Seven Crashes, page 24
Hayek’s interpretation of the Depression was also quite different from that of either Keynes or Friedman. In January 1931, he had traveled to Cambridge to give a lecture in which he explained to a stunned audience the flaws of what he called the “new gospel” as preached by Herbert Hoover, Henry Ford, but also by the underconsumptionist economists William Trufant Foster and Waddill Catchings: that the Depression could be counteracted by a strengthening of consumer purchasing power or by the injection of “additional money.” This view, for which there was substantial sympathy in Cambridge, Hayek explained, “for many years has already been the tacit foundation of practical politics.” In its place, he suggested a complex model in which the problems were created by the time lags in finishing investment or producers’ goods, and argued that the demand for producers’ goods had been “artificially increased by additional credits granted to production.” But the worst consequences followed from consumer demand being “artificially and constantly increased by authoritative influence.”62 The argument looked like a reassertion of Jevons’s insistence on the time dimension of production as producing substantial price movements. In Hayek’s account, the Depression had been so severe because the U.S. monetary authorities had stopped a natural end to the boom in 1927, and had engaged in “deliberate attempts . . . to prevent, by all conceivable means, the normal process of liquidation.”63 These themes were fundamentally anticipations of Hayek’s more extensive treatment in Prices and Production (1932), which contained the same emphasis on the importance of relative prices as shaping the structure of production, and the same warning about the “misdirection of production caused by additional credit.” Price averages could not be a satisfactory basis for judging the stance of monetary policy.64 In the Cambridge formulation, Hayek added a ringing peroration: “It may very well be that we are in a crisis of capitalism, but not because the capitalistic system has proved a failure but because for more than a decade we have been systematically destroying capital.”65
Keynes was not present at the 1931 lecture on which Hayek’s book was based, but his disciple Richard Kahn had broken the icy silence to ask, “Is it your view that if I went out tomorrow and bought a new overcoat, that would increase unemployment?” Hayek responded, “Yes, but it would take a very long mathematical argument to explain why.”66 Another Keynesian, the Hungarian Nicholas Kaldor, who had started as a disciple of Hayek’s, later provided a stunning and complete demolition of Hayek’s argumentation, which obviously stood at profound odds with either the Cambridge or the Chicago visions of how economies operated.
Hayek’s clearest work was The Road to Serfdom (1944), which was not so much an analysis of either Nazi or Soviet economics, but an analysis of how the mixed economy of Weimar Germany in the 1920s had led to economic and political breakdown (and hence to the Nazis), and how it might provide a warning to policy-makers in the postwar era.
Friedman (like Keynes) did not believe that Hayek was a real economist, and ensured that he was not appointed in the University of Chicago Economics Department, but rather to the high-level interdisciplinary ideas factory, the Committee on Social Thought. In Chicago, Hayek once attended Friedman’s seminar and witnessed a discussion of money supply in the UK, but gave the impression of being bored by the technicalities and never returned.67 On the other hand, Friedman (also like Keynes) admired Hayek’s approach to political philosophy, and in particular the elaboration of the ideas in The Road to Serfdom. He thought “personally Hayek was a lovely man, a pure intellectual. He was seriously interested in the truth and in understanding. He differed very much in this way from Mises.”68
There was a basic commonality between Friedman and Hayek in viewing the problems of the 1970s as arising fundamentally from misguided intervention by governments. In November 1973, in the immediate aftermath of the Yom Kippur War and the first oil shock, Friedman explicitly used Hayek’s language of the “road to serfdom” in defense of the idea that markets respond to price signals, and that interference with those signals is self-defeating because of the perverse effects it generates:
The oil problem offers a particularly clear illustration of how the price system promotes both freedom and efficiency, how it enables millions of us to cooperate voluntarily with one another in our common interest. It brings out equally why the only alternative to the price system is compulsion and the use of force. It is a mark of how far we have gone on the road to serfdom that governmental allocation and rationing of oil is the automatic response to the oil crisis. This will not prevent higher prices, which will in fact do the job but you may be sure that the rationing authorities will take the credit.69
In the spring of 1974, with chaotic gas lines in the United States and many western European countries, Friedman highlighted the contrast of the American with the German response: “After the Arabs cut output, Germany imposed no price controls on petroleum products. It did initially restrict Sunday driving but soon removed that restraint. The price of petroleum products jumped some 20 or 30 per cent, but there were no long lines, no disorganization. The greedy consumers found it in their own interest to conserve oil in the most painless way. The greedy oil tycoons found it in their own interest to see to it that petroleum products were available for those able and willing to pay the price.”70 The international comparison looked like an appropriate natural experiment in policy design and government competence.
Though they shared a broadly similar concern with the effects on the economy of the distortion or upending of price signals as a result of political actions, Friedman and Hayek viewed the problem from different ends of an analytical telescope. Friedman saw the fundamental problem as expressed in price movements that could be simply measured as inflation or deflation. There was thus a simple remedy: control of monetary growth in a nearly mechanical way. He preferred a policy rule, such as a continued 2 percent expansion of a measure of the money supply. By contrast, Hayek wanted to examine the political and social order that created the framework for policy decisions, and was suspicious of any broad approach to macroeconomic aggregates and variables. The core of the Austrian tradition for him lay in the differential movement of prices: any moment when prices moved together more or less homogenously in one direction suggested the presence of distortions that would generate wrong signals. Economic agents required constantly changing and differentiated price movements in order to make decisions about a changing world.
In “The Methodology of Positive Economics” (1953), Friedman argued that the goal of science was to be “in principle independent of any particular ethical position or normative judgments.”71 A hypothesis, no matter how unrealistic its assumptions, was good if it resulted in better predictions. “Viewed as a body of substantive hypotheses, theory is to be judged by its predictive power for the class of phenomena which it is intended to ‘explain.’ Only factual evidence can show whether it is ‘right’ or ‘wrong’ or, better, tentatively ‘accepted’ as valid or ‘rejected.’”72 Thus, for instance, “[t]he articles on both sides of the [marginalist] controversy largely neglect what seems to me clearly the main issue—the conformity to experience of the implications of the marginal analysis—and concentrate on the largely irrelevant question whether businessmen do or do not in fact reach their decisions by consulting schedules, or curves, or multivariable functions showing marginal cost and marginal revenue.”73 Or, even more strikingly, Friedman believed that there was no need to assume that there was perfect competition to make Marshallian empirical observation a useful guide to the outcome of the price determination process. It was important to look at empirical developments and then derive empirical results that might be directly applied to make better policy.
By contrast, Hayek thought the question of motivation and how knowledge was established was central to the analytical process, and then also to formulating appropriate responses. He emphasized the centrality of human consciousness in all social sciences, including economics. “It is probably no exaggeration to say that every important advance in economic theory during the last hundred years was a further step in the consistent application of subjectivism. That the objects of economic activity cannot be defined in objective terms but only with reference to a human purpose goes without saying.”74 He conceived of money as analogous to a language, used to inform and translate human wants by means of prices as signals or signs to which humans would respond. As a consequence, he paid much less attention to devising policy rules, and more to thinking about the framework within which economic agents would interact.
Friedman’s 1967 Presidential Address to the American Economics Association is widely considered as “a turning point in the history of macro economic research.”75 It applied his method to produce a guide for monetary policy: a policy rule. The central analytical point concerned the existence of natural levels of economic activity: of employment, and also of interest rates. The natural interest rate was contrasted with a market or nominal rate: “The monetary authority can make the market rate less than the natural rate only by inflation. It can make the market rate higher than the natural rate only by deflation.”76 At any moment of time, there is some level of unemployment which has the property that it is consistent with equilibrium in the structure of real wage rates.77 Monetary policy should not in consequence seek to alter the level of employment in terms of small-scale adjustments: “We simply do not know enough to be able to recognize minor disturbances when they occur or to be able to predict either what their effects will be with any precision or what monetary policy is required to offset their effects.”78 Friedman predicted that the Phillips curve that had appeared in the data throughout the 1950s and 1960s, in which rising prices reduced unemployment, would break down if policy-makers followed conventional Keynesian wisdom and started to exploit it.79
This part of Friedman’s analysis received considerable support in that the speech followed an independently derived argument about the long-run verticality of the Phillips curve, developed by Edmund Phelps, on the basis of an argument about the ignorance of both sides in the wage-determination process.80 Expectations were central to the Phelps argument, which amounted to an anticipation of many of the themes of the rational expectations revolution that followed in the 1970s.
In the last part of his address, Friedman derived a rule: “the monetary authority should guide itself by magnitudes that it can control, not by ones that it cannot control. If, as the authority has often done, it takes interest rates or the current unemployment percentage as the immediate criterion of policy, it will be like a space vehicle that has taken a fix on the wrong star. No matter how sensitive and sophisticated its guiding apparatus, the space vehicle will go astray. And so will the monetary authority.”81 The central bank could avoid large fluctuations in economic activity (such as the Great Depression) by adopting publicly the policy of achieving a steady rate of growth in a specified monetary total. The precise rate of growth, like the precise monetary total, he thought to be less important than the adoption of some stated and known rate.82 In a footnote, he suggested a 2 percent growth rate as a suitable guide.
History has been less kind to this part of the Presidential Address. Martin Eichenbaum dismissed it as “chaff.”83 Franco Modigliani accepted the natural rate hypothesis but added, “Friedman went on to say other things in that paper that were not right.”84 In retrospect, the prescriptions looked appallingly vague. Saying that it did not matter what money measure was adopted looked like a hand-waving exercise: and when central banks tried to do something like monetary targeting in the early 1980s, they were wracked with contentious divisions over precisely which money measure should be adopted.85 The monetary aggregates behaved in different ways, and there was a striking amount of financial innovation, such as interest-bearing checking accounts (or NOW accounts in U.S. parlance), which seemed to violate the traditional assumption that money did not carry interest.
Friedman had always believed that empirical observations could be used to generate better policy rules. The practical recommendation of the Presidential Address followed directly from the analysis in the Monetary History of the United States that there was a very clear long-term historical relationship between changes in income and changes in the money stock. The statistical work showed how remarkably stable over a long period of time was the “money multiplier,” the ratio of the percentage change in income to the percentage change in the money stock: in the United States this figure had been around 2. The reserve base fixed by the central bank determined the money stock (via the “money multiplier”), which in turn determined nominal income (via the velocity of money). The ratio between currency and deposits was also quite stable over long periods of time.86 The view that there was a highly stable money demand function could also be derived—rather more tentatively—from historical UK data.87 But from the 1970s, the relationship on both sides of the Atlantic shifted in an unpredicted way, and velocity became highly unstable.88 The econometrics of Friedman’s approach was subject to a considerable onslaught.89 The Chicago vision thus concentrated on a measure of reserve base, whose relation with other monetary aggregates was historically clear, but where the relationship became unsteady as it began to play a part in policy.
The Monetary History, written jointly with Anna Schwartz, constituted Friedman’s most striking legacy to the policy debate. It owes something to the tradition of business-cycle research pioneered by Wesley Mitchell. Friedman later reflected on how Mitchell’s “theoretical work is throughout interwoven with his empirical work and made a part of an ‘analytic description’ of the phenomena under study.”90 It has been criticized for not providing an adequate explanation of how banking crises may occur independently: the book’s central demonstration was intended to be that capitalism or the financial system was by no means inherently flawed, but rather that the dramatic monetary contraction which led to bank failures was produced by policy mistakes in the Federal Reserve system. The overall conclusion has also been criticized as “ideologically loaded,” or a restatement of a conclusion that had already appeared in Friedman’s best-selling manifesto Capitalism and Freedom (1962): “The fact is that the Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy.”91 And critics complained that the central thesis of the Monetary History was built on “pedestrian statistical techniques and historical analysis that had been dismissed as old-fashioned by some of the leading economists of their day.”92 Krugman indeed complained in his remarkable and offensive obituary that “over time Friedman’s presentation of the story grew cruder, not subtler, and eventually began to seem—there’s no other way to say this—intellectually dishonest.”93
There is an irony in the way that Friedman correctly attacked the empirical observations that produced the Phillips curve, arguing that they need not always hold, while developing a model based on a similar empirical relationship about income and money. Like the Phillips curve, it correctly described a reality of the 1950s and 1960s (and indeed in this case earlier); but like the Phillips curve, the relationship misbehaved in the 1970s and later.
Friedman started his counterrevolutionary manifesto, which he delivered in London as the Harold Wincott Lecture, by claiming that Keynes would agree with him: “if Keynes were alive today he would no doubt be at the forefront of the counter-revolution. You must never judge a master by his disciples.”94 The message looked ambiguous: monetary policy was powerfully influential, but at the same time it could not be used as a powerful tool of policy management. “The depression is a tragic testament to the effectiveness of monetary policy, not a demonstration of its impotence. But what mattered for the world of ideas was not what was true but what was believed to be true.” The constant reference to the Depression was needed because a reference to long-run data series and constants (such as the observed demand for money function) would not convince an audience of the central message: “Nonetheless, the public at large cannot be expected to follow the great masses of statistics. One dramatic episode is far more potent in influencing public opinion than a pile of well-digested, but less dramatic, episodes.” The reason why money was not suited to micromanagement was because the immediate operations produced a pendulum effect on interest rates: “One important feature of this mechanism is that a change in monetary growth affects interest rates in one direction at first but in the opposite direction later on. More rapid monetary growth at first tends to lower interest rates. But later on, as it raises spending and stimulates price inflation, it also produces a rise in the demand for loans which will tend to raise interest rates. In addition, rising prices introduce a discrepancy between real and nominal interest rates.” It looks here as if Friedman is moving to a theory of how expectations affect the impact of policy: expectations of higher inflation would push up the nominal interest rate. The overall lesson was strikingly clear: “It follows from the propositions I have so far stated that inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. However, there are many different possible reasons for monetary growth, including gold discoveries, financing of government spending, and financing of private spending.” He might have added that all of these reasons are more likely to occur in times of disruption and uncertainty.
