Milton Friedman: From Modern Monetary Theory to Monetarism

Yves here. Please welcome István Tóth, who was so gracious as to submit this article. It describes the way that Milton Friedman adopted some ideas that the precursor to Modern Monetary Theory, “functional finance” embraced, at a time when the latter was a hot topic. Tóth then describes how Friedman’s ideas evolved into something very different, his famed monetarism.

Some observations, since not all readers will know the fine points. One is the reliance of Friedman and his allies on “fractional reserve banking” as how the banking system works. That has been disproven although far too many business schools and economic departments remain anchored to discredited ideas. Banks do not intermediate existing savings (that is another fallacy, the “loanable funds theory” which plagues modern macroeconomics). They create money out of thin air. New loans create deposits. Paying back loans destroys money. The constraint on this process is reserves, which the central bank will create subject to its interest rate target.

In addition, Friedman’s monetarist were disproven in central bank experiments under Reagan and Thatcher. They found that changes in money supply did not correlate with any macroeconomic variable, which is the opposite of what Friedman posited.

By István Tóth, Economist, Managing director of Port of Gönyű, Hungary

In his 2012 book Modern Money Theory—a particularly elaborate exposition of the school that goes by that name—L. Randall Wray makes a rather surprising observation: in his 1948 essay A Monetary and Fiscal Framework for Economic Stability, Milton Friedman outlined a fiscal–monetary framework that bears a striking resemblance to Abba Lerner’s concept of functional finance, which in turn stands as a cornerstone of modern monetary theory.

Modern monetary theory (MMT) rests on a single central insight: unlike other actors in the economy, the state is not merely a user of money but also its issuer. Since, in technical terms, the state can create money without limit, its spending is not constrained by revenues; it is constrained only by the scarcity of real resources. In other words, the state can finance any expenditure by creating money, independently of taxation. Proponents of MMT—following the ideas of Beardsley Ruml, a former president of the New York Fed—argue that the primary role of taxation is not to fund public expenditures, but to serve socially desirable purposes (by discouraging or encouraging certain activities), as well as to regulate the amount of money in circulation. For this reason, the budget balance itself has little economic policy significance: it is a mere residual, the arithmetic difference between revenues and expenditures, a figure in an accounting statement. It is precisely here that MMT meets Lerner’s doctrine of functional finance.

As Lerner explained in his 1943 essay Functional Finance and the Federal Debt, the true measure of economic policy success is not the balance of the budget but—very much in line with Keynesian thinking—the achievement of full employment and high utilization of productive capacity, paired with stable prices. In other words, the equilibrium of the economy as a whole. Fiscal policy should be judged solely by its impact on the economy, not by the conservative requirements of orthodox budgetary thinking. The evidence of excessive government spending is not a budget deficit, but inflation; likewise, the evidence of insufficient government spending is not a budget surplus, but unemployment. For this reason, government should regulate the volume of its expenditures so as to avoid both unemployment and inflation, while the budget balance remains of secondary importance. Ensuring full employment may well involve persistent deficit financing—as long as the price level remains stable, this poses no real economic problem. According to Lerner, government could even sustain full employment without debt growth, relying purely on money creation. In this case too, avoiding inflation is the sole limiting factor. To curb inflation, government may raise taxes or issue bonds to withdraw money from circulation, emphasizing that in this context government bonds play no financing role, serving only to regulate the money supply.

In his 1948 essay, Friedman proposed that the Federal Reserve refrain from open market operations and other discretionary interventions, while requiring commercial banks to hold 100 percent reserves against all demand deposits. As a result, changes in the money supply would depend exclusively on the government’s fiscal balance. Friedman also advocated a fixed structure of government expenditures and revenues. Taken together, these measures would make the volume of money in circulation fluctuate with the level of economic activity: in recession, deficits financed by money creation would expand the money supply, while in booms, surpluses would contract it. In this way, the budget’s position would exert an automatic countercyclical effect on purchasing power and aggregate demand. The abolition of open market operations, the requirement of 100 percent reserves, and the fixed fiscal structure were all meant to ensure the smooth functioning of this mechanism.

Wray’s suggestion, then, is not without merit: Friedman’s 1948 fiscal–monetary framework indeed departed from fiscal orthodoxy, and the regulation of the money supply through the budget balance, in the service of economic stability, did resemble Lerner’s functional finance. Yet there was an important difference: Friedman’s ultimate aim was to insulate policy from the uncertainties of discretionary decision-making by means of an automatic rule-based framework—a quasi-autopilot mechanism—whereas Lerner’s functional finance sought to provide theoretical foundations for discretionary fiscal policy.

Where, then, did the theoretical similarity come from? Wray argues in his 2012 book that in the 1940s the idea of functional finance was “in the air,” widely shared across the political spectrum and far from marginal. This claim, however, is only partly accurate. By the mid-1930s many economists had indeed accepted that in times of recession government could stimulate demand through active spending—even deficit spending. Yet Lerner himself complained that most of his contemporaries approached the principles of functional finance timidly, with compromises and only partial understanding. The prevailing interpretation of deficit financing remained half-orthodox, as most economists refused to embrace its full logical implications. What can be said with certainty is this: Friedman did not draw his 1948 framework from the Keynesian air of the times.

Friedman did spend two years at the University of Chicago in the 1930s—first as a graduate student (1932–33), then as a research assistant (1934–35)—but he did not return there as a faculty member until 1946. In the early stage of his career Friedman was mainly occupied with price theory, and it was only with the 1948 essay that he gave his first indication of turning to monetary economics. In fact, the essay can be seen as his debut as a monetary economist. Yet it was not particularly original: Friedman’s fiscal–monetary framework was a direct continuation of what the Keynesian Alvin Hansen had labeled the “Mints–Simons program,” developed by a handful of University of Chicago economists during the 1930s and early 1940s.

In those years a small circle of Chicago economists—notably Paul Douglas, Frank Knight, Lloyd Mints, and Henry Simons—constructed a policy-oriented framework for economic stability, built on Irving Fisher’s equation of exchange and spurred by the turmoil of the Great Depression. While they differed on details, they shared the conviction that business cycles were caused by instability in the velocity of money—that is, in money demand—which was further amplified by the fractional reserve banking system. In other words, economic fluctuations had fundamentally monetary roots, and fractional reserve banking was eo ipso unstable. They also attributed the Great Depression to an autonomous fall in velocity. On this point, their views closely paralleled those of Keynes with respect to the downturn phase of the cycle. They also agreed that fluctuations in velocity could be offset by appropriate changes in the money supply. Yet they maintained that in times of crisis Federal Reserve open market operations were ineffective, as banks were unwilling to lend and firms unwilling to borrow. Put differently, in crisis, policy instruments operating through the banking system were useless, and monetary expansion had to be carried out through the government’s fiscal position—i.e., by financing increased budgetary expenditures with money creation, which directly injected additional money into the economy. Consequently, the Chicago economists called for abandoning the gold standard, introducing flexible exchange rates, mandating 100 percent reserves, and—most importantly—using deficit-financed spending in times of crisis. At the same time, they also viewed discretionary fiscal policy as a source of instability. Thus, to prevent crises, they advocated introducing a monetary rule that would render the velocity of money more predictable and stable. These ideas were essentially formulated as early as 1933, and Friedman’s 1948 essay was directly rooted in them. Far from being “in the air,” they laid the foundations of a specifically Chicagoan monetary tradition.

Yet the Mints–Simons tradition of the 1930s and 1940s—what is now often referred to as “old Chicago”—was not identical with the monetarism later associated with Milton Friedman. Through his correspondence with Clark Warburton, the first genuine monetarist economist, and through his joint empirical and historical research with Anna Schwartz, Friedman in the early 1950s began to distance himself from the Mints–Simons framework, and over the course of that decade eventually turned it upside down. As we have seen, the old Chicago economists believed that economic instability stemmed from autonomous shifts in money demand and the inherent fragility of the banking system, which had to be offset by adjusting the money supply. Friedman, by contrast, came to the conclusion that money demand and the banking system were essentially stable, while the true source of instability was the fluctuation of the money supply itself, resulting from the discretionary policies of the Fed. This realization also implied that monetary policy could be highly effective—though not always to the economy’s benefit. In other words, whereas old Chicago sought a framework to counteract instability arising from the private economy, the monetarist Friedman’s aim was to establish a rule-based system that would shield the private economy’s inherent stability from disruptions caused by discretionary policy. In this last respect, he remained faithful to the old Chicago tradition. Just over a decade after the 1948 essay, his 1960 book A Program for Monetary Stability presented the fully armed Friedman of monetarism.

In his 2012 book, Wray refers to Friedman partly in order to enlist a prestigious name in support of functional finance, and partly to suggest that Lerner’s ideas in the 1940s were “in the air” and anything but marginal. The history of ideas, however, paints a somewhat different picture. Friedman only approached functional finance in 1948, as a temporary adherent of the Mints–Simons program—a program that was far from widely accepted at the time. Moreover, Wray overlooks the fact that invoking Friedman is somewhat double-edged: for while it may be true that Friedman began as a sort of “proto-MMTer,” he ultimately became the leading monetarist. Which may also be taken to mean that today’s MMT enthusiasts, too, might yet find their way toward monetarism.

References

Friedman, M. (1948). A Monetary and Fiscal Framework for Economic Stability. American Economic Review, 38(3), 245–264.
Friedman, M. (1960). A Program for Monetary Stability. New York: Fordham University Press.
Lerner, A. (1943). Functional Finance and the Federal Debt. Social Research, 10(1), 38–51.
Tavlas, G. (2023). The Monetarists: The Making of the Chicago Monetary Tradition, 1927–1960. Chicago: University of Chicago Press.
Wray, L. R. (2012). Modern Money Theory. London: Palgrave Macmillan.