Economists and politicians considered the pamphlet an uncouth assault on their ability to shape and regulate markets through government action. It was a rude insult to the mood of the times. But it marked the birth of Milton Friedman the free-market economist; and it would be Friedman’s ideas that, albeit much later, would ultimately prevail.
The same year, Friedman published Income from Independent Professional Practice, co-authored with Simon Kuznets, outlining the work they had done at the National Bureau of Economic Research. It is a dense statistical work of 600 pages, but it makes a strong public policy argument that Friedman the political radical would come back to again and again. It showed that the chief beneficiaries from occupational licensure – official regulation of professions such as doctors, dentists, lawyers, accountants and engineers – are the professionals themselves, rather than the public whom this measure is supposed to protect. Because regulation restricts competition, the public end up paying higher fees for a poorer service.
The Chicago economist
Friedman’s career at Minnesota was cut short by the offer of a teaching post at the University of Chicago – America’s leading centre for economics teaching and research. Although Friedman’s early teachers had mostly moved on, Chicago still retained a respect for markets that was deeply unfashionable elsewhere. Heavily influenced by Keynes, the overwhelming majority of economists and political scientists advocated a mixed economy with a large degree of government ownership and control – or even a democratic socialism. It seemed unimaginable that the market could achieve better results than deliberate planning and careful regulation. Keynes had demonstrated, to almost everyone’s satisfaction, that the capitalist economy had run out of steam, and needed government investment to kick-start job creation. Even at the best of times, he thought, capitalism was inherently unstable – a point demonstrated by the 1929 crash and the turmoil that followed.
At Chicago, Friedman once again came under the influence of iconoclastic economists, of whom Frank Kinght was probably the most persuasive. Knight understood, and was able to explain, how the market system steered resources to where they were most urgently needed, without the need for government direction, planning or controls. Indeed, one of Knight’s students from the 1940s, James Buchanan – who would also receive the Nobel Prize for economics – wrote that within six weeks of enrolling in Knight’s price theory course, he had been converted from a rabid socialist to a zealous advocate of free markets.
Another thing that Knight preached was that nothing should be sacrosanct in academic argument and debate. Though the orthodoxy of the time might be to believe that capitalism had deep failings and needed strong government intervention to correct them, Knight urged his colleagues and students not to shy away from questioning its assumptions, methods and conclusions.
For his part, Friedman believed that Keynes’s macroeconomic analysis provided quite a useful way of understanding the economy. Its flaw, though, was that it was riddled with false assumptions and factual mistakes. True to his nickname of Mr Macro, he analysed the economy with the tools that Keynes had invented, using the same sweeping concepts such as national income, government spending, and total unemployment, consumption and investment. Indeed, one of the things that made him so effective a critic of Keynes’s followers was that he argued from within the same framework that they accepted and understood. But he deliberately confronted their prejudices with his 1948 article ‘A Monetary and Fiscal Framework’, which impertinently suggested that unfettered capitalism, built on the foundation of private property, produced much greater economic efficiency – and a larger measure of freedom and democracy too – than the socialist or interventionist alternatives. And this was not a question of theory. It was a matter of evidence.
Evidence was at the core of Friedman’s concept of economic science. As he explained in The Methodology of Positive Economics, the choice of what goals we should strive for is a question of values and ethics. But economics must deal with facts, not values. Its subject is whether or not a particular policy helps to achieve our chosen goals. Economics is a science like any other: in science we formulate theories and make predictions about what an action will achieve, and then check the facts to see if we were right. Does the minimum wage, for example, reduce poverty (by giving workers higher wages) or increase it (by creating unemployment)? The evidence provides an answer that people can agree on, regardless of how high they rank poverty among our many social problems.
The monetary theorist
To Friedman, economics is about making accurate predictions, not about refining elegant mathematical models. Economists should aim to understand the big economic issues of the day, test their theories against the facts, and so find solutions that improve people’s lives. It may have been this idea that drew him to the fight against inflation – a particularly big problem in the postwar years – and to the economic theory with which he is most strongly associated, the quantity theory of money. He saw the quantity of money in circulation as a powerful predictor of future prices, and therefore a powerful tool for combating inflation.
Keynesians – that is, nearly all of Friedman’s professional contemporaries before the 1980s – dismissed the quantity theory as outdated and crude. At its crudest, it runs like this: governments control the amount of money in their country’s economy by printing new banknotes and minting new coins. If they print or mint a lot more currency, then – like anything that suddenly becomes more plentiful – its value falls. Producers then demand more pounds or more dollars for their goods and services, because they now value those notes and coins less. In other words, prices rise. We call this inflation, and its cause is a rise in the quantity of money. Control the production of money, and you control inflation.
Friedman did not invent the quantity theory; it had been around for centuries. But mainstream economists attributed price rises to other causes – the rising cost of oil or food imports, for example. And even if the quantity of money did increase, they thought, people might not spend it; perhaps it would just sit in their wallets or bank accounts, where it had no effect on the economy or prices at all – Keynes’s famous ‘liquidity trap’.
By the mid-20th century, the quantity theory seemed dead and buried; but it was not. In a 1956 article, ‘The Quantity Theory of Money: A Restatement’, Friedman brilliantly revived it. The theory’s power to predict inflation hinged not on the supply of money from governments, but on the demand for that money from consumers – the amount that people actually choose to keep readily to hand. Friedman proved that this demand is surprisingly stable. If extra money is created, it does not languish unused in people’s wallets or bank accounts: consumers actually keep a pretty constant amount of cash to hand. Any extra, they spend; and it is this extra spending that bids up prices. The quantity theory really does explain inflation.
Friedman’s 1962 A Monetary History of the United States, co-authored with Anna Jacobson Schwartz, demonstrated the impact of money on inflation in enormous detail. It furnished a fine example of the role of money in inflation: during the American Civil War, the South suffered huge price rises – which ended abruptly after Northern troops captured the presses that printed the South’s money. It also showed that the Great Depression, a time of dramatic price falls, stemmed not from any inherent instability of capitalism, but from the US Federal Reserve’s inept constriction of the supply of money.
“During the Civil War the North, late in the Civil War, overran the place in the South where the printing presses were sitting up, where the pieces of paper were being turned out. Prior to that point, the South had a very rapid inflation. If my memory serves me right, something like 4% a month. It took the Confederacy something over two weeks to find a new place where they could set up their printing presses and start them going again. During that two-week period, inflation came to a halt. After the two-week period, when the presses started running again, inflation started up again. It’s that clear, that straightforward.”
– Milton Friedman, Free to Choose,