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Economic Insights

FEDERAL RESERVE BANK OF DALLAS VOLUME 7, NUMBER 2 as Public

If asked to name a famous economist, most Americans would probably say Milton Friedman. usually make their contributions behind the scenes at think tanks, gov- ernment agencies or universities. Friedman has done that, but he also has taken his ideas and policy proposals directly to his fellow citizens through books, magazine columns and, especially, television. It is not an exaggeration to say he has been the most influential American economist of the past century. He has changed policy not only here at home but also in many other nations, as much of the world has moved away from economic controls and toward economic . Milton Friedman marks his 90th birthday on , 2002, and the Dallas Fed commem- orates the occasion with this issue of Economic Insights. Happy birthday, Milton! —Bob McTeer Professor Steven N.S. Cheung Professor President, Bank of Dallas Milton Friedman

Milton Friedman has been an ardent introduced the young economist to the uct accounts and many of the tech- and effective advocate for free enter- works of Cambridge School of Eco- niques applied to them in the 1920s prise and monetarist policies for five nomics founder . Jones, and ’30s. Because Friedman’s early decades. He was born in , N.Y., a pivotal figure in the monetarist camp, study in involved constant in 1912, the son of Jewish immigrants introduced Friedman to contact with theorists such as Burns, who had come to America in the late and the early school, espe- Mitchell and Kuznets, it is not surpris- 1890s. He attended public schools, then cially Knight’s Risk, Uncertainty, and ing that he became more focused on entered in 1928. Being . macroeconomic issues like monetary away from home for the first time gave After Friedman received his under- theory and cycles than on Friedman important early work experi- graduate degree from Rutgers, Jones the of Burns’ own ences, as well as insights into entrepre- arranged a scholarship for him to study favorite, Marshall.1 neurship and the business processes of economics at the , Unable to secure a university the market (Friedman and where Friedman received an M.A. in appointment because of anti-Semitism Friedman 1998, 25–27). 1933. During that year in Chicago, he and a dearth of openings, Friedman Originally a math major, Friedman also met his future wife, fellow eco- began his career in 1935 in Washington, switched to economics in his third year nomics student Rose Director, who be- D.C., during the early days of the New at Rutgers, a decision that brought him came an active partner in his profes- Deal. At the National Resources Com- into the classrooms of two men who sional work. He continued his graduate mittee, he used his statistical acumen to would guide his later life: study at and com- help develop better consumer spend- and, especially, Arthur F. Burns. Burns pleted his Ph.D there in 1946. ing studies so that improved historical later became a fixture at the National While at Columbia, Friedman met data and better indexes could be Bureau of Economic Research (NBER), and was influenced by other famous developed. Friedman’s knowledge of one of ’s foremost authori- economists, including John Maurice sampling theory was especially relevant ties on business cycles and, ultimately, Clark, and NBER in this undertaking, and his first journal chairman of the Federal Reserve Board founder . Friedman articles resulted from these early efforts. of Governors (1970–78). Burns led was soon working at the NBER as an In the late 1930s, Friedman began Friedman to begin an appreciation of assistant to , famous for collecting and analyzing data on the what good scholarship entailed and developing the national income prod- and size of income, which later figured prominently in what he asserts that a simpler theory is prefer- considers his best work, A Theory of the able if it predicts a higher number Function. In this 1957 of outcomes—a variation on Occam’s book, he for the first time put forth his Razor—and that a good theory will famous permanent income hypothesis. “surprise” us by predicting counterintui- This explanation for consumption be- tive outcomes. A good theory is one havior offered an alternative to the the- that “explains a lot by little” and has ory propounded in John Maynard been subjected to many attempts at Keynes’ The General Theory of Employ- empirical “falsification,” a philosophical ment, , and . Friedman’s stance that Friedman apparently ab- work showed Keynes’ stable, predict- sorbed from .2 To his credit, able is an em- and regardless of the correctness of his

pirically inaccurate estimator of short- views on scientific method, Friedman’s run, aggregate consumption. Friedman own empirical work conforms to his Rose and Milton Friedman in 1987. offered his alternative permanent in- view of the proper way to “do science.” come function, along with a theoretical Friedman contributed to another discussion that plausibly explained important effort while in Washington For the Friedman family it meant a move why his theory was better. In produc- during World War II. At the Treasury to City, where Milton joined ing this work, Friedman put into prac- Department, he helped create the cur- the Statistical Research Group at tice a methodology that became the rent federal income withholding Columbia University in 1943. This group foundation of one of the most cited system. Friedman says he now regrets worked on a number of war-related and attacked—and defended—articles his role, although at the time he be- issues, from proximity fuses in bombs in the history of economics: On the Meth- lieved the new system was superior to the vulnerability of bombers during odology of (1953, to the one it replaced (Friedman and their runs. Statisticians’ role in the war 1–43). Friedman 1998, 123). Working in Wash- has generally been overlooked, but The most controversial contention ington gave him great insight and the their contributions were important, in this essay is that a theory’s assump- chance for a firsthand look at how especially as they developed the tech- tions don’t matter because predictive bureaucracies function. niques still used today in modern power is everything. The essay also The war brought many changes. econometric analysis. After the war, Friedman spent a year teaching at the University of Historical Myths in American Economic Development Minnesota, then took a job at the University of Chicago in 1947 and While the nineteenth century was a period of rugged , almost every other feature stayed there until his retirement from of the myth [of the robber barons] is false. Far from being a period in which the poor were being teaching in 1977. While at Chicago, he ground under the heels of the rich and exploited unmercifully, there is probably no other period in his- tory, in this or any other country, in which the ordinary man had as large an increase in his standard became the leader of the first recog- of living as in the period between the Civil War and the First World War, when unrestrained individu- nized counterrevolution against Key- alism was most rugged. The evidence of this is to be found in the that economists have con- nesianism. Keynes’ view poses that gov- structed of what was happening to national income, but it is documented in a much more dramatic ernment could, and should, fine-tune way by the numbers of people who came to the United States during that period. That was a time the nation’s macroeconomic perform- when we had completely unrestricted , when anybody could come to these shores and the motto on the Statue of had some real meaning. This was a country of hope and of promise ance, simultaneously guaranteeing an for immigrants and their children….Did people come to this country to be ground under the heels of end to the and perpetual merciless capitalists? Did they come to make their own conditions worse? . There is no more dramatic way in which people can vote than with their feet. The fact that East Friedman, a classical liberal who Germany had to build a wall to keep people from going to West Germany is striking evidence of which believes in free markets, opposed this country had the better conditions of life. In the same way, the fact that year after year hundreds of thousands of people left the countries of Europe to come to this country was persuasive evidence that view and the theoretical mechanisms they were coming to improve their lot, not to worsen it. Far more effective evidence, I believe, than that justified it. He developed the eco- any statistics on per capita real income, which show that real income went up decade after decade at nomic paradigm that the University of a rate of 2, 2.5, 3 percent per year. They came with empty hands....It was the poor and the miserable Rochester’s named mone- who flocked here, and they found a home and the opportunity to improve their lot. And they found it, tarism. Friedman himself disapproves not despite rugged individualism but because of rugged individualism. It was rugged individualism that induced the developments in industry, in , that offered opportunities to people. ■ of this “unlovely” term (Friedman and Friedman 1998, 228). Nonetheless, his —Bright Promises, Dismal Performance: An Economist’s Protest, 62–63 resurrection of the classical school’s foundation for its monetary theory— Studies in the Quantity Theory of of any other economist. Contributing to A Monetarist Money (1956) and A Monetary History his visibility were his triweekly column Looks at of the United States (1963). The speech in magazine (1966–84) and The recognition that substantial infla- was the presidential address to the his 10-part PBS program tion is always and everywhere a monetary American Economic Association in 1967. (1980), which complemented a book of phenomenon is only the beginning of an Its thesis was that the so-called trade- the same name cowritten with Rose. understanding of the cause and cure of infla- off between inflation and unemploy- During this period, he also was an tion. The more basic questions are: Why do ment, known as the , was adviser to three presidential candidates: governments increase the quantity of money too rapidly? Why do they produce inflation not a sustainable, long-run policy option. (unofficially), Richard when they understand its potential for harm? In the speech, Friedman resurrected Nixon and . Many policy Before turning to those questions, it is the classical notion of real factors de- ideas that emerged from this period worth dwelling a while on the proposition termining long-run employment, with bear his stamp: the all-volunteer mili- that inflation is a monetary phenomenon. monetary changes unable to lower the tary, the , floating Despite the importance of that proposition, despite the extensive historical evidence to rate in the long run. money-exchange rates, the Dutch auc- support it, it is still widely denied—in large Considered heresy at the time, the nat- tion procedure for selling government part because of the smoke screen with which ural rate hypothesis—as it has come to securities, school vouchers and opposi- governments try to conceal their own be known—is now taught, alongside tion to wage–. The list is responsibility for inflation. his permanent income hypothesis, as long and impressive, both in its scope If the quantity of and services available for purchase—output, for short— standard macroeconomic theory. and in the original thinking applied were to increase as rapidly as the quantity of In 1962, Friedman published a to several of these issues. The 1976 money, would tend to be stable. book based on a series of lectures he Nobel Memorial Prize in Economic Prices might even fall gradually as higher gave at seminars sponsored by the Sciences cemented in the public’s mind incomes led people to want to hold a larger Volker Foundation. That book—- his position as one of the world’s lead- fraction of their wealth in the form of money. Inflation occurs when the quantity of money ism and Freedom, cowritten with his ing economists. Ironically, Friedman dis- rises appreciably more rapidly than output, wife, Rose—subsequently sold half a likes this publicity aspect of the Nobel and the more rapid the rise in the quantity of million copies in 18 languages and Prize (Friedman and Friedman 1998, money per unit of output, the greater the rate launched Friedman’s career as one of 443). of inflation. There is probably no other America’s policy . His name After leaving Chicago in 1977, proposition in economics that is as well established as this one. ■ is known to more Americans than that Friedman became a senior fellow at —Money Mischief: Episodes in Monetary History, 193 Does Business Have a “Social Responsibility?” The view has been gaining widespread acceptance that corporate officials and labor leaders have a “social responsibility” that goes beyond serving the interest of their stockholders or their the quantity theory—led to the estab- members. This view shows a fundamental misconception of the character and nature of a free econ- lishment of a demand-side alternative omy. In such an economy, there is one and only one social responsibility of business—to use its to Keynes for conducting macroeco- resources and engage in activities designed to increase its profits so long as it stays within the rules nomic policy. Given Friedman’s posi- of the game, which is to say, engages in open and free , without deception or fraud….It is the responsibility of the rest of us to establish a framework of such that an individual in pur- tion at Chicago, the prestige of its eco- suing his own interest is, to quote again, “led by an to promote an end nomics department and the ability of which was no part of his intention. Nor is it always the worse for the society that it was no part of his students, it is hardly surprising that it. By pursuing his own interest, he frequently promotes that of the society more effectually than caught on across the when he really intends to promote it. I have never known much good done by those who affected nation and became highly influential to trade for the .” Few trends could so thoroughly undermine the very foundations of our free society as the during the 1960s and ’70s. Monetarism acceptance by corporate officials of a social responsibility other than to make as much money for stresses the importance of the quantity their stockholders as possible. This is a fundamentally subversive doctrine. If businessmen do have of money as an instrument of govern- a social responsibility other than making maximum profits for stockholders, how are they to know ment policy and as a determinant of what it is? Can self-selected private individuals decide what the social interest is? Can they decide business cycles and inflation. how great a burden they are justified in placing on themselves or their stockholders to serve that social interest? Is it tolerable that these public functions of taxation, expenditure, and control be What accounted for this shift in exercised by the people who happen at the moment to be in charge of particular enterprises, cho- thinking by economists, bankers and sen for those posts by strictly private groups? If businessmen are civil servants rather than the politicians who had so fervently argued employees of their stockholders then in a democracy they will, sooner or later, be chosen by the for Keynesianism for two decades? A public techniques of election and appointment. ■ series of articles and books and one — and Freedom, 133–34 speech did the trick. The books were ——— (1981), Milton Friedman’s Monetary Who Pays for Foreign Export Subsidies? Framework: A Debate With His Critics (Chicago: University of Chicago Press). Another source of “unfair competition” is said to be subsidies by foreign governments to their producers that enable them to sell in the United States below cost. Suppose a foreign government ——— (1982), gives such subsidies, as no doubt some do. Who is hurt and who benefits? To pay for the subsi- (Chicago: University of Chicago Press), orig. dies the foreign government must tax its citizens. They are the ones who pay for the subsidies. U.S. pub. 1962. consumers benefit. They get cheap TV sets or automobiles or whatever it is that is subsidized. Should we complain about such a program of reverse foreign aid? Was it noble of the United States ——— (1983), Bright Promises, Dismal to send as gifts to other countries in the form of Marshall Plan aid or, later, for- Performance: An Economist’s Protest (San eign aid, but ignoble for foreign countries to send us gifts in the indirect form of goods and ser- Diego: Harcourt Brace Jovanovich). vices sold to us below cost? The citizens of the foreign government might well complain. They must suffer a lower standard of living for the benefit of American consumers and some of their fellow cit- ——— (1992), Money Mischief: Episodes in izens who own or work in the industries that are subsidized. No doubt, if such subsidies are intro- Monetary History (New York: Harcourt Brace duced suddenly or erratically, that will adversely affect owners and workers in U.S. industries pro- Jovanovich). ducing the same products. However, that is one of the ordinary risks of doing business. Enterprises never complain about unusual or accidental events that confer windfall gains. The free enterprise ——— (1993), Why Government Is the system is a profit and loss system. As already noted, any measures to ease the adjustment to sud- Problem (Palo Alto, Calif.: Hoover Institution). den changes should be applied evenhandedly to domestic and foreign trade. ■ —Free to Choose: A Personal Statement, 45 Friedman, Milton, and (1980), Free To Choose: A Personal Statement (New York: Harcourt Brace Jovanovich).

Stanford’s Hoover Institution and Notes ——— (1998), Two Lucky People: Memoirs moved to . Even in retire- 1 He did not ignore Marshall and microeco- (Chicago: University of Chicago Press). ment, Friedman continues to travel, nomics, however. He has written or coauth- Friedman, Milton, and (1963), lecture and write, still in the fray of ored many articles on choice under uncer- A Monetary History of the United States, contested ideas, still expressing his tainty and has examined Marshall’s demand 1867–1960 (Princeton, N.J.: Princeton views on current economic and politi- function in great detail. See Friedman (1949). University Press). cal issues. He will be remembered, of Some economists argue that Friedman’s course, for his technical brilliance as an great success in changing minds on macro Hirsch, Abraham, and Neil De Marchi (1990), economist. However, like the 19th- issues flows from his mastery of microeco- Milton Friedman: Economics in Theory and century French economist–journalist nomics. See Walters (1987, 426). Practice (New York: Simon and Schuster Frédéric Bastiat, Friedman’s ability to 2 Popper (1968). Two points: Popper was International). engagingly and directly communicate inconsistent in his belief in the inductive economic theory to average people problem or its possible solution, and falsifi- Popper, Karl (1968), The Logic of Scientific may well be his greatest legacy. cation can only work if a theory is formulated Discovery (New York: Harper Torchbooks). On May 9, 2002, Friedman was in such a way that it can be falsified by Walters, Alan (1987), “Milton Friedman,” in The honored for lifetime achievements by empirical evidence. New Palgrave: A Dictionary of Economics, vol. President George W. Bush, who said 2, ed. John Eatwell, Murray Milgate and Peter during the ceremony, “He has used Sources and Suggested Reading Newman (New York: Stockton Press). a brilliant mind to advance a moral Frazer, William, and Lawrence Boland (1983), vision—the vision of a society where “An Essay on the Foundation of Friedman’s men and women are free, free to choose, Methodology,” 73 but where government is not as free to (March): 129–44. override their decisions. That vision has changed America, and it is chang- Friedman, Milton (1949), “The Marshallian Economic Insights is a publication of the Federal Reserve Bank of Dallas. The views Demand Curve,” Journal of ing the world.” expressed are those of the authors and should Federal Reserve Chairman Alan 57 (December): 463–95. not be attributed to the Federal Reserve System. Greenspan, who attended the cere- ——— (1953), “On the Methodology of mony, added, “There are many Nobel Please address all correspondence to Positive Economics,” in Essays in Positive Prize winners in economics, but few Economic Insights Economics (Chicago: University of Chicago Public Affairs Department have achieved the mythical status of Press), 1–43. Federal Reserve Bank of Dallas Milton Friedman.” ■ P.O. Box 655906 ——— (1957), A Theory of the Consumption Dallas, TX 75265-5906 —Robert L. Formaini Function (Princeton, N.J.: Visit our web site at www.dallasfed.org. Senior Economist Press).