The Hindu Business Line : The Friedman legacy

In an objective assessment of the theories and ideas of Milton Friedman, ALOK RAY pays tribute to the economist who was both way ahead of his time in his impassioned advocacy of the free market and yet sometimes detached from the realities of the day.

The two most influential economists of the 20th century were John Maynard Keynes (1883-1946) and Milton Friedman (Nobel Laureate in Economics who passed away last month aged 94). One straddled the first half of the century like a colossus, while the other dominated the second half, often challenging and contradicting the former's ideas.

What are the basic Keynesian macroeconomic ideas he was fighting against? In simple terms, Keynes argued that bouts of unemployment are inevitable in a capitalist free market economy. There is no automatic cure for this problem. That is why the world had to pass through the prolonged and painful Great Depression of the 1930s, when more than a quarter of the US' labour force was unemployed for many years.

To Keynesians, the basic cause of recession and unemployment is insufficient aggregate demand. And the Keynesian solution? In a recession, governments should increase public expenditure and generate demand directly. Cutting taxes would also help indirectly by increasing private expenditure as people have more after-tax income to spend. On the other hand, if demand exceeds the economy's capacity to produce, inflation would set in. Then, the government would have to cut down its expenditure and increase taxes. Thus, an activist state is essential to achieving high employment without inflation.

Friedman contested these ideas at several levels. At the empirical level, he argued, with reams of data, that sharp contractions in money supply turned a mild recession into the Great Depression. Thus, the Great Depression and the associated unemployment are not the fault of a free market system. The basic problem lies with the policy-makers, in particular the central bank, which followed wrong money supply policies.

Flexible labour market

Friedman believed that in a flexible labour market, there is an inherent tendency to return to full employment. So, the basic cause of involuntary unemployment is downward wage rigidity — primarily engineered by trade unions or by bureaucrats/politicians in the form of minimum wage laws — which keeps wages above market clearing levels.

Latter-day theorists have advanced several other reasons (especially many versions of the so-called efficiency wage theory) why the market wage rate may well be permanently above the market clearing wage, causing involuntary unemployment, even in a flexible market without labour unions or minimum wage legislation. To that extent, Friedman's theory about labour market inflexibility being the principal culprit for involuntary unemployment has been considerably weakened.

Money supply growth

At another level, Friedman argued, based on his empirical work, that the velocity of money (that is, how many times a rupee changes hand to finance expenditure in a given year) is fairly stable. Hence, steady growth in money supply would stabilise aggregate expenditure. Consequently, he suggested that the central bank should not be given the authority to fiddle with money supply growth. It should keep money supply growing at a stable rate to keep pace with growing (full employment level) GDP. This will ensure steady growth without inflation.

Friedman would agree that deliberate changing of government expenditure and taxes (fiscal policy) and money supply (monetary policy) may, under ideal conditions, help stabilise the economy against fluctuations in economic activity. But given various practical problems (such as inaccurate understanding of the state of the economy by policymakers and the lags with which policies take effect), activist policies are more likely to aggravate business cycles. So, as a rule of thumb, policymakers should not use discretionary counter-cyclical policies. In effect, he was against an activist state, even for stabilising the macro economy.

Despite the intellectual appeal of his ideas, no central bank has strictly followed the rule of steady money supply growth or the hands-off approach for stabilisation of the economy. All central banks let money supply adjust to various shocks to the economy.

Further, all governments (including those of Mrs Margaret Thatcher and Ronald Reagan, which supposedly followed Friedman's ideas) have adjusted expenditures, taxes and interest rates to smoothen out fluctuations in the level of economic activities. Friedman also grudgingly accepts that Greenspan was fairly successful in using monetary policy to bring the US out of the recent recession. In that sense, his macro policy prescriptions have failed to carry into practice.

Effect of tax cuts

However, his ideas on the trade off between inflation and unemployment and the effects of temporary versus permanent tax cuts have found much greater acceptability among both professional economists and policymakers. Most would agree with Friedman that it is not possible to sustain a lower rate of unemployment over a considerable length of time simply by increasing the inflation rate and reducing real wages. Workers cannot be fooled for long.

Friedman also modified the Keynesian idea that consumption depends primarily on current income. His permanent income hypothesis argues that a person's current consumption depends basically on his permanent income or the average lifetime income. Consequently, a permanent cut in taxes (which increases permanent income) will have a much stronger stimulating effect on the economy than a tax cut that people consider temporary. This is now a part of the standard text-books.

It is possible to argue that he has been more successful in his micro policy prescriptions, especially in his advocacy for a flexible exchange rate system, education vouchers, all-volunteer army in peace time, negative income-tax for the poor, deregulation of industries, privatisation of state-owned enterprises and a much greater role of free markets in guiding resource allocation.

Friedman provided the intellectual case for a flexible exchange rate when the fixed exchange rate system ruled the world. Today, most countries in the world are on some form of floating exchange rate. The education voucher system, by which he wanted to give parents the right to decide the school where they would send his children — thereby promoting competition and improving the quality of education — is now being advocated even by the Indian Planning Commission.

Countries such as Russia, China and Vietnam are moving away from socialism to private enterprise and free markets. Deregulation and privatisation are the buzzwords everywhere. Friedman's negative income-tax proposal has been largely implemented in the US in the form of Earned Income-Tax Credit. In the debate on conscription versus a volunteer army in the US, Friedman convinced the policymakers of the superiority of a volunteer army.

Ahead of his time

Some of his ideas were, and are still being, expanded on by his colleagues and students; a few of them have subsequently become Nobel Laureates in Economics. Phrases like "there is no free lunch" and "the business of businesses is business", attributed to Friedman, are now part of everyday language. Most academicians would also accept his methodological point that the test of a model or theory lies in its predictive power, rather than in the realism of its assumptions. Perhaps, the problem with Milton Friedman was that, in his eagerness to push his ideas, he sometimes seemed to be `overselling' them. For example, in developing his case for capitalism and freedom he did not pay enough attention to the vastly unequal initial distribution of wealth. His suggestion for a negative income-tax for low-income families — as a substitute for the welfare state — was grossly inadequate. He underplayed the role of regulation, even for the purpose of keeping the market competitive.

Market failures, to him, were matters of intellectual possibility that deserve no more than passing mention. In his worldview, only children and lunatics need the state to look after their interests. The rest (including the unemployed and the sick) can take care of themselves in a free market.

In many ways, he was ahead of his time. For example, he advocated economic liberalisation for India in the 1950s when he visited the country during the golden days of planned economic development. But in some respects, he was behind the times, especially in the areas of concern for the underprivileged and the environment. Nonetheless, he was at his persuasive best when arguing passionately for individual freedoms and the free market. To end with one of his views on the subject: "The only way that has ever been discovered to have a lot of people co-operate together voluntarily is through the free market. And that's why it's so essential to preserving individual freedom."

(The author is a former Professor of Economics, IIM Calcutta. His e-mail: alokray15@yahoo.com)

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