Thursday, November 27, 2014

Friedman Completed Keynes

The most famous and influential American economist of the past century died in November. Milton Friedman was not the most famous and influential economist in the world -- that honor belongs to John Maynard Keynes. But Milton Friedman ran a close second.

From one perspective, Milton Friedman was the star pupil of, successor to, and completer of Keynes’s work. Keynes, in his General Theory of Employment, Interest and Money , set out the framework that nearly all macroeconomists use today. That framework is based on spending and demand, the determinants of the components of spending, the liquidity-preference theory of short-run interest rates, and the requirement that government make strategic but powerful interventions in the economy to keep it on an even keel and avoid extremes of depression and manic excess. As Friedman said, “We are all Keynesians now.”

But Keynes’s theory was incomplete: his was a theory of employment, interest, and money. It was not a theory of prices. To Keynes’s framework, Friedman added a theory of prices and inflation, based on the idea of the natural rate of unemployment and the limits of government policy in stabilizing the economy around its long-run growth trend – limits beyond which intervention would trigger uncontrollable and destructive inflation.

Moreover, Friedman corrected Keynes’s framework in one very important respect. The experience of the Great Depression led Keynes and his more orthodox successors to greatly underestimate the role and influence of monetary policy. Friedman, in a 30-year campaign starting with his and Anna J. Schwartz’s A Monetary History of the United States , restored the balance. As Friedman also said, “and none of us are Keynesian.”

From another perspective, Friedman was the arch-opponent and enemy of Keynes and his successors. Friedman and Keynes both agreed that successful macroeconomic management was necessary - that the private economy on its own might well be subject to unbearable instability ­and that strategic, powerful, but limited economic intervention by the government was necessary to maintain stability. But, while for Keynes, the key was to keep the sum of government spending and private investment stable, for Friedman the key was to keep the money supply -- the amount of purchasing power in readily spendable form in the hands of businesses and households-- stable.

A relatively minor, technical difference in means, you might say. A difference of opinion that rested on different judgments about how the world works, which could (and ultimately was) resolved by empirical research, you might say. And you would be half right. For this difference in means, tactics, and empirical judgments rested on top of deep gulf in Keynes’s and Friedman’s moral philosophy.

Keynes saw himself as the enemy of laissez-faire and an advocate of public management. Clever government officials of goodwill, he thought, could design economic institutions that would be superior to the market -- or could at least tweak the market with taxes, subsidies, and regulations to produce superior outcomes. It was simply not the case, Keynes argued, that the private incentives of those active in the marketplace were aligned with the public good. Technocracy was Keynes’s faith: skilled experts designing and fine-tuning institutions out of the goodness of their hearts to make possible general prosperity -- as Keynes, indeed, did at Bretton Woods where the World Bank and IMF were created.

Friedman disagreed vociferously. In his view, it usually was the case that private market interests were aligned with the public good: episodes of important and significant market failure were the exception, rather than the rule, and laissez-faire was a good first approximation. Moreover, Friedman believed that even when private interests were not aligned with public interests, that government could not be relied on to fix the problem.

Government failures, Friedman argued, were greater and more terrible than market failures. Governments were corrupt. Governments were inept. The kinds of people who staffed governments were the kinds of people who liked ordering others around.

At the same time, Friedman believed that even when the market equilibrium was not the utilitarian social-welfare optimum, and even when government could be used to improve matters from a utilitarian point of view, there was still an additional value in letting human freedom have the widest berth possible. There was, Friedman believed, something intrinsically bad about government commanding and ordering people about -- even if the government did know what it was doing.

I do not know whether Keynes or Friedman was more right in their deep orientation. But I do think that the tension between their two views has been a very valuable driving force for human progress over the past hundred years.

Read more from our "Milton Friedman at 100" Focal Point.

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    1. CommentedLudwig van den Hauwe

      Interesting article. In the terms of Axel Leijonhufvud´s grouping of theories as either "saving-investment theories" or "quantity theory" Keynes and Friedman both qualify as quantity theorists, despite Leijonhufvud´s own attempt to make Keynes out to be a Wicksellian. An alternative distinction can be based on alternative levels of aggregation of macroeconomic theorizing in the spirit of Hayek´s critique of Keynes, but this viewpoint goes on to be neglected by mainstream theorizing. Both Keynes and Friedman neglected the effects of changes in the interest rate on the economy´s structure of capital; this is the Wicksellian theme according to which there can be a temporary but significant discrepancy between the bank rate and the natural rate of interest. On the other hand interpreting Keynes has long been and still remains open to controversy. Post-Keynesians in the style of Minsky would almost certainly object against categorizing Keynes as a quantity theorist...

    2. CommentedThomas Haynie

      Great Article. I accept that Friedman contributed meaningfully to the field of economics. What bothers me is the overly large push towards Laissez-faire markets in the face of its historical and now current records. My own opinion is that the best path lies between the two until some new theory encompasses both and explains more of what is unexplained satisfactorily. Unfortunately, because economics is so politically charged Friedman is lifted to nearly saintly status by the Libertarian movement. Completely disregarding his many failures, such as the great monetary experiment, and treating is ideas as scientific and biblical law. These flawed views and assumptions make their way into public policy and set the ball rolling towards the negative edge of laissez-Faire markets, which in my research is more frequent and deeper financial panics, crashes, and recessions. His ideas of market incentives behind self regulation, also espoused by Greenspan seem almost bizarre to the sentient mind, given access to a history book and an iota of logic. My personal sense of deflation in Friedman came from watching old interviews of him on You Tube. His argument that crime in Central Park was high because it was a public property seems silly now in retrospect. I fear the economist that has such brazen confidence as to make such proclamations as this. Or another “There is nothing wrong with the American healthcare system, That is an agenda that had to be created and sold” . . . yet here we are 20+ years later revisiting the “created issue” with the evidence that the rest of the developed world pays less and gets more for their healthcare than we do. At one point does freedom from government become oppression by private groups?

    3. CommentedHelena Hessel

      Amazingly clear article. Wonderful! If only now the policymakers could follow up with equally clear policy measures...