Sunday, November 23, 2014

Re-Capturing the Friedmans

BERKELEY – On my desk right now are reporter Timothy Noah’s new book The Great Divergence: America’s Growing Inequality Crisis and What We Can Do about It and Milton and Rose Director Friedman’s classic Free to Choose: A Personal Statement. Considering them together, my overwhelming thought is that the Friedmans would find their task of justifying and advocating small-government libertarianism much harder today than they did in 1979.

Back then, the Friedmans made three powerful factual claims about how the world works – claims that seemed true or maybe true or at least arguably true at the time, but that now seem to be pretty clearly false. Their case for small-government libertarianism rested largely on those claims, and has now largely crumbled, because the world, it turned out, disagreed with them about how it works.

The first claim was that macroeconomic distress is caused by the government, not by the unstable private market, or, rather, that the form of macroeconomic regulation required to produce economic stability is straightforward and easily achieved.

The Friedmans almost always made the claim in its first form: they said that the government had “caused” the Great Depression. But when you dug into their argument, it turned out that what they really meant was the second: whenever private-market instability threatened to cause a depression, the government could avert it or produce a rapid recovery simply by purchasing enough bonds for cash to flood the economy with liquidity.

In other words, the strategic government intervention needed to ensure macroeconomic stability was not only straightforward, but also minimal: the authorities need only manage a steady rate of money-supply growth. The aggressive and comprehensive intervention that Keynesians claimed was needed to manage aggregate demand, and that Minskyites claimed was needed to manage financial risk, was entirely unwarranted.

Real libertarians never bought the Friedmans’ claim that they were as advocating a free-market, “neutral” monetary regime: Ludwig von Mises famously called Milton Friedman and his monetarist followers a bunch of socialists. But, whatever its packaging, the belief that macroeconomic stability requires only minimal government intervention is simply wrong. In the United States, Federal Reserve Chairman Ben Bernanke has executed the Friedmanite playbook flawlessly in the current downturn, and it has not been enough to preserve or rapidly restore full employment.

The second claim was that externalities were relatively small, or at least that they were better dealt with via contract and tort law than through government regulation, because the disadvantages of government regulation outweighed the harm done by those externalities that the legal system could not properly address. Here, too, reality does not seem to have endorsed Free to Choose. In the US, this is most apparent in changing attitudes toward medical-malpractice lawsuits, with libertarians no longer viewing the court system as the preferred arena to deal with medical risk and error.

The third, and most important, claim is the subject of Noah’s The Great Divergence. In 1979, the Friedmans could confidently claim that, in the absence of government-mandated discrimination (for example, the South’s segregationist Jim Crow laws), the market economy would produce a sufficiently egalitarian distribution of income. After all, it had appeared to do so – at least for those who did not suffer from legal discrimination or its legacies – for the entire post-WWII era.

So the Friedmans argued that a minimal safety net for those whom bad luck or a lack of prudence had rendered destitute, and elimination of all legal barriers to equality of opportunity, would lead to the most equitable outcomes possible. Profit-seeking employers, using and promoting human talents, would bring us as close to a free society of associated producers as is attainable in this fallen sublunary sphere.

Here, too, the Friedmans’ hopes have been disappointed. The end of American preeminence in education, the collapse of private-sector unions, the emergence of a winner-take-all information-age economy, and the return of Gilded Age-style high finance have produced an extraordinarily unequal pre-tax distribution of income, which will burden the next generation and make a mockery of equality of opportunity.

It would have been nice if the political program laid out a generation ago in Free to Choose had lived up to the Friedmans’ billing. It would have been nice if a relatively equal and prosperous society with full employment and equal opportunity had followed from a government that stood back from the economy and provided nothing but a minimal safety net, courts, and a constantly growing money supply.

Alas, that did not happen. And it did not happen because the world described by the Friedmans is not the world in which we live.

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    1. CommentedLudwig van den Hauwe

      But note that Milton Friedman (with Anna Schartz) in 1986 published a paper "Has Government Any Role in Money?" in the Journal of Monetary Economics in which he came perhaps as close as he ever did to the viewpoint of the "real libertarians", as you call them, by concluding that "leaving monetary and banking arrangements to the market would have produced a more satisfactory outcome than was actually achieved through governmental involvement." The view of these "real libertarians" is that we are experiencing the present troubles because of credit expansion and interest rate manipulation engineered by the central banks (among other forms of intervention) and that the true solution is to be found not at the level of monetary policy, but at the level of institutional reform, in particular the abolishment of central banks and the establishment of free banking. It is quite understandable that academics at leading universities cannot afford to risk their reputations by discussing such revolutionary proposals, given that these are poltiically totally infeasable in the forseeable future anyway, but I haven´t heard any one good theoretical argument refuting the views of the free bankers. The free banking argument is a particular application of Mises´ more general argument tending to demonstrate the impossibility of socialism; prices are bottom-up social phenomena and when you start manipulating them (or trying to do so) in a top-down fashion, the result can only be chaos and economic discoordination.

    2. CommentedDarko Oracic

      Milton Friedman criticized central banks for creating economic instablity by overreacting. Central bankers tend to overreact because they lack both knowledge and patience. No other theory describes better what has happened in recent years. Both the Fed and the ECB overreacted to high inlation (caused by previous overly expansionary policy), raised interest rates too high and caused the Great Recession. The fact that leading economists don't see the obvious reflects the sorry state of today's macroeconomics. We miss Milton Friedman dearly.

        CommentedCraig Hardt

        Actually, Darko, the great recession happened because of artificially high prices in the U.S. housing market stemming from the financial innovation known as mortgage-backed-securities (MBS). As interest rates were low, investors looked for higher yields both in emerging markets and in bond-like securities created to satisfy demand for these supposedly less risky (relative to equities) assets. Unfortunately, as ratings agencies continued to offer high credit ratings on these MBS, most failed to realize that mortgages were being handed out like candy to home buyers completely incapable of staying on top of their overpriced mortgages. When the inevitable crash in housing prices happened, investors were suddenly left with huge amounts of valueless MBS. Due to another financial innovation (credit-default swaps) they were usually highly leveraged in these untenable investment positions. The result was the collapse of the financial markets around the world, and subsequently, the great recession.

        Central banks raising interest rates had nothing to do with causing the great recession. In fact, had the raised interest rates earlier on during the housing boom, it may have limited exposure in the financial markets to MBS as more investors would have put their money in traditional bonds.

    3. CommentedJonathan Lam

      Gamesmith94134: Re-Capturing the Friedmans

      “Alas, that did not happen. And it did not happen because the world described by the Friedmans is not the world in which we live.”

      Friedman did give credits in the monetarism that small-government libertarianism in stimulating the economy in selling bonds to produce growth and stabilize the social development. The theory on liquidity and sustainability came across the margin of affordability made the resources finite and perpetuity on growth should aligned with its modifications like inflation and deflation to adjust the pace of growth. However, our government sees monetarism as the tool to eliminate inflation and deflation; and the recent social safety net like education and medical shifted to commercialism that broke line; since then, the government attempt to shift its cost to the public. Later, the sub-prime rate lending to house laid a heavy load on the government when the economy was overly stimulated with lesser employment or out-sourced from the factories, which caused the stagnated labor cost and created a downward spiral in the margin of affordability that the most middle class supports and grows on.

      At first, the suppression of recession by cutting interest rate and reality of the support of the margin of affordability, our government lied about the reality of the sub-prime housing debtors which relied on the inflated price of their house to sustain its margin of affordability. The capitalization of the real estate market collapsed after the halt of inflation and stagnated labor cost and job positions were out-sourced.

      Secondly, the cut of the support from the middle class in the financial make most capital market search on the short term investment and commodity market, it made the capital market worse that it went to the emerging market nations for a short term investment and lesser for the local development after the local real estate market turned sour.

      Thirdly, Americans, the consumers of the world, were heavy in debts after the credit exhausted. Then the flight of cash flow toward the emerging market nations took the credits with them when the banks are insoluble and bankrupted. Our government bailed them out with trillions of bonds that FED loaned with low interest. Then, the argument on the sustainability and liquidity is greatly disrupted by the margin of affordability that our government took its liberty to marketing the capitals of social goods like education and medication to fit its budgets.

      Perhaps, what we talk about undercutting the recession or depression, government participates in shifting the cost of social goods to its publics and deforming the nature of the business cycles like inflation, recession that made monetarism works on its own merits. I certainly said we deserve a depression locally and globally if we subjectively let monetarism works to adjust to all claims including government’s too.

      May the Buddha bless you?

    4. CommentedElizabeth Pula

      Here's a link to a super little interview that adds a bit of aspects and in depth perspective to DeLong's super little article:

    5. CommentedElizabeth Pula

      Absolutely excellent analytical report, and methodology report on by Lawrence Mishel and Natalie Sabadish-05/02/2012
      The report is comparison of top 350 CEO salaries and options etc. to production workforce since the 1970's and through 2011- As factual as can be available from as reliable sources as possible.

    6. CommentedElizabeth Pula

      The only problem today is that we are no longer dealing with market economies. There is no egalitarian distribution of income because we are dealing with various systems of organizational rotating exploitation. Economies are only one activity of the systems.

    7. CommentedLanny Arvan

      "But, whatever its packaging, the belief that macroeconomic stability requires only minimal government intervention is simply wrong. In the United States, Federal Reserve Chairman Ben Bernanke has executed the Friedmanite playbook flawlessly in the current downturn, and it has not been enough to preserve or rapidly restore full employment."

      The above seems to be a closed economy analysis. Don't we need as well an open economy perspective and consider what European (and Asian) central bankers have done? Perhaps in the 1930s, a closed economy analysis was sufficient. How can one believe that now? I'm no fan of Milton Friedman, but were he alive today wouldn't he be talking about global monetary policy?

      He would then lose on the point that the right stabilization was straightforward and minimal, but he could still win on the idea that if the central bankers coordinated in the right way they could restore things.

    8. CommentedPaul A. Myers

      What now seems desirable is that government through fiscal and other policy techniques maintain a constant level of growth of demand that would result in a steadily growing employment base. Monetary policy should be a subordinate tool used to attain the overall goal.

      A very overlooked aspect of government regulation and programs is that government is the big instrument of risk reduction. Risk reduction is crucial to stable growth and provides the social framework in which private capital can earn its best rate of return. The striking example of government's role in risk reduction was the great success of postwar government-sponsored mortgage finance, which was possibly the single biggest contributing factor to sustainable, stable economic growth.

      That the Bush administration so recklessly supported the undermining of this pillar of stability still does not get the level of opprobrium that it so richly deserves, probably because so many other failures have crowded this failure to the sidelines.

      The policy architects of the modern Republican party have used Friedmanism as a pretext to undermine the effectiveness of government in what too often is just a cheap arbitrage against public policy and public welfare.

      Everything around us in the economic sphere says that Keynesian demand management works and that over-reliance on monetary policy as a silver bullet doesn't. And way too many Democrats in Washington DC simply don't grasp the Keynesian framework; they think the chairman of the Federal Reserve is the sole official responsible for the prosperity of the American economy. Then of course we could start talking about Europe....

    9. CommentedKonrad Kerridge

      The Author understates his points. Perhaps because he is a product of and immersed in US-based economic thinking and perhaps is targeting US readers. I believe there are few non US educated serious economists (perhaps a few, say in the UK) who would still argue that the points that Friedman made provide the most useful economic framework. To most, this is an old discredited paradigm of economics. To many economists outside of the US, I suspect that the importance and omnipresence of market failures means that they are central to any new paradigm of economics. Additionally, I suspect that the dominant non-US view is that 'laissez faire' economics CREATES inequality and can also create poverty when and where growth is inadequate, which is frequently. Finally I suggest that Freidman's view that economics and politics can be separated and that only minimal government involvement is required in markets is anachronistic. Government failures are acknowledged as are market failures but it perhaps is not useful to think of them as such separate entities in such an interwoven system.