Authors: David Smith
Friedman, who was to later feature in his own television series on economics, providing a graphic demonstration of the way inflation is created by switching on a banknote printing press, made three key contributions. The first, in 1956, was his revival of Fisher’s quantity theory of money. His paper, ‘The Quantity Theory of Money: A Restatement’, did more than dust off Fisher’s work. He also addressed one of the fundamental Keynesian criticisms of monetarism, that there could never be a stable and predictable relationship between M, money, and P, prices, because the amount of money people wished to hold – the demand for money – was inherently unstable. Friedman agreed that money was only one of a number of assets that people wanted, the others being anything from stocks and shares through to cars, consumer durables and houses. He also developed, as noted earlier, the concept of ‘permanent’ income. The permanent income hypothesis was simply the idea that people have a notion of what their long-run, or permanent, income is. In other words, they look beyond temporary windfalls and shortfalls. Tied to this, said Friedman, they also have a clear idea of how much money they want to hold, for precautionary and other purposes, in relation to that permanent income. So what happens when the money supply increases? Everybody finds that they have more money, in relation to those other assets and their permanent income, than they want. Their response is to get rid of the money by buying, not only other financial assets (saving), but cars, washing machines, anything. An increase in the money supply stimulates spending. Part of that spending results in higher economic growth but much of it, he argued, would spill over into inflation. Inflation, he said famously, was ‘always and everywhere’ a monetary phenomenon, and the relationship between money and prices was as robust as any in science.
His second big contribution, with Anna Schwarz, was a massive exercise,
A Monetary History of the United States
, published in 1963. This not only demonstrated that the relationships he had postulated in his version of the quantity theory worked in practice (although others disputed that) but, more importantly, it provided a completely different take on America’s Great Depression of 1929–33. It was, said Friedman and Schwarz, nothing to do with Keynes’s liquidity trap, or a crisis in capitalism to which only public works programmes could provide the answer. Instead, there was a straightforward monetary explanation. The Federal Reserve, America’s central bank, had become worried about the pace of economic expansion in 1928, when the roaring twenties were still roaring, and started to apply the monetary brakes. It applied them a little too hard and by the following year, when banks were failing across America as financial confidence ebbed, the money supply was dropping like a stone. The Great Depression was, said Friedman, testimony to the power of monetary policy. The economy ‘fell because the Federal Reserve System forced or permitted a sharp reduction in the monetary base, because it failed to exercise the responsibilities assigned to it in the Federal Reserve Act to provide liquidity to the banking system’.
The natural rate
Finally, Friedman gave us a tool that economists and policymakers use extensively, with varying success. The ‘natural rate of unemployment’ sounds like a very clinical concept, which is perhaps why it is more usually expressed these days as the much clumsier ‘non-accelerating inflation rate of unemployment’ (Nairu). Horrible expression, it just means the unemployment rate at which inflation is stable. Push unemployment too low, and upward pressures on wages – together with expectations of rising prices – will result in higher inflation. Allow unemployment to rise too high and the result should be falling inflation. It sounds more precise than it is. Economists waste a lot of time trying to work out what the Nairu is, only to find that in practice unemployment can fall below that level without triggering higher inflation. In the late 1990s unemployment in Britain and the United States dropped well below existing estimates of the Nairu. Anyway, back to the natural rate. In his presidential address to the American Economic Association in 1967, Friedman took on the Keynesian Phillips curve. The Phillips curve, which you may remember was invented at the London School of Economics by the same Bill Phillips who designed and built machines to display the workings of the economy, demonstrated the relationship between unemployment and wage inflation. When unemployment went up, inflation went down, and vice versa. For governments fine-tuning the economy through Keynesian demand management (small touches on the tiller by means of tax or public spending changes), the Phillips curve told them what to do. If inflation is too high, just apply the brakes by raising taxes and cutting spending – in other words create a bit of unemployment. If inflation is very low and unemployment high, then create a bit of growth, perhaps by boosting public spending. To Friedman this represented a fundamental misunderstanding of the way inflation worked, and he developed the natural rate to demonstrate why.
Let us say the natural rate of unemployment in the economy is 5 percent of the workforce. It is at this level because, perhaps, there is always a certain amount of ‘frictional’ unemployment – people moving between jobs – but also because some people lack the necessary skills, and others are stuck in regions where there is little work available and it is difficult for them to move elsewhere. Now suppose a government is elected on a promise of halving unemployment. It tries to do so by expanding the economy, both through fiscal and monetary policy (increasing the money supply). Initially it works. Faced with greater demand firms take on even those workers whose skills are not quite right and expand output. They also raise prices, confident about doing so because they see demand in the economy as strong, not least because of all those extra people in jobs. Lower unemployment results in higher inflation. Perhaps the inflation rate goes up from 2 to 4 percent. So far this is just the Phillips curve. But Friedman then examined the next round. What would happen if the government tried to keep unemployment below its natural rate by keeping its foot on the accelerator? Next time round, workers would remember the higher inflation of the previous episode and would want compensating for it in higher wages. Their ‘expectations’ have changed. They now expect inflation to be 2 percent higher than its current rate, in other words 6 percent, and so it goes on. The key point was that trying to keep unemployment below its natural rate did not just mean accepting a one-off rise in inflation. It meant accepting an accelerating rate of inflation (hence the Nairu). So is there nothing policymakers can do about unemployment, if its natural rate or Nairu happens to be high? Not at all. One of the big debates at present is how Europe can reduce its high Nairu, without accepting an accelerating inflation rate, by making its job markets more flexible.
The earliest and perhaps purest expression of the natural rate doctrine by a British politician was in 1976 when James Callaghan, the Labour Prime Minister, had reluctantly recognized that the old policies had run their course. In his speech to his 1976 party conference, written by his monetarist convert son-in-law Peter Jay, Callaghan said:
We used to think that you could just spend your way out of recession, and increase employment, by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it worked by injecting inflation into the economy. And each time that happened, the average level of unemployment has risen. Higher inflation, followed by higher unemployment. That is the history of the last twenty years.
Lucas and the rationalists
Friedman’s introduction of the natural rate of unemployment emphasized the role of expectations in influencing behaviour and the effectiveness of policy. Friedman’s version of the Phillips curve is sometimes known as the ‘expectations-augmented’ Phillips curve. In the 1970s a group of American economists took this a stage further. Robert Lucas, Thomas Sargent and John Muth, particularly Lucas, gave us ‘rational’ expectations. Rational expectations was, like all great breakthroughs, very simple. The Lucas critique of conventional Keynesian economics was that it assumed people were stupid. Take a typical situation in British electoral politics. The governing party, seeking re-election, has a spring Budget ahead of a summer election. It cuts taxes and ensures interest rates are falling (not so easy now with an independent Bank of England). Voters feel good, happily give their support, but a few months later, as night follows day, taxes and interest rates are going back up again. If voters are stupid that might happen over and over again. Rational expectations proposed that, just like laboratory rats or mice, we learn from our mistakes. If we get stung once, we won’t go there again. This applied, of course, not just to pre-election economic policy but also to policy in general. Keynesian demand management worked because people responded to the initial economic stimulus, the tax cuts or extra public spending, by spending more themselves, blissfully unaware of the higher inflation that would follow. The Lucas critique said this would not happen. People would immediately look through to the higher inflation, and not respond to the inducements of policymakers. They would beware governments bearing gifts.
Are people rational in this way? It is hard to say. The mere fact that governments have persisted with election economics for very many years would suggest that it is possible to fool some of the people at least some of the time. There are plenty of examples where people continue doing things long after it appears to be rational. The boom in technology shares in the second half of the 1990s resulted in a peak for the Nasdaq (the US index of mainly technology stocks) of over 5,000 in March 2000. Within a year or so the index had plunged to less than a third of that peak. Well before shares had reached the peak Alan Greenspan, the Federal Reserve chairman, had warned of ‘irrational’ exuberance. There is another interesting idea attached to the behaviour of, for example, share markets. The ‘efficient market hypothesis’ says, in essence, that a market will settle at a level that efficiently reflects the current state of information available to investors. How can a market be efficient which is over 5,000 one year and 1,500 the next? The answer, which may not be entirely helpful to anybody wanting to determine in a scientific way whether stocks are cheap or dear, is that part of the information being used efficiently by investors at the peak was that there were plenty of suckers out there apparently willing to buy, whatever the price.
Anyway, back to rational expectations. The Lucas critique suggested that there was no point governments trying to prevent cyclical variations in the economy – boom and bust – because people and businesses would always, by operating rationally, be able to second-guess policy decisions. Lucas had another reason for rejecting such a policy approach. He is also a proponent of what is called ‘real business cycle theory’. The Keynesians believed that the business cycle (the tendency of the economy to have periods of boom followed by slow growth or recession) was caused by variations in demand, in other words in investment and consumer demand. The real business cycle theorists argue, in contrast, that the cycle is due to variations in supply, to positive and negative economic shocks. In particular, periods of boom are caused by the discovery or spread of new technology – such as America’s information and communications technology (ICT) boom of the 1990s – while recessions happen when the positive shocks have worn off and, for example, productivity (output per worker) growth is low. The traditional Keynesian solution of trying to prevent recession by increasing government spending is misplaced. Some would go so far as to claim that any kind of stabilization policy, for example the Bank of England cutting interest rates in a slowdown, is inappropriate. Booms and recessions are part of the natural order of things, they would argue, and trying to prevent them may do more harm than good. Few policymakers, it should be said, subscribe to this view.
Laffer and the supply-siders
Every era brings to the fore economists who seem particularly attuned to the political mood. In the 1980s when, under Ronald Reagan in America and Margaret Thatcher in Britain, there was an emphasis on tax cuts as a way to restore incentives and boost long-run growth, it was the supply-siders. A few years earlier Arthur Laffer, then an economics professor at the University of California, was demonstrating to a writer from the
Wall Street Journal
how raising taxes could destroy the economy’s productive potential. On a restaurant napkin he drew the Laffer curve. It showed that there are tax rates, zero and 100 percent, when the government gets no revenue at all. When the tax rate is zero, it is self-evident that no revenue comes in. But none comes in either with a 100 percent tax rate because there is no point anybody working. Between those two points, there will be a range of combinations of tax rates and revenue. As drawn by Laffer, tax revenue would rise in line with increases in tax rates up to a certain point but then revenue would fall, because high tax rates provide a disincentive for people to work. If the country was already beyond that point, it could even be the case that cutting tax rates would bring in extra revenue. The supply-siders, who included Paul Craig Roberts and Robert Mundell, provided intellectual support for tax cuts.
Supply-side economics goes beyond tax cuts, however, and it is no longer associated just with the American right and their bible, the
Wall Street Journal
. Supply-side economics embraces anything that raises the economy’s long-run, or sustainable, growth rate. This might be tax cuts, or it might be increasing competition by breaking up cartels, attacking the restrictive practices of trade unions, improving the climate for business start-ups, or making it easier to hire and fire workers. Supply-side economics means taking action to enable the economy to achieve its potential, and increasing that potential.