by Drew J Jones
Fri Nov 17th, 2006 at 02:48:13 PM EST
For bruno-ken and Miguel....
There are really only four major figures worth speaking of in my field: Adam Smith, David Ricardo, John Maynard Keynes, and Milton Friedman. The first three are long gone -- the youngest of them having died in 1946. Three days ago, Friedman finally passed, and, as I said in yesterday's open thread, with his death the era of giants in economics comes to a close. Most people are familiar with his libertarian political views, but I thought I'd throw a diary together on his contributions to economic theory.
Friedman was, of course, the founder and leader of the Chicago School of thought, perhaps better known as Monetarism. More than anyone, Friedman resurrected the idea of real variables -- as opposed to nominal variables -- only changing permanently because of changes in other real variables, thus helping to lay the foundation for modern Neoclassicalist economic thought. Perhaps his greatest achievement, in particular, came in the form of his brilliant dismantling of what is known as the Phillips Curve. And that is where I will begin.
I. An Army of One
As I've said many times of Keynes, the Average Joe one meets on the street has no idea how much Keynes's ideas have influenced his life. It is, quite literally, impossible for me to pick up a newspaper or even discuss current economic events without seeing his fingerprints. The same can be said, albeit to a lesser extent, of Milton Friedman. But, anyway, back in 1958, New Zealand-born economist AW Philllips published an academic paper titled "The relationship between unemployment and the rate of change of money wages in the UK 1861-1957" in the journal Economica. This would later be transferred to show a relationship between inflation and the unemployment rate, as you can see in the graph above.
Many prominent Keynesians, including Nobel Laureates Paul Samuelson and Robert Solow, along with many (if not most) economists, took this apparent relationship to imply that governments could choose an acceptable balance between inflation and unemployment. With a bit higher inflation, it appeared we could push the unemployment rate well below the levels we were historically accustomed to. This quickly became the accepted norm.
Milton Friedman saw the flaw in this idea, arguing that the seemingly-permanent relationship the Phillips Curve described was an illusion -- that there was, in fact, no tradeoff between inflation and unemployment in the long run. Instead, Friedman predicted, businesses' inflation expectations would change, prices would be set higher to avoid shortages, and the curve would shift out, requiring that government pump even more cash into the system to get the same result. It would, Friedman said, turn into a vicious cycle, eventually ending in both rising unemployment as well as rising inflation.
That was in 1968. By 1976, Friedman had become the most famous economist on the planet.
This is not to say that Keynesianism was completely wrong. In truth, the 1973 oil shock, when plugged into the old IS-LM model that John Hicks developed after Keynes wrote The General Theory, will, in fact, yield an outcome of stagflation. Whether one was more to blame than the other is anybody's guess, -- everybody agrees, however, that Nixon was an idiot -- but both problems fed each other to deal a severe blow to western economies at the time. Regardless of the faults, or lack thereof, of Keynesians in the '60s and '70s, Friedman's Monetarist "counterrevolution" took hold and dominated economic thought until the mid-1980s, after which New Keynesianism would begin to rise, but that's another diary.
At the same time Friedman dismantled the Phillips Curve, he developed the Natural Rate (of Unemployment) theory, also known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU). This theory stated that unemployment, for various reasons, could never fall below a certain floor and remain sustainable because of the pressure on wages that would be associated with such a tight labor market. If workers' real wage increases are set well above increases in their marginal product, it will result simply in a market-based redistribution rather than a real increase in national welfare, and inflationary pressures will eventually begin to hit the market, thus pushing up interest rates and slowing the economy.
II. The Long Run Does Matter
In 1957, at the height of the Keynesian Consensus, Friedman developed an important theory of household behavior called the Permanent Income Hypothesis (PIH). Keynesians had traditionally taken a very specific understanding of consumption's relation to income -- that consumption would increase with income, but that it was subject to diminishing returns. (As income rises, the proportion of real income growth which is dedicated to the consumption of goods and services declines.) Meaning,
c'(y) > 0, and c''(y) < 0,
where c = consumption and y = income.
The PIH stated, however, that individuals made decisions based on expected income over their entire life-cycle, and that they would smooth consumption out over that life-cycle so as to maximize utility given the household's (or individual's) time preference. Friedman's theory introduced, as the Wiki article notes, assets into the consumption function, and adjusts future consumption and income into its present-day value, so that
c(t)+(c(t+1)÷(1+r)) = A(t)+y(t)+(y(t+1)÷(1+r))
in a two-period model, assuming I haven't completely fucked up the math by forgetting the model, which is admittedly quite an assumption at times. (If so, of course blame me.) Here, t denotes period one, t+1 denotes period two, and r denotes the interest rate (dividing by (1+r) being the adjustment of future consumption and income to present value). A(t), obviously, represents assets.
His success would give rise to many other big names of the last thirty years -- most notably Robert Lucas, who developed the theory of Rational Expectations (RATEX), which attempts to lay out a basic framework explaining how decisions in the present are influenced by expectations of the future. Lucas's theory is an extension of the PIH, whereby changes in expectations, and thus behavior, arise from random disturbances. Later papers would also introduce the impact (say) on happiness from households' children and grandchildren into utility functions, furthering the focus on how we make decisions about the future. The Monetarists, and Neoclassicalists in general, were obviously more concerned with mathematics than the Keynesians have traditionally been. This, too, is partly a product of Friedman, who, also being a statistician, insisted on models to predict outcomes.
III. The Depression
In 1963, Friedman coauthored, with Anna J. Schwartz, A Monetary History of the United States, 1867-1960, the Bible of Monetarism. The book sought to examine the relationship between economic activity and the money supply. His work in this book, as well as academic papers, would help to focus attention on measures of the money supply ("monetary aggregates") used by the Fed -- M1, M2 and M3. In particular, Monetarists point to the contraction of M1 from 1931 to 1933 as the cause of the Great Depression. The Depression was thus, in his view, the result of missed opportunities at the Fed to stabilize the economy. The book was so successful that current Fed chairman Ben Bernanke (then a governor under Alan Greenspan) remarked in 2002, at a celebration of Friedman's 90th birthday, "Regarding the Great Depression. You're right, we did it. We're very sorry."
Believing that significant changes in the money supply would result in undesirable consequences, Friedman became an advocate of central banks attempting to maintain a steady rate of inflation. Today, Britons and Europeans know this as an inflation target.
Love him or hate him, -- and, in my experience, there are usually few in between -- Friedman's impact is undeniable. On the whole, I consider his contributions to have been positive. As I've said, this was a giant of a social thinker -- and one who was far too modest to ever admit to it. I'll guarantee that not one student of economics has taken a class in the last couple of days without entering a discussion of Friedman's work. No doubt more than a few fierce debates have been held. I maintain my belief that he was, at heart, a Keynesian (and he was hated by many Austrians and some Neoclassicalists for it), but that he added to the brilliant ideas we were lucky enough to receive from Keynes and, in many ways, forced Keynesians to get their act together.
Rare is the occasion that someone as talented, decent and, frankly, inspiring as Friedman comes along. I hope we're fortunate enough to enjoy the work of many more scholars like him. Too few have been able to see the big picture. Friedman was, without question, the greatest of those few in recent history.