Hayek and Friedman: Head to Head
How Methods Shape Substance
Adapted from “Hayek and Friedman”
Edward Elgar Companion to Hayekian Economics
Edited by R. Garrison and N. Barry
Published by Edward Elgar (forthcoming)
July 26, 2013
Hayek and Friedman: Head to Head
How Methods Shape Substance
The Level of Aggregation
Keynes, Friedman, and Hayek on Aggregation:
M = quantity of money
V = velocity of money
P = price level
Q = real GDP
Capital-based
is
Milton Friedman’s
Theorizing
at amacroeconomics
high
monetarism
level of was
distinguished
byhigher
itsMaynard
propitious
based on a still
aggregation,
John
level of
Keynes
disaggregation,
brings
aggregation.
argued
that market
Thewhich
equation
economies
of into
view
bothperversely—especially
the
problem
of interexchange
perform
MV=PQ
made
use of the
an
temporal
resource
and the
all-inclusive
market
mechanisms
output allocation
variable
that are(Q),
potential
for
abring
market
putting into
supposed
toeclipse
saving
thesolution.
issue
andof the
F. A. Hayek
showed
that
allocation
investment
ofinto
resources
balancebetween
withaone
coordination
of savingand
andinvestment
current consumption
another.
investment
decisions couldand
be
for Seeing
the future.
unemployment
achieved
by
resource
Seeingidleness
nomarket-governed
problems
as theemerging
norm,
movements
in interest
rates. He also
from thecalled
Keynes
market
foritself,
countercyclical
Friedman
recognized
that
this aspect
the
focused
fiscal
andonmonetary
the relationship
policiesof
between
and
market
economy
is especially
the government-controlled
ultimately
for a “comprehensive
money
vulnerable
the
manipulation
of
supply andto
socialization
the
of
overall
investment.”
price level.
interest rates by the central bank.
Hayek and Friedman: Head to Head
How Methods Shape Substance
Contrasting Methods
Keynes, Friedman, and Hayek on Method
John Maynard Keynes
“Keynes was the type of theorist who developed his
theory after he had developed a sense of relative
magnitudes and of the size and frequency of changes
in these magnitudes.”
“He concentrated on those magnitudes that changed
most, often assuming that others remained fixed for
the relevant period.”
Allan Meltzer, Keynes’s Monetary Theory: A Different Interpretation (1988)
Keynes, Friedman, and Hayek on Method
Milton Friedman
“I
believe
Keynes’s
theory
"We're
all that
Keynesians
now
….” is the right kind of
theory in its simplicity, its concentration on a few key
“We all use the
language
and apparatus….”
magnitudes,
andKeynesian
its potential
fruitfulness.”
Milton Friedman, “Keynes’s Political Legacy,”
in John Burton, ed.,
Keynes’s
General
Theory:inFifty
On (1986
)
Milton
Friedman
as quoted
TimeYears
Magazine
(1968)
Keynes, Friedman, and Hayek on Method
Friedrich Hayek
For
“There
The
Hayek,
rolemay
of the
then,
welleconomist,
exist
the cause-and-effect
betterHayek
‘scientific’
points
evidence
relationship
out [in
between
[i.e.,Pure
his
empirically
Theory
central-bank
demonstrated
of Capital,
policy1941],
during
regularities
isthe
precisely
boom
among
and
to
the
‘key’subsequent
identify
macroeconomic
the features
economic
ofmagnitudes]
the downturn
market process
forhave
a false
athat
firstorder
theory,
are
“hidden
claim
which
on
from
will
ourthe
be
attention,
accepted
untrained
despite
because
eye.” theitmore
is more
salient
‘scientific,’
co-movements
than for a valid
in macroeconomic
explanation, which is
magnitudes
rejected because
that characterize
there is no significant
the post-crisis
quantitative
spiraling
evidenceof
forthe
it.”economy into deep depression.
Paraphrased
Friedrich Hayek,
from“The
R. Garrison,
Pretence“Hayek
of Knowledge,”
and Friedman:
Nobel Head
Lecture,
to Head,”
1974
in The Elgar Companion to Hayekian Economics (forthcoming)
Hayek and Friedman: Head to Head
How Methods Shape Substance
A Difference in Focus
Keynes, Friedman, and Hayek on Focus
John Maynard Keynes
Keynes attributes the downturn to psychological
factors affecting the investment community (rather
than to movements in interest rates).
“I suggest that a more typical, and often predominant,
explanation of the crisis is … a sudden collapse in the
marginal efficiency of capital” (G.T., 1936, p. 315)
Keynes main focus, however, is on the dynamics of
the subsequent downward spiral---and on policies
aimed at reversing the spiral’s direction.
Keynes, Friedman, and Hayek on Focus
Milton Friedman
Friedman is dismissive of the whole issue of the
cause of the initial downturn in 1929, referring to it
as an “ordinary,” “run-of-the mill,” “routine,” “gardenvariety” recession.
His focus
is on policy
blunders
that occurred
on the
The
correlation
between
movements
in the money
heels ofand
themovements
downturn and
on the
correlation
supply
in total
output
leaves no
between
decrease
the money supply and the
doubt
as the
to the
central in
issue.
decrease in real GDP.
Keynes, Friedman, and Hayek on Focus
Friedrich Hayek
Friedrich Hayek focuses on the policy-infected
aspects of the boom and their implications of the
boom’s sustainability.
The post-bust reallocation of labor and capital
takes time,
butwe
thejustifiably
particularsay
dimensions
e.g.,
QUERY:
Can
that “The of,
bigger
Great Depression
(itsbust”?
length and depth) are to
the boom;
the bigger the
be explained largely in terms of the policy
perversities that hampered the recovery.
Hayek and Friedman: Head to Head
How Methods Shape Substance: A Summary
For Hayek, the ABCT is fundamentally a theory of
the unsustainable boom. Accounting for the actual
depth and length of the depression that ensues
requires an economic and historical account of
each particular episode.
For Friedman, the analysis of a business cycle
consists almost wholly of an empirical accounting
of the depression’s depth and length.
THE CASE OF THE CABBAGE-EATING MISSISSIPPI MONSTER
Austrian and Chicago Methodology in Action
Suppose that in late October of 1929, a thousandpound monster descended on Mississippi soil. It
spent the next three-and-a-half years eating all the
cabbages (and quite a few rabbits) between Tupelo
and Pascagoula. By early March of 1933, the
monster weighed four-thousand pounds.
Two investigators are sent to Mississippi to get a
handle on the situation. One is from Vienna, the
other is from Chicago.
THE CASE OF THE CABBAGE-EATING MISSISSIPPI MONSTER
Austrian and Chicago Methodology in Action
The Viennese investigator asks, “Where in the
world did this hideous thing come from?”
It turns out, on further investigation, that the
monster was the unintended consequence of some
ill-conceived government-sponsored bionics
project.
THE CASE OF THE CABBAGE-EATING MISSISSIPPI MONSTER
Austrian and Chicago Methodology in Action
The Chicagoan shows up, shoves the Austrian
aside, and says, “Never mind how this thing got
here, the REAL question is: How did it grow from
1000 pounds to 4000 thousand pounds? How did
an ordinary, run-of-the-mill, garden-variety monster
quadruple its weight in 40 months?
The Chicagoan’s answer, of course, is: it was all
those cabbages. (He couldn’t get good data on the
rabbits.) The correlation between cabbage
consumption and weight gain of the Mississippi
monster leaves no doubt as to the central issue.
THE CASE OF THE CABBAGE-EATING MISSISSIPPI MONSTER
Austrian and Chicago Methodology in Action
QUERY: Do we suspect that data availability is
what led the Chicagoan to his conclusion? And that
the lack of hard data pertaining to the monster’s
origins caused him to be dismissive of questions
about where the thing came from?
These and related suspicions are what underlie the
message in Hayek’s Nobel address on “The
Pretense of Knowledge.”
.
Friedman’s
Monetarism:
MV=PQ
with a lag of 18-30 months.
With a nearly constant velocity of money
and Output (Q) growing slowly,
the price level (P) moves with the money
supply (M).
Friedman’s Monetarism:
MV=PQ
with a lag of 18-30 months.
“Inflation is always and everywhere a monetary
phenomenon.”
Friedman’s Monetarism:
MV=PQ
with a lag of 18-30 months.
Friedman’s Monetary Rule:
Increase the money supply at a slow and steady
rate to achieve long-run price-level constancy.
Friedman’s Monetarism:
MV=PQ
But what happens within the Q aggregate
as a result of the monetary injection?
RATE OF INTEREST
with a lag of 18-30 months.
S
+ΔM
D
SAVIING (S)
INVESTMENT (D)
Friedman’s Monetarism:
MV=PQ
But what happens within the Q aggregate
as a result of the monetary injection?
with a lag of 18-30 months.
Friedman declares the 1920s as the Golden Years of
the Federal Reserve. He ignores interest rates during
the 1920s because they didn’t change much.
That is, they didn’t pass the Keynes criterion.
Friedman’s Monetarism:
MV=PQ
But what happens within the Q aggregate
as a result of the monetary injection?
with a lag of 18-30 months.
But what if they should have changed---but weren’t
allowed to?
Friedman’s Monetarism:
MV=PQ
But what happens within the Q aggregate
as a result of the monetary injection?
with a lag of 18-30 months.
During
But thethe
Federal
1920sReserve,
breakthroughs
guided by
in technology
the “real-bills
increase
doctrine”the
metdemand
each increase
for loanable
in demand
funds for
andcredit
put
upward
with an pressure
increase in
onsupply---thus
interest rates.keeping the
interest rate from rising.
Friedman’s Monetarism:
MV=PQ
But what happens within the Q aggregate
as a result of the monetary injection?
with a lag of 18-30 months.
Seeing
QUERY:no
Which
change
view,
in interest
Friedman’s
rates,
rates
or when
Hayek’s,
Friedman
theyis should
dismissed
more risen
have
firmlyinterest
(because
anchored
rates
ofinthe
as
theatechnological
empirical
potential (historical)
independent
advances),
variable
Hayek was
circumstances
in his
ableeconometric
oftothe
identify
1920s?
some
equations.
critical “market
forces hidden from the untrained eye.”
Does Keynes recognize the significance
of the loanable funds market in the
For him,ofsaving
is dependent
context
business
cycles? only on
income, and investment expenditures are
No.
Hepredominantly
denies that saving
depends on
based
on psychological
the
interest rate on
and“animal
he (all spirits.”
but) denies
considerations,
that investment depends on the interest
rate. He jettisons the loanable-funds
Does
theory.Friedman recognize the significance
of the loanable funds market in the
For him,ofthe
focus iscycles?
on total output (Q,
context
business
as in MV=PQ), which includes the
No.
Heof
assumes
this marketgoods
is working
output
both consumption
and
well
and so goods.
he ignores it in dealing with
investment
the key issue of the relationship between
the money supply and the price level.
S = -a + (1-b)Y.
I = I0
MV = PQ
THE GREAT RECESSION
Consequences of the Housing Boom
A Critical Comparison:
The Dot-Com Boom and Bust (1990s)
cushioned with underlying real growth
The Housing Boom and Bust (2000s)
compounded by mortgage market distortions.
In a typical cyclical
episode, the boom
begins as a genuine
boom that reflects
technological
breakthroughs.
RATE OF INTEREST
Boom and Bust: The Dot-Com Episode
S
+ΔM
D
SAVING (S)
INVESTMENT (D)
increased expansion
demand fordrives
creditsaving
puts upward
The monetary
back topressure
its initial
on interest
rates. for a still-greater level of borrowing.
level
while allowing
An
Theartificial
Fed counters
boom rides
the upward
piggyback
pressure
on a genuine
on interest
boom.
rates by “accommodating” the increase in demand for
funds with an increase in supply.
This boom began
with increasingly
aggressive housing
policy that increased
the supply of
mortgage loans.
RATE OF INTEREST
Boom and Bust: The Housing Episode
S
+Subsidy
S+Subsidy+ΔM
D
SAVING (S)
INVESTMENT (D)
double shift
in theofsupply
loanable
funds
The increased
supply
creditof
put
downward
compounded
both the
downward pressure on interest
pressure
on interest
rates.
ratesFed
andfurther
the excessive
borrowing.
The
increased
the supply of loanable
funds
to avoid
reduced
in other
markets
The artificial
boom
rodelending
piggyback
on the
distortion of
(and
to stimulate
recovery from the dot-com bust).
mortgage
markets.
“too low for too long”
Friedman’s View of a Monetary Contraction
MV=PQ
A sharp monetary contraction puts downward
pressure on P and Q.
If P is sticky downward, Q will fall dramatically.
Evidence
showsbetween
that between
October
The
correlation
movements
in of
the1929
money
and March
of 1933 decreasing
M was leaves
the essential
supply
and movements
in total output
no
(primary,
cause
of the decrease in Q.
doubt
as todominant)
the central
issue.
Friedman’s Monetarism:
MV=PQ
with a lag of 18-30 months.
The
Irony of Monetarism:
Greenspan:
The monetary rule that allows the economy to
“We
don’t
what money
is,presupposes
anymore.” a
perform
atknow
its laissez-faire
best
critical
of intervention
(Regulation
Q)switched
that
…whichpiece
explains
why the Federal
Reserve
makes
the money supply
operationally
definable.
from money-supply
targeting
to interest-rate
targeting in the early 1980’s
Friedman’s Monetarism:
MV=PQ
with a lag of 18-30 months.
Also, consider:
The velocity of money
The bank operating ratios (excess reserves)
The geographical distribution of US dollars
Friedman’s “Plucking Model”
of Cyclical Movements
Vienna vs. Chicago
on Monetary Issues
Why was Milton Friedman so unreceptive
to the Austrians’ capital-based theory?
Friedman’s Monetarism:
MV=PQ
with a lag of 18-30 months.
Inflation
Note: Q =
is always
QC + QIand everywhere a
monetary
phenomenon.
but the effect of interest-rate changes on relative
movements
of consumption
and investment and
But
what goes
on in the short-run---during
on the pattern of investment is no part of the
that critical 18-30 months?
theory.
Clark-Knight (Black Box) Capital Theory
John Bates Clark
1847 — 1938
Frank H. Knight
1885 — 1972
Hayek and Friedman: Head to Head
How Methods Shape Substance
Does the interest rate play
any role at all within
the output aggregate?
Milton Friedman (1969 [1961]), “The Lag Effect in Monetary Policy,” in Milton
Friedman, The Optimum Quantity of Money and Other Essays, Chicago: Aldine.
Friedman allows for a possible effect on interest rates:
Holders of cash will…bid up the price of assets. If the
extra demand is initially directed at a particular class
of assets, say, government securities, or commercial
paper, or the like, the result will be to pull the prices of
such assets out of line with other assets and thus
widen the area into which the extra cash spills. The
increased demand will spread sooner or later affecting
equities, houses, durable producer goods, durable
consumer goods, and so on, though not necessarily in
that order…. These effects can be described as
operating on “interest rates” if a more cosmopolitan
[i.e., Austrian] interpretation of “interest rates” is
adopted than the usual one which refers to a small
range of marketable securities.
“The key feature of
MAINTENANCE OF SOURCES
this process [during
SOURCES
which interest rates
are low] is that it
SERVICES
DO NOT OPEN
tends to raise the
prices of sources of
both producer and consumer services relative to the
prices of the services themselves…. It therefore
encourages the production of such sources and, at the
same time, the direct acquisition of the services rather
than of the sources. But these reactions in their turn
tend to raise the prices of services relative to the prices
of sources, that is, to undo the initial effects on interest
rates.
MAINTENANCE OF SOURCES
SOURCES
SERVICES
DO NOT OPEN
The final result may be a rise in expenditures in all
directions without any change in interest rates at all;
interest rates and asset prices may simply be the
conduit through which the effect of the monetary
change is transmitted to expenditures without being
altered at all….”
Hayek and Friedman: Head to Head
How Methods Shape Substance
But how, then, does Friedman
account for the lag
between rising M and rising P?
Friedman accounts for the 18-30 month lag:
CONSUMPTION
“It may be … that monetary expansion induces
someone within two or three months to contemplate
building a factory; within four or five, to draw up
plans; within six or seven, to get constructions started.
The actual construction may take another six months
and much of the effect on the income stream may
come still later, insofar as
initial goods used in
construction are withdrawn
from inventories and only
subsequently lead to
increased expenditure by
suppliers.”
INVESTMENT
GREG MANKIW’S BLOG
Random Observations for Students of Economics
September 16, 2006:
Curious question from Mankiw:
“How can you identify my car?”
Gregory Mankiw
Former Chairman
Council of Economic Advisors
George W. Bush Administration
mvpy writes:
You know, I hate to spoil things, but I must say, I think Milton
Friedman has a better plate. This is from an article I came across:
"Years ago, trying to find the Friedman’s apartment in San
Francisco, I knew I was in the right location when I spotted a car
with a license plate that read “MV = PT."
A. Delaique writes:
Milton Friedman's license plate was MV = PQ, not MV = PT.
Picture here : http://gribeco.free.fr/article.php3?id_article=12
mvpy writes:
You know, I hate to spoil things, but I must say, I think Milton
Friedman has a better plate. This is from an article I came across:
"Years ago, trying to find the Friedman’s apartment in San
Francisco, I knew I was in the right location when I spotted a car
with a license plate that read “MV = PT."
A. Delaique writes:
Milton Friedman's license plate was MV = PQ, not MV = PT.
Picture here : http://gribeco.free.fr/article.php3?id_article=12
Anonymous writes:
That's pretty ridiculous..
Canée writes:
I love economists.
Hayek and Friedman: Head to Head
How Methods Shape Substance
Adapted from “Hayek and Friedman”
Edward Elgar Companion to Hayekian Economics
Edited by R. Garrison and N. Barry
Published by Edward Elgar (forthcoming)
July 26, 2013