A Scoreboard for Friedman

Adding to Don’s observations below, here’s a partial list of Friedman’s achievements, with a score out of ten for each.

  1. The permanent income hypothesis. This was advanced in A Theory of The Consumption Function (1957). Keynes had argued that household consumption varies with current income in a simple way: if your after-tax income goes up by $100, your consumption increases by about $80, with the remaining $20 being saved. Friedman argued that the increase could be anything from zero to the full hundred, depending on whether the change in income was regarded as permanent or transitory. Together with Modigliani’s ‘life-cycle hypothesis’, this idea greatly enriched the way macroeconomists think about consumption decisions, which are now seen in terms of an unfolding plan shaped by long-term earnings expectations. In empirical terms, it also explained why consumption proved much less volatile than Keynes’ theory leads one to expect. 9/10 for useful theoretical innovation prompted by painstaking analysis of numbers, marred by occasional questionable massaging of the data.
  2. The NAIRU hypothesis. Most famously in “The Role of Monetary Policy” his 1968 Presidential Address to the AEA, Friedman developed this idea in parallel with this year’s Nobel laureate Edmund Phelps. As I commented when the prize was announced, there is nothing remarkable in the idea that there is some threshold level of unemployment beyond which the economy becomes inflation-prone. What was new was the idea that, because expectations of inflation are self-confirming, prices will not just rise, but will do so at an accelerating rate. Whether or not this is always and everywhere true, it became the core principle governing central banking. The implication is that if central banks drop their guard and let the economy grow too fast, unemployment will rise above the NAIRU, and the inflation monster will escape from its cage. 8/10 for largely favourable influence on current policies.
  3. Popular Polemics. Capitalism and Freedom (1962) and Free to Choose: A personal statement, with Mrs Friedman (1980). How ever you respond to these books, you can’t deny they are well written and very beguiling. A reader predisposed to laisser-faire ideology will be smitten, overjoyed to be handed such an armoury of arguments for privatisation and the user-pays principle, and against regulation and redistribution. A reader who is instinctively repelled by the idea that capitalism is a democracy ruled by ‘dollar votes’, will still find many of the arguments hard to dismiss. 7/10 for raising public understanding of economic issues, too one-sided for my taste.
  4. Methodology. “The Methodology of Positive Economics” (1953) became the point of departure for all future discussions of methodology economics. This is partly because at first blush the thesis seemed so outrageous: namely, that it doesn’t matter if the assumptions of a theory are false, as long as it generates accurate predictions. In the underworld of the ‘methodology’ specialist in economics, one can find a spectrum of opinion: at one end Friedman’s article is dismissed as na¯ve, contradictory and meaningless; at the other end it is defended as a respectable and coherent case for ‘instrumentalism’. But in the mainstream it’s Holy Writ, the definitive answer to anyone who objects to what economists do, and a licence for most applied economists to carry on with a clear conscience doing what they do: deriving simple behavioural predictions from optimisation problems, then going ahead to test them against sample data. The key thing here is that you don’t worry whether individuals understand their own behaviour in terms of a mechanical response to material incentives they behave ‘as if’ they were doing so. 6/10 for helping economists to sleep peacefully.
  5. Monetarism. This is Friedman’s signature doctrine, expounded in “The Quantity Theory of Money: A restatement” (1956), in the volume he edited entitled Studies in Quantity Theory; and also in Inflation: Causes and consequences, (1963). This was an attempt to modernise the classical quantity theory of money, according to which the value of money depends on the quantity of money in circulation. The implication is that inflation is caused by an excessively rapid increase in the quantity of money. In the eighteenth century when the ‘money supply’ was still a stock of coins, this was self-evidently true. But in a modern system where money is mostly paper credit the money supply is arbitrary, and indeed it becomes impossible to distinguish between demand and supply. The great monetary theorists Thornton and Wicksell, bookends of the nineteenth century, both argued that inflation makes it necessary for firms and households to obtain more deposits, and this increases the money supply. The inflation itself is caused by excessively low interest rates that stimulate business investment beyond what the nation’s resources can accommodate. In attempting to reassert the quantity of money itself as a causal variable, Friedman propelled monetary theory, and the art of central banking, backwards. 3/10 for influence on theory and policy, with mostlly regressive results.
  6. General contribution to the history of macroeconomic thought. Friedman’s ability as a theoretician was exceeded by his talent for analysing empirical data, but even the latter was eclipsed by his flair for intellectual demagoguery. This is particularly evident in his dismissive attitude to Keynes and Keynesian ideas. Obviously Friedman’s policy recommendations are very un-Keynesian. But at the same time he made full use of the conceptual apparatus developed by Keynes, and in many ways his research program was compatible with Keynesian one. It became largely possible to represent Keynesian and monetarist positions as special cases of the same general theory (if not Keynes’s General Theory), and macroeconomics in the 1970s consisted largely of empirical investigations designed to adjudicate between Keynesian and monetarist claims about details such as the ‘interest elasticity of money demand’, something that would not have been possible without a common frame of reference. At the end of the day monetarism still attributes macroeconomic fluctuations to variations in demand, unlike the other ‘right wing’ schools of macroeconomic theory the rational expectations and real business cycles schools. Nonetheless Friedman made it his business to promulgate the idea that Keynes had nothing whatever of value to offer. He would not even give Keynes credit for the notion of liquidity preference, a major innovation in monetary theory; instead he invented, to the eternal consternation of Don Patinkin and Harry Johnson, a ‘Chicago verbal tradition’ in which the idea (in a more sophisticated version) had been employed by Friedman’s mentors long before Keynes thought of it. 1/10 for entertaining pantomime.
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Robert Braby
Robert Braby
15 years ago

Phelps-Friedman revisited:

James, you have been very generous in your assessment of the natural rate hypothesis. I have not been a fan of the vertical long-run Phillips curve (LPC) with its natural rate assumption; it provides a very poor explanation of the behaviour of the Australian economy over the past 35 years.
The fundamental weakness of the short-run Phillips curve (SPC) I believe is that the inverse relationship between unemployment and inflation only prevails when inflation is demand generated. But if inflation is caused by exogenous cost pressures, the relationship becomes positive and the curve shifts upwards and outwards, as it did in the stagflation period of the seventies when OPEC and the unions were all-powerful. The LPC model offered no explanation of this, at least for Australia, and empirical estimates of full employment and the natural rate diverged markedly.
Some years ago I developed an alternative explanation, using social preference indifference curves and fitting them to the SPC. This approach followed some pioneering work done by Lipsey, Nordhaus and Smythe in the USA, but was unique for Australia. As the SPC moved upwards and outwards, a tangency locus curve could be drawn to show how the economy established equilibrium in a stagflation setting, even though it had moved far away from full employment.
I tested the model with data from public opinion polls of public attitudes to inflation and unemployment (as measures of social preference) and was pleasantly surprised to find that they provided a satisfactory fit to the model, especially as the tangency locus shifted clockwise over the 25 year period, reflecting a softening of attitudes to unemployment relative to inflation.
My efforts proved too radical for my peers, who seemed to think that because it did not conform to the monetarist model it must be wrong!

Patrick
Patrick
15 years ago

Where is the inspiring countless people to care about economics generally and free markets specifically? 8/10!

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
15 years ago

Thanks for a great summary James.

6/10 is a good score to give his stuff on the methodology of positive economics. I’m sympathetic with its motivation in many ways, (part of its point was as defence of perfect competition in modelling on the grounds of its simplicity and tractability – fine with me) but it’s kind of Pigeon Popper.

Friedman may have been methodologically mean to Keynes’ legacy, but he was generous to him in his assessment of him as an economist in an essay he wrote on him.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
15 years ago

Btw, anyone interested in podcasting the old master – there are a couple of MP3 interviews here and here. I’ve not listened to them yet so can’t comment on their quality.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
15 years ago

Here’s Brad DeLong – erudite, edifying and entertaining as ever.

“Lord, enlighten thou our enemies,” prayed nineteenth-century British economist and moral philosopher John Stuart Mill in his Essay on Coleridge http://olldownload.libertyfund.org/Texts/MillJS0172/Works/Vol10/PDFs/Mill_1277.pdf. “Sharpen their wits, give acuteness to their perceptions, and consecutiveness and clearness to their reasoning powers: we are in danger from their folly, not from their wisdom; their weakness is what fills us with apprehension, not their strength.”

For every left-of-center American economist in the second half of the twentieth century, Milton Friedman (1912-2006) was the incarnate answer to John Stuart Mill’s prayer. His wits were smart, his perceptions acute, his arguments strong, his reasoning powers clear, coherent, and terrifyingly quick. You tangled with him at your peril. And you left not necessarily convinced, but well aware of the weak points in your own argument.

Jason Soon
Jason Soon
15 years ago

If you read his methodology essay carefully I do not think you can classify Friedman as a hard core positivist at all. There are too many hedges there. As James said it was more about neutralising the silly ‘false assumptions’ kinds of arguments than an endorsement of ‘verifiability’. This assessment by MR is more spot on:
http://www.marginalrevolution.com/marginalrevolution/2006/11/the_methodology.html

I’ve never read Milton as a naive positivist, although some of the quotations from his article sound that way. Milton was more of a methodological pluralist and a Marshallian. Do what works. Bring a variety of kinds of evidence to bear on a problem (it is sad how neglected this principle is in modern economics), be pragmatic, and don’t reject a model just because it doesn’t meet one of your prejudices. I think that is what he meant by not judging a model by its assumptions. Falsifiability is a chimera, but did Friedman really seek or advocate that as a standard? Most of all he wanted propositions with empirical content. He understood that no single fact can refute a theory, and that many tests are of frameworks, not single propositions. Data should and indeed must be viewed through the lens of theory, and our goal should be to solve problems.

harry clarke
15 years ago

Well-done James though I am unsure about your ranking of monetarism as 3/10 and perhaps the pantomine bit 1/10. I think you are right overall in your judgements but money supply targeting was in vogue for quite a while and it did lead to an ongoing focus on inflation.

You can distinguish between the theoretical impacts of MF (very real) and his influence (very very real).

Joshua Gans
Joshua Gans(@joshua-gans)
15 years ago

Thanks to everyone who commented.

Robert, on the general point about cost push, isn’t it standard practice to include exogenous shocks when you estimate Phillips Curves? As for your own theory, I don’t grasped it fully. I understand the locus you’re talking about – a diagram of it would look like an income expansion path. But surely each ‘equilibrium’ is just a choice the representative houshold would make if it were able: I don’t see any mechanism that would turn it into an actual outcome revealed in the data. Unless you think that governments can somehow deliver the combination the average voters wants, given the menu available at each point in time. Is there a paper I can download? Alternatively I could email you for a copy.

Harry, I was juggling three criteria: how good the theory is; how great its influence on practice; and how beneficial the practice. The NAIRU theory led to a basically sensible if overcautious monetary policy; monetarism was influential, but didn’t do any good.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
15 years ago

James,

Wouldn’t you agree that monetarism was instrumental in developing the idea that ensuring price stability (ie an absence of inflation) was a core requirement of macro-policy after a generation of Keynesian soft headedness? The method of squeezing inflation out of the system was pretty crook (but then no-one – monetarist or not – has been much chop at finding more acceptable ways to do it). But it was a start.

Bring Back the Curr
Bring Back the Curr
15 years ago

Nick,

It wasn’t Keynesian softheadness but those useless barstard keynesians that led to that.

Robert Braby
Robert Braby
15 years ago

James, what is the relevance of your comment about cost-push? My view is that exogenous shocks were more destabilising to the SPC than the endogenous wage responses of the Phelps-Friedman model, which seem to me to have had somewhat limited application in Australia over the last 35 years. That is not to say that the situation might not be reversed in future, although I think it would be political suicide for a government to ignore public opinion if inflation accelerates close to full employment. (In countries prone to hyper-inflation the situation might be very different, so I have no opinion regarding them.)

Re my social preference derived equilibrium – yes, I have assumed that governments are poll driven. My data provides support for this, except when the Fraser government went against public opinion with its ‘fight inflation’ strategy – with John Howard as Treasurer!!

If you email your postal address to bobopet@netspace.net.au I can send you a hard copy.

Joshua Gans
Joshua Gans(@joshua-gans)
15 years ago

Wouldn’t you agree that monetarism was instrumental in developing the idea that ensuring price stability (ie an absence of inflation) was a core requirement of macro-policy after a generation of Keynesian soft headedness?

No. There were two key realisations about inflation: (1) that expectations were self confirming, and (2) that labour market pressure can develop at a high (and rising) rate of unemployment. Some of the insights came from monetarists, but their monetarism – that is, their fixation with the money supply – didn’t add value.