The End of Monetarism Jude Wanniski June 13, 2003

Memo To: SSU Students
From: Jude Waniski
Re: Milton Friedman changes his mind

For the first offering of this summer session, we have an article from the June 6 Financial Times that I could hardly believe. Here was Milton Friedman, the architect of Monetarism, confessing that it was not a success. Simon London, the FT reporter who got this incredible concession from the 91-year-old Nobel Laureate over a recent lunch in the Bay Area, correctly notes that it would have "saved a lot of grief" if the admission had come 20 years ago. It was Friedman's thesis that the Federal Reserve could produce non-inflationary economic growth simply by increasing the quantity of money at a steady 3% a year. It was through his influence on President Richard Nixon, through then-Treasury Secretary George Shultz, that Nixon in the spring of 1973 decided to "float the dollar" so the monetarist experiment could be tried. In 1971, Friedman had earlier supported the Keynesian decision to break the dollar/gold link when the dollar/gold price was $35. It soon doubled and doubled again, which is why in early '73 Shultz, who had replaced John Connally at Treasury, decided to end the pretense that the gold link could be re-established. The greatest inflation in U.S. history ensued. Throughout, it was the Canadian Robert Mundell who warned these events would prove disastrous.

It is too bad that Mr. London did not explore this admission with Friedman, perhaps asking if he believed the float of the dollar should now end and be re-established at a reasonable exchange rate with gold. Instead, he indicates monetarism was a "partial success" in that it ended the inflation that was already rampant in 1973. What actually happened is that the ending of the gold standard in 1971 produced the inflation that monetarism supposedly ended in the early 1980's in the first years of the Reagan administration. President Jimmy Carter was actually at the helm when the Federal Reserve in the fall of 1979 formally switched to the money targets Friedman specified. The gold price went from $300 to $850 in a matter of months and Carter was driven from office with the economy in shambles.

It was the Reagan tax cuts of 1981 that increased the demand for liquidity and in the process broke the inflation; the Volcker Fed did not supply the liquidity the market needed. Chairman Paul Volcker was struggling to hit the Friedman targets. The dollar deflated, with gold dropping below $300 at one point in early 1982. Faced with the prospect of the bankruptcies of some of the major US money-center banks, Volcker advised Treasury Secretary Donald Regan that he could no longer focus on Friedman's targets as he had to inject massive liquidity into the system. Friedman predicted there would be runaway inflation if that happened, but there were instead huge rallies in the stock market and the bond market and the beginning of the Reagan boom. It was the real end of monetarism, but until now Professor Friedman pretended not to notice. It is to his great credit that he has done so, knowing how much damage the experiment did at the time. To his credit, Mundell never really criticized Friedman for attempting the monetarist experiment, simply saying at one point that "the forces of history were determined to try one of their periodic experiments with a managed currency," i.e., one de-linked from gold.

Now if only a reporter will take Milton to lunch and ask him about another gold standard.

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Lunch with the FT: Milton Friedman
By Simon London
FT.com site; Jun 06, 2003

Hold on to your hats and prepare to be amazed: Milton Friedman has changed his mind.

"The use of quantity of money as a target has not been a success," concedes the grand old man of conservative economics. "I'm not sure I would as of today push it as hard as I once did." Granted, this is hardly a conversion of Damascene significance. But, heck, it's a start. It also shows that, at the age of 91, Friedman still has his critical faculties intact. The man once described as "the most consequential public intellectual of the post-war era" is still engaged - and engaging.

We are at the North Beach Restaurant in San Francisco. While he will be forever linked with the "Chicago school" of economics, Friedman and Rose, his wife and sometime co-author, moved to the area in the late 1970s when he retired from teaching.

The restaurant is only a couple of blocks from Friedman's home and, it transpires, is a regular haunt. He receives a voluble welcome.

Those under the age of 40 are probably unaware how consequential Milton Friedman has been. His mild recantation on monetary targeting would have caused a sensation - and perhaps saved a lot of grief - had it been uttered 20 years ago. In the early 1980s, both the US and the UK set interest rates according to Friedman-style targets for money-supply growth. The common aim was to bring down inflation without the pain of recession.

The common outcome, however, was partial success. Inflation fell, but at enormous cost in terms of unemployment.

The fact that central banks the world over have given up trying to "fine-tune" economies to an imaginary perfect pitch is a measure of his wider influence. Money-supply targets may have been replaced by inflation targets - but the Friedman influence remains strong.

If this was not enough for one lifetime, Milton Friedman the polemicist has been at least as influential as Milton Friedman the economist. His championing of small government, low taxes and market forces helped set the terms of public policy debate through the 1980s and beyond.

It comes as no surprise to find he has strong views about the menu, too. On Friedman's recommendation, I order sand dabs, a flatfish said to be something of a house speciality. The professor opts for eggplant and we agree on two green salads to start, with iced water all round.

Free To Choose, the "personal statement" published with Rose in 1979, closed with the observation that the intellectual climate was shifting away from collectivism in favour of free market ideology. What has happened in the 20 years since, I wonder? "The fall of the Berlin Wall, which occurred 10 years after Free to Choose was completed, means that support for socialist, collectivist forms of social organisation has all but disappeared...

"On the other hand, anti-collectivism has not meant anti-big government. In terms of the attitude towards big government, it is very hard to say that there has been any improvement. There may have been backsliding." I point out that government spending fell as a proportion of national income during the 1990s, reversing a long upward trend. Surely this was a sign of big government in retreat? More a sign of political gridlock in Washington, he responds, with President Clinton's Democrat White House pitched against a Republican-controlled Congress.

He adds, with an air of disappointment, that spending under George W Bush is back on an upward trend. "The second President Bush appears to have inherited the free-spending tendencies of the first," he says dismissively. What, then, of the tax cuts that the president recently signed into law? "His insistence on tax cuts is good," he concedes. "That is the only real way of bringing pressure on Congress to hold down spending. In my view, the size of government is determined much more by how much they can raise in taxes than by any ideological theory." The entrees arrive very, very hot.

"To go back to your original question, the tide of public opinion has continued to go against government. People are as suspicious as ever of government - big or small. Unfortunately, the slowness with which public opinion affects policy has not changed."

His favourite example of the mismatch between public opinion and public policy is school vouchers. Such a scheme, he says, would unleash market forces in the education sector by giving parents the right to choose which school their child attends. Funding would be granted in the first instance to the child, not the school. Schools would then have to compete for business by raising standards or pleasing parents in other ways.

"There is no doubt about public opinion," he says, tucking in to his eggplant. "Everyone knows that the public school system is lousy. The solutions proposed are all ineffective with one exception: a greater degree of parental choice - more competition. The majority of the American public is in favour of child-centred financing. But the teachers unions exercise such strong political control that it is very, very difficult to make any progress."

Listening to him it is easy to understand why his formula appealed to political leaders - think Margaret Thatcher and Ronald Reagan - who craved black-and-white answers to complex questions. As well as turning out academic papers and polemics, Friedman in his prime was also a prolific producer of newspaper articles. One of his most influential appeared in The New York Times Magazine circa 1970, arguing that business should keep its nose out of social affairs and concentrate on maximising returns to shareholders.

"The only responsibility of companies is to make a profit," he wrote - providing thousands of future MBA students with an easy starting point for essays on the topic of corporate purpose.

This is one area, I suggest, in which the tide of opinion has surely turned against him. Recent scandals involving Enron, WorldCom and others have added to the interest in "business ethics" started in the late 1990s amid growing concern about environmental degradation and globalisation.

Nonetheless, Friedman's passion for shareholder primacy remains undiminished. The fashionable idea that companies should balance the needs of shareholders, employees, customers, communities and other "stakeholders" strikes him as wrong-headed.

"The stakeholder notion is a very dangerous notion. It is a socialist notion. It says that employees are major stakeholders. It is really a movement towards employee-run enterprises." But what about the claim that human capital is as important to businesses as financial capital? Surely employees - the providers of human capital - should have some say in the way businesses are run?

His answer is twofold. First, human capital is not new. The share of wages and earnings in national income has been remarkably stable through the decades. Second, the best system of corporate governance is one that provides the best incentives to use capital efficiently. The self-interest of employees in retaining their jobs will often conflict with this overriding objective. Besides, shareholders enjoy none of the contractual protection enjoyed by employees. Thus, they bear the residual risk when a company fails.

"You want control... in the hands of those who are the residual recipients because they are the ones with the direct interest in using the capital of the firm efficiently. How do you like the sand dabs?" Sand dabs, it turns outs, are a favourite in the Friedman household. Rose's sand dabs are unmatched even by the North Beach Restaurant.

I ask whether he has changed his famously sceptical views about European monetary union. After all, the euro has been around for a couple of years and is, as we speak, kicking sand in the face of a weak dollar. Surely this suggests that the European single currency could be a long-term success.

"I've been wrong so far, so I don't have too much confidence in my view. But I think within the next 10 to 15 years the eurozone will split apart. The British government, on balance, should stay out of it." I remark that Friedman the economist seems less sure of himself these days than his polemicist alter ego.

After a long pause, he agrees: "You form a philosophy at a certain stage and for the rest of your life it dominates. On the big issues of policy I don't think there is anything I've changed my mind about."

* * * * *

Please note that Friedman still rejects the Laffer Curve on tax policy, repeating the assertion he has been making for decades that taxes should be cut in order to starve the government of spending. There is no growth dynamic in his fiscal world.

You can direct questions on this topic to me directly at jwanniski@polyconomics.com

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