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Wednesday, October 3, 2012

Capitalism and Freedom: A 50th Anniversary Tribute to Milton Friedman

It is difficult for younger people (those who reached college age after 1980) to fully appreciate Milton Friedman’s contributions in his 1962 book, Capitalism and Freedom. Friedman’s proposals for relying less on government coercion and more on market incentives and freedom to address problems have not been shockingly outrageous to those who came of age at the beginning of the Reagan administration or later. Whether or not these younger people agreed with Friedman’s policy recommendations, most knew they were being taken seriously by important people. The older of us can more fully appreciate Friedman’s contributions today because we can recall that his ideas were either unheard of or dismissed as ridiculous when put forth in Capitalism and Freedom.

For example, I majored in economics in college and took my first principles course (macroeconomics) in 1960. The course emphasized the Keynesian model and how this model made it possible to moderate the business cycle with fiscal policy. The role of money was hardly mentioned since the model suggested that the real economy was unaffected by the money supply and inflation was entirely explained by excess aggregate demand. Friedman probably was not mentioned in this course. He probably came up in subsequent courses, in passing, as an example of someone who continued to believe in things like the ability of market forces to bring an economy out of recession or depression without government intervention.

Never mentioned in any of my classes were proposals found in Capitalism and Freedom, such as increasing reliance on market competition by eliminating occupational licensing, replacing the draft with a market for military personnel, and requiring government schools to face market competition for students by providing parents with educational vouchers. In the principles and intermediate microeconomics courses, the graphical presentations were accompanied with comments noting that the material had little relevance to public policy.

In 1962 Friedman was a voice in the wilderness making the case for markets and freedom when the vast majority of academic economists believed that the best (if not the only) hope for economic progress was government spending guided by Keynesian fiscal policy. Fortunately Friedman’s voice was amplified by the impressive logic and clarity of his arguments. But before 1962 his arguments were targeted exclusively toward academic economists, most of whom tried to ignore or belittle them, though the best knew they had to pay attention to Friedman whether they agreed with him or not.

Poking Holes in Keynes

In 1941, before Friedman became well known to leading economists, he considered himself a Keynesian. But at the University of Chicago, where he taught from 1946 to 1976, he started seeing problems with Keynes’s model that were overlooked by the rest of the profession. In 1957 he published A Theory of the Consumption Function using longitudinal data to show that the marginal propensity to consume did not decrease as national income increased, as Keynes had argued, and Friedman provided a theoretical explanation for this empirical result. This book undermined the popular Keynesian argument that as a country’s income increased, more government spending would be required to maintain aggregate demand and prevent underconsumption from causing persistent unemployment.

In 1963 Friedman published an article and a book that created further skepticism about the validity of Keynesian economics. With David Meiselman he published “The Relative Stability of Monetary Velocity and the Investment Multiplier in the United States, 1897–1958,” which estimated a Keynesian multiplier of zero—meaning that an additional dollar spent by the federal government would simply substitute government spending for the same amount of private spending, doing nothing to stimulate economic activity. That year, 1963, also saw the publication of A Monetary History of the United States: 1867–1960 by Friedman and Anna J. Schwartz, the fruit of 15 years of data collection and careful analysis. Despite the best effort of Keynesians to discredit this book, its powerful empirical and theoretical case made it embarrassing for economists to continue dismissing the importance of money supply changes on short-run economic activity and the long-run price level.

Friedman’s 1967 presidential address to the American Economic Association (published in the American Economic Review under the title “The Role of Monetary Policy”) examined an empirical finding known as the Phillips Curve, which indicated high inflation was associated with low unemployment and low inflation with high unemployment. This seemed to support the Keynesian position that the only way to reduce unemployment is by accepting more inflation and the only way to reduce inflation is by accepting more unemployment. Friedman acknowledged that the Phillips Curve effect existed in the short run but used monetary theory to explain how both inflation and unemployment can simultaneously increase (or decrease) in the long run, something the Keynesian model cannot explain. Within a few years of this address, the American economy was suffering from both escalating inflation and unemployment, and it became increasingly apparent that Keynesian economics had been seriously damaged by Friedman’s intellectual assault.

Reputation and Fame

These examples of Friedman’s destruction of the Keynesian consensus are but a small sample of his contributions to our understanding of economics. But they are enough to explain the towering professional reputation Friedman had achieved by the mid-1970s, a reputation demanding that his recommended policies in Capitalism and Freedom be taken more seriously than they were in 1962. But they also suggest another factor in his influence on public policy.

As impressive as Friedman’s professional reputation was by the mid-’70s, the stagflation (economic stagnation with increasing unemployment and inflation) that characterized the American economy in the last half of the decade extended his reputation among the general public. Friedman established a public following in the 1960s, primarily through his Newsweek column, which started in 1966. This was surely a factor in the increased recognition that came his way in the form of talks on campuses, talks to business groups (he was invariably critical of business’s seeking political protections against competition), and a well-publicized 1973 interview in Playboy. But this public recognition made a quantum leap with his receipt of the Nobel Prize in economics in 1976, followed by the widespread recognition that he had explained and anticipated the stagflation that was dominating the economic news and puzzling Keynesian economists. In addition to columns and interviews in magazines, Friedman appeared on highly rated television shows such as the Phil Donahue Show. Friedman was probably the only economist in the world who could attract a large audience when there were only three TV networks, each aimed at a mass viewership.

The point is that when stagflation undermined confidence in Keynesian policies, public attention turned to Friedman and the alternative economic policies he had spent years developing and popularizing. Friedman recognized this as a critical factor in his influence when he stated in the preface to the 1982 edition of Capitalism and Freedom: “Only a crisis—actual or perceived—produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around. That, I believe, is our basic function: to develop alternatives to existing policies, to keep them alive and available until the politically impossible becomes politically inevitable.”

In 1979 Paul Volker, the new Federal Reserve chairman, knew that curing economic stagflation required something other than Keynesian policies, and he followed Friedman’s advice by attacking stagflation with tight monetary policy. As Friedman (and the Phillips Curve) predicted, the initial effect was to increase unemployment. But as Friedman also predicted (as opposed to the Phillips Curve), after a lag needed to erode inflationary expectations, both inflation and unemployment started falling and the rate of economic growth increased.

Keynes’s Enduring Appeal

This is not to argue that Friedman won the battle against Keynesianism in the political arena. Just because Keynesian economics is in retreat among academic economists does not automatically reduce its appeal to politicians. Few politicians can resist policies that give the superficial appearance of addressing problems quickly in ways that generate political support even if they are counterproductive. Keynesian policies satisfy these conditions. Keynesians consider aggregate demand to be the primary force driving economic growth, and they believe that people can increase their demand quickly in response to government spending that increases their incomes. This spending can be targeted to concentrate immediate benefits on particular interest groups in ways that save the jobs of identifiable people who will be aware, and appreciative, of the politicians who supported the spending. It is far more difficult to trace the widespread reductions in spending by others—and the jobs lost or simply never created—to those politicians, much less to the Keynesian policies they supported. In contrast, Friedman’s policy recommendations work through markets by effectively increasing the economy’s productive capacity with the understanding that consumption comes before production only in the dictionary. But these policies work indirectly, over the long run, to provide dispersed and incremental improvements in our wealth. Thus this benefit goes largely unnoticed, and politicians cannot easily take credit for it even if it is noticed.

This takes us back to the importance of Friedman’s observation on the importance of alternative policies being available when events make it clear that existing policies aren’t working. The failure of Keynesian policies during the Great Recession first eroded public support. It is doubtful that a majority of American politicians today would claim to be Keynesians—many advocate reduced federal spending despite high unemployment. How effectively this will translate into action remains to be seen, but events have clearly shifted the center of political gravity in Friedman’s direction.

His proposals extend to more concerns than macroeconomics, and when they have succeeded politically it typically has been because events made them politically salient. One of the most politically successful of the policies proffered in Capitalism and Freedom is the all-voluntary military, a policy enacted in January 1973 and catalyzed by the unpopularity of the Vietnam war. One of the book’s least politically successful attacks on public policy is against occupation licensure, even in medicine, which Friedman argued is inconsistent with the principles of a free society. Arguably this lack of success is explainable by the absence of any event that focused public concern on the problems with occupational licensure, not any deficiency in the power of Friedman’s argument.

The second-longest chapter in Capitalism and Freedom is devoted to education and school choice. No one can deny that school choice has become an important political movement in the United States, having gone from being completely ignored by the government school lobby to being considered a serious threat. On the other hand, the movement has met with powerful political opposition and numerous setbacks. Government education (K-12) has not reached a crisis point, instead declining incrementally. Its biggest victims have been the relatively poor, whose votes can be taken for granted by political representatives who consistently cater to the special-interest demands of teachers’ unions.

Space prevents me from giving additional examples to show that the political success of Friedman’s proposals is determined largely by events that impact the public. This is not to deny that the power of Friedman’s ideas has been critically important to their political success. But when ideas run as counter to political incentives as Friedman’s do, they face enormous difficulty in getting a political hearing, no matter how brilliant they are. Yet the brilliance with which Friedman made his arguments in Capitalism and Freedom was essential, if not sufficient, to achieving political success.

  • Dwight R. Lee is the O’Neil Professor of Global Markets and Freedom in the Cox School of Business at Southern Methodist University.