Milton Friedman and the Federal Reserve: Then and Now
J. Daniel Hammond
Hultquist Family Professor
Department of Economics
Wake Forest University
What would Milton Friedman say about the question we are asking at this conference,
“was the Federal Reserve a bad idea?” The question has particular relevance for us in
light of the recent financial crisis and recession, and innovations in Federal Reserve
policy in reaction to these events. But we cannot know what he would say, since his death
on November 16, 2006 was just over a year before the latest recession began and three
months before the Federal Home Loan Mortgage Corporation announced that it would no
longer purchase the riskiest subprime mortgages and mortgage-backed securities. So
Friedman didn’t remark on the recent monetary and financial problems. His last word on
monetary policy, “Why Money Matters,” was published in the Wall Street Journal the
day after he died, on November 17, 2006. So my presentation will be partly speculative,
what might Friedman say if he were participating in this conference. But most of my
presentation will be historical, for there is an historical record in what Friedman wrote
about the Federal Reserve. Although Friedman’s ideas evolved, there was an underlying
consistency. And the consistency in Friedman’s views has a counterpart in the
consistency he saw in the Federal Reserve’s history. So while recent financial and
economic problems may appear to mark a turning point in monetary and financial affairs,
Friedman saw a continuity running through the many events and personalities that make
up the Fed’s history since its founding in 1914. This allows us to bracket, fairly closely I
suggest, what we might hear from Friedman if he were here with us this weekend.
1
The historical record from which I will draw includes more than Friedman’s
judgments about the Federal Reserve and monetary policy. It also includes Friedman’s
approach to business cycle analysis. Milton Friedman’s era was also the era of generalequilibrium mathematization of economics, the era of mathematical economists who
looked on Friedman’s approach as outdated. Comparing Friedman’s approach to
economic analysis and policymaking with the foremost exemplar and proponent of
mathematization of economics, Paul Samuelson, can help us understand our current
situation. What I am suggesting is that a three way comparison of Friedman, Samuelson,
and policy-making at the Federal Reserve today will help us to see not only that
Friedman was largely correct in his misgivings about central banking at the Federal
Reserve, but that he was also more generally correct in his misgivings about the postWorld War II rush to bring economists’ expertise to bear on matters of what we might
call economic engineering of prosperity and stability. This is the context in which I will
set the question of whether there should be a Federal Reserve.
Let’s start with what we can gather in a straightforward manner from the record of
Friedman’s written work. What did Friedman say over the course of his career about the
Federal Reserve’s performance over its history and how would the current crisis fit into
that history? Next we will compare Friedman and Paul Samuelson on the matter of what
and how much can be done about the business cycle. Then we will get into the matter that
is necessarily more interpretative – what might Friedman say about the Federal Reserve
today?
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Friedman on the Federal Reserve
Friedman and Anna J. Schwartz began their long-time collaboration on the NBER
money and business cycles project in 1948, shortly after Friedman wrote “A Monetary
and Fiscal Framework for Economic Stability” (Friedman 1948). Friedman had studied
business cycles under Wesley C. Mitchell at Columbia University and taught business
cycles at the University of Wisconsin, but he had little previous experience with central
banking. From Mitchell, Friedman learned that price rigidities and lags in response were
key elements of business cycles. The proposal in his 1948 paper was designed to mitigate
their effects. What he proposed was that fractional reserve deposit banking be eliminated,
the federal deficit be wholly monetized, and that the federal budget be balanced on a fullemployment basis. He analyzed the likely performance of the economy under this system
compared with the performance under the status quo of descretionary policy decisions,
and concluded that the “automatic,” non-discretionary policy rule would reduce
instability. Friedman stressed throughout the article that his evidence on policy lags was
conjectural, and he called for research on the actual timing of lags.
Anna Schwartz brought experience and expertize in money and banking to the
monetary project. She had compiled a data series for currency covering the period 1917
to 1944, and was working on the companion series for bank deposits. In spring 1948 she
sent Friedman a list of readings on monetary and banking history, warning him that the
literature was pretty bad, but suggesting that he would acquire less misinformation from
the readings on her list than from others. Friedman spent the summer reading and joined
Schwartz in the work of compiling data. This is a point worth noting. Friedman and
Schwartz began their monetary project not by reading monetary theory or
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macroeconomic theory, but by building data and reading banking history. And this was to
beome a hallmark of their approach to monetary economics; their work was empirical
and historical.
Friedman formed his first tentative judgment about the question addressed in our
conference after reading the materials suggested by Schwartz. This was that the Federal
Reserve had on balance been a destabilizing force since 1914, and that the nation might
have been better off had the Fed not been created. He and Schwartz did not address the
counterfactual question directly in their best known work, the Monetary History (1963),
but they came close by concluding that on balance the Fed had been a source of monetary
instability.
The reform measure finally enacted [in response to the banking panic of
1907] – the Federal Reserve System – with the aim of preventing any such
panics or any such restriction of convertability in the future did not in fact
stem the worst panic in American economic history and the severest
restrictions of convertability, the collapse of the banking system from
1930 to 1933 terminating in the banking holiday of March 1933. That
same reform, intended to promote monetary stability, was followed by
about thirty years of relatively greater instability in the money stock than
any experienced in the pre-Federal Reserve period our data cover, and
possibly than any experienced in the whole of U.S. history, the
Revolutionary War alone excepted (Friedman and Schwartz, A Monetary
History of the United States, 1867-1960, 1963).
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Friedman gave a preview of the Monetary History and his evaluation of the case
for alternative monetary institutions in his 1959 Millar Lectures at Fordham University
(M. Friedman, A Program for Monetary Stability, 1960) and a 1960 lecture at the
University of Virginia (M. Friedman, “Should There be an Independent Monetary
Authority?,” 1960). In the Fordham lectures, he reviewed the case for government
involvement in money and banking -- arguments based on the real resource cost of a
commodity money, the technical monopoly character of a fiduciary monetary system, and
the historical record of nearly universal government regulation of money. He also
reviewed American monetary history. He then switched attention to strategy, concluding
that:
The central problem is not to construct a highly sensitive instrument that
can continuously offset instability introduced by other factors, but rather
to prevent monetary arrangements from themselves becoming a primary
source of instability. What we need is not a skilled monetary driver of the
economic vehicle continuously turning the steering wheel to adjust to the
unexpected irregularities of the route, but some means of keeping the
monetary passenger who is in the back seat as ballast from occasionally
leaning over and giving the steering wheel a jerk that threatens to send the
car off the road (M. Friedman, A Program for Monetary Stability, 1960, p.
23).
The proposals Friedman made were in the direction of streamlining and simplifying
policy, and protecting the public from arbitrary use of power by policymakers. He
proposed confining monetary policy to a single instrument, open market operations;
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requiring 100% reserves on all bank deposits; and requiring that open market operations
be guided by a money stock growth rate rule. This rule might be mandated by Congress,
as he suggested in the Virginia lecture, or it might be adopted by the Fed itself. Friedman
acknowledged that his proposal for a fixed money stock growth rule was counterintuitive.
In theory “leaning against the wind,” i.e., discretionary policy, looked better than a “do
nothing” fixed money growth rate rule. But Friedman predicted that in practice the rule
would provide more stability than discretionary “leaning against the wind.”
Why? First, because the empirical evidence suggested that changes in the growth
rate of the money stock had effects that were long and variable.1 This meant that in order
to effectively lean against the wind, the Fed would have to lean against future winds. Not
only that. Because of the variability of the lag, they would have to lean against a wind
that would be blowing at an uncertain time in the future. Second, he opposed leaving
policy open to Fed officials’ discretion because countercyclical policy was open to
different interpretations as to content. For example, is the policy objective price level
stability or low unemployment, or both; and how stable and how low; and stable and low
over what time frame? It was too easy to agree that the Fed should lean against the wind
because that directive was a container with a “stabilization” label, but without definite
content. Therefore, people with diverse ideas of the content could agree ex ante that the
Fed should lean against the wind, but have little basis for agreement ex post about
whether it had effectively done so. Friedman thought that disagreement, uncertainty, and
lack of accountability were built in to any system without a clear policy target.
1
On average 16 months from the peak in money growth to the peak in general business activity, and 12
months from trough to trough, with the range of lags from 6 to 29 months for peaks and 4 to 22 months for
troughs.
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Why should the policy rule be defined in terms of the money stock rather than say
the price level or the unemployment rate? Here again, Friedman’s concern was for clear
lines of responsibility. It was not useful to make the Fed responsible for something that
they were only partially able to control. The Fed had total control over their balance sheet
and over nothing else, but the money stock was closer to their balance sheet in the causeeffect chain than were the inflation rate and other macroeconomic variables. This
closeness had two dimensions, time lags and cause-effect links.
In the mid-1980s Friedman revisited the question of monetary institutions (M.
Friedman, “Monetary Policy: Tactics Versus Strategy,” 1987). By this time he had come
to believe that fundamental reform was needed. As a matter of tactics, he remained in
favor of setting a single monetary aggregate growth rate target and using open market
operations as the policy instrument. Central bankers had the technical ability to pursue
stabilizing policy via a monetary growth rate rule. They may have had the desire to do so.
But the institutional cards were stacked against them. The results he expected from a
monetary aggregate growth rate target were “increased predictability, reduced churning,
[and] loss of inscrutability.” But, “these are at the same time the major reasons for
making so drastic a change and the major obstacle to its achievement. It would simply
upset too many dovecotes” (M. Friedman, “Monetary Policy: Tactics Versus Strategy,”
1987, p. 367).
The institutional (strategy) reform Friedman proposed was to take monetary
policy away from the Fed – take it away from the Fed and not give it to anyone else. That
is, he suggested freezing the quantity of high-powered money. Private institutions would
continue to be allowed to issues claims on high-powered money, as deposits but also as
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hand-to-hand currency. There might or might not be reserve requirements. Friedman
favored eliminating them. With the stock of high-powered money frozen, the money
stock and volume of monetary transactions would be determined by the money multiplier
and velocity of circulation.
The great advantage of this proposal is that it would end the arbitrary
power of the Federal Reserve system to determine the quantity of money
and would do so without establishing any comparable locus of power and
without introducing any major disturbances into other existing economic
and financial institutions (M. Friedman, “Monetary Policy: Tactics
Versus Strategy,” 1987, p. 379).
Friedman expected that the result of such a reform would be price level stability or mild
deflation, with greater stability in growth of real income than the Federal Reserve had
achieved.
The Fed’s Reaction to the Financial Crisis and Recession
Now we turn to the recent financial crisis and recession. The St. Louis Fed’s
timeline of events and policy actions in the financial crisis (http://timeline.stlouisfed.org/)
begins three months after Friedman’s death with the announcement by the Federal Home
Loan Mortgage Corporation that it would no longer purchase the most risky subprime
mortgages and mortgage-backed securities. At the time, late February 2007 the federal
funds rate target was 5.25%. By the end of year the target had been reduced to 4.25%, the
FOMC had announced that “downside risks to growth have increased appreciably”
(August 17), and created the Term Auction Facility for provision of funds to depository
institutions against a wide variety of collateral. President Bush signed the Economic
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Stimulus Act of 2008 (PL 110-185) on February 13, 2008. The Fed created a second new
lending facility, the Term Securities Lending Facility, on March 11, 2008, and announced
three days later that they were “monitoring market developments closely and will
continue to provide liquidity as necessary to promote the orderly functioning of the
financial system.” Later that month the New York Fed announced that it was providing
term financing for the merger of Bear Stearns with JP Morgan. In September the Fed
created another new lending facility, the Asset-Backed Commercial Paper Money Market
Mutual Fund Liquidity Facility and began purchase of federal agency discount notes.
October 2008 was a month of several new initiatives. President Bush signed the
Emergency Economic Stabilization Act of 2008 (PL 110-343), which created the
Troubled Asset Relief Program; the Fed created the Commercial Paper Funding Facility
to provide a liquidity “backstop” to U.S. issuers of commercial paper; the Federal
Reserve Board authorized the New York Fed to “borrow” up to $37.8 billion in fixed
income securities from AIG in return for cash collateral; and the Fed created the Money
Market Investor Funding Facility. In November the U.S. Treasury became a shareholder
in AIG, the Fed joined the Treasury and FDIC in a bailout of Citigroup, and the Fed
created the Term Asset-Backed Securities Lending Facility. These policy innovations are
not quite what Friedman meant when he looked for “increased predictability, reduced
churning, [and] loss of inscrutability.”
On December 11, 2008 the NBER Business Cycle Dating Committee announced
that a recession had begun in December 2007. According to Friedman’s estimates the
average trough-to-trough monetary policy lag was twelve months. If that was the case,
under the best circumstances the FOMC would have softened their policy in December
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2006. They did not do so. At their December 12, 2006 meeting the FOMC voted to hold
the federal funds rate at 5.25%, where it had been since it was raised by 25 basis points in
June of that year. The sole dissenter at the December meeting preferred an increase to
5.50%. The committee’s statement read:
Economic growth has slowed over the course of the year, partly reflecting
a substantial cooling of the housing market. Although recent indicators
have been mixed, the economy seems likely to expand at a moderate pace
on balance over coming quarters.
Readings on core inflation have been elevated, and the high level of
resource utilization has the potential to sustain inflation pressures.
However, inflation pressures seem likely to moderate over time, reflecting
reduced impetus from energy prices, contained inflation expectations, and
the cumulative effects of monetary policy actions and other factors
restraining aggregate demand.
Nonetheless, the Committee judges that some inflation risks remain. The
extent and timing of any additional firming that may be needed to address
these risks will depend on the evolution of the outlook for both inflation
and economic growth, as implied by incoming information
(http://www.federalreserve.gov/newsevents/press/monetary/20061212a.ht
m).
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Twelve months before the recession began, twelve months being Friedman’s estimate of
the average length of the monetary policy lag, the FOMC did not see the recession
coming.
Friedman and Mathematical Economists on the Business Cycle
The question of how much economists know about the business cycle, and thus
how much expertise they can bring to the policymaking table, including crucially their
ability to forecast business conditions, was an important part of what separated
Friedman’s views from the mainstream over the course of his career.2 A good place to
begin seeing this difference is in the late 1940s, as Friedman and Schwartz were
beginning their monetary project for the NBER. Recall that Friedman had little
experience with monetary economics at the outset. But his two most important mentors,
Arthur F. Burns and Wesley C. Mitchell, had instilled in him firm convictions of how to
do economics. From Burns he learned the Marshallian approach to economics, which
involved use of relatively low-brow theory in close relation with measureable entities –
theory that could be used to extract useful information from data. From Mitchell,
Friedman learned National Bureau techniques for analyzing data on business cycles and
he also learned that constructing economic data is as important as constructing economic
theory.
We can see Friedman’s early perspective on business cycle analysis in his review
of Jan Tinbergen’s Business Cycles in the United States of America, 1919-1932.
Tinbergen’s book was one of the early attempts to estimate coefficients of a general
equilibrium model of the business cycle, work for which he was awarded the very first
Nobel Prize in Economic Science (shared with Ragnar Frisch). Tinbergen and Frisch
2
See (Hammond 1996).
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were cited “for having developed and applied dynamic models for the analysis of
economic processes” (http://nobelprize.org/nobel_prizes/economics/laureates/1969/#).
Friedman was less impressed in 1940 than the Nobel committee later was in 1969. He
wrote of the estimates:
Tinbergen’s results cannot be judged by ordinary tests of statistical
significance. The reason is that the variables with which he winds up, the
particular series measuring these variables, the leads and lags, and various
other aspects of the equations besides the particular values of the
parameters … have been selected after an extensive process of trial and
error because they yield high coefficients of correlation (M. Friedman,
“Review of Business Cycles in the United States of America” by Jan
Tinbergen, 1940, p. 659, emphasis in original).
Friedman quoted his teacher Wesley Mitchell to the effect that a statistician can take
almost any pair of data series and manipulate them to obtain a high correlation coefficient
between the two. What Tinbergen failed to do is to test his model with data from outside
the sample that he used to estimate the coefficients. Friedman did such a test in a
rudimentary form and found that the model did not explain the out-of-sample
observations very well.
A decade later Friedman commented on another test of a general equilibrium
business cycle model. In this case Carl Christ tested the model on out-of-sample data, as
Friedman had suggested for Tinbergen. But Friedman was still not impressed with the
results. He set up an alternative, and extremely simple, model in which the values of
endogenous variables were predicted to be unchanged from period to period. This was in
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effect running a contest between a highly sophisticated theory of the business cycle and
“we know nothing about the business cycle.” “We know nothing” won the contest!
Friedman concluded that economists using the big general equilibrium “system” models
were striving for something well beyond their reach. Greater progress would be made in
“analysis of parts of the economy in the hope that we can find bits of order here and there
and gradually combine these bits into a systematic picture of the whole (M. Friedman,
“Comment on 'A Test of an Econometric Model for the United States, 1921-1947,'” by
Carl Christ, 1951, p. 114).
We tend to think of Friedman as a “monetarist” and economists on the other side
of debates about business cycles as Keynesians. But the critiques we just examined were
before Friedman was a monetarist. The position he represented was the NBER approach
to business cycle analysis. His opponents in the 1940s tended to be Keynesians, but the
pressing issue was not so much what one thinks are the causes and cures for the business
cycle, but how one searches for answers to the question and how much is known. A good
illustration of this debate is in Arthur Burns’s 1946 annual report of the NBER, where
Burns was Director of Research. Burns criticized Keynesians for presuming that they had
figured the business cycle out, and for relying on theory with scant resort to economic
data other than highly aggregated data. Keynesians saw compensatory fiscal policy as the
solution to the cycle. Refering to a set of assumptions behind the analysis, about the
shape and stability of the consumption function, the relative size of consumption effects
of tax cuts and tax hikes, and so forth, Burns concluded:
Although assumptions such as these may be extremely helpful at a stage in
our thinking about an exceedingly complicated problem, it seems that the
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inferences to which they lead cannot be regarded as a sceintific guide to
governmental policies (Burns, Economic Research and the Keynesian
Thinking of Our Times, 1946, p. 11).
Burns continued:
Keynes’ adventure in business cycle theory is by no means exceptional.
My reason for singling it out is merely that the General Theory has
become for many, contrary to Keynes’ own wishes, a sourcebook of
established knowledge. Fanciful ideas about business cycles are widely
entertained both by men of affairs and by academic economists. That is
inevitable as long as the problem is attacked on a speculative level, or if
statistics serve only as a casual check on speculation. To develop a reliable
picture of the business cycles of actual life it is necessary to study with
fine discrimination the historical records of numerous economic activities
… Work on this plan is costly and time-consuming; it means turning back,
revising, rethinking, redoing; it often leads to disappointments and taxes
patience. But there is no reliable shortcut to tested knowledge (Burns,
Economic Research and the Keynesian Thinking of Our Times, 1946, p.
21).
Friedman’s, Mitchell’s, and Burns’s approach to business cycle analysis and their
sense of what was known and unknown about cycles was viewed as out-dated by many in
the midst of enthusiam for Keynesian theory and mathematization of economics and
statistics. Economists developed a hubris for which experience at the National Bureau
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provided immunity. This hubris is in full flower in Paul Samuelson’s writings about the
business cycle.
Samuelson was a mathematical economist, whose work was by and large pure
theory, without empirical data. In the autobiography he wrote for the Nobel Prize
Samuelson quotes an earlier autobiographical piece in which he proclaimed himself “the
last ‘generalist’ in economics.” And he was indeed a generalist in subject matter if not
method. Lloyd Metzler’s review of Samuelson’s Foundations of Economic Analysis
(Metzler 1948), which was Samuelson’s Ph.D. dissertation, noted that the book was a
contribution to economic method, with illustrations of the method from a variety of fields
such as taxation, international trade, business cycles, money and banking, and
employment. But problems in these fields were not treated with depth. That is, the
analysis made no use of institutions and data. What Samuelson’s method offered in place
of depth was unification. It was mathematically difficult, but offered in the unification a
kind of simplification, for economic analysis in the disparate fields could be reduced to
problems of equilibrium and maximization. Metzler admired Samuelson’s contribution,
but was skeptical that analysis could be taken very far without resort to empirical
evidence. This would be a limitation, for example, “in the study of complicated and
unsymmetrical systems such as one encounters in business cycle theory” (1948, p. 910).
Samuelson’s was the second Nobel Prize in Economics. Assar Lindbeck opened
the 1970 presentation speech by calling attention to the formalization of two sides of
economics, statistical analysis and economic theory. The previous year Frisch and
Tinbergen were honored for their contributions to the formalization of statistical theory
and analysis -- econometrics “designed for immediate statistical estimation and empirical
15
application” (Lindbeck, 1970). Samuelson was being honored for his contributions to the
formalization of economic theory, “without any immediate aims of statistical, empirical
confrontation” (Lindbeck, 1970).
Nonetheless, Samuelson regarded economics and all science as empirical. In the
opening chapter of his textbook Economics (1948), he wrote:
It is the first task of modern economic science to describe, to
analyze, to explain, to correlate these fluctuations of national income.
Both boom and slump, price inflation and deflation, are our concern. This
is a difficult and complicated task. Because of the complexity of human
and social behavior, we cannot hope to attain the precision of a few of the
physical sciences. We cannot perform the controlled experiments of the
chemist or biologist. Like the astronomer we must be content largely to
“observe” (Samuelson, Economics, 1948, p. 4).
And a few pages later:
Properly understood, therefore, theory and observation, deduction and
induction cannot be in conflict. Like eggs, there are only two kinds of
theories: good ones and bad ones. And the test of a theory’s goodness is its
usefulness in illuminating observational reality. Its logical elegance and
fine-spun beauty are irrelevant. Consequently, when a student says,
“That’s all right in theory but not in practice,” he really means “That’s not
all right in theory,” or else he is talking nonsense (Samuelson, Economics,
1948, p. 8).
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Several of Samuelson’s earliest papers were on macroeconomics, including
“Interactions Between Multiplier Analysis and the Accelerator Principle” (1939) and
“The Theory of Pump-Priming Reexamined” (1940). These two articles provide us with a
view of how the mathematical formalist of Foundations handled macroeconomic theory
when most people writing in macroeconomics did so with more words than mathematical
symbols, more diagrams than theorems and proofs. Samuelson’s older contemporaries
were economists such as J.M. Keynes and Alvin H. Hansen, and Friedman’s mentor
Wesley C. Mitchell.
In the 1939 article Samuelson sought to generalize multiplier analysis along lines
begun by Hansen. Samuelson’s contribution was to move the analysis from arithmetical
examples to algebraic analysis of income sequences contingent on a government
expenditure stimulus, i.e., mathematization of multiplier-accelerator theory. Samuelson
produced a four-way taxonomy of the behavior of income under different assumed
combinations of multiplier and accelerator coefficients. He warned that his analysis
assumed a constant marginal propensity to consume and a constant accelerator coefficient,
although these would actually change with the level of income. The analysis was thus
strictly a marginal analysis to be applied to the study of small oscillations.
Nevertheless, it is more general than the usual analysis. Contrary to the
impression commonly held, mathematical methods properly employed, far from
making economic theory more abstract, actually serve as a powerful liberating
device enabling the entertainment and analysis of ever more realistic and
complicated hypotheses (Samuelson, “Interactions Between the Multiplier
Analysis and the Principle of Acceleration,” 1939, 78).
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In the 1940 article Samuelson considered whether a countercyclical fiscal deficit
might be self-eliminating, i.e., whether the income generated by the fiscal stimulus might
produce enough tax revenue to close the deficit. He presented no explicit mathematical
analysis in the article, beyond a reference to the 1939 piece, but reasoned to a theorem of
multiplier analysis – “that the increase of expenditure of an extra dollar cannot result in
increased tax revenues of as much as a dollar even though all succeeding time is taken
into consideration” (Samuelson, “The Theory of Pump-Priming Reexamined,” 1940, 503).
He derived this conclusion from analytical assumptions and analytical
presumptions. By analytical assumptions I mean assumptions the role of which was to
simplify and thus facilitate analysis. By analytical presumptions I mean presumptions
about the nature of the economic system. In the first category were the assumptions that
induced private investment is proportional to the increase in consumption from one
period to the next, and that prices remain unchanged. In the second category were
presumed actual characteristics of the economy. These were that:
(1) “the economic system is not perfect and frictionless so that there exists the
possibility of unemployment and under-utilization of productive resources” …
(2) “there exists the possibility of, if not a definite tendency toward, cumulative
movements of a disequilibrating kind” …
(3) “the average propensity to consume is less than one, at least at high levels of
national income” …
(4) “even in a perfect capital market there is no tendency for the rate of interest to
equilibrate the demand and supply of employment” …
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(5) “there exist no technical difficulties to prevent the government from financing
deficits of the magnitudes discussed.” (Samuelson, “The Theory of PumpPriming Reexamined,” 1940, 492-94).
Samuelson gave no justification for these presumptions other than that they were
regarded as fundamental in recent business cycle literature.
He divided economic downturns into two categories, (1) downturns that arise
from exhaustion of investment opportunities, and (2) downturns that arise from inventory
accumulation based on expected but unrealized price increases. He suggested that the
Great Depression belonged at least in part in the first category, i.e., the Depression was
caused in part by exhaustion of investment opportunities. With regard to recessions that
are caused by unwarranted inventory accumulation he suggested that “waiving the
difficulties of quickly engineering a spending policy, there seems to be every reason in
this case for the government to act promptly so as to maintain the national income and aid
in the orderly reduction of inventories” (Samuelson, “The Theory of Pump-Priming
Reexamined,” 1940, 497).
Notice how much is swept aside by Samuelson’s waiver of the difficulties of
quickly engineering a spending policy – all of the politics of budget writing plus the
matter of targeting expenditures at the industries that have surplus inventories. Also
notice that if Samuelson’s two categories are exhaustive, then no downturns begin in the
public sector, from misguided fiscal policy or monetary policy. What Friedman and
Schwartz were to later conclude about the Great Depression and what many economists
believe exacerbated the recent real estate bubble is ruled out a priori.
19
At a 1959 AEA session on price level stability Samuelson and Robert Solow
devoted more than half of their discussion to impediments to the use of historical data for
identification of different types of inflation -- demand-pull, cost-push, and demand shift.
The authors were critical of one-sided explanations of inflation for these typically ignored
the “intricacies involved in the demand for money,” relied on aggregate ex post data and
partial equilibrium analysis, and failed to account for the possibility that effects may
precede causes. Following this rather pessimistic rendering of the problems involved in
evaluating historical instances of inflation, Samuelson and Solow turned to A.W.
Phillips’s “fundamental schedule relating unemployment and wage changes” in the U.K.,
the Phillips Curve. From a scatter plot of U.S. data on unemployment rates and increases
in hourly earnings, a plot without actual numerical values, they offered suggestions about
the Phillips Curve for the U.S. They began by noting deficiencies in the data:
The first defect to note is the different coverages represented in the two
axes. Duesenberry has argued that postwar wage increases in
manufacturing on the one hand and in trade, services, etc., on the other,
may have quite different explanations: union power in manufacturing and
simple excess demand in the other sectors. It is probably true that if we
had an unemployment rate for manufacturing alone, it would be somewhat
higher during the post war years than the aggregate figure shown. Even if
a qualitative statement like this held true over the whole period, the
increasing weight of services in the total might still create a bias. Another
defect is our use of annual increments and averages, when a full-scale
study would have to look carefully into the nuances of timing.
20
A first look at the scatter is discouraging; there are points all over the
place. But perhaps one can notice some systematic effects (Samuelson and
Solow, “Analytical Aspects of Anti-inflation Policy,” 1960, 188).
The systematic effects that they inferred in the plot were:
1. 1933 to 1941 are sui generis; if there is a Phillips curve it has a positive slope.
The anomaly is the result either of NRA pricing codes or of structural
unemployment.
2. The data for the early years of World War II are also atypical, though less so.
3. The remainder of the data “show a consistent [Phillips curve] pattern”
4. The Phillips curve shifted upward “slightly but noticeably” in the 1940s and
1950s. In the earlier period “manufacturing wages seem to stabilize absolutely
when 4 or 5 per cent of the labor force is unemployed,” but since 1946 “one
would judge now that it would take more like 8 per cent unemployment to keep
money wages from rising.”
5. The data may or may not represent an aggregate supply curve. If so, the
movements along it indicate demand pull and shifts indicate cost push. But if
employers in anticipating full employment give wage increases during slack
periods, this makes it problematic to interpret the Phillips curve relationship as an
aggregate supply curve.
Samuelson and Solow conclude on this pessimistic note:
We have concluded that it is not possible on the basis of a priori reasoning
to reject either the demand-pull or cost-push hypothesis, or the variants of
the latter such as demand-shift. We have also argued that the empirical
21
identifications needed to distinguish between these hypotheses may be
quite impossible from the experience of macrodata that is available to us;
and that, while use of microdata might throw additional light on the
problem, even here identification is fraught with difficulties and
ambiguities (Samuelson and Solow, “Analytical Aspects of Anti-inflation
Policy,” 1960, 191).
Despite their pessimistic acknowledgment of the difficulties, Samuelson and Solow
ventured “guesses” portrayed in their figure 2, which is a smooth, non-linear Phillips
curve “roughly estimated” from the most recent twenty-five years of data. The guesses
are that:
1. five to six per cent unemployment is required to have wage increases that match
productivity growth,
2. four to five percent inflation is required to keep unemployment at three per cent.
They warned that the policy trade-offs indicated by their Phillips curve were at best shortterm. The trade-offs could well change in the future. Nonetheless, their diagram and
inferences are surprisingly precise in light of the serious difficulties they brought to light
about drawing inference from the data.
Shortly after he presented the paper with Solow at the 1959 AEA meeting,
Samuelson wrote an evaluation of Federal Reserve policy. The primary question on his
mind was what might be inferred from both the Fed’s policy record and criticisms that
the Fed has waited overly long to ease credit conditions in 1957. Samuelson took issue
with two lines of criticism – the claim that monetary policy was powerless and the claim
that the Fed would gain from a fixed policy rule. His argument against a policy rule was
22
based on the same presumption as Milton Friedman’s argument for a policy rule – that
little was known of the complexities of the macroeconomy. Where Friedman drew the
implication from economists’ ignorance that a rule could be used to minimize mistakes,
Samuelson drew the implication that the rule itself was likely to be ill designed and thus
exacerbate business cycles. He advocated policy based on two principles: “prudent man”
forecasting and willingness to respond quickly to changing conditions.
I would say that the problem of lags should predispose us even more
toward the following view: instead of adapting policy passively to the
recent past, the authorities should try to form a judgment of what a prudent
informed man thinks the rough probabilities are for a couple of quarters
ahead and should take action accordingly, being perfectly prepared to
change their tack as new evidence becomes available to modify these
prudent probabilities (Samuelson, “Reflections on Monetary Policy,” 1960,
264).
Who is the “prudent informed man”? Is he a mathematical economist?
We have seen something of Friedman’s approach to business cycle analysis in our
review of his writings on the Federal Reserve. Tellingly for understanding his approach
to business cycles, Friedman called for study of the length and regularity of monetary and
fiscal policy lags. In contrast with Samuelson’s ability to begin and finish a formal
theoretical project on his own in a brief time, Friedman’s empirical and historical work
involved a team of researchers including not only himself and Anna Schwartz, but a host
of students in the workshop in Money and Banking.3 Where Samuelson’s goal was a
3
In the early years his students included Phillip Cagan, David Meiselman, John J. Klein, Richard T. Selden,
and Eugene Lerner.
23
unified theory of disparate economic phenomena, Friedman’s goal was an empirically
verified theory of one particular economic phenomenon, the business cycle. He presented
the first somewhat complete results to the Joint Economic Committee of the U.S.
Congress in 1958, a decade after his call for this research.4 By that point, Friedman had
modified his rule to the familiar constant growth rate at 3 to 5 percent per year. He wrote:
The extensive empirical work that I have done since that article [“A
Monetary and Fiscal Framework for Economic Stability” (1948)] was
written has given me no reason to doubt that the arrangements there
suggested would produce a higher degree of stability; it has, however, led
me to believe that much simpler arrangements would do so also; that
something like the simple policy suggested above would produce a very
tolerable amount of stability. This evidence has persuaded me that the
major problem is to prevent monetary changes from themselves
contributing to instability rather than to use monetary changes to offset
other forces (Friedman, “The Supply of Money and Changes in Prices and
Output,” 1958, p. 106, n. 19).
Friedman and Schwartz’s “Money and Business Cycles” (1963) illustrates the
difference in Friedman’s heavily empirical approach to macroeconomics and
Samuelson’s approach as we have seen it in several articles. Friedman and Schwartz
used thirty-two pages to present and analyze extensive data records of money and
business cycle turning points, with data covering the period from 1867 to 1960. They
observed first that the money stock tended to rise rather than fall through most business
cycle contractions. They removed the positive trend from the series by taking logarithmic
4
See also Friedman (1959, 1960, 1961).
24
first differences and examined patterns in rates of change in the money stock over deep
and mild contractions. Then they presented the data both in charts and in numerical tables
to uncover the cyclical timing and amplitude of money growth through NBER reference
cycles. In their analysis everything is out on the table. Friedman and Schwartz made
interpretive judgments about patterns in their data, as Samuelson and Solow did about
hourly earnings changes and unemployment, but they presented all the information
readers would need to make their own judgments.
Their conclusions for major business cycles were that:
1. There is a one-to-one relation between money changes and changes in money
income and prices, …
2. The changes in the stock of money cannot consistently be explained by the
contemporary changes in money income and prices (Friedman and Schwartz,
“Money and Business Cycles,” 1963, 50).
By this they meant that although causation goes both ways between money and nominal
income, money has an active role in the business cycle.
There seems to us, accordingly, to be an extraordinarily strong case for the
proposition that (1) appreciable changes in the rate of growth of the stock
of money are a necessary and sufficient condition for appreciable changes
in the rate of growth of money income; and that, (2) this is true both for
long secular changes and also for changes over periods roughly the length
of business cycles. To go beyond the evidence and discussion thus far
presented: our survey of experiences leads us to conjecture that the longerperiod changes in money income produced by a changed secular rate of
25
growth of the money stock are reflected mainly in different price behavior
rather than in different rates of growth of output; whereas the shorter
period changes in the rate of growth of the money stock are capable of
exerting a sizable influence on the rate of growth of output as well
(Friedman and Schwartz, “Money and Business Cycles,” 1963, 53).
From their analysis of the evidence Friedman and Schwartz provided their own version
of what Samuelson strived for and was generally acknowledged by other economists to
have attained – a unified theory of economic phenomena. Only for Samuelson the
unification was in the mathematical method of constrained optimization. Friedman and
Schwartz’s unification was in observed empirical regularities, in a monetary theory of
business cycles.
Friedman and Schwartz were well aware that their explanation of business cycles
was in competition with others, such as the Keynesian theory that investment was the
prime cause.
It is perhaps worth emphasizing and repeating that any alternative
interpretation must meet two tests: it must explain why the major
movements in income occurred when they did, and also it must explain
why such major movements should have been uniformly accompanied by
corresponding movements in the rate of growth of the money stock. The
monetary interpretation explains both at the same time. …
We have emphasized the difficulty of meeting the second test. But
even the first alone is hard to meet except by an explanation which asserts
that different factors may from time to time produce large movements in
26
income, and that these factors may operate through diverse channels –
which is essentially to plead utter ignorance (Friedman, “The Supply of
Money and Changes in Prices and Output,” 1958, 54).
Conclusion
Paul Samuelson was a vigorous advocate for the mathematization of economics,
recognizing the particular virtue of math in laying bare logical relationships. But
mathematical general equilibrium did not equip him to say much at all about economic
conditions and the policies conditions called for at any particular time and place. This
task was left to the “prudent informed man.” In a 1967 discussion with Arthur Burns,
Samuelson described his forecasting technique:
I am not now referring to the regressions of the computer but I am
speaking now of the regressions of the mind, the intuitive forecasting
which I do. The other day a colleague of mine … said to me, “Paul, how
long do you think it will take before a computer will replace you?”... I
thought for a moment, and as the question seemed to be asked in a mean
way, I replied, “Not in a million years” (Burns and Samuelson, 1967, pp.
92-93).
Friedman was more modest about what he knew, less sanguine about what any experts
knew, and believing in the power of monetary policy, more wary of the potential for
harm from misguided policies. In the words of his mentor Arthur Burns, Friedman
believed that “there is no reliable shortcut to tested knowledge.” The program in
business cycle research on which Friedman and Schwartz embarked in 1948 was begun
by Wesley Mitchell at the beginning of the twentieth century. After more than half a
27
century of painstaking research the results were still “provisional.” The project had
produced knowledge, but not of the type and detail that would allow macroeconomic
fine-tuning.
What might Friedman say about the Federal Reserve today? Friedman reflected
on Alan Greenspan’s tenure as Chairman of the Board of Governors in January 2006.
Over the course of a long friendship, Alan Greenspan and I have generally
found ourselves in accord on monetary theory and policy, with one major
exception. I have long favored the use of strict rules to control the amount
of money created. Alan says I am wrong and that discretion is preferable,
indeed essential. Now that his 18-year stint as chairman of the the Fed is
finished, I must confess that his prerformance has persuaded me that he is
right – in his own case (M. Friedman, “The Greenspan Story: ‘He Has Set
a Standard’”, 2006).
The measure by which Friedman judged Greenspan’s performance was maintaining price
level stability, i.e., preventing inflation. This was, in his view, the only justifiable
objective of monetary policy. He made no mention of preventing recessions or financial
bubbles. This was not because he regarded price level stability as the only desideratum.
Certainly the longest business cycle expansion in the twentieth century, from March 1991
until March 2001, was in the back of Friedman’s mind. But he saw price level stability
as the only goal the Fed could reasonably expect to accomplish, and in preventing
inflation he believed the Fed would “as if by an invisible hand” mitigate recessions.
Friedman by nature expected people to be well intentioned. If they disagreed
among themselves, or with him, he assumed the disagreement was an honest
28
disagreement over facts that could be resolved by investigation and education. Not
unconnected to this he had a great deal of the Progressive-era faith in science as the
solution to social problems. But as time passed and old debates dragged on he became
increasingly aware that misguided economic policies are not always mistakes due to
ignorance. Often policymakers, be they at the Fed, in Congress, or in the bureaucracy, are
getting just what they want – power. Thus as we have seen, Friedman moved from design
of tactics for central bankers to a proposal that monetary control be taken away from the
central bankers.
Would he advocate doing away with the Fed? We can be sure that events over the
past four years would be cause for reconsidering his appreciation of Alan Greenspan’s
tenure at the Fed, and that he would decry the capricious innovations in Fed policy that
we have witnessed. He would not look favorably on power wielded in an arbitrary way
by unelected officials. But whether we would be better off without the Fed depends very
much on the alternative. The American public has come to presume that Samuelson’s
“prudent men and women” can run the economy. I suspect that Friedman might tell us, if
he were here today, that if the American people unlearn this myth, it may not matter so
much whether we have the Federal Reserve or some other central banking institution. The
institutional matters will follow the public’s newfound wisdom about what government
can and cannot accomplish.
29
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32