Friedman Debunked the Gospel of Keynes

By Steven Pearlstein
Friday, November 17, 2006; D01

One thing that baffles those of us with no training in economics is that two people who hold diametrically opposite views can both be held out as giants of their profession.

After all, if the great British economist John Maynard Keynes was right that government can smooth out the business cycle by stimulating and managing demand for goods and services through such mechanisms as public-works programs, deposit insurance and deficit spending, then how could Milton Friedman be right that the better approach is for government to cut taxes, curb regulation and focus on the supply of money in circulation?

Or how do we square Keynes's prescription that global finance can be stabilized through fixed exchange rates with Friedman's formula of floating exchange rates?

There is, of course, a political analogy to this conundrum. The same country reveres the memory of Franklin Roosevelt for pulling us out of the Great Depression while crediting Ronald Reagan with restoring the competitiveness of the American economy.

The dirty little secret is that there are few scientific truths in economics analogous to the laws of thermodynamics or genetics. Economics is a social science, not a physical one, in which people and systems are constantly adapting to changing conditions. The policies that may be good for one era may not be right for the next. And it is the truly great economists who spot the changing dynamics, acknowledge the inadequacy of the old prescriptions and are clever enough to come up with something better.

In this respect you can say that Milton Friedman, who died yesterday, was the greatest economist of our time. He was not simply the most influential economist since Keynes, but a worthy successor, building on Keynes's insights even as he discredited key aspects of Keynesian economic management.

In the 1950s, as socialism was gaining credence around the world and Keynesian thinking dominated economics textbooks, Friedman's skepticism about government management of the economy was viewed as nothing short of heresy. But by the mid-1970s, as the country was beset by stagnant growth and high inflation, it became clear the Keynesian model had played itself out. Suddenly, Friedman's ideas didn't look so kooky.

"I grew up in a Keynesian household," recalls Larry Summers, the former Treasury secretary and Harvard president whose mother and two uncles were respected economists. "And as an undergraduate, I was taught an economics that had demand but no supply." But in time, says Summers, it dawned on him and most others in the profession that Keynesian theory was not so much wrong as incomplete.

With his focus on the overall demand for goods and services in the economy, Keynes overlooked the importance of the supply of money in circulation. Friedman argued that controlling that supply was a better tool for managing the economy than taxation and spending policies.

Inflation, it turned out, wasn't as benign an antidote to unemployment as Keynes had thought, nor was there necessarily a trade-off between the two, as he presumed.

And many Keynesian policies meant to correct for very real imperfections in the marketplace turned out to have big imperfections of their own.

The intellectual roots of Friedman's "economic liberalism" run back to Adam Smith and Alfred Marshall, and were spun out at the University of Chicago with his pal George Stigler and intellectual superstars including Ronald Coase, Zvi Griliches, Gary Becker, Robert Lucas and Kevin Murphy. But even as the profession moved toward fancy mathematics and modeling, Friedman went the other way, constantly striving to connect theory with people and policy.

With his wife, Rose, he wrote a regular column for Newsweek, churned out books in simple English and produced a television series for PBS. And over the years, he provided a steady stream of influential advice to politicians and policymakers, beginning with Barry Goldwater and Richard Nixon, and extending through Ronald Reagan, Margaret Thatcher and Alan Greenspan.

Friedman wasn't always right. His dogmatic monetarism clouded his economic predictions during the 1980s and '90s, in part because of globalization and new financial instruments that made it difficult to measure the money supply, let alone control it. And after the success of the Greenspan era at the Federal Reserve, Friedman was forced to acknowledge that maybe humans could do a better job managing monetary policy than the computer he once recommended.

Friedman's abiding distrust of government action also blinded him to its successes. But it would be wrong to confuse his libertarian instincts with lack of human sympathy. He was an early proponent of the negative income tax, now known as the earned income tax credit -- which supplements the wages of millions of low-income workers. And while he opposed rent control, public education and Social Security, he promoted government vouchers to help people buy housing, education and medical care.

Whether he was right or wrong, whether you agreed with him or not, it is certainly true, as Summers noted yesterday, that Friedman improved the quality of thinking in every debate he entered. The same might be said of his friend John Kenneth Galbraith, who was as energetic in defending the Keynesian view as Friedman was in discarding it -- and who also died this year.

Many of Friedman's ideas have become so fundamental to modern economic thinking, it's easy to forget how unconventional they once were. Federal Reserve Chairman Ben S. Bernanke put it nicely in 2003, at a conference organized by the Dallas Fed to celebrate Friedman's life and work.

"I am reminded," Bernanke said, "of the student first exposed to Shakespeare, who complained to the professor: 'I don't see what's so great about him. He was hardly original at all. All he did was string together a bunch of well-known quotations.'"

Steven Pearlstein can be reached

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