A sympathetic biography portraying the much-celebrated economist’s journey from Keynesian ‘institutionalism’ to empirical monetarism, entailing portraiture of leading 20th-century schools of economics, where economics is portrayed as the natural foil to law – practicality versus theoretical equity.
In the 1920s, the predominant classical school synthesized price theory and marginal analysis with laissez-faire, characterized by Alfred Marshall and exemplified by Andrew Mellon. Irving Fisher’s quantity theory enlarged the neoclassical view: M (supply of money) times V (its velocity) equaled P (the level of prices) times T (the volume of transactions). As the depression set in, neoclassic theory lost credibility. The rising Keynes accepted the importance of prices but emphasized the role of timing and dynamics of supply as seen in the current (when demand sets price) and the short run (when the management of supply enables the supplier to lift prices). (Then in the long run, efficiencies gear supply to demand reducing price; secular time accounts for when social changes reconfigure supply and demand altogether). Meanwhile Chicago’s Frank Knight theorized entrepreneurship, offering the precision of math while seeking for pattern and causation, and econometricians went fully into comprehensive theory and planning. Such institutionalism (which also entailed the study of large, established players such as corporations and unions), most popular at Columbia, Wisconsin, Brookings, Amherst, and the National Bureau of Economics (NBER), shunned the neoclassical, seeing markets as evidencing degrees of monopoly or alternately inefficiencies.
Friedman, unusually, crossed over to work among institutionalists at Columbia and NBER, before returning to the neoclassical and subsequent price theory at Chicago. By 1937 neoclassicism committed to Marshall’s ‘freedom of industry and enterprise’. From 1940, Friedman often testified to Congress on behalf of Treasury Secretary Henry Morgenthau’s view of income tax as a fairer means of funding rising government expense; taxpayers would increase from 4 million in 1939 to 43 million in 1945. Notwithstanding Morgenthau’s contribution to the Bretton Woods system, historians often label the 1940s Friedman’s Keynesian phase.
His postwar return to Chicago brought a turn to quantitative testing of theory, seeking not for conformity with formal logic but the deduction of yet-unobserved facts, which evidence must be falsifiable and not later contradicted by future evidence. Keynesianism was enshrined in the 1946 Employment Act, an econometric effort to maximize employment, production, and purchasing power as represented by IS – LM (investment times saving equals liquidity times demand for money); falling interest rates lift output, goosed by the Keynesian multiplier, whereas demand for money lifts interest. New Deal planning, seen by Knight as social control, had become aggregate (i.e., fiscal) demand management, represented by Paul Samuelson. But Friedman argued statistical criteria were insufficient to judge the model: the test was the real world, not inputs already in the econometric model. In other words, one shouldn’t derive theory after sifting facts but start with theory to be tested by facts.
In modeling the economy, competition was preferable to Keynesian planning. At Chicago, Friedman sidelined the econometric Cowles Commission, opposing its ideal narratives comprising multi-equation models, rational agents, and perfect information as untestable, instead favoring predictive accuracy. He had discovered Hegel’s notion that a plan must have a unitary conception, a controlling view to be enforced, which led to Friedman’s observation that when frustrated, government turns to coercion. A republic which starts to plan relinquishes its view of people as paramount.
Friedman thought price theory deficient in the instances of natural monopoly (which are beneficial), market monopolies (firms which capture a controlling role in pricing), and certain externalities. Market monopolies divided the neoclassic from the New Deal liberal, hence it was vital to establish its features. He did not see the US on the road to serfdom, for it would have the good sense to shun overbearing government on either side, but did embrace economics’ theoretical role in advancing liberty. Then in the 1950s Hayek reoriented the field toward the interplay of politics and economics, which Friedman later addressed in Capitalism and Freedom). Capitalism was not a self-sufficient ethic; freedom differentiated it from planners and socialists further left; liberty ought to surpass equality, as in Stigler. Hence Friedman shifted his research from industries to markets, replacing firms, workers, and interests with efficiencies (cost-benefit analysis) and prices (not price regulation).
Whereas Washington in the 1930s worried about the instability of capitalism, the capital in the 1950s fretted over the role of the Federal Reserve, prompted by the qualities of fractional-reserve banking and the Fed’s liquidity mistakes during the Depression. If, as in Keynes, V drove the economy then the Fed alone could remedy slowdowns. But in Marshall’s view, market and/or short-term unpredictability naturally stabilized over longer periods, so money supply was more important. Such was Friedman’s leaning.
Friedman articulated his permanent income hypothesis in 1957’s Theory of the Consumption Function: people make consumption decisions not on their current income but expected long-term average, smoothing decision. This challenged Keynes’ idea of contemporaneous, marginal decision making. Consequently, fiscal stimulus would have less impact because it’s transitory. The idea explained stable postwar consumption regardless of business cycles. Along with the previous year’s Quantity Theory of Money, Consumption completed the first phase of Friedman’s challenge to institutional orthodoxy: seeing off Cowles, rehabilitating Marshall, and now confronting Keynes.
Friedman’s support for large parts of Keynesian new Deal, namely the multiplier effect, amounted to rejecting Austrian (Hayekian) austerity; government must prop up the economy in crisis. But the economics profession had discarded the specifics and saw only general applicability, and so cast aside monetary policy. But monetarism substituted managing velocity for managing inflation. The goal of full employment, e.g., 4% unemployment, doubled as the inflation target. Capitalism and Freedom (1962) asserted government’s role was to protect liberties including economic choice making. Anna Schwartz deserved more credits for its authorship, especially for its resonance beyond pure economics.
By approximately 1970, Friedman was more a policy wonk than practicing economist. He was thus estranged from Arthur Burns, who did not distinguish between changes in relative price and systemic inflation, which allowed for thinking inflation could be quarantined into sectors and treated with price controls. Burns was an institutionalist, explaining the surprise of his endorsing Nixon.
The rational expectations school sees public anticipation as incorporated in the Keynesian general equilibrium model, as exemplified by the Cowles commission. Its purpose was to rework Samuelson’s neoclassical synthesis of price theory and Keynesian demand management, applying pricing tools to macro behaviors e.g., inflation, and also to incorporate unpredictable movements / changes by including monetary rules, in order to make the model work (while sidestepping political philosophy). The 1980s, it rose to surpass Keynesianism as rival to Friedman’s monetarism.Volker kept Friedman at arm’s length, seeing monetarism as sometimes too rigid for central banking, and not liking the latter’s calling for an end to the Fed’s independence. But he acknowledged inflation was always a monetary phenomenon: for him, monetarism ws more art than science, since the velocity of money is erratic in crises.
The economic market is freer, more democratic than the political arena, Friedman thought. But a trip to Chile catalyzed the realization that both were expected of Western democracies. Political freedom was a necessary, long-term condition for economic freedom, in something of a reversal, resonant of Hayek. Meanwhile he saw socialism had turned to calling for transfer of wealth instead of means of ownership. At his zenith, Friedman turned to excoriating tax, a kind of Hayekian culmination.
NB: ‘Social control’ was originally a Progressive term meaning planning for efficient use of resources including labor.