Economist's View: Brad DeLong: Friedman and Keynes

リンク: Economist's View: Brad DeLong: Friedman and Keynes.

Brad DeLong on Friedman and Keynes:

Friedman completed Keynes, by J. Bradford Delong, Project Syndicate:  ...From one perspective, [Milton] Friedman was the star pupil of, successor to, and completer of Keynes’s work. Keynes ... set out the framework that nearly all macroeconomists use today. That framework is based on spending and demand, the determinants of the components of spending, the liquidity-preference theory of short-run interest rates, and the requirement that government make strategic but powerful interventions in the economy to keep it on an even keel and avoid extremes of depression and manic excess. As Friedman said, “We are all Keynesians now.”

But Keynes’s theory was incomplete: his was a theory of employment, interest, and money. It was not a theory of prices. To Keynes’s framework, Friedman added a theory of prices and inflation, based on the idea of the natural rate of unemployment and the limits of government policy in stabilising the economy around its long-run growth trend...

Moreover, Friedman corrected Keynes’s framework in one very important respect. The experience of the Great Depression led Keynes and his more orthodox successors to greatly underestimate the role and influence of monetary policy. Friedman, in a 30-year campaign starting with his and Anna J Schwartz’s A Monetary History of the United States, restored the balance. As Friedman also said, “and none of us are Keynesian.”

From another perspective, Friedman was the arch-opponent ... of Keynes and his successors. Friedman and Keynes both agreed that ... powerful, but limited economic intervention by the government was necessary to maintain stability. But, while for Keynes, the key was to keep the sum of government spending and private investment stable, for Friedman the key was to keep the money supply — the amount of purchasing power in readily spendable form ... — stable.

A relatively minor, technical difference ... you might say. ... [But] this difference in means, tactics, and empirical judgments rested on top of deep gulf in Keynes and Friedman’s moral philosophy.

Keynes saw himself as the enemy of laissez-faire and an advocate of public management. Clever government officials of goodwill, he thought, could design economic institutions that would ... tweak the market with taxes, subsidies, and regulations to produce superior outcomes. It was simply not the case, Keynes argued, that the private incentives of those active in the marketplace were aligned with the public good. Technocracy was Keynes’s faith: skilled experts designing and fine-tuning institutions ... to make possible general prosperity...

Friedman disagreed vociferously. In his view, it usually was the case that private market interests were aligned with the public good: episodes of important and significant market failure were the exception, rather than the rule... Moreover, Friedman believed that even when private interests were not aligned with public interests, government could not be relied on to fix the problem.

Government failures, Friedman argued, were greater and more terrible than market failures. Governments were corrupt. Governments were inept. The kinds of people who staffed governments were the kinds of people who liked ordering others around.

At the same time, Friedman believed that even when the market equilibrium was not the utilitarian social-welfare optimum, and even when government could ... improve matters ..., there was still an additional value in letting human freedom have the widest berth possible. There was, Friedman believed, something intrinsically bad about government commanding and ordering people about — even if the government did know what it was doing.

I do not know whether Keynes or Friedman was more right in their deep orientation. But I do think that the tension between their two views has been a very valuable driving force for human progress over the past hundred years.

Posted by Mark Thoma on November 29, 2006 at 04:06 PM in Economics | Permalink

TrackBack

TrackBack URL for this entry:
http://www.typepad.com/t/trackback/6984701

Listed below are links to weblogs that reference Brad DeLong: Friedman and Keynes:

Comments

I wouldn't call Friedman a defender of freedom except in the limited sphere of "freedom of choice". He certainly has nothing to say about "freedom from necessity".
On the other hand, Keynes might be advocating "freedom from necessity" in a certain way.

Either way, it's a good tension to have.

Posted by: evagrius | Nov 29, 2006 4:33:41 PM

Friedman was correct that you could have high inflation and unemployment at the same time and Keynes was wrong. I think Milton Friedman was one of the most brilliant economist ever. Unfortunately, coverting all of his efforts into policy is not possible.

Posted by: David | Nov 29, 2006 7:10:53 PM

I am going to refrain from expressing my contempt for libertarianism, Friedman's included, and simply note that Friedman and Keynes were not offering competing visions to the specific problem of the Great Depression, nor did either man do much to address the specific institutional reforms actually undertaken, in the U.S., in response to the Great Depression.

Friedman was arguing that the Great Depression could have been avoided, had the Federal Reserve acted sensibly. In this, he was certainly correct, and it is to his credit that he did a good deal to overturn the reactionary conventional wisdom -- the "sensible" "serious" centrist nonsense that held sway for over a century -- which from Andrew Jackson's day, had caused so much economic wreckage.

Of course, in the event, the Great Depression had occurred, and Keynes was trying to cope with that reality. Sensible monetary policy might well have prevented the Great Depression instead of aggravating it into an overwhelming catastrophe, but it did not, and Keynes would have been judged a fool for presenting an analysis of how a catastrophe, which had already occurred might have been prevented, when what was urgently needed was a remedy for the catastrophe, not a preventive measure already made useless by events.

Monetary policy, by itself, was utterly useless against the magnitude of the Great Depression in the U.S. and the world, generally. Keynes was actively trying to convince people of both the necessity and the feasibility of an effective remedy for the catastrophe, which could no longer be prevented, but only remedied.

Before everyone gets too warm and fuzzy over the juxtaposition of the non-opposing positions of Friedman and Keynes, it ought to be noted that neither did a particularly great job addressing what was actually done to remedy the Great Depression.

FDR employed an "everything and the kitchen sink" approach, without actually employing the kind of fiscal deficit and massive public works spending advocated by Keynes, until forced by the necessities of World War II. And, until WWII, the Great Depression persisted, which certainly lends support to Keynes. But, FDR did institute a number of reforms, which affected the securities markets and banking (SEC, FDIC, Glass-Stegall), as well as strengthening the hand of Labor (unionization rose markedly, unemployment compensation was instituted, etc.)

FDR also made a lot of highly effective public investments in infrastructure, which brought large areas of the U.S., which had been left out of industrialization for a century, into the 20th century, with rural electrification, the Columbia River and Tennessee River projects and a lot of other stuff.

The libertarian Friedman, of course, was completely allergic to the detailed regulation of securities markets and banking, and always inclined to discount or conveniently forget great civic achievements. Keynes was much more sympathetic to the infrastructure investments, which so greatly extended the reach of the modern world in the U.S. Economists have been pretty much useless in the great deregulation wars, since Reagan. The Great Savings & Loan debacle, foisted on us by the Republicans, was uselessly explained after the fact, while the massive transfer of wealth to the very rich is generally overlooked. Where in this vaunted "tension" between the mythic Friedman and the mythic Keynes is attention to institutional detail?

The other, oft-overlooked aspect of recovery from the Great Depression, as it actually occurred, was the forced savings of the high-employment WWII period, followed by the high investment period of the GI Bill and post-WWII industry.

Friedman was basically a modified quantity of money theorist whose money looked an awfully lot like an artificial commodity, while Keynes's theory had a gaping hole, papered over by Hick's IS/LM analysis kludge. Neither really had a good story about the role of financial assets, the role of the quantity or quality of available financial assets, the relation of financial asset values to expected real income flows, or really any of the issues, which continue to plague our understanding.

Posted by: Bruce Wilder | Nov 29, 2006 8:23:01 PM

http://www.pbs.org/wgbh/commandingheights/
shared/video/qt/mini_p02_07_300.html

Posted by: Ninjaplease | Nov 29, 2006 10:35:16 PM

There was definitely a hole in Keynes' theory of the Great Depression. This has thankfully been filled by the article "Fisher, Keynes and the Corridor of Stability" by Robert Dimand (American Journal of Economics and Sociology, Vol. 64, No. 1 (January, 2005), pp. 185-199). This article is I think the missing link that established that the Keynesian Liquidity Trap that characterised the Great Depression was a result of debt deflation as described by Fisher. This establishes that Friedman and Schwartz's view of the great Depression has the causality reversed - the economic contraction led to the contraction in monetary aggregates, notably M3. The Fed or its the equivalent could do little to avert this.

I think averting the process of debt deflation cannot be accomplished through monetary policy (Bernanke following Friedman believes the opposite). This again points to the contrast between Keynes and Friedman. Evidence in support of the incorrectness of Friedman's view is seen in the experience of Japan in the 1990s where the government succeeded only in increasing M1 while M3 continued to shrink (see paper by Krugman (1997 on this) and asset prices, notably housing, continued to fall. The reason why monetary policy cannot avert debt deflation is that asset prices are bid up to unrealistically high levels during booms based on the same "animal spirits" that govern investment. When markets turn then so do expectations which cannot easily be reversed and certainly not by monetary policy.

Financial innovation as described by Minksy leads to greater increases in asset prices during booms as it permits greater amounts of borrowed funds to flow into asset markets making asset prices more sensitive to the business cycle. As a result the risks of debt deflation during cyclical downturns increases over time. The reasoning behind this is simple - the ultimate effect of all financial innovation is to increase the level of debt relative to income. At the macro level this entails an increase in the debt to GDP ratio.

Therefore the Great Depression can be viewed as the natural course of the business cycle in economies subject to financial innovation. The full downswing portion of the business cycle can be forestalled by Keynesian counter-cyclical policy however this has to be accompanied by financial regulation. If not, financial innovation risks creating pro-cyclical swings in asset prices that will ultimately swamp Keynesian counter-cyclical policy. Since 1980 we have witnessed the elimination or substantial reduction in almost all legislation governing the financial sector. This combined with disinflation and financial innovation set in motion a period of sustained increase in private credit relative to GDP. The foregoing suggests that an imminent recession could morph into an economic depression if it triggers debt deflation

Posted by: Alex Grey | Nov 30, 2006 10:27:12 AM

Alex Gray:

"This combined with disinflation and financial innovation set in motion a period of sustained increase in private credit relative to GDP. The foregoing suggests that an imminent recession could morph into an economic depression if it triggers debt deflation."

Assuming a recession/depression is imminent, what would be the best means to prevent it? In other words, how does one prevent debt deflation during periods of economic contraction? I understand the Keynesian and Monetarist cure for such a thing, but what is the preventive?

And whatever the preventive is, someone needs to tell the Chinese, because from where I sit, they look a lot like 1920's America and 1980's Japan.

Posted by: Stephen Keith | Nov 30, 2006 11:10:37 AM

mark-

good article! i was shocked at the diatribes against friedman but given the hostility towards the field here it should not have come as a suprise.

Posted by: adam | Nov 30, 2006 12:33:10 PM

delong delong
shallow as a gong

Posted by: slink | Nov 30, 2006 5:40:32 PM

Stephen Keith,

Re your followup to Alex Grey, the answer is preventative: take away the punch bowl just as the parth gets rolling. Stephen Roach (Morgan Stanley), says: "The Federal Reserve is trapped in a moral-hazard dilemma of its own making. It dates back to the Great Bubble of the late 1990s and the central bank’s unwillingness to take away the proverbial punch bowl just when the party was getting good. The close brush with deflation that then ensued was a painfully classic post-bubble aftershock. That experience underscores the greatest shortcoming of modern-day central banking -- the inability of monetary policy to cope successfully with asset bubbles and the deflationary perils they engender. The history of the 1930s and Japan in the 1990s are grim reminders of that shortcoming." Roach quote plucked from my In Greenspan's Wake: Inflation, Deflation, Jumanji post, 8/05

Posted by: Dave Iverson | Nov 30, 2006 7:35:02 PM