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Monetary Central Planning and the State, Part 24: Milton Friedman’s Framework for Economic Stability


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In the post-World War II period in the United States, there have been few voices as important for the defense of the free market as that of Milton Friedman. In his 1962 book Capitalism and Freedom, he forcefully challenged the trend towards increasing government control over economic life. Friedman eloquently argued that economic liberty was vital for the preservation of both personal and political freedom. And he recommended market-oriented solutions to various social problems in place of “big government.” Friedman reformulated and popularized this theme for a global audience in his television series and book, Free to Choose (1980).

Equally important, Milton Friedman has been a voice of reason and scholarly rigor in opposition to many of the dominant Keynesian ideas. He demonstrated that many of the most cherished Keynesian assumptions were based on faulty economic theorizing and an erroneous understanding of the historical facts. It is not an exaggeration to say that Friedman was a prime mover in significantly changing the focus of postwar macroeconomic theory from the direction given to it by Keynes in the 1930s.

In doing so, Friedman has been a true disciple and defender of the Chicago tradition. From his teachers at the University of Chicago in the 1930s, he learned the superiority of the market order over the regulated economy and the planned society. But he also adopted their views on monetary and banking reform. His 1960 volume, A Program for Monetary Stability, contains a defense of Henry Simons’s proposal for 100% reserve banking under a fiat-money system managed by the government. Probably Simons’s greatest influence on Milton Friedman concerned the desirability of government’s following articulated, long-run policy “rules” in place of discretionary monetary and fiscal powers in pursuit of short-run policy goals. (See “Monetary Central Planning and the State, Part XXIII: Henry Simons and the ‘Chicago Plan’ for Monetary Reform” Freedom Daily, November 1998.)

In a 1951 essay, “The Effects of a Full-Employment Policy on Economic Stability,” Friedman showed that short-run, activist Keynesian policies were likely to generate more, rather than less, economywide instability. He pointed out that there were inescapable “time lags” between “undesired” changes in the level of general economic activity and government policy responses to counteract them.

The Keynesian presumption had been that any observed deviations in macroeconomic employment and output from a targeted level of full employment should immediately bring a response through increases or decreases in taxes and government spending to move the economy back to its appropriate full-employment level. Constant adjustments in government taxing and spending could prevent both inflation and depression. (See “Monetary Central Planning and the State, Part XXI: The Keynesian Revolution and the Early Critics of Keynes,” Freedom Daily, September 1998.)

Friedman pointed out that three time lags were likely to prevent the smooth success of such Keynesian policies. First, there existed a lag between an actual change in the macroeconomy and the collection of the statistical data on the basis of which it would become known to the policymaker that there was a problem needing correction. Second, there was a lag between the recognition that there was a problem and the decision leading to the actual implementation of a change in fiscal or monetary policy. And, third, there was the lag between the undertaking of the policy action and its working through the economy and affecting the general level of employment and output.

He argued that from the time the data had been collected, interpreted, and acted upon to the time a change in policy had begun to have its full effects, the economy would not have stood still. The economy would have been following its own “natural” path. As a result, by the time the policy change actually had its effect, the need for that particular policy may have passed. Even worse, the new policy’s effects might not only be too late to solve the problem, they could help to create a new problem that needed fixing.

For example, suppose that the statistical data at the policymaker’s disposal suggested the macroeconomy was heading into a downturn. The policymaker might conclude that what was needed was increased government deficit spending to stimulate “aggregate demand.” But by the time the government’s additional deficit spending started to have its effects, the economy might have “moved on” and naturally begun to recover from any recessionary tendencies. The new government spending would then be added to a normal market-induced recovery, possibly threatening to push up aggregate demand too much, resulting in government-created inflationary problems. But the policymaker might not know his “anti-depression” policies were generating an inflationary problem until it was too late, once again because of those time lags. The inevitable informational ignorance on the part of the policymaker and the inescapable delay before any policy change had its full effects on the economy meant that discretionary government policy always ran the risk of doing the supposedly right thing too late and making any new situation worse than if the government had merely left the market alone.

Did that mean, therefore, that Friedman believed government should leave the market economy alone? No, it did not. Three years earlier, in 1948, he had published an article entitled “A Monetary and Fiscal Framework for Economic Stability.” First, the monetary framework should be one like that advocated by Henry Simons: 100% reserve banking with a government-managed fiat money. Second, the level of government spending in the society should be based on a long-run political consensus concerning the government programs and services for which the public was willing to pay through taxes. Third, there should be a progressive income tax, primarily relying on a personal income tax. And, fourth, the government should not run annual balanced budgets. Instead, government budget deficits and surpluses would be used as the primary policy tool to maintain a targeted level of national income in the economy.

Suppose the economy were to go into a downturn. Aggregate demand for goods and services would decline, and employment would fall off with a resulting decrease in total income earned in the society. A decline in national income would result in a decrease in government tax revenues. But instead of government’s adjusting its spending to the lower level of tax receipts to maintain a balanced budget, the government would maintain the same level of expenditures that would have been fully funded by taxes if the economy had continued to operate at full employment. A budget deficit would “automatically” result, which the government would service either by issuing non-interest-earning securities or merely by printing money. The amount of government deficit-spending on goods and services or in the form of unemployment insurance payments would more or less maintain aggregate demand in the economy at the level that would have prevailed if there had not been a market-generated lapse from full employment.

If the economy, instead, were to be “overheating,” with national income rising above a full-employment level, inflationary forces would now be at work. Again, government would maintain its own level of targeted expenditures, with a budget surplus “automatically” coming about as tax revenues began to exceed the amount of government spending because of rising incomes. The additional dollars siphoned off the market through higher tax revenues would be taken out of circulation, tending to slow down and bring the inflation to a halt. The government’s budget surpluses would prevent aggregate demand from rising above a level of national income consistent with full employment.

Friedman advocated a progressive income tax because he wanted it to be used as a macroeconomic policy tool. As incomes fell during an economic downturn, individuals would fall into lower tax brackets, meaning that individuals would be retaining a larger after-tax percentage of whatever income they earned. In an inflationary environment, incomes would be rising, resulting in people’s retaining a smaller after-tax percentage of their income as they were pushed up into higher tax brackets. Thus, a progressive income tax would serve as an instrument for government to manipulate the amount of private-sector spending out of different levels of national income.

Governments, under Friedman’s plan, would no longer have the discretion to change taxing and spending to try to maintain a targeted level of full employment. Instead, the “rule” would be: maintain the desired level of government expenditure that would be fully covered by taxes if the economy were operating at full employment. If the economy started to fall into recession or overheat into inflation, government budget deficits or surpluses, respectively, would “automatically” result. Maintaining the targeted level of government spending would compensate for any fluctuations in private-sector aggregate demand that would threaten to create either unemployment or inflation.

Given the dominance of Keynesianism in the late 1940s and early 1950s, it is easy to see that the thinking behind Friedman’s arguments was to demonstrate two things: first, to show that a discretionary policy of “demand management,” as advocated by the Keynesians, could in fact be counterproductive because of the time lags between deciding that a policy should be changed and the full effects from any change in policy; and, second, to suggest that the Keynesian goal of maintaining a full employment level of aggregate demand could be attained by simply following the rule of maintaining a desired full-employment level of government spending and allowing government budget deficits and surpluses to “automatically” bring about the necessary corrections in total spending in the economy.

Nonetheless, Friedman’s arguments served to reinforce the fundamental assumptions underlying the entire Keynesian framework:

  • First, and most important, that a market economy could not be “left alone” because it contained the potential for a lapse from full employment that needed and required fiscal and monetary correction through government action.
  • Second, that taxes were not an unfortunate “necessary evil” that should be kept at the minimum, consistent with the performance of those limited “essential functions” of protection of life, liberty, and property, which (whether one agrees with it or not) was the view of the older classical liberals who were always suspicious of any government taking of people’s private income and wealth. Instead, a progressive income tax was to be a conscious macroeconomic tool for demand-management policy by government.
  • And, third, that government monopoly control over the supply of money was desirable and essential for government manipulation of private-sector activity in the market, regardless of whether the target was a stable price level, full employment, or a certain level of national income.

Whether it was his intention or not, Friedman’s proposed “monetary and fiscal framework for economic stability” legitimated the Keynesian arguments for government intervention in the market economy. By accepting the Keynesian “terms of the debate,” the only issues remaining in dispute concerned how government should try to demand-manage the market economy, not whether it was needed or whether government should.

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    Richard M. Ebeling is a professor of economics at Northwood University. He was formerly president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).