Milton Friedman, R.I.P.

It’s strange that a Nobel Prize winning economist whose theories have proven to be both relevant and durable is instead eulogized primarily for his role as a libertarian polemicist.

Mind you, I hold Friedman in high regard, more for his economic thinking than his politics (although even there I am selectively in agreement). His research into money supply and economic growth determined that money supply played a far greater role than government spending and investment (in direct contradiction to Keynesians, who had held sway from the late 1930s through the 1970s).

In the early 1980s, Federal Reserve Chairman Paul Volcker embarked on a great, and seemingly risky monetarist experiment, adhering to strict targets for monetary growth to combat persistent and corrosive inflation. In the late 1970s, the economy had succumbed to the malaise of stagflation. Stock prices were depressed. Financial statements were not very meaningful, since the value of different line items were being eroded at various rates. Businesses were accordingly reluctant to invest, since the results of any financial analysis were hostage to the assumptions about inflation. And this era saw the end to buy and hold investing, since the assumptions of stability on which it rested were shattered, and ushered in new notions like interest rate risk, volatility, convexity, and duration.

Volcker’s medicine, strict and tight control of the money supply, was unpopular and painful. Short term interest rates shot up to 22%. Banks were bleeding on their credit card portfolios. Investment grade companies could issue debt only by paying interest rates in the mid ‘teens. Credit was scarce to non-existent. The economy fell into a sharp contraction. I remember, as a young person on Wall Street, how everything stopped at 4:00 p.m. on Thursdays (which then was after the stock market closed) when the weekly money supply figures were announced. Yet Volcker and Friedman were borne out. Inflation, which hit a high of 13.5% in 1981, fell to 3.2% in 1983 and has remained stable since then.

Despite their success, Friedman’s monetarism has fallen somewhat into disuse. The Fed under Greenspan and now Bernanke, prefers inflation targeting to controlling the money supply, since the proliferation of many forms of “near money” like credit cards, make it difficult to measure money supply and velocity (had Greenspan had his bright young Fed economists studying money supply rather than the overall level of stock prices perhaps he would have solved this puzzle). However, the Fed’s accommodative stance in sharp downturns, like the 1998 Asian crisis or 9/11, comes straight out of Friedman’s research into the causes of the Great Depression.

But Friedman is remembered more for his role in promoting free markets, through books like “Free to Choose,” and his column in Newsweek. Again, if you consider the ethos of the 1980s, it’s easy to see why his views were welcomed. Despite the present anxiety about terrorism, the Soviet Union in its heyday posed a much greater threat (after all, they had plenty of nukes). America’s confidence had faltered due to Vietnam, the oil shock, stagflation, the hostage crisis in Iran. Friedman’s staunch libertarianism fit the Regan/Thatcheritte hostility to big government and vigorous defense of capitalist values, in contrast with the “Evil Empire” of Soviet planning and central control.

When presented at that level of abstraction, democracy versus authoritarianism, individual choice versus government fiat, it’s hard to argue with Friedman. But this Manichean view doesn’t translate neatly into the real world.

Take his central belief, that free markets are preferable to government control. The problem with that simple dichotomy is that well functioning markets seldom exist without some level of government intervention (note this insight comes from Columbia professor Amar Bhide’s 1992 Harvard Business Review article, “Efficient Markets, Deficient Governance”). A market where parties who don’t have a pre-existing relationship meet needs mechanisms to assure safety for its participants. Financial markets are heavily regulated. Even simple retail transactions are subject to a host of consumer protection laws.

It also isn’t clear that so-called free markets deliver on their promise of better prevailing economic conditions. Look at Chile, which is touted as an example of the success of Friedman’s Chicago School of thinking. Pinochet embarked on a broad ranging program of reform, ending the minimum wage, selling off state enterprises, outlawing collective bargaining, eliminating all taxes on capital and business profits, privatizing pensions and running a budgetary surplus. The result? The economy collapsed.

When Pinochet seized control in 1973, unemployment was 4.3%. In 1983, after a decade of reforms, real wages had fallen 40% and unemployment stood at 22%. In 1982 and 9883, GDP fell 19%. Riots and strikes forced the government to reverse course and implement Keynesian remedies which helped usher in Chile’s touted prosperity. Bolivia, Brazil, and Venezuela have had similar bumpy results with economic liberalization and have in varying degrees reversed course. Similarly, in Russia, according to Nobel Prize winner and former World Bank chief economist Joseph Stiglitz, “The transition from communism to the market, which was supposed to bring new prosperity, instead brought a drop in income and living standards by as much as 70 per cent.”

Stiglitz, in his new book “Making Globalization Work,” describes the mixed results of open (well, more open) markets:

The sad truth … is that outside of China, poverty in the developing world has increased over the past two decades. Some 40 per cent of the world’s 6.5 billion people live in poverty (up 36 per cent from 1981), a sixth – 877 million – live in extreme poverty (3 per cent more than in 1981). The worst failure is Africa , where the percentage of the population living in extreme poverty has increased from 41.6 per cent in 1981 to 46.9 per cent in 2001 … this means the number of people living in extreme poverty has almost doubled, from 164 million to 316 million….Today, most academic economists agree that markets, by themselves, do not lead to efficiency; the question is whether government can improve matters.
Another shortcoming of markets is that the participants don’t shoulder the cost of “externalities” such as pollution, resource depletion, or global warming. But that is a huge topic, which we will likely get to in future posts.
Markets are undoubtedly good for certain things, like price discovery and allocation of resources. And keeping government intervention to a practical minimum is also a sound idea. But the idea of free markets has become orthodoxy, and is too often used to defend corporate practices that have comparatively little to do with either freedom or markets (for example, Wal-Mart’s low wages being subsidized by taxpayers because its workers use emergency rooms, food stamps, and other public services).

Indeed, some of Friedman’s ideas, such as a negative income tax and legalization of drugs, would horrify the conservatives who have embraced free market ideology, It is ironic that Friedman, who took pride in his role of promoting empiricism in the social sciences, unwittingly ushered in era of market fundamentalism.

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