Was Milton Friedman the last economist?

Macroeconomics can lead policy-making or it can follow it. Since Milton Friedman, and Robert Lucas, it has been following.

Friedman was an important macroeconomist because he diagnosed what was failing in the prevailing policies of the time. He convinced others of his diagnosis, and when policy makers took his prescriptions on board he was perceived to be vindicated. Lucas’s contribution was complementary.[1]

The prevailing reference point for thinking about macroeconomic policy-making in the 1960s and the early 1970s was the Philips Curve.[2] In its original form, this was an empirical observation that unemployment and nominal wage growth are inversely related. The deeper belief that emerged during this phase was of a trade-off between inflation and unemployment. Unfairly, as it is not clear what they really believed, history tends to attribute this to Samuelson and Solow’s famous 1960 AER paper, which concludes by suggesting that a higher rate of inflation could produce a lower rate of unemployment. As is often the case, particularly when an unsubstantiated side-remark becomes a tenet of ideology, all caveats are forgotten.

It subsequently became clear that this rule of thumb was flawed, or more accurately, it could not be exploited by policymakers. In simple terms, ever higher rates of inflation coincided with temporary reductions in unemployment, and a rising overall trend. By the late 1960s, Friedman provided a reasonably concise and convincing refutation of the premise. He made clear why reducing real wages through inflation would only temporarily reduce unemployment. Simply put, people would start to expect inflation. It follows, that repeated surprises of higher inflation would be required to sustain a fall in the unemployment rate. Lucas’s work on rational expectations (RE) had been pre-empted in different forms by many, including Friedman in his comments on Latin America. But Lucas was explicit about the forward-looking nature of expectations. It is a distraction to focus on the “rational” component of RE. The key point is that if policy makers say they are going to raise inflation to reduce real wages and increase employment, what do you expect trade unions and firms to do? They will bargain and negotiate on the basis of higher inflation. If individuals are forward-looking and pay attention to what policy makers are saying, policy-makers will not be able to “surprise” them with higher inflation – so estimates of a relationship between inflation and unemployment based on history are likely to break-down.

Plausible, intelligent, economics could explain the facts. Friedman also had clear prescriptions. Simplifying a lot, the struggle at the time was not how to reduce high unemployment caused by recession. The mainstream was suggesting that what we would now call “structural” unemployment could be reduced by tolerating higher inflation. Friedman’s reasoning reinforced the empirical facts suggesting this was a fallacy. Reducing the long-term rates of unemployment would require difficult microeconomic reforms – such as labour market deregulation.

Friedman and Lucas led policymakers, indeed the world. And everyone followed. The belief that structural unemployment could be reduced by inflation was abandoned. From a political perspective, the conclusion was the opposite. The trade off was not between the inflation rate and unemployment but the power of labour and the unemployment rate. This ideology remains dominant.

What has happened since? Friedman won an intellectual battle, but his specific prescriptions for monetary policy failed miserably. Reducing broad money growth brought inflation under control, but attempts to target monetary aggregates created too much volatility in output and interest rates. Monetarism falls apart as soon as you ask, “which monetary aggregate should we target?”.[3]

So policymakers came up with their own solutions, their thinking dominated perhaps more than anything by the perceived success of the Bundesbank in the 1970s and ‘80s. Gradually, through the 1980s, central banks abandoned monetary targets, and converged largely of their own accord on inflation-targeting – having flirted, in various parts of the world, with exchange rate anchors.

So was Friedman the last policy-relevant macroeconomic theorist? The landscape that emerged under Friedman’s shadow in the 1980s remains defining. Since the early 1990s monetary policymakers have pursued their own hunches, independently of developments in macroeconomic theory, largely responding to economic trends. Macroeconomics as a body of knowledge seems to have contributed little substantive. It is reactive. The Fed concocted a set of beliefs about how to deal with asset bubbles after the tech boom bust. The IMF randomly experimented during the Asian and Latin American crises – not really knowing what to do with weakly-anchored fiat money regimes. And having ignored the financial sector for decades the economics profession sleep-walked into the greatest financial crisis since the depression and has had nothing new to say about what to do next (intellectually, financial reform is case of “back to the ‘50s”). Academia seems content with re-igniting past debates – either crassly in the blogosphere – witness the noise around David Levine’s confusing rant – or rewriting what is already well-known with greater degrees of complexity and formalism.[4]

Much of the work in macroeconomic theory has simply rationalised what policy makers are already doing. Michael Woodford, perhaps the pre-eminent macro policy theorist of the last twenty years is explicit about this tangential, backward-looking role for theory. As he says the introduction to what Ken Rogoff describes as “the most important book in monetary theory in the last two decades”, the exhaustively thorough Interest & Prices: Foundation of a Theory of Monetary Policy:

“This work is a progress report on my struggles with two problems … the first is the problem of reconciling macroeconomics with microeconomic theory … The second is the problem of reconciling central bankers’ understanding of what they do with the way that monetary policy is conceived in theoretical monetary economics.”

This hardly encourages the reader to proceed. It is also a very narrow ambition in the context of the great macroeconomists. Great theorists in the tradition of Keynes and Friedman start with the frank premise that policymakers are almost certainly making huge errors, and add the additional – more arrogant assumption – that they have the answers. And those answers involve overturning deeply-held, and prevalent, beliefs. Is anyone doing that now?

There is an optimistic interpretation of all of this. Perhaps Keynes, amended by select insights from Friedman and Lucas, did in fact solve the substantive issues in macroeconomics. That seems to be Krugman’s view. When I say Keynes “solved everything”, I mean that it is now a matter of course everywhere that when there is a recession you ease fiscal and monetary policy.[5] That is what America, China, the UK, and the rest of the developed world have done in every recession in the last twenty years.[6] I have a lot of sympathy with Krugman’s perspective that A Level, or “high school”, economics was broadly vindicated post-crisis. After all, the US economy is already close to full employment.

A more realistic perspective is that we may be starting to encounter some genuinely new problems. Japan was a warning. Two central tenets of all mainstream macro theory have broken down. Inflation, inflation expectations, nominal GDP and interest rates are not under the control of central banks, as currently construed. If we accept that premise – and I think the evidence points in that direction – nominal GDP targets, price level targets, changing inflation targets are all irrelevant proposals. They are simply unavailable policy choices. Secondly, there are very good reasons to doubt that consumption growth is negatively correlated with real interest rates when interest rates are already low. Betting on an effect from an even lower negative real overnight interest rate is wishful thinking. Faced with economies where demand is immune to the effects of low interest rates, populations are wealthy and ageing, and technological disruption is spreading. We may need some genuinely new thinking.[7]

[1] For completeness, I should say Friedman, Lucas, Rapping, Phelps and Muth deserve the credit for putting expectations back at the heart of macroeconomic policy-making. Expectations were of course central to the General Theory, a theme Minsky pursued, but this was peripheral in policy-making ideology. Where Friedman “wins” is in his success in shifting the dominant belief-set. Since Friedman, macro policy has been dominated by a belief that the way to sustainably reduce unemployment is through labour market deregulation. The deepest irony however, is that the “micro foundations” of “expectations” are far more plausible in a world with trade unions, if you believe that institutions matter. In deregulated labour markets it is far less clear how “expectations” are formed and translate into wages and prices. Theory caused institutional change, which undermined the theory!

[2] James Forder details the much more nuanced, and fascinating, reality of the economic history of the Philips Curve and the policy discussions of the time.

[3] Friedman didn’t really believe in the ability of policy makers to smooth cyclical fluctuations in demand: “After all, uncertainty and instability are unavoidable concomitants of progress and change.” He thought the best policy could do could do was avoid major monetary disasters. A view I think Lucas still subscribes to.

[4] There are of course notable exceptions. In the US, Krugman, de Long, Summers, Blyth and others have relentlessly weighed in on the debate. In the UK, the likes of Simon Wren-Lewis and Tony Yates have determinedly raised the tone and quality of policy analysis; as has Steve Keen, from a heterodox perspective. In the Eurozone, Stephen Kinsella, Karl Whelan, Paul de Grauwe and Willem Buiter spring to mind.

[5] Apart from the Eurozone, where madness is written into law.

[6] The extent to which the UK engaged in “austerity” post-crisis is trivial relative to the overall increase in government borrowing as a result of automatic stabilisers.

[7] James Forder is critical of the accuracy of the synopsis of economic thought I have presented, but I think he protests too much. It is erroneous to deny a prevalent belief in the 1960s and 70s of some trade-off between unemployment and inflation. Arguably it is still a widespread belief. If one is not explicit about the distinction between “inflation” and “expected inflation” a trade-off follows logically from the assumption of nominal rigidities, which then – as now – was central to explanations of short-run cyclicality (despite Keynes’s best attempts to argue that depressions could occur even with fully flexible wages and prices – a theme Roger Farmer has taken up brilliantly). Forder also argues that the emphasis on expectations predates Phelps, Friedman, Lucas & Rapping. That is of course true. Indeed, in an earlier paper, which uses adaptive expectations, Lucas and Rapping cite Hicks and Tobin as holding similar views on price expectations. They also cite Muth. But that does not negate the fact that post-Friedman and Lucas expectations went centre-stage, a point Bob Solow graciously concedes. Friedman’s entire argument is about the difference between anticipated and unanticipated inflation. Lucas’s argument is that if policy makers change their target, all model parameters change. This changed the discourse, permanently. Today, central bankers cannot speak without mentioning “expectations”.

About The Author

Eric Lonergan is a macro hedge fund manager, economist, and writer. His most recent book is Supercharge Me, co-authored with Corinne Sawers. He is also author of the international bestseller, Angrynomics, co-written with Mark Blyth, and published by Agenda. It was listed on the Financial Times must reads for Summer 2020. Prior to Angrynomics, he has written Money (2nd ed) published by Routledge. He has written for Foreign AffairsThe Financial Times, and The Economist. He also advises governments and policymakers. He first advocated expanding the tools of central banks to including cash transfers to households in the Financial Times in 2002. In December 2008, he advocated the policy as the most efficient way out of recession post-financial crisis, contributing to a growing debate over the need for ‘helicopter money’.

7 Responses

  1. James Forder

    If you read my book – Macroeconomics and the Phillips curve myth – you will find there is much more to it than ‘protesting’ about whether people believed in a tradeoff. Of course lots of people thought there was some kind of relationship between inflation and unemployment – not by any means everyone, though. But anyway, for those who did take that view – how did they rationalise it? The Phillips curve myth says it was by means of supposing that wage bargainers could be continuously fooled by inflationary policy. Well, more or less no one thought that. Indeed, perhaps no one at all.

    Even those who did think there was a relationship between inflation and unemployment did not necessarily think it a terribly important matter. And the idea that there was a more or less universal presumption that the ‘prevailing reference point’ should be the Phillips curve strikes me as definitely false. It seems true if one reads things written in the 1980s and later; but not if one reads the things written in the period in question.

    And even in the 1970s, the view that expectations moved ‘centre stage’ obscures much more than it clarifies. There was more – much more – econometric investigation of expectations. That is true. But what motivated that? Not that anyone was denying that expectations would adjust to reality. And more importantly, what else was going on in the investigation of inflation and unemployment? Well, plenty. The fact that most economists today care only to discuss the expectations issues means precisely that – it is a fact about most economists today, not one about what happened in the 1970s.

    I’m afraid the business of repeating the myth, is that simple as well. One repeats the myth, another quotes the one who has repeated it, and says that is ‘evidence’. The real evidence lies in the economics of the 1960s and the 1970s, not the reports of it from the 1980s and after. It is that real evidence that my book uses.

  2. Eric Lonergan

    Thanks James. I have not had a chance to read your book yet, but I look forward to doing so. I have read your paper, which I provided a link to, “Nine views of the Phillips curve”, which I found fascinating. It highlighted to me how rich the debate at the time was. I am also of the view that the past is much richer and subtler than collective memory suggests. And there are forgotten gems – such as the ideas of Schultze which you refer to. That said, I would add two caveats. I think relying on published research as a guide to what people “really believed” at the time needs to be treated cautiously. Journal articles always contain caveats, tend to be more balanced, and usually cite a broad literature. This always gets forgotten. My post on the Pigou effect, for example, reveals that Friedman in his 1968 AER address advocates a money-financed fiscal stimulus in a liquidity trap – that is certainly not the collective recollection.

    Also, what is highlighted by others, emphasized, and “remembered”, is often not refuted by the authors themselves. Proponents of popular ideas often collaborate in the stereotyping of their ideas. This is a current issue, not just an historical one. Consider the debate over Rheinhart and Rogoff. Their research carries many caveats and subtleties – but when, and how much, they and others emphasize these varies. Or take a broad example, the current criticism of “mainstream” economics. This criticism is, I believe, very valid. But this is not a conclusion you would reach if you looked at published research. It is profoundly varied – but most of it is not read, and certainly could not be described as ‘influential’. “Prevailing beliefs”, for want of a better term, may not be objectively sampled by what was published or even said. Some data exist only in our minds.

  3. James Forder

    Thanks Eric. I’m pleased you found that little paper interesting. I’m afraid I don’t get the point of the rest of your response. You suggest caution about relying on published research, but make no suggestion as to what we should rely on. You say published research contains caveats. But my claim is not that there are no uncaveated cases of Phillips curve inflationism from the 1960s. It is that the whole story is a myth.

    In your second paragraph I am not sure whether you are saying it is the few papers that are ‘remembered’ that matter, or the broader ‘forgotten’ literature. Anyway, the point of my book is that I looked at both. The ‘remembered’ papers do not say what the myth says they did; and neither do the vast majority of the ones no one ever bothers to read. Where is it you think I should have looked to find truth in this great myth?

    • Eric Lonergan

      I am not sure we disagree. I am unconvinced by this hypothesis: that there was not an influential view in the 1960s and 70s which held that there was an exploitable trade off between inflation and unemployment. I am partly not convinced because I think it is not an unreasonable view.

      I am also simply pointing out that published research is – in its own way – a biased historical document. In this sense: it is often the most careful statement of the author’s “view”.

      Are there other ways of attempting to determine what influential beliefs were at the time? There are transcripts of policy meetings, interviews and recollections. I cite one, the recollections of Bob Solow.

      Solow makes some of my points. Of his 1960 article, he says “I think you’ll find in it tucked away somewhere every necessary qualification.” My interpretation of this is an admission that published articles involve, by convention, hedging one’s bets. At the same time, the authors may be very aware that the view will be interpreted more dogmatically. I observe this pattern in lots of economics research.

      Consistent with this interpretation, Solow goes on to say, “Yes, we even thought about expectations. From some points of view, then, I feel we could pat ourselves on the back and say we got it right. On the other hand, the article was clearly more optimistic about policy use of Phillips curve trade-offs than I, or Paul Samuelson, would now be. We did think of all those qualifications but we almost certainly didn’t focus on them enough.”

      I find that very believable; although it is also possible (perhaps likely) his memory is somewhat biased.

      That said, I am very sympathetic to what you have written – and more importantly, I think that in making your argument you draw attention to a much richer body of work. In a sense, I don’t care so much about whether the “Philips curve narrative” is a myth or not – in making the case that it is, you tell a far more interesting story.

      A final point: I would not hope to find “truth” in this area. The concepts of the history of economic thought – “what people believed” “prevailing opinion” “universal presumption” “what most economist care about” – are at best vague concepts, at worse inaccurate. Often the same individual holds inconsistent beliefs. That poses a necessary limit to this endeavour. Thanks for your thoughts, and I look forward to reading the book!


Leave a Reply

Your email address will not be published.

* Checkbox GDPR is required


I agree