Milton Friedman and Monetarism: Where He Went Wrong
As soon as Milton's Friedman's death was confirmed critics emerged out with praise on one hand and condemnation on the other hand. Their target, as expected, was the alleged failure of "monetarism". Ross Gittins of the Sydney Morning herald smugly stated that "monetarism was wrong and didn't work". "It was a theory built on assumptions that didn't hold. 'Money' was something hard to define and measure in practice. The assumption that central banks could control the supply of money was mistaken" and "the stagflation problem of the '70s was largely the product of a cost-push inflation problem built up as a result of decades of misguided government intervention in markets". (Milton got a lot of things right -- except monetarism, 18 November). Richard Adams of the Guardian simply asserted that monetarism is a failed doctrine (The Age, Friedman's legacy is largely symbolic, 21 November).
Alex Millmow, senior lecturer in economics at the University of Ballarat, argued that "[a]part from problems controlling the growth in the money supply, Friedman's prescription of deflating economic activity to snap freeze the inflation problem meant enduring high unemployment, and was politically untenable". To support this view he quoted Friedman's apparent recantation that "the use of quantity of money as a target has not been a success. I'm not sure that I would as of today push it as hard as I once did". (The Canberra Times, The rivalry of two great economists lives on, 21 November).
Michael Kinsley, American editor of The Guardian, was no better. According to this brilliant economic theorist "[t]he free market cannot be setting the right price for financial assets like shares of stock, because often there are different prices with equal claims to be the product of free-market capitalism". He then quoted the discredited John Kenneth Galbraith to the effect that "the free market in corporate shares doesn't produce well-run companies". (The Age, What capitalism just cannot get right, 22 November).
The above views are typical of much of the commentary surrounding Friedman's contribution to economics. They are also typical in the sense that none of these people have the slightest clue about actual "monetarism", otherwise they would have known precisely where Friedman went wrong. The truth is that the "Chicago school's" approach to money, despite the fancy mathematics, had not advanced much further than Jean Bodin's (1530-1566) monetary analysis, according to which the price level rose in proportion to the increase in the quantity of money. For a much more illuminating, and certainly more sophisticated approach, we should turn to the bullion controversy that Walter Boyd initiated in 1801 with his letter to Prime Minister Pitt in which he gave the following as a definition of money:
By the words 'Means of Circulation, 'Circulating Medium', and 'Currency', which are used almost as synonymous terms in this letter, I understand always ready money, whether consisting of Bank Notes or specie, in contradistinction to Bills of Exchange, Navy Bills, Exchequer Bills, or any other negotiable paper, which form no part of the circulating medium, as I have always understood that term. The latter is the Circulator; the former are merely objects of circulation.
Boyd's letter set in motion a debate from which our own economists could learn a great deal. The definition of money and whether money is neutral were two important elements of this debate. Monetarists like David Ricardo, who had been heavily influenced by John Wheatley (1772-1830), argued that changes in general prices are precisely proportional to changes in the quantity of money. This meant that not only was the quantity of money was all that mattered but money was neutral, meaning that changes in the money supply had no effect on individual prices, and therefore monetary-induced change in the structure of production would not emerge.
Opposing Ricardo et al on this issue was Lord King who correctly observed that the demand for money was always uncertain and variable. He then went on to describe how an increase in the quantity of money would alter relative prices and incomes, thus showing why money could not be neutral. (We now call this distributive process the Cantillon effect). In addition, Lord King and Walter Boyd fully understood that though money factors always predominated real factors also played a role in influencing prices.
There was also Henry Thornton's insight that forcing the rate of interest below its market rate would expand the money supply which then artificially stimulates the "needs of business"1. This results in 'savings' exceeding investment, what is now called "forced savings" and what Jeremy Bentham termed "forced frugality". It is clear that these early economists understood that for 'savings to exceed investment' a monetary expansion is necessary. In the words of Malthus:
Whenever, in the actual state of things, a fresh issue of notes comes into the hands of those who mean to employ them in the prosecution and extension of profitable business, a difference in the distribution of the circulating medium takes place, similar in kind to that which has been last supposed; and produces similar, though of course, comparatively inconsiderable effects, in altering the proportion between capital and revenue in favour of the former. The new notes go into the market as so much additional capital, to purchase what is necessary for the conduct of the concern. But, before the produce of the country has been increased, it is impossible for one person to have more of it, without diminishing the shares of others. [Emphasis added].
This diminution is affected by the rise of prices, occasioned by the competition of the new note, which puts it out of the power of those who are only buyers, and not sellers, to purchase as much of the annual produce as before: While all the industrial classes, -- all those who sell as well as buy, -- are, during the progressive rise of prices, making unusual profits; and, even when this progression stops, are left with the command of a greater proportion of the annual produce than they possessed previous to the new issues. (See Hayek's (Prices and Production, Lecture I, Pub. Augustus M. Kelley 1967, first published in 1931).
What we had here is a proto-Austrian analysis, the same one that Milton Friedman and his colleagues rejected. Under the influence of John Bates Clark Frank Knight, a leading economist at Chicago came to treat capital as a self-perpetuating homogeneous fund that reproduces itself. This view clearly denies the existence of stages of production and the role of time in production while treating maintenance and reproduction as an automatic process independent of human action.
The Chicago approach to capital therefore leads to the assumption that production is instantaneous, consisting of a single stage of production in which there are no intermediate capital goods. (This is presented in textbook as the circular flow of income). As Böhm-Bawerk pointed out in 1895 this model could resurrect the underconsumption fallacy, which is precisely what has happened. With production -- consisting of a single self-reproducing stage -- and consumption occurring simultaneously an increase in savings would cause a recession. Another serious problem with the Chicago school is its adoption of the mechanistic monetary approach. And this returns us to Milton Friedman2.
In order to get the money supply to match the economic data he was forced to include all manner of credit instruments among his monetary aggregates. But if he and his colleagues had taken note of Richard Cantillon (1680?-1734) and the ideas of Boyd, Lord King, Thornton, etc., he might have abandoned the mechanistic approach and realized the value of treating money as very active agent with considerable powers of disruption. In turn this could have led him to accept the Austrian analysis that not only sees capital as heterogeneous but the demand for money as being as important as the supply. That Friedman knew all was not right with the quantity theory was hinted at in the following statement:
"[T]he price level fell to half its initial level in the course of less than fifteen years and, at the same time, economic growth proceeded at a rapid rate. The one phenomenon was the seedbed of controversy about monetary arrangements that was destined to plague the following decades; the other was a vigorous stage in the continued economic expansion that was destined to raise the United states to the first rank among the nations of the world. And their coincidence casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible. (Milton Friedman and Anna J. Schwartz, A Monetary History of the United States 1867-1960, Princeton, N.J.: Princeton University Press, 1971).
There was a similar price phenomenon in Britain which saw wholesale prices fall by about 32 per cent from 1873 to 1896. (S. B. Saul, The Myth of the Great Depression 1873-1896, Macmillan Publishers 1985). The reason for these price falls was the demand for money rose at a faster rate than the supply of money. This is just a fancy way of saying that production outstripped the gold supply. (This is not a deflationary situation. Deflation occurs when the absolute quantity of money falls thus raising its value).
Friedman claimed that the Austrian explanation of the 'business cycle' had failed the statistical test and was therefore false. But it was Friedman who was wrong. His mistake was to use GDP data which omits intermediate spending between stages of product. In other words, Friedman's approach missed the most important element from the Austrian perspective. During 1999 I was continually warning that the fall in manufacturing jobs and output signalled that the US economy was already sliding into recession even though GDP and the demand for labour were rising. This meant that spending between stages of production had to be falling. All of which was concealed by the GDP approach. No wonder Steve Slifer, chief economist at Lehman Brothers, said of the US economy in January 2001:
It's really an odd-looking slowdown. The manufacturing sector is, in fact, in a recession but not the overall economy. At least not yet.
To explain periodic recessions Friedman came up with the "plucking model". Imagine a string stretched between two points. The consistency of the string is such that one can pluck it at various points so that they sag. These are the busts. According to Friedman this merely shows that what goes down must go up. But this is no explanation at all. Yoshio Suzuki, a Japanese economist, certainly thinks so. Moreover he believes that the Austrian analysis fits the bill. According to Suzuki:
As Hayek teaches us, easy money does not always raise the price of goods and services, but always creates an imbalance in the structure of the economy, particularly in the capital markets. . . . This is exactly what happened in Japan [in the 1980s]. (Dr. Yoshio Suzuki, Comment on Papers by Benegas Lynch and Skousen, Mont Pelerin Society Meetings, September 27, 1994, Cannes, France. Suzuki also stated: "In my 40 years' experience as a monetary economist, I have never felt as strongly as I do today the need to bring back to life the essence of Hayek's trade cycle theory").
The most devastating criticism of the quantity theory of money was made by Benjamin M. Anderson who said that
The formula of the quantity theorists is a monotonous "tit-tat-toe" -- money, credit, and prices. With this explanation the problem was solved and further research and further investigation were unnecessary, and consequently stopped -- for those who believed in this theory. It is one of the great vices of the quantity theory of money that it tends to check investigation for underlying factors in a business situation. The quantity theory of money is invalid. . . . We cannot accept a predominantly monetary general theory either for the level of commodity prices or for the movements of the business cycle. (Economics and the Public Welfare, pp. 70-71, LibertyPress 1979 first published 1949. Anderson also produced a damning indictment of the quantity theory in his The Value of Money, Libertarian Press Inc., first published in 1917).
As for the likes of Gittins and Adams, let me make a couple of observations. During the Whitlam years December 1972 to November 1975 the CPI rose by more than 40 per cent. During the same period currency leapt by 75 per cent. February 1975 to December 1975 saw bank deposit jump by21 per cent and M1 by 20 per cent. (The RBA had no figures for bank deposits and M1 prior to February 1975). So much for the mindless claim that the problem was one "of a cost-push inflation". Even Keynesian economists, at least the sensible ones, admit "that for any inflation to be sustained it must be accommodated by increases in the money supply". (Richard Lipsey, Paul C. Langley, Dennis Mahoney, Positive Economics for Australian Students, Weidenfeld and Nicolson, second edition, p. 70).
Kinsley comments serve to emphasize why journalists should steer clear of economics. Is he seriously arguing that Microsoft is not a well run company and that Bill Gates is incompetent? His comment comments about the pricing of assets is just as silly. Shares are priced according to the discounted value of their anticipated future earnings. Therefore it ought to be plain, except to the likes of Kinsley, that shares will be valued differently by different players in accordance with their expectations of future earnings. Moreover, he is clearly unaware of the fact that loose monetary policies inflate and distort asset prices.
Milton Friedman made a significant contribution by emphasising the link between political freedom, the rule of law and free markets3.. Unfortunately his support for the crude quantity theory was a huge step backwards for monetary theory.
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1. Unfortunately Lord King and Thornton rejected Boyd's accurate definition of money and added debt instruments to the money supply. This is why Peel's 1844 Bank Act. Failed.
2. See Israel M. Kirzner's An Essay on Capital, Pub. Augustus M. Kelley 1966.
3. Some smart-aleck lefties still argue that Chile refutes Friedman's claim that there is a link between freedom and free markets. These political bigots deliberately turn a blind eye to the indisputable fact that Chile is now a democracy while socialist Cuba still suffers under the dying hand of a vicious Marxist dictator.
The Austrian definition of Australia's money supply:
M1 (which equals cash and checking accounts) plus government deposits, including state RBA deposits. Government liabilities equal deposits of governments and government instrumentalities.