The history of economic thought in the twentieth
century is a bit like the history of Christianity in the sixteenth century.
Until John Maynard Keynes published The General Theory of Employment,
Interest, and Money in 1936, economics—at least in the English-speaking
world—was completely dominated by free-market orthodoxy. Heresies would
occasionally pop up, but they were always suppressed. Classical economics,
wrote Keynes in 1936, "conquered
But classical economics offered neither
explanations nor solutions for the Great Depression. By the middle of the
1930s, the challenges to orthodoxy could no longer be contained. Keynes played
the role of Martin Luther, providing the intellectual rigor needed to make
heresy respectable. Although Keynes was by no means a leftist—he came to save
capitalism, not to bury it—his theory said that free markets could not be
counted on to provide full employment, creating a new rationale for large-scale
government intervention in the economy.
Keynesianism was a great reformation of economic
thought. It was followed, inevitably, by a counter-reformation. A number of
economists played important roles in the great revival of classical economics
between 1950 and 2000, but none was as influential as Milton Friedman. If
Keynes was Luther, Friedman was Ignatius of Loyola, founder of the Jesuits. And
like the Jesuits, Friedman's followers have acted as a sort of disciplined army
of the faithful, spearheading a broad, but incomplete, rollback of Keynesian
heresy. By the century's end, classical economics had regained much though by
no means all of its former dominion, and Friedman
deserves much of the credit.
I don't want to push the religious analogy too far.
Economic theory at least aspires to be science, not theology; it is concerned
with earth, not heaven. Keynesian theory initially prevailed because it did a
far better job than classical orthodoxy of making sense of the world around us,
and Friedman's critique of Keynes became so influential largely because he
correctly identified Keynesianism's weak points. And just to be clear: although
this essay argues that Friedman was wrong on some issues, and sometimes seemed
less than honest with his readers, I regard him as a great economist and a
great man.
Milton Friedman played three roles in the
intellectual life of the twentieth century. There was Friedman the economist's
economist, who wrote technical, more or less apolitical analyses of consumer
behavior and inflation. There was Friedman the policy entrepreneur, who spent
decades campaigning on behalf of the policy known as monetarism—finally seeing
the Federal Reserve and the Bank of England adopt his doctrine at the end of
the 1970s, only to abandon it as unworkable a few years later. Finally, there
was Friedman the ideologue, the great popularizer of
free-market doctrine.
Did the same man play all these roles? Yes and no.
All three roles were informed by Friedman's faith in the classical verities of
free-market economics. Moreover, Friedman's effectiveness as a popularizer and propagandist rested in part on his
well-deserved reputation as a profound economic theorist. But there's an
important difference between the rigor of his work as a professional economist
and the looser, sometimes questionable logic of his pronouncements as a public
intellectual. While Friedman's theoretical work is universally admired by
professional economists, there's much more ambivalence about his policy
pronouncements and especially his popularizing. And it must be said that there
were some serious questions about his intellectual honesty when he was speaking
to the mass public.
But let's hold off on the questionable material for
a moment, and talk about Friedman the economic theorist. For most of the past
two centuries, economic thinking has been dominated by the concept of Homo economicus. The hypothetical Economic Man knows what he
wants; his preferences can be expressed mathematically in terms of a
"utility function." And his choices are driven by rational
calculations about how to maximize that function: whether consumers are
deciding between corn flakes or shredded wheat, or investors are deciding
between stocks and bonds, those decisions are assumed to be based on
comparisons of the "marginal utility," or the added benefit the buyer
would get from acquiring a small amount of the alternatives available.
It's easy to make fun of this story. Nobody, not
even Nobel-winning economists, really makes decisions that way. But most
economists—myself included—nonetheless find Economic Man useful, with the
understanding that he's an idealized representation of what we really think is
going on. People do have preferences, even if those preferences can't really be
expressed by a precise utility function; they usually make sensible decisions,
even if they don't literally maximize utility. You might ask, why not represent
people the way they really are? The answer is that abstraction, strategic
simplification, is the only way we can impose some intellectual order on the
complexity of economic life. And the assumption of rational behavior has been a
particularly fruitful simplification.
The question, however, is how far to push it.
Keynes didn't make an all-out assault on Economic Man, but he often resorted to
plausible psychological theorizing rather than careful analysis of what a
rational decision-maker would do. Business decisions were driven by
"animal spirits," consumer decisions by a psychological tendency to
spend some but not all of any increase in income, wage settlements by a sense
of fairness, and so on.
But was it really a good idea to diminish the role
of Economic Man that much? No, said Friedman, who argued in his 1953 essay
"The Methodology of Positive Economics" that economic theories should
be judged not by their psychological realism but by their ability to predict
behavior. And Friedman's two greatest triumphs as an economic theorist came
from applying the hypothesis of rational behavior to questions other economists
had thought beyond its reach.
In his 1957 book A Theory of the Consumption
Function—not exactly a crowd-pleasing title, but an important
topic—Friedman argued that the best way to make sense of saving and spending
was not, as Keynes had done, to resort to loose psychological theorizing, but
rather to think of individuals as making rational plans about how to spend
their wealth over their lifetimes. This wasn't necessarily an anti-Keynesian
idea—in fact, the great Keynesian economist Franco Modi-gliani
simultaneously and independently made a similar case, with even more care in
thinking about rational behavior, in work with Albert Ando. But it did mark a
return to classical ways of thinking—and it worked. The details are a bit
technical, but Friedman's "permanent income hypothesis" and the
Ando-Modigliani "life cycle model" resolved several apparent
paradoxes about the relationship between income and spending, and remain the
foundations of how economists think about spending and saving to this day.
Friedman's work on consumption
behavior would, in itself, have made his academic reputation. An even bigger
triumph, however, came from his application of Economic Man theorizing to
inflation. In 1958 the New Zealand–born economist A.W. Phillips pointed out
that there was a historical correlation between unemployment and inflation,
with high inflation associated with low unemployment and vice versa. For a
time, economists treated this correlation as if it were a reliable and stable
relationship. This led to serious discussion about which point on the
"Phillips curve" the government should choose. For example, should
the
In 1967, however, Friedman gave a presidential
address to the American Economic Association in which he argued that the
correlation between inflation and unemployment, even thought it was visible in
the data, did not represent a true trade-off, at least not in the long run.
"There is," he said, "always a temporary trade-off between
inflation and unemployment; there is no permanent trade-off." In other
words, if policymakers were to try to keep unemployment low through a policy of
generating higher inflation, they would achieve only temporary success.
According to Friedman, unemployment would eventually rise again, even as
inflation remained high. The economy would, in other words, suffer the
condition Paul Samuelson would later dub "stagflation."
How did Friedman reach this conclusion? (Edmund S.
Phelps, who was awarded the Nobel Memorial Prize in economics this year,
simultaneously and independently arrived at the same
result.) As in the case of his work on consumer behavior, Friedman applied the
idea of rational behavior. He argued that after a sustained period of
inflation, people would build expectations of future inflation into their
decisions, nullifying any positive effects of inflation on employment. For
example, one reason inflation may lead to higher employment is that hiring more
workers becomes profitable when prices rise faster than wages. But once workers
understand that the purchasing power of their wages will be eroded by
inflation, they will demand higher wage settlements in advance, so that wages
keep up with prices. As a result, after inflation has gone on for a while, it
will no longer deliver the original boost to employment. In fact, there will be
a rise in unemployment if inflation falls short of expectations.
At the time Friedman and Phelps propounded their
ideas, the
By predicting the phenomenon of stagflation in
advance, Friedman and Phelps achieved one of the great triumphs of postwar
economics. This triumph, more than anything else, confirmed
Milton Friedman's status as a great economist's economist, whatever one may
think of his other roles.
One interesting footnote: although Friedman made
great strides in macroeconomics by applying the concept of individual
rationality, he also knew where to stop. In the 1970s, some economists pushed
Friedman's analysis of inflation even further, arguing that there is no usable
trade-off between inflation and unemployment even in the short run, because
people will anticipate government actions and build that anticipation, as well
as past experience, into their price-setting and wage-bargaining. This doctrine,
known as "rational expectations," swept through much of academic
economics. But Friedman never went there. His reality sense warned that this
was taking the idea of Homo economicus too
far. And so it proved: Friedman's 1967 address has stood the test of time,
while the more extreme views propounded by rational expectations theorists in
the Seventies and Eighties have not.
"Everything reminds
To understand what monetarism was all about, the
first thing you need to know is that the word "money" doesn't mean
quite the same thing in Economese that it does in
plain English. When economists talk of the money supply, they don't mean wealth
in the usual sense. They mean only those forms of wealth that can be used more
or less directly to buy things. Currency—pieces of green paper with pictures of
dead presidents on them— is money, and so are bank deposits on which you can
write checks. But stocks, bonds, and real estate aren't money, because they
have to be converted into cash or bank deposits before they can be used to make
purchases.
If the money supply consisted solely of currency,
it would be under the direct control of the government—or, more precisely, the
Federal Reserve, a monetary agency that, like its counterpart "central
banks" in many other countries, is institutionally somewhat separate from
the government proper. The fact that the money supply also includes bank
deposits makes reality more complicated. The central bank has direct control
only over the "monetary base"—the sum of currency in circulation, the
currency banks hold in their vaults, and the deposits banks hold at the Federal
Reserve—but not the deposits people have made in banks. Under normal
circumstances, however, the Federal Reserve's direct control over the monetary
base is enough to give it effective control of the overall money supply as
well.
Before Keynes, economists considered the money
supply a primary tool of economic management. But Keynes argued that under depression
conditions, when interest rates are very low, changes in the money supply have
little effect on the economy. The logic went like this: when interest rates are
4 or 5 percent, nobody wants to sit on idle cash. But in a situation like that
of 1935, when the interest rate on three-month Treasury bills was only 0.14
percent, there is very little incentive to take the risk of putting money to
work. The central bank may try to spur the economy by printing large quantities
of additional currency; but if the interest rate is already very low the
additional cash is likely to languish in bank vaults or under mattresses. Thus
Keynes argued that monetary policy, a change in the money supply to manage the
economy, would be ineffective. And that's why Keynes and his followers believed
that fiscal policy—in particular, an increase in government spending—was
necessary to get countries out of the Great Depression.
Why does this matter? Monetary policy is a highly
technocratic, mostly apolitical form of government intervention in the economy.
If the Fed decides to increase the money supply, all it does is purchase some
government bonds from private banks, paying for the bonds by crediting the
banks' reserve accounts—in effect, all the Fed has to do is print some more monetary
base. By contrast, fiscal policy involves the government much more deeply in
the economy, often in a value-laden way: if politicians decide to use public
works to promote employment, they need to decide what to build and where.
Economists with a free-market bent, then, tend to want to believe that monetary
policy is all that's needed; those with a desire to see a more active
government tend to believe that fiscal policy is essential.
Economic thinking after the triumph of the
Keynesian revolution—as reflected, say, in the early editions of Paul
Samuelson's classic textbook[*]— gave
priority to fiscal policy, while monetary policy was relegated to the
sidelines. As Friedman said in his 1967 address to the American Economic
Association:
The wide acceptance of [Keynesian]
views in the economics profession meant that for some two decades monetary
policy was believed by all but a few reactionary souls to have been rendered
obsolete by new economic knowledge. Money did not matter.
Although this may have been an exaggeration,
monetary policy was held in relatively low regard through the 1940s and 1950s.
Friedman, however, crusaded for the proposition that money did too matter,
culminating in the 1963 publication of A Monetary History of the
Although A Monetary History is
a vast work of extraordinary scholarship, covering a century of monetary
developments, its most influential and controversial discussion concerned the
Great Depression. Friedman and Schwartz claimed to have refuted Keynes's
pessimism about the effectiveness of monetary policy in depression conditions.
"The contraction" of the economy, they declared, "is in fact a
tragic testimonial to the importance of monetary forces."
But what did they mean by that? From the beginning,
the Friedman-Schwartz position seemed a bit slippery. And over time Friedman's
presentation of the story grew cruder, not subtler, and eventually began to
seem —there's no other way to say this—intellectually dishonest.
In interpreting the origins of the Depression, the
distinction between the monetary base (currency plus bank reserves), which the
Fed controls directly, and the money supply (currency plus bank deposits)
is crucial. The monetary base went up during the early years of the Great
Depression, rising from an average of $6.05 billion in 1929 to an average of
$7.02 billion in 1933. But the money supply fell sharply, from $26.6 billion to
$19.9 billion. This divergence mainly reflected the fallout from the wave of
bank failures in 1930–1931: as the public lost faith in banks, people began
holding their wealth in cash rather than bank deposits, and those banks
that survived began keeping large quantities of cash on hand rather than
lending it out, to avert the danger of a bank run. The result was much less
lending, and hence much less spending, than there would have been if the public
had continued to deposit cash into banks, and banks had continued to lend
deposits out to businesses. And since a collapse of spending was the proximate
cause of the Depression, the sudden desire of both individuals and banks to
hold more cash undoubtedly made the slump worse.
Friedman and Schwartz claimed that the fall in the
money supply turned what might have been an ordinary recession into a
catastrophic depression, itself an arguable point. But even if we grant that
point for the sake of argument, one has to ask whether the Federal Reserve,
which after all did increase the monetary base, can be said to have caused the
fall in the overall money supply. At least initially, Friedman and Schwartz
didn't say that. What they said instead was that the Fed could have
prevented the fall in the money supply, in particular by riding to the
rescue of the failing banks during the crisis of 1930–1931. If the Fed had
rushed to lend money to banks in trouble, the wave of bank failures might have
been prevented, which in turn might have avoided both the public's decision to
hold cash rather than bank deposits, and the preference of the surviving banks
for stashing deposits in their vaults rather than lending the funds out. And
this, in turn, might have staved off the worst of the Depression.
An analogy may be helpful here. Suppose that a flu
epidemic breaks out, and later analysis suggests that appropriate action by the
Centers for Disease Control could have contained the epidemic. It would be fair
to blame government officials for failing to take appropriate action. But it
would be quite a stretch to say that the government caused the epidemic,
or to use the CDC's failure as a demonstration of the superiority of free
markets over big government.
Yet many economists, and even more lay readers,
have taken Friedman and Schwartz's account to mean that the Federal Reserve
actually caused the Great Depression—that the Depression is in some sense a
demonstration of the evils of an excessively interventionist government. And in
later years, as I've said, Friedman's assertions grew cruder, as if to feed
this misperception. In his 1967 presidential address he declared that "the
US monetary authorities followed highly deflationary policies," and that
the money supply fell "because the Federal Reserve System forced or permitted
a sharp reduction in the monetary base, because it failed to exercise the
responsibilities assigned to it"—an odd assertion given that the monetary
base, as we've seen, actually rose as the money supply was falling. (Friedman
may have been referring to a couple of episodes along the way in which the
monetary base fell modestly for brief periods, but even so his statement was
highly misleading at best.)
By 1976 Friedman was telling readers of Newsweek
that "the elementary truth is that the Great Depression was produced by
government mismanagement," a statement that his readers surely took to
mean that the Depression wouldn't have happened if only the government had kept
out of the way—when in fact what Friedman and Schwartz claimed was that the
government should have been more active, not less.
Why did historical disputes about the
role of monetary policy in the 1930s matter so much in the 1960s? Partly because they fed into Friedman's broader anti-government
agenda, of which more below. But the more direct application was to
Friedman's advocacy of monetarism. According to this doctrine, the Federal
Reserve should keep the money supply growing at a steady, low rate, say 3
percent a year—and not deviate from this target, no matter what is happening in
the economy. The idea was to put monetary policy on autopilot, removing any
discretion on the part of government officials.
Friedman's case for monetarism was part economic,
part political. Steady growth in the money supply, he argued, would lead to a
reasonably stable economy. He never claimed that following his rule would
eliminate all recessions, but he did argue that the wiggles in the economy's
growth path would be small enough to be tolerable —hence the assertion that the
Great Depression wouldn't have happened if the Fed had been following a
monetarist rule. And along with this qualified faith in the stability of the
economy under a monetary rule went Friedman's unqualified contempt for the
ability of Federal Reserve officials to do better if given discretion. Exhibit
A for the Fed's unreliability was the onset of the Great Depression, but
Friedman could point to many other examples of policy gone wrong. "A
monetary rule," he wrote in 1972, "would insulate monetary policy
both from arbitrary power of a small group of men not subject to control by the
electorate and from the short-run pressures of partisan politics."
Monetarism was a powerful force in economic debate
for about three decades after Friedman first propounded the doctrine in his
1959 book A Program for Monetary Stability. Today, however, it is a
shadow of its former self, for two main reasons.
First, when the
Second, since the early 1980s the Federal Reserve
and its counterparts in other countries have done a reasonably good job,
undermining Friedman's portrayal of central bankers as irredeemable bunglers.
Inflation has stayed low, recessions—except in
By 2004, the Economic Report of the President,
written by the very conservative economists of the Bush administration, could
nonetheless make the highly anti-monetarist declaration that "aggressive
monetary policy"— not stable, steady-as-you-go, but aggressive—"can
reduce the depth of a recession."
Now, a word about
And under those conditions, monetary policy proved
just as ineffective as Keynes had said it was in the 1930s. The Bank of Japan,
In effect,
In 1946 Milton Friedman made his debut as a popularizer of free-market economics with a pamphlet titled
"Roofs or Ceilings: The Current Housing Problem" coauthored with
George J. Stigler, who would later join him at the
First, the pamphlet demonstrated Friedman's special
willingness to take free-market ideas to their logical limits. Neither the idea
that markets are efficient ways to allocate scarce goods nor the proposition
that price controls create shortages and inefficiency was new. But many
economists, fearing the backlash against a sudden rise in rents (which Friedman
and Stigler predicted would be about 30 percent for the nation as a whole),
might have proposed some kind of gradual transition to decontrol. Friedman and
Stigler dismissed all such concerns.
In the decades ahead, this single-mindedness would
become Friedman's trademark. Again and again, he called for market solutions to
problems—education, health care, the illegal drug trade—that almost everyone
else thought required extensive government intervention. Some of his ideas have
received widespread acceptance, like replacing rigid rules on pollution with a
system of pollution permits that companies are free to buy and sell. Some, like
school vouchers, are broadly supported by the conservative movement but haven't
gotten far politically. And some of his proposals, like eliminating licensing
procedures for doctors and abolishing the Food and Drug Administration, are
considered outlandish even by most conservatives.
Second, the pamphlet showed just how good Friedman
was as a popularizer. It's beautifully and cunningly
written. There is no jargon; the points are made with cleverly chosen
real-world examples, ranging from
The odds are that the great swing back toward
laissez-faire policies that took place around the world beginning in the 1970s
would have happened even if there had been no Milton Friedman. But his tireless
and brilliantly effective campaign on behalf of free markets surely helped
accelerate the process, both in the
Consider first the macroeconomic
performance of the
Part of the reason the second postwar generation
didn't do as well as the first was a slower overall rate of economic growth—a
fact that may come as a surprise to those who assume that the trend toward free
markets has yielded big economic dividends. But another important reason for
the lag in most families' living standards was a spectacular increase in
economic inequality: during the first postwar generation income growth was
broadly spread across the population, but since the late 1970s median income,
the income of the typical family, has risen only about a third as fast as
average income, which includes the soaring incomes of a small minority at the
top.
This raises an interesting point. Milton Friedman
often assured audiences that no special institutions, like minimum wages and
unions, were needed to ensure that workers would share in the benefits of
economic growth. In 1976 he told Newsweek readers that tales of the evil
done by the robber barons were pure myth:
There is probably no other period
in history, in this or any other country, in which the ordinary man had as
large an increase in his standard of living as in the period between the Civil
War and the First World War, when unrestrained individualism was most rugged.
(What about the remarkable thirty-year stretch
after World War II, which encompassed much of Friedman's own career?) Yet in
the decades that followed that pronouncement, as the minimum wage was allowed
to fall behind inflation and unions largely disappeared as an important factor
in the private sector, working Americans saw their fortunes lag behind growth
in the economy as a whole. Was Friedman too sanguine about the generosity of
the invisible hand?
To be fair, there are many factors affecting both
economic growth and the distribution of income, so we can't blame Friedmanite policies for all disappointments. Still, given
the common assumption that the turn toward free-market policies did great
things for the
Similar questions about the lack of
clear evidence that Friedman's ideas actually work in practice can be raised,
with even more force, for
On the contrary, the perception of most Latin
Americans is that "neoliberal" policies
have been a failure: the promised takeoff in economic growth never arrived,
while income inequality has worsened. I don't mean to blame everything that has
gone wrong in Latin America on the Chicago School, or to idealize what went
before; but there is a striking contrast between the perception that Friedman
was vindicated and the actual results in economies that turned from the
interventionist policies of the early postwar decades to laissez-faire.
On a more narrowly focused topic, one of Friedman's
key targets was what he considered the uselessness and counterproductive nature
of most government regulation. In an obituary for his one-time collaborator
George Stigler, Friedman singled out for praise Stigler's critique of
electricity regulation, and his argument that regulators usually end up serving
the interests of the regulated rather than those of the public. So how has
deregulation worked out?
It started well, with the deregulation of trucking
and airlines beginning in the late 1970s. In both cases deregulation, while it
didn't make everyone happy, led to increased competition, generally lower
prices, and higher efficiency. Deregulation of natural gas was also a success.
But the next big wave of deregulation, in the
electricity sector, was a different story. Just as Japan's slump in the 1990s
showed that Keynesian worries about the effectiveness of monetary policy were
no myth, the California electricity crisis of 2000– 2001—in which power
companies and energy traders created an artificial shortage to drive up
prices—reminded us of the reality that lay behind tales of the robber barons
and their depredations. While other states didn't suffer as severely as
Those states that, for
whatever reason, didn't get on the deregulation bandwagon in the 1990s now
consider themselves lucky. And the luckiest of all are those cities that
somehow didn't get the memo about the evils of government and the virtues of
the private sector, and still have publicly owned power companies. All of this
showed that the original rationale for electricity regulation—the observation
that without regulation, power companies would have too much monopoly
power—remains as valid as ever.
Should we conclude from this that deregulation is
always a bad idea? No—it depends on the specifics. To conclude that
deregulation is always and everywhere a bad idea would be to engage in the same
kind of absolutist thinking that was, arguably, Milton Friedman's greatest
flaw.
In his 1965 review of Friedman and
Schwartz's Monetary History, the late Yale economist and Nobel laureate
James Tobin gently chided the authors for going too far. "Consider the
following three propositions," he wrote. "Money does not matter. It
does too matter. Money is all that matters. It is all too easy to slip from the
second proposition to the third." And he added that "in their zeal
and exuberance" Friedman and his followers had too often done just that.
A similar sequence seems to have happened in Milton
Friedman's advocacy of laissez-faire. In the aftermath of the Great Depression,
there were many people saying that markets can never work. Friedman had the
intellectual courage to say that markets can too work,
and his showman's flair combined with his ability to marshal evidence made him
the best spokesman for the virtues of free markets since Adam Smith. But he
slipped all too easily into claiming both that markets always work and that
only markets work. It's extremely hard to find cases in which Friedman
acknowledged the possibility that markets could go wrong, or that government
intervention could serve a useful purpose.
Friedman's laissez-faire absolutism contributed to
an intellectual climate in which faith in markets and disdain for government
often trumps the evidence. Developing countries rushed to open up their capital
markets, despite warnings that this might expose them to financial crises;
then, when the crises duly arrived, many observers blamed the countries'
governments, not the instability of international capital flows. Electricity
deregulation proceeded despite clear warnings that monopoly power might be a
problem; in fact, even as the
What's odd about Friedman's absolutism on the
virtues of markets and the vices of government is that in his work as an
economist's economist he was actually a model of restraint. As I pointed out
earlier, he made great contributions to economic theory by emphasizing the role
of individual rationality—but unlike some of his colleagues, he knew where to
stop. Why didn't he exhibit the same restraint in his role as a public
intellectual?
The answer, I suspect, is that he got caught up in
an essentially political role. Milton Friedman the great economist could and
did acknowledge ambiguity. But Milton Friedman the great champion of free
markets was expected to preach the true faith, not give voice to doubts. And he
ended up playing the role his followers expected. As a result, over time the
refreshing iconoclasm of his early career hardened into a rigid defense of what
had become the new orthodoxy.
In the long run, great men are remembered for their
strengths, not their weaknesses, and Milton Friedman was a very great man
indeed—a man of intellectual courage who was one of the most important economic
thinkers of all time, and possibly the most brilliant communicator of economic
ideas to the general public that ever lived. But there's a good case for
arguing that Friedmanism, in the end, went too far,
both as a doctrine and in its practical applications. When Friedman was
beginning his career as a public intellectual, the times were ripe for a
counterreformation against Keynesianism and all that went with it. But what the
world needs now, I'd argue, is a counter-counterreformation.
[*] See
Paul A. Samuelson, Economics: The Original 1948 Edition (McGraw-Hill,
1997).