contributor to international economic disintegration."

To this day Friedman could not see the signs of disintegration, be it the explosive increase of the money supply, or the Babeldom of foreign exchange trading at $ 720 trillion per annum when the combined GNP of all the nations on earth is a paltry $ 40 trillion per annum.

"Irredeemable currency is a cesspool in which economic disease and human conflict are spawned. It is a wrecker of people, of families, and of nations. It is a road to the despotism of dictatorship."

It was in Russia in 1917; it was in Germany in 1933; in was in China in 1949, to mention but three outstanding examples. Does Friedman really believe that it cannot happen here?

"Irredeemable currency is a symptom of a great national sickness. It 'engages all the hidden forces of economic law on the side of destruction which not one man in a million is able to diagnose'(according to Keynes, writing in 1919)."

Apparently, Friedman is not the one.

"What is the meaning of a gold standard and a redeemable currency? It represents integrity. It insures the people's control over the government's use of the public purse. It is the best guarantee against the socialization of a nation. It enables a people to keep a check rein on their government and banks. It prevents currency expansion from getting ever farther out of bounds until it becomes worthless. It tends to force standards of honesty on government and bank officials. It is the symbol of a free society and an honorable government. It is a necessary prerequisite to economic health. It is the first economic bulwark of free men."

It is a great tragedy of our age that Friedman, the self-styled defender of the freedom of the individual and the free market, could not see this.

Floating or sinking?

In the 1950's Friedman concocted his pseudo-theory how the floating system of foreign exchange rates would provide an automatic adjustment mechanism to balance the external accounts of trading nations. This was supposed to show that a gold standard was not prerequisite of bringing about equilibrium in foreign trade. To say that Friedman was not a friend of the gold standard is a gross understatement. He maintained that the gold standard was a "price-fixing scheme" and as such, was anathema to the free market.

A monetary scientist should known better than putting the cart before the horse. A gold standard does not fix the price of gold any more than the tail wags the dog. Once gold is in circulation, it is the price of bonds and notes that governments and banks are all too anxious to fix in terms of the gold coin of the realm. If they can, gold gives their obligation great respectability. If they can't, then well-informed people will make their own conclusion about the quality of the paper.

According to Friedman's theory, under freely floating foreign exchanges a country in deficit would experience a loss in the exchange value of its national currency vis-a-vis a country in surplus which would, in turn, experience a gain. The former would be a more attractive market to buy from and less attractive to sell to; it would now export more and import less. The latter would be a less attractive market to buy from and more attractive to sell to; it would now export less and import more. The resulting changes in the export-import cocktail would restore balance in trade.

Friedman's theory in effect asserts that the worst currency is the best and the best is the worst. It is absurd. After 1971 this theory was put to the test by Nixon. The result, judged from 35 years' perspective, was an unmitigated disaster. The monetary, financial, and economic stature of the United States now lies in ruins in consequence Friedman's floating dollar. 'Floating' is a euphemism for 'sinking'. The sinking dollar has turned the country from the greatest creditor into the greatest debtor the world ever knew. It used to be a monetary giant; now it is a dwarf treated with contempt abroad. And the worst is still to come. We are facing a credit collapse.

Floating did not solve the problems the United States was facing in 1968. It made them worse. The devaluation and the subsequent deliberate weakening of the dollar did not make the American exporters stronger; it made them weaker. The weak dollar was a huge bonanza for the foreign competitors of America. They were able to buy more imported goods per unit of exports. By contrast, Americans were able to buy less. The deficit was financed by an unprecedented debt-pyramid spinning out of control. The terms of trade for America has been fast deteriorating. It is not just the foreign purchasing power of the dollar that is on skid row. So is its domestic purchasing power, the doctoring of statistics notwithstanding. The widely fluctuating value of the obligations of the U.S. government is a butt of some very unkind jokes by foreigners.

What caused the great Depression?

In their "Monetary History" published in 1963 Friedman and Anna Schwartz blamed the Great Depression of the 1930's on the 'Great Contraction' of the money supply in the United States during the period 1929 to 1933. This is where Friedman went wrong. He made the classical error of fallacious reasoning post hoc ergo propter hoc, mixing up cause and effect. He blindly assumed that the Great Depression was caused by Federal Reserve. He never examined other possible causes, going farther back in history.

Unnoticed by Friedman and Schwartz, 1909 was a milestone in the history of money. That year, in preparation for the coming war, France and Germany decided to concentrate monetary gold in their own coffers. They stopped paying civil servants in gold coin. To make this legally possible the notes of the Bank of France and the Reichsbank were made legal tender. Most people did not even notice the subtle change. Gold coins stayed in circulation for another five years. It was not the disappearance of gold coins from circulation that heralded the destruction of the world's monetary system. There was an early warning: the 'crowding out' of real bills from the portfolio of central banks by finance and treasury bills, in consequence of the French and German governments' decision to make bank notes legal tender. Thus the clearing system of the international gold standard fell victim to sabotage. It took twenty years before the chickens of 1909 came home to roost. Come home they did with a vengeance. However, by 1929 the memory of the 1909 sabotage faded. No one realized that a causal connection existed between the two events: making the bank notes legal tender and the wholesale destruction of jobs twenty years later.

Real Bills Doctrine

Friedman calls himself a 'monetarist', meaning that he is a devotee of the Quantity Theory of Money. Like all quantity theorists, he is a sworn enemy of Adam Smith's Real Bills Doctrine. He has never understood completely the market in real bills as it existed before World War I, the function of which was to serve as the clearing system for the international gold standard.

When the victorious powers dictated their peace terms after the cessation of hostilities, they intentionally disallowed the international bill market to resume its functions. They wanted foreign trade to follow a political rather than an economic agenda, in this case, to keep their former adversaries on short leash. At the same time, they wanted to retain the outward trappings of a gold standard. They failed to realize that the gold standard would sooner or later collapse without the support of its clearing system, the bill market. Worse still, they failed to see that world trade would contract as a consequence. Worst of all, they were too obtuse to understand that the elimination of the bill market would be followed, albeit with some lag, a horrendous and intractable unemployment problem confronting the entire world. This was correctly foreseen and predicted in 1930 by the German economist Heinrich Rittershausen [3].

Had the victors allowed the market in real bills to resume its proper functions after the signing of peace treaties, world trade would have recovered quickly and the international gold standard would have continued to hold sway over the world. With a little bit of luck, economists would have suggested that legal tender laws were thoroughly bad, sensible governments would have been removed from the books. Thre would have been no great depression, and no massive and persistent word-wide unemployment.

Destruction of the wage fund

The fact of the matter is that, prior to World War I, wages of the overwhelming majority of workers, namely all those engaged in the consumer goods sector, were financed by the international bill market. This is a point that eluded not only Milton Friedman but Ludwig von Mises as well. Payment of wages is due long before the sale of merchandise to the ultimate gold-paying consumer. In some cases the employer paying wages may have to wait as long as three months before he can collect his share of the proceeds from the sale of merchandise. Thus, then, there is the problem of financing wage payments. Unless this problem was solved satisfactorily, mass unemployment would ensue. The wage fund was not financed out of savings. Under the gold standard it was financed through the spontaneous circulation of real bills.

Whenever certain goods were in urgent demand, their movement through the channels of production and distribution was financed by self-liquidating credit. This also included all wages payable to workers handling the maturing consumer goods as they were moving along the 'assembly line' of the production and distribution channels on their way to the consumer. The credit was liquidated out of the proceeds of the sale: the gold coin given up by the ultimate consumer when he removed the merchandise from the market at the end of the 'assembly line'. The system worked admirably well. Bills drawn on the retailer by the producer would circulate spontaneously. They enjoyed ephemeral monetary privileges, which treasury bills and finance bills didn't. The producer could buy supplies against this credit, or he could discount these bills at his bank to get gold coins with which he would pay wages. Bills were the most liquid form of earning assets in existence. Banks were keenly competing for them. As they were bought and sold at a discount to face value in the international bill market, holders of bills could derive a gold income from their bill portfolio.

It is no exaggeration to say that the discovery of the spontaneous circulation of self-liquidating credit is one of the great achievements of the human intellect, on a par with the discovery of indirect exchange. Without it the great economic progress in the Modern Age would be unthinkable.

The victorious powers after World War I, led by blind hatred for the vanquished, wanted to make foreign trade bilateral instead of multilateral. Exports and imports were made subject to political rather than economic considerations, so that the victors could discriminate against their former adversaries. In this effort they inadvertently ruined the natural system of financing production and payments of wages. They dissipated the wage fund. They blocked the spontaneous circulation of self-liquidating credit in the world, the only safe and sound source from which wage payments could be financed. They were unaware that in doing so they have dealt a mortal blow to the international gold standard, and that they have brought upon the world the intractable problem of massive and persistent unemployment.

This problem has been haunting us ever since, as there is still no satisfactory way of financing the wage fund of workers in the consumer goods sector in the absence of a gold standard cum real bills. There is no way bills could circulate under the regime of irredeemable currency. Not because real bills are anathema to Friedman; but because the idea of a real bill maturing into paper money is preposterous. A real bill must mature into a present good such as the gold coin. A real bill is a future good and the only reason it may circulate spontaneously is that it, as it were, 'matures' into the gold coin. It would not circulate if it matured into another future good, such as a bank note, redeemable or not.

No less preposterous is the idea that the wage fund could be financed out of savings. The sums involved are far too large for that. The only alternative to gold standard cum real bills is the regime of irredeemable currency. But then the government has to assume the responsibility for paying the handouts of the welfare state: pay workers for not working, and pay farmers for not farming. Tertium non datur: no third alternative. The regime of irredeemable currency and the so-called welfare state are Siamese twins. Here, in a nutshell, is Friedman on the horns of a dilemma.

Optimal rate of increasing the stock of money

Of course, Friedman says he has a panacea in mind for all the economic ills of the world. Just entrust the issuance of high-powered money, at a steady optimal rate, to the Federal Reserve. He was jubilant when Arthur Burns was named as the new chairman at the Fed. If anybody, he could do it. He could put the tenets of monetarism into practice. Well, he didn't. Neither did other chairmen, Bernanke's "apology" to Friedman on his 90th birthday notwithstanding. Central bankers consider Friedman's prescriptions "impractical" and they have said so. Friedman retaliated by quipping that "even a clever horse thrashing corn can do it, why can't dummies at the Fed?" If they did, there would be neither inflation, nor deflation. The economy could stay on an even keel. Simplistic, ain't it?

The idea that there is an 'optimal rate' of increasing the stock of money, and it could be determined scientifically, is chimerical. Creditors would challenge the 'optimal rate' saying it is too high; debtors would fight it saying it is too low. The federal government, being the greatest debtor of them all, would apply pressure on the Fed to support the latter.

If the power to increase the money supply is delegated to an agency dressed in scientific garb, then this agency is a front behind which impostors hell-bent to usurp unlimited power under false pretenses hide. No matter how you look at it, the power to issue the currency is unlimited power. Unlimited power means unlimited corruption.

Mene Tekel Upharsin

In so far as Friedman has any coherent theory of money at all, it is the theory that, even though the creation of wealth must be trusted to private hands and to the free play of the market, the creation of money must not -- notwithstanding the monetary provisions of the U.S. Constitution. Money creation must be put squarely into the hands of the government -- never mind the Constitution which is, after all, just a piece of paper (with apologies to George W. Bush).

Naturally, the U.S. government and the Federal Reserve were all too eager to embrace unlimited power assigned to them by Friedman, never mind that this power was not 'enumerated' in, nay, was explicitly denied by the Constitution of the United States. Friedman's defense of a floating currency is pseudo-scientific claptrap, modernistic stuff designed to impress the mind untrained in monetary science (as opposed to "dismal monetary science"). The unfortunate part is that permanent damage has been inflicted to social science faculties of our colleges and universities, where so many have abandoned true science for the dismal kind 'following the leader' -- which in practice meant following the scent of money.

When Friedman's monetary theory is put in the scale against the U.S. Constitution, the verdict is: "Mene tekel upharsin" (you have been weighed and found wanting). One should think that a theory in the citation for Nobel Prize must be well worth a constitutional amendment. Apparently it isn't. The U.S. government and the Federal Reserve don't want to rock the boat. 'Let the sleeping dog lie'. It is too risky to introduce a constitutional amendment. The credentials of Friedman may not be strong enough to withstand public furor that would erupt if the paper dollar, hardly worth one constitutional gold cent, were supposed to be carved into the stone of the U.S. Constitution. Policy-makers could never muster the necessary moral courage to initiate an amendment to do it. They would rather live with the odium of running a blatantly unconstitutional monetary regime. They may think that the imprimatur of another central bank, in this case the Swedish Riksbank furnishing funds for Nobel prizes in economics, is a perfect substitute for such a constitutional amendment. Never mind the conflict of interest that the prize was given to reward suggestions for unconstitutional ways to create the money.

In "Two Lucky People", written together with his wife Rose, Friedman said: "We do not influence the course of events by persuading people that we are right when we make what they regard as radical proposals. Rather, we exert influence by keeping options available when something hast to be done at a time of crisis".

Well, Mr. Friedman, crisis is knocking right on our door. Options to reinstate a gold standard cum real bills, thanks to you and to Mr. Keynes, apparently are no longer are available.

[1] The Real Culprit, by Walter E. Spahr, Monetary Notes, July 1, 1959.
[2] The Debate Is Not Over, by Walter E. Spahr, U.S.A., May 9, 1958.
[3] Arbeitslosigkeit und Kapitalbildung, by Heinrich Rittershausen, Jena: Fischer, 1930
[4] Unemployment: Human Sacrifice on the Altar of Mammon, by Antal E. Fekete, September 30, 2005;



Author: Antal E. Fekete

Antal E. Fekete
Professor, Intermountain Institute of Science and Applied Mathematics, Missoula, MT 59806, U.S.A.

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The publication of this letter is for your information and amusement only. The author is not soliciting any action based upon it, nor is he suggesting that it represents, under any circumstances, a recommendation to buy or sell any security. The content of this letter is derived from information and sources believed to be reliable, but the author makes no representation that it is complete or error-free, and it should not be relied upon as such. It is to be taken as the authors opinion as shaped by his experience, rather than a statement of facts. The author may have investment positions, long or short, in any securities mentioned, which may be changed at any time for any reason.

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