The Triumph of Milton Friedman

The truly influential lobbies and movements in American politics become bipartisan. They understand the American people's nasty habit of taking their frustrations out on the party in power, and take out insurance accordingly. Neither AIPAC, nor the NRA, nor the AARP in its glory years (which have passed along with most of the GI generation), needs to worry too much about election results: they are far too deeply entrenched in both parties to be set back by the whims of the electorate. The same is true, we can now see, of drug companies and health insurance giants, who successfully turned the Democratic reform proposals into such a joke, in many ways, that the people lost interest in them. (The New York Times today reports that Billy Tauzin, the former Democratic-turned-Republican Congressman from Louisiana who became the drug industry's leading lobbyist, is in trouble with his employers because he had assumed the bill would pass, and struck a deal with the White House which they now regret.)

Over the last couple of weeks I read a fascinating book, How Markets Fail, by John Cassidy, a British-born journalist who writes frequently on financial issues of The New Yorker. Cassidy has the kind of flexible intellect that a career in journalism (unlike one in the academy) can still produce, and his book does many things. Not only does it trace the development of economic thought over the whole of the twentieth century, with particular emphasis on the irrational faith in markets that has come to dominate the profession (and loving attention to the hardheaded individuals who have repeatedly exposed the fallacies behind that faith), but he also has written a concise history of the changes in our financial structure over the last thirty years or so and of the current financial crisis. And by the time I reached the end of the book, I understood a great deal about the Obama Administration's very limited response to that crisis, and about the depth of the crisis we now face and exactly how hard it may be to get out of it. I cannot remotely do justice to Cassidy's book in a single post but I will focus on the most important things it taught me.

Like everything I read about economics, the book transported me back almost 45 years, to my freshman year at college, where Economics 1 was my best course. (My section man tried hard to talk me into switching my major from history, but fortunately--as we shall see--I didn't.) Unlike most such courses today, from what I can make out, the one--taught by a committee of leading Harvard economists, including Otto Eckstein and John Kenneth Galbraith--combined basic theory--we looked at lots of graphs--with a good deal of reading about how the world actually worked. In the first half of the course we focused on microeconomics, learning about rational behavior among firms and consumers--but even then, I could see, and indeed was encouraged to see, that the microeconomic models seldom if ever described real behavior. Firms obviously spent much of their time, energy and money trying to subvert the competitive market to create an artificial advantage, most notably through advertising, which might induce consumers to pay more for their product than for another similar one. Price fixing among oligopolies remained endemic--and so on. In our last meeting, our section man warned us that a lot of work remained to be done in microeconomics.

He and his senior colleagues waxed far more enthusiastic about contemporary macroeconomics. Keynesians all, they believed they had solved the great problem of their youth, cyclical depressions. Running small deficits (certainly by later standards!) to stimulate the economy had now become economic orthodoxy, and the country was in the middle of a boom that eventually lasted (with the help, sadly, of the Vietnam War) for eight years. We spent time on monetary policy, and the Harvard department included at least one believer in the idea that interest rates alone could satisfactorily regulate the economy, but focused more on fiscal policy. Government spending, we learned, was good for the economy, if only because the government, unlike private individuals, spent everything it received, increasing the stimulating effect on the economy.

During one class we were introduced to the work of a University of Chicago eccentric named Milton Friedman--one of the rare birds who had resisted Keynesian orthodoxy and believed in very limited government and free markets. "It's good for you to be exposed to this," said the section man--but Friedman, as it turned out, was destined to be far more influential over my lifetime than any of the other economic thinkers we studied that year, including Keynes. And his influence, I now understand, also lies behind the Obama Administration's response to the financial crisis.

Let us not get too far ahead of ourselves too quickly. Several things brought down the Keynesian consensus. One was another pillar of contemporary orthodoxy, free trade. By 1965-6 German competition was already putting some pressure on Detroit, and during the next decade Japanese competition began to make tremendous inroads. The combined power of big industries and big unions was both keeping wages and prices high in the US and weakening us against foreign competition. The Vietnam War put a big hit into the value of the dollar, making these problems still worse. The Democratic coalition broke up over civil rights and foreign policy. The patient Milton Friedman and his acolytes were ready to jump into the breach. Government, they argued, was the problem, not the solution. Left to its own devices (and with careful management of the money supply by the Federal Reserve Board), the economy would thrive. Yes, we would always suffer from a "natural" level of unemployment--a delightfully flexible concept, since it could be adjusted to match whatever unemployment happened to be--but the market would inevitably create the best economy that we could have.

Now it is one of Cassidy's great insights to focus on Friedman's analysis of the Great Depression, which he obviously had to work into his model somehow to retain any credibility at all. Something, obviously, had gone horribly wrong from 1929 through 1933, and Friedman had to identify it. He decided the that the crisis had gotten so bad, essentially, for just one reason: the Federal Reserve Board had responded to the initial stock market crash by tightening credit instead of expanding it. Had they behaved properly, he argued we would have had no depression at all. That allowed him to dispense with the kinds of explanations that had been popular at the time--particularly the idea that the Depression began and continued because too few people had enough money to spend, and that only a redistribution of income, brought about largely by government policies, could get us out of it.

Friedman also believed in small government and balanced budgets--but when Ronald Reagan rode Friedman's ideas into power in 1981, those aspects of his ideas went out the window. Paul Volcker, the Fed chairman, decided to wring inflation out of the economy by raising interest rates to unprecedented levels. The result was the worst downturn since the 1930s, and the beginning of the deindustrialization of America that has only accelerated ever since--but inflation was brought under control. Ironically, Reagan's tax cuts meanwhile supplied the biggest Keynesian stimulus to the economy since the Second World War. It was not until sometime in Reagan's second term that unemployment had fallen to 1980 levels, but the monetarist orthodoxy was firmly established. Few people also noticed the fiscal consequences of Reagan's policies: that an enormous tax burden had been shifted from higher income tax brackets to average American workers, whose payroll taxes soared and began funding a large portion of the federal budget. The idea of free markets in general was also firmly established, and the undoing of New Deal restrictions on financial markets began.

And here we come to the crux of the matter. Since Reagan, no Administration--not Bush I or Bush II, Clinton, or Obama--has really questioned the monetarist orthodoxy. The economics profession has decided that markets always work, and the economists who actually manage our economy have decided that their role is to make cheap credit flow. This was particularly true under Alan Greenspan, the friend and disciple of Ayn Rand, another intellectual who in the 1960s ranked as a right-wing nut, but whose great days of influence lay before her. What is particularly devastating about these economic principles, both inside and outside the academy, is that they militate against any serious look at what is actually happening in the American economic world. There is no need to ask how many farms are being lost, how many plants closed, and how many semi-skilled service jobs are being eliminated or outsourced to the Indian subcontinent, if one simply assumes that the market is always right and any outcome must lead to greater economic progress. Throw in the deregulation of the banking industry and a gigantic accumulation of debt, and the near-collapse of our economic system in 2008 follows.

I am not spending much time on the nuts and bolts of Cassidy's argument, but one point was so striking that I have to mention it. It concerns the kind of herd behavior which, rather than rational thought, actually guides men and women in the marketplace. A number of well-placed traders, analysts and fund managers did realize during the dot-com bubble and then later during the housing bubble that things had gotten hand and that a crash was inevitable, but they found it impossible to act on their beliefs because to do so would cut their short-term gains and very possibly cost them their jobs. That was another illustration of Keynes's definition of a sound banker--not a banker who is never ruined, but one who is ruined along with all the others.

Now as I and others have been remarking for a year now, none of the Obama economic team, led by Larry Summers and Tim Geithner, seriously questions any of the orthodoxy of the last twenty years or the changes--such as the creation of the mega-banks--that they have brought about. Cassidy even quotes Summers (the nephew of neo-Keynesian giant Paul Samuelson) to the effect that he had learned to appreciate the wisdom of Milton Friedman. But the key man in all this, in more ways that one, is Ben Bernanke, who has just been nominated and confirmed for another term as Chairman of the Federal Reserve Board. The press routinely describes Bernanke as a specialist in the Great Depression, which in a sense is true--much of his academic work, which I have now dipped into a bit myself, does indeed deal with the Depression. It does not, however, deal with how we actually got out of it, through New Deal public works programs and, ultimately, the mobilization for the Second World War. Instead, Bernanke's work takes off from Milton Friedman's idea that the depression was caused, deepened and prolonged by failures in the credit markets to which the Fed did not appropriately respond.

A particularly striking example of Bernanke's approach is his article, "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,"
The American Economic Review, Vol. 73, No. 3 (Jun., 1983), pp. 257-276, which explicitly begins with Friedman's idea that a drop in the money supply caused the depression and tries to supplement it with other closely related explanations. As an orthodox monetarist, Bernanke apparently believed (and could well believe today) that a natural process should inevitably match available capital to the most productive uses available, therefore raising the economy to the highest possible level of activity. He suggests in this article that this was not happening during 1930-33 because lenders could not tell good borrowers from bad ones, and credit markets therefore froze up. Credit became either more expensive or altogether unavailable. Bernanke did give the federal government credit for aggressive steps to restore the health of the financial system after 1933, but he said nothing, in this article at least, about other New Deal measures, including the curtailment of agricultural supply to raise prices or the introduction of huge public works programs. Fix the financial markets, the article implied, and everything else will take care of itself.

Knowing how Bernanke (and, pretty clearly, Summers and Geithner as well) think explains a very great deal about Administration rhetoric. Summers declared months ago that the recession was over. The President repeatedly brags of having avoided another Great Depression--because the collapse of major financial institutions has been avoided and the stock market has begun rising again. The President also focuses on the need to loosen credit markets, ignoring the comments of various business owners to the effect that what they really need is not loans, but customers with money to spend. This is not to say that many Bush and Obama Administration measures were not indeed absolutely necessary to prevent something worse--they probably were, although they have also left in place the megabanks that, as Cassidy clearly shows, got us into this mess and very likely will do so again. The problem is that the Administration is betting both its own future and the economic health of the American people on the idea that Milton Friedman and his disciples were right: that the only measure necessary to avoid the Great Depression was the proper handling of the money supply and credit markets. If Friedman's ideas fail this new real-world test, the economic and political consequences will be incalculable.

The Administration has, of course, bowed to Keynes by passing its stimulus package of approximately $800 billion in its first months in office. That package, however, turns out to have been a defensive rather than offensive measure: it saved tens of thousands (at least) jobs in state and local government, but it has not put significant numbers of unemployed back to work. The deficit has increased to about $1.2 trillion annually at the moment--an increase of a trillion dollars in just a few years. In a nation with a GDP of about $14 trillion, that is a great deal of money--but it is an order of magnitude less than the $10 trillion which, the International Monetary Fund estimates, has been pledged by various governments and central banks to back up the worthless assets of financial institutions. Far more money, in short, has been spent to bail out the irresponsible financial institutions who got us into this mess (and Cassidy shows just how), than to put ordinary men and women back to work--even though the evidence that those institutions can actually create a healthy economy is dubious at best. Very few economists remain outside the monetarist consensus, even though a few of those that do, including Paul Krugman, Joseph Stiglitz and James Galbraith, remain highly visible. None of them has been appointed to a major policy position.

I admit that I was shocked, reading Cassidy, to see how far economics in the academy had departed from reality over the last few decades. I should not have been, since developments in my own discipline are just as bad, but I was. The collapse of history will also have serious political effects, but the people of the world will pay a much higher price for the collapse of economic thought if Friedman, as I believe, turns out to have been fundamentally wrong. We really have no idea how we shall ever get US unemployment down to even five or six per cent--levels which were regarded as a failure when I started Economics 1. We are, once again, gambling, for the time being, that the system will take care of itself. If it does, it will be the first time--and we cannot predict what political developments will have taken place before our economic elite is forced to face reality.