Mark Skousen, ed.
Dissent on Keynes: A Critical Appraisal
of Keynesian Economics
New York: Praeger Publishers, 1992, pp.
131-147
Is Milton Friedman a Keynesian?
Roger W. Garrison
He Isn't But He Is There is a story about a young
job candidate interviewing for an entry-level position in the geography
department of a state university. One senior faculty member, whose
opinion of our modern educational system was not especially high, asked
the simple question, "Which way does the Mississippi River run?" In
ignorance of the biases of this particular geography department and in
fear of jeopardizing his employment prospects, the candidate boldly
replied, "I can teach it either way."
When the question "Is
Milton Friedman a Keynesian?" was first suggested to me as a topic, I
couldn't help but think of the uncommitted geographer. But in this case,
opposing answers can be defended with no loss of academic
respectability. When teaching at the sophomore level to students who are
hearing the names "Keynes" and "Friedman" for the first time, I provide
the conventional contrast that emerges naturally out of the standard
account of the "Keynesian Revolution" and the "Monetarist
Counter-Revolution." To claim otherwise would come close to committing
academic malpractice. Either a casual survey or a careful study of the
writings of Keynes and Friedman reveals many issues on which these two
theorists are poles apart.
Yet, one can make the
claim that Friedman is a Keynesian and remain in good scholarly company.
Both Don Patinkin (Gordon, 1974) and Harry Johnson (1971) see Friedman's
monetary theory as an extension of the ideas commonly associated with
Keynes. Some of their arguments, however, run counter to those of the
Austrian school, which serves as a basis for this chapter. And while
Friedman, by his own account, was quoted out of context as saying,
"We're all Keynesians now," his in-context statement is thoroughly
consistent with an Austrian assessment. More than two decades ago,
during an interview with a reporter from Time magazine, Friedman
commented that "in one sense, we are all Keynesians now; in another, no
one is a Keynesian any longer." The two senses were identified in his
subsequent elaboration: "We all use the Keynesian language and
apparatus; none of us any longer accepts the initial Keynesian
conclusions" (Friedman 1968b, p. 15).
Patinkin and Johnson have
each argued that Friedman's attention to the demand for money, and
particularly his inclusion of the rate of interest as one of the
determinants of money demand, puts him closer to Keynes than to the
pre-Keynesian monetary theorists. Friedman has responded by insisting
that the inclusion of the interest rate in the money-demand function is
a minor feature of his theoretical framework (Gordon, 1974, p. 159).
Austrian monetary theorists, who pay more attention to the interest rate
than does Friedman and as much attention to it as did Keynes, have a
different perspective on the interest-rate issue. Both Keynes and
Friedman have neglected the effects of change in the interest rate on
the economy's structure of capital. From an Austrian viewpoint this sin
of omission, which derives from a common "language and apparatus," makes
both Keynesianism and Monetarism subject to the same Austrian critique.
Keynesianism: From the Treatise to the General
Theory It is important to note, then, that the sense in
which the statement "We're all Keynesians now" is true—from both a
Monetarist and an Austrian perspective—involves a circumscribed "all."
Monetarists are included; Austrians are not. Drawing out the essential
differences among these schools of thought requires that we begin by
considering the common "language and apparatus" that predates Friedman's
(1969a) restatement of the quantity theory of money and that predates
even Keynes's General Theory. The Austrians can be identified as
Keynesian dissenters on the basis of Keynes's earliest macroeconomics.
Keynes's two-volume
Treatise on Money, which appeared in 1930, was not well received
by economists who drew their inspiration from Carl Menger and Eugen von
Böhm-Bawerk. Although the macroeconomics found in Keynes's
Treatise is not readily recognizable today as Keynesian theory,
the theoretical building blocks and methods of construction are largely
the same. The macroeconomic aggregates of saving, investment, and output
are played off against one another in a manner that establishes
equilibrium values for the interest rate and price level.
In an extended critique
of this early rendition of Keynesianism, F. A. Hayek found many
inconsistencies and ambiguities, but his most fundamental
dissatisfaction derived from Keynes's mode of theorizing—from his
"language and apparatus": "Mr. Keynes's aggregates conceal the most
fundamental mechanisms of change" (Hayek, 1931a: p. 227). Keynes had
argued that changes in the rate of interest have no significant effect
on the rate of profit for the investment sector as a whole. Hayek's
point was that profit reckoned on a sector-wide basis is not a
significant part of the market mechanism that governs production
activity. A change in the rate of interest means that profit prospects
for some industries rise, while profit prospects for others fall. The
systematic differences in profits rates among industries, and not the
average or aggregate of those rates, are what constitute the relevant
"mechanisms of change."
There were fundamental shifts in Keynes's thinking during the six years
between his Treatise and his General Theory, but none that
could be considered responsive to Hayek's critique. In the General
Theory, impenetrable uncertainty about the future clouded the
decision processes of investors and wealth holders; the interest rate
became a product of convention and psychology, largely if not wholly
detached from economic reality; changes in market conditions were
accommodated by income adjustments rather than price or interest-rate
adjustments; and unemployment equilibrium became the normal state of
affairs. Selective
readings of what Keynes actually wrote—as well as creative readings of
what he may have intended to write—have given rise to conflicting
interpretations of Keynes's message. In many instances, disagreements
about Keynesian answers to macroeconomic questions derive from
disagreements about what the relevant macroeconomic questions are. Is
Keynes asking: How, in particular, do markets actually work? Or is he
asking: Why, in general, do they not work well? More specifically, does
the interest-inelastic demand for investment funds enter importantly
into his theory, or does the instability of investment demand, driven as
it is by the "animal spirts" of the business world, swamp any
consideration of interest inelasticity? Does the highly interest-elastic
demand for money enter importantly into his theory, or does the
instability of money demand, based as it is on the "fetish of
liquidity," swamp any consideration of interest elasticity?
Interpreters such as G.
L. S. Shackle (1974) and Ludwig M. Lachmann (1986, pp. 89-100 and
passim), who focus on the pervasive uncertainty that enshrouds
the future and the utter baselessness of long-term expectations, impute
great significance to the animal spirts, as they affect the bulls and
bears in investment markets, and to the fetish of liquidity, as it
affects their willingness to make a commitment to either side of any
market. Wealth holders are sometimes more willing, sometimes less
willing, to part with liquidity; speculators are sometimes bullish,
sometimes bearish, in their investment decisions. Such behavior gives
rise to continuously changing market conditions and to a continuously
changing pattern of prices. The sequential patterns of prices in a
market economy, predictable by neither economist nor entrepreneur, are
likened to the sequential patterns of cut glass in a kaleidoscope.
There certainly is no
reason to expect, in this vision of the market process, that prices,
wage rates, and interest rates will be consistent with the coordination
of production activities over time or even that they will be consistent
with the full employment of labor at any one point in time. "Keynesian
Kaleidics," as this strand of Keynesianism is sometimes called, is not
so much a particular understanding of the operation of a market economy
as a denial that any such understanding is possible. Clearly, Friedman
is not a Keynesian in this sense.
Interpreters such as John
Hicks (1937) and Alvin Hansen (1947), whose focus penetrated Keynes's
cloud of uncertainty, have identified a set of behavioral relationships
which, together with the corresponding equilibrium conditions, imply
determinate values of total income and the interest rate.(1)
In the most elementary formulation, net investment (I) must equal net
saving (S), and the demand for liquidity (L) must be accommodated by the
supply of money (M). This ISLM framework, more broadly called
income-expenditure analysis, has in many quarters—but not in Austrian
ones—come to be thought of as the analytical apparatus common to all
macroeconomic theories. Appropriate assumptions about the stability of
investment and money demand, interest elasticities, and price and wage
rigidities allow for the derivations of either Keynesian or Monetarist
conclusions.
Friedman vs. Keynes Within the context of
income-expenditure analysis, it is appropriate to think of Friedman's
Monetarism as being directly opposed to Keynesianism. Although both
Keynesianism and Monetarists accept the same high level of aggregation,
one which closes off issues believed by the Austrians to be among the
most important, they have sharp disagreements about the nature of the
relationships among these macroeconomic aggregates. Several such
disagreements, many as reported or implied by Friedman (1970), are
included in the following list.
1. Keynesians believe that the interest rate, largely, if not
wholly, a monetary phenomenon, is determined by the supply of and
demand for money. Monetarists believe that the interest rate, largely
a real phenomenon, is determined by the supply of and demand for
loanable funds, a market which faithfully reflects actual
opportunities and constraints in the investment sector.
2. In the Keynesian vision, a change in the interest rate has
little effect on (aggregate) investment; in the Monetarist vision, a
change in the interest rate has a substantial effect on (aggregate)
investment. This difference reflects, in large part, the short-run
orientation of Keynesians and the long-run orientation of
Monetarists.
3. Keynesians conceive of a narrowly channeled mechanism through
which monetary policy affects national income. Specifically, money
creation lowers the interest rate, which stimulates investment and
hence employment, which, in turn, give rise to multiple rounds of
increased spending and increased real income. The nearly exclusive
focus on this particular channel of effects, together with the belief
that investment demand is interest-inelastic, accounts for the
Keynesian preference for fiscal policy over monetary policy as a means
of stimulating or retarding economic activity. Government spending has
a direct effect on the level of employment; money creation has only an
indirect and weak effect. Monetarists conceive of an extremely
broad-based market mechanism through which money creation stimulates
spending in all directions—on old as well as new investment goods, on
real as well as financial assets, on consumption goods as well as
investment goods. Nominal incomes are higher all around as a direct
result of money creation, but with a stable demand for money in real
terms, the price level increases in direct proportion to nominal money
growth so that real incomes are unaffected.
4. Keynesians believe that long-run expectations, which have no
basis in reality in any case, are subject to unexpected change.
Economic prosperity is based on baseless optimism; economic
depression, on baseless pessimism. Monetarists believe that profit
expectations reflect, by and large, consumer preferences, resource
constraints, and technological factors as they actually exist.
5. Keynesians believe that economic downturns are attributable to
instabilities characteristic of a market economy. A sudden collapse in
the demand for investment funds, triggered by an irrational and
unexplainable loss of confidence in the business community, is
followed by multiple rounds of decreased spending and income.
Monetarists believe that economic downturns are attributable to inept
or misguided monetary policy. And unwarranted monetary contraction
puts downward pressure on incomes and on the level of output during
the period in which nominal wages and prices are adjusting to the
smaller money supply.
6. Keynesians believe that in conditions of economy-wide
unemployment, idle factories, and unsold merchandise, price and wages
will not adjust downward to their market-clearing levels—or that they
will not adjust quickly enough, or that the market process through
which such adjustments are made works perversely as falling prices and
falling wages feed on one another. Monetarists do not believe that
such perversities, if they exist at all, play a significant role in
the market process. They believe instead that prices and wages can and
will adjust to market conditions. The fact that such adjustments are
neither perfect nor instantaneous is, in the Monetarists' judgment, no
basis for advocating governmental intervention. A market process that
adjusts prices and wages to existing market conditions is preferable
to a government policy that attempts to adjust market conditions to
existing prices and wages. An Austrian Perspective on the
Common Language and Apparatus The contrast between Keynesianism,
as interpreted by Hicks and Hansen, and Monetarism, as outlined by
Friedman (Gordon 1974), is based upon their common analytical framework.
The recognition of this common framework underlies the assessment by
Gerald P. O'Driscoll and Sudha R. Shenoy (1976, p. 191) that
"Monetarism... does not differ in its fundamental approach from the
other dominant branch of macroeconomics, that of Keynesianism."(2)
But the Keynesian/Monetarist income-expenditure analysis, no less than
the analysis in Keynes's Treatise on Money, is subject to Hayek's
early criticism. The aggregates conceal the most fundamental mechanisms
of change. While many of the conflicting claims can be reconciled in
terms of the short-run and long-run orientation of Keynesians and
Monetarists, respectively, and in terms of their contrasting
philosophical orientations, neither vision takes into account the
workings of failings of the market mechanisms within the investment
aggregate. Austrian
macroeconomics(3)
is set apart from both Keynesianism and Monetarism by its attention to
the differential effects of interest rate changes within the investment
sector, or—using the Austrian terminology—within the economy's structure
of production. A fall in the rate of interest, for instance, brings
about systematic changes in the structure of production. A lower
interest rate favor production for the more distant future over
production for the more immediate future; it favors relatively more
time-consuming or roundabout methods of production as well as the
production and use of more durable capital equipment. The "mechanisms of
change" activated by a fall in the interest rate consist of profit
differentials among the different stages of production. The market
process that eliminates these differentials reallocates resources away
from the later stages of production and into the earlier stages; it
gives the intertemporal structure of production more of a future
orientation. The ultimate
consequence of this capital restructuring brought about by a decrease in
the rate of interest depends fundamentally upon the basis for the
decrease. If the lower rate of interest is a reflection of an increased
willingness to save on the part of market participants, then the capital
restructuring serves to retailor the production process to fit the new
intertemporal preferences. Continual restructuring of this sort—along
with technological advancement—is the essence of economic growth. If,
however, the lower rate of interest is brought about by an injection of
newly created money through credit markets, then the capital
restructuring, which is at odds with the intertemporal preferences of
market participants, will necessarily be ill-fated. The period marked by
the extension of artificially cheap credit is followed by a period of
high interest rates when cumulative demands for credit have outstripped
genuine saving. The artificial, credit-induced boom will necessarily end
in a bust. The Austrian
theory of the business cycle identifies the market process that turns an
artificial boom into a bust. The misallocation of resources within the
investment sector requires a subsequent liquidation and reallocation.
The more extensive the misallocation, the more disruptive the
liquidation. After the prolonged period of cheap credit during the
1920s, for instance, a substantial reallocation of capital from
relatively long-term projects to relatively short-term ones was
essential for the restoration of economic health. A higher than normal
level of unemployment characterized the period during which workers who
lost their jobs in the over capitalized sectors of the economy were
absorbed into other sectors.(4)
Accounting for the
artificial boom and the consequent bust is no part of Keynesian
income-expenditure analysis, nor is it an integral part of Monetarist
analysis. The absence of any significant relationship between boom and
bust is an inevitable result of dealing with the investment sector in
aggregate terms. The analytical oversight derives from theoretical
formulation in Keynesian analysis and from empirical observation in
Monetarist analysis. But from an Austrian perspective, the differences
in method and substance are outweighed by the common implication of
Keynesianism and Monetarism, namely that there is no boom-bust cycle of
any macroeconomic significance.
In the General
Theory, the interest rate is sometimes treated as if it depends on
monetary considerations alone, such as in Chapter 14, where Keynes
contrasts his own theory of interest with the classical theory. The
supply of and demand for money (alone) determine the equilibrium rate of
interest, which in turn determines the level of investment and hence the
level of employment. The essentially one-way chain of determinacy makes
no allowance for the pattern of saving and investment decisions to have
any effect upon the rate of interest While this rarified version of
Keynesian macroeconomics has not survived the translation from the
General Theory to modern textbooks, it can by easily represented
as a special case of the ISLM construction, one in which the LM curve is
a horizontal line that moves up or down with changes either in liquidity
preferences or in the supply of money. Using more formal terminology,
the system of equations is recursive, such that the rate of interest can
be determined independently of the other endogenous variables. Within
this framework, there is simply no scope for a boom-bust cycle as
envisioned by the Austrians.
In the more general ISLM
framework, the rate of interest and the levels of investment, saving,
and income are determined simultaneously rather than sequentially, but
Keynes downplays any cyclical movements in these magnitudes that might
result from the two-way chains of causation. He emphasizes instead the
possibility of economic stagnation—of enduring secular unemployment. In
Chapter 18 of the General Theory, his stocktaking chapter, Keynes
envisions an economy in which there are minor fluctuations of
income—and hence of employment—around a level of income
substantially below the economy's full-employment potential. Only
in his "Short Notes Suggested by the General Theory" does Keynes attempt
to account for the cyclical fluctuations considered inherent in the
nature of capitalism. The crises, or upper turning point, is caused by a
change in long-term profit expectations that motivate the business
community—expectations that are "based on shifting and unreliable
evidence" and are "subject to sudden and violent changes" (Keynes, 1936,
p. 315). The recovery, or lower turning point, is governed by the
durability of the capital in existence at the time of the crisis. But in
the Keynesian vision, the economy recovers only to some equilibrium
level of unemployment, not to its full-employment potential.(5)
More tellingly, Keynes
perceives a one-way chain of causation from money supply as a policy
variable to investment (and hence employment) as a policy goal. The
monetary authority increases the money supply; the interest rate falls
until money demand exhausts supply; investment increases, as does
employment. A new equilibrium is established in which the rate of
interest is permanently lower and the levels of investment and
employment are permanently higher. In the income-expenditure framework,
the temporal pattern of investment does not enter into the analysis, and
the distinction between a genuine boom and an artificial boom is itself
an artificial distinction.
Friedman's Plucking Model Keynesian analysis does not
disprove the Austrian idea that a credit-induced boom leads to a bust.
By adopting a higher level of aggregation, it simply fails to bring this
issue into focus. Nor is the Austrian idea disproved by the Monetarists,
who rely on a highly aggregated statistical analysis for clues about the
relationship between booms and busts. Levels of aggregate output that
characterize a typical downturn do not correlate well with a preceding
upturn, but the magnitude of the downturn does seem to be related to the
magnitude of the succeeding upturn. In the Monetarists' empirical
analysis, there appears to be a bust-boom, rather than a boom-bust
cycle.
Friedman
(1969b, pp. 27-277) has offered what he calls a "plucking model" of the
economy's output over the period 1879-1961.(6)
Imagine a string glued to the underside of an inclined plane. The degree
of incline represents long-run secular growth in output. If the string
were glued at every point along the inclined plane, it would represent
an economy with no cyclical problems at all. Cyclical problems of the
type actually experienced can be represented by plucking the string
downward at random intervals along the inclined plane. In this
representation of the economy's actual growth path, the economic process
that gives us healthy secular growth occasionally comes "unglued." While
the consequent sagging of economic performance is unrelated to the
previous growth, recovery to the potential growth path is necessarily
related to the extent of the sag. But for the slight degree of incline,
there would be a one-to-one relationship between downturn and subsequent
recovery. On the basis of
this Monetarist representation, the Austrian ideas are rejected, not so
much on the basis of the answers offered, but on the basis of the
questions asked. What is the market process that turns a boom into a
bust? There is no empirical evidence that suggests any such process to
be at work. What is the market process that turns a slump into a
recovery? This is the empirically relevant question, in the Monetarists'
view. The suggested answer, which has the flavor of textbook
Keynesianism, involves the conventional operation of market forces in
the face of institutional price and wage rigidities (Ibid., p.
274). As Friedman clearly
recognizes, the dismissal of the possibility of a boom-bust cycle and
the empirical identification of the bust-boom cycle both derive from the
inherent asymmetry of deviations from the potential growth path. The
economy's output can fall significantly below its potential level, but
it cannot rise significantly above it. The fact that Friedman's
formulation is in terms of aggregate output, however, suggests that the
Austrian critique of early Keynesianism is equally applicable to modern
Monetarism: Professor Friedman's aggregates conceal the most fundamental
mechanisms of change. The
economy's output consists in the output of consumer goods plus the
output of investment goods. An artificially low rate of interest can
shift resources away from the former category and into the latter. More
importantly, it can skew the pattern of investment activities toward
production for the more distant future; it can overcommit the investment
sector to relatively long-term projects. Such money-induced distortions
are wholly consistent with the changes in aggregate output over
the nine-decade period studied by Friedman.
In terms of the plucking
model, the Monetarists observe that some segments of the string are
glued fast to the inclined plane and other segments are not. But in
terms of their macroeconomic aggregates, there is nothing in the nature
of the string—or the glue—as we move along a glued section toward an
unglued one that explains why the glue fails. Monetarists instead
conceive of the string as plucked down by some force (an inept central
bank) that is at work only on the segments that constitute the downturn.
The Austrians, working at a lower level of aggregation, examine the
makeup of the string (the allocation of resources within the investment
sector) and the consistency of the glue (the rate on interest and
pattern of prices upon which resource allocation has been based during
the boom). They conclude that if the interest rate has been held
artificially low by monetary expansion, the intertemporal allocation of
resources is inconsistent with actual intertemporal preferences and
resource availabilities. The string is destined to become unglued.
Contrasting Theories of Interest Friedman's plucking model
is more notable for the aspects of the market process it ignores than
for the general movements of macroeconomic aggregates it represents.
Movements in the rate of interest and consequences of those movements
for the allocation of resources within the macroeconomic aggregates play
no role in either Monetarism or Keynesianism. In fact, the very choice
of a particular level of aggregation reflects a judgment about which
aspects of the market process are significant enough to be included in
macroeconomic theory. Relationships between the aggregates are
significant; relationships within the aggregates are not. The
aggregates chosen by Keynes were accepted by Friedman, indicating that
the two theorists made the same judgment in this regard.
Their bases for judgment,
however, are not the same. Opposing views about the nature and
significance of the rate of interest and of changes in that rate
underlie the decisions by Keynes and Friedman to neglect the
considerations that are so dominant in Austrian macroeconomics. All
three views can be identified in terms of the interest-rate dynamics
first spelled out by the Swedish economist Knut Wicksell. The
natural rate of interest, so called by Wicksell, is the rate
consistent with the economy's capital structure and resource base. If
allowed to prevail, it would maintain an equilibrium between saving and
investment—and would also keep constant the general level of prices. The
bank rate of interest, by contrast, is a direct result of bank
policy. Credit expansion lowers the bank rate; credit contraction raises
it. Macroeconomic equilibrium can be maintained, according to Wicksell,
only by a monetary policy that keeps the bank rate equal to the natural
rate.(7)
Therefore, a banking system that pursues a cheap-credit policy (by
holding the bank rate of interest below the natural rate) throws the
economy into macroeconomic disequilibrium.
While the Austrians,
beginning with Mises (1971), adopted Wicksell's formulation as the basis
for their own theorizing, deviating from it only in terms of the
consequences of a credit-induced macroeconomic disequilibrium, neither
Keynesians no Monetarists share Wicksell's concern about the
relationship between the bank rate and the natural rate. In summary
terms, Keynes denied that the concept of the natural rate had any
significance; Friedman, who accepts the concept, denies that there can
be deviations of any significance from the natural rate.
Although Keynes had
incorporated a modified version of Wicksell's natural rate in his
Treatise on Money, he could find no place for it in his
General Theory. In the earlier work, full employment was the
norm; and the (natural) rate of interest kept investment in line with
available saving. In the later work, the rate of interest is determined,
in conjunction with the supply of money, by irrational psychology (the
fetish of liquidity), and the level of employment accommodates itself to
that interest rate. Keynes argued that " there is ... a different
natural rate of interest for each hypothetical level of employment" and
concluded that "the concept of the 'natural' rate of interest ... has
[nothing] very useful or significant to contribute to our analysis"
(Keynes 1936, pp. 242-43).
In Friedman's Monetatism,
competition in labor markets gives rise to a market-clearing wage rate,
which singles out from Keynes's hypothetical levels of employment the
one level for which labor supply is equal to labor demand. The concept
of the natural rate of interest, that is, the rate that clears the loan
market and keeps investment in line with savings, fits as naturally into
the Monetarists' thinking as it fits into Wicksell's. In fact, Friedman
coined the term "natural rate of unemployment" to exploit the similarity
between the Wicksellian analysis of the loan market and his own analysis
of the labor market (Friedman, 1976, p. 228). According to Wicksell, a
discrepancy between the bank and the natural rates of interest gives
rise to a corresponding discrepancy between saving and investment;
according to Friedman, a discrepancy between the actual and the natural
rates of unemployment reflects a corresponding discrepancy between the
real wage rate, as perceived by employers, and the real wage rate, as
perceived by employees. Macroeconomic disequilibrium plays itself out in
ways that eventually eliminate such discrepancies in loan markets (for
Wicksell) and in labor markets (for Friedman).
While the Wickesll-styled
dynamics in labor markets have been of some concern to Monetarists, the
corresponding loan-market dynamics play no role at all in Monetarism.
The bank rate of interest never deviates from the natural rate for long
enough to have any significant macroeconomic consequences. Whatever
effects there are of minor and short-lived deviations are trivialized by
Friedman as "first-round effects" (Gordon, 1974, pp. 146-48). That is,
the initial lending of money, the first round, is trivial in comparison
to the subsequent rounds of spending, which may number twenty-five to
thirty per year. Friedman summarily dismisses all such interest-rate
effects, as spelled out by modern Keynesians (Tobin) and by Austrians
(Mises), and affirms that his own macroeconomics is characterized by its
according "almost no importance to first-round effects" (Ibid., p
147). Austrian
macroeconomics is distinguished from the macroeconomics of both Keynes
and Friedman by its acceptance of the Wicksellian concept of the natural
rate and by its attention to the consequences of a bank-rate deviating
from the natural rate. It is distinguished from Wicksellian
macroeconomics, however, in terms of the particular consequences taken
to be most relevant. For Wicksell (1936, pp. 39-40 and passim), a
deviation between the two rates puts upward pressure on the general
level of prices. If, for instance, the natural rate rises as a result of
technological developments, inflation will persist until the bank rate
is adjusted upward. A relatively low bank rate may create "tendencies"
for capital to be reallocated in ways not consistent with the natural
rate, but those tendencies do not, in Wicksell's formal analysis, become
actualities. Real factors continue to govern the allocation of capital,
while bank policy affects only the general level of prices
(Ibid., pp. 90 and 143-44). But because both the Swedish and the
Austrian formulations are based upon Böhm-Bawerkian capital theory, the
particular "tendencies" identified by Wicksell correspond closely to the
most relevant "mechanisms of change" spelled out by Hayek. Also,
Wicksell's informal discussion, which accompanies his formal exposition,
gives greater scope for actual quantity adjustments within the capital
structure (Ibid., pp. 89-92).
For the Austrians, the
effects of a cheap-credit policy on the general level of prices is, at
best, of secondary importance. If in fact the discrepancy between the
two rates of interest is attributable to technological developments, as
Wicksell believed it to be (Ibid., p. 118), then the resulting
increase in the economy's real output would put downward pressure on
prices, largely, if not wholly, offsetting the effect of the credit
expansion on the price level. If, alternatively, the discrepancy is more
typically attributable to inflationist ideology, as Mises (1978a, pp.
134-38) came to believe, then, in the absence of any fortuitous
technological developments, the credit expansion would put upward
pressure on prices in general. Still, this general rise in prices, this
fall in the purchasing power of money, is of less concern to the
Austrians than the changes in relative prices that result from the
artificially low bank rate of interest.
The "tendencies" for
reallocation within the capital sector acknowledged by Wicksell become
"actualities" in the Austrian view. The market process is not so
fail-safe as to preclude any investment decision not consistent with the
overall resource constraints. Newly created money put into the hands of
entrepreneurs at an artificially low interest rate allows them to
initiate production processes that eventually conflict with the
underlying economic realities (Hayek, 1967c, pp. 69-100). Where Wicksell
claimed that tendencies toward reallocation do not become actualities,
the Austrians claim that actual reallocations induced by credit
expansion are unsustainable. The artificial boom ends in a bust.
In his discussion of
Keynesian and Austrian concerns about interest-rate effects, Friedman
claims that the importance of ultimate effects, as compared to
first-round effects, is an empirical question (Gordon 1974, p. 147). The
Austrians recognized that ultimately, after boom, bust, and
recovery, empirical analysis would reveal no lingering effects of the
initial credit expansion on the bank rate of interest relative to the
natural rate. The economy overall would be less wealthy for having
suffered a boom-bust cycle, and hence the natural rate itself might well
be higher. But the relative magnitudes of the initial and ultimate
effects is no basis for ignoring the market process that produced them.
The first-round effects constitute the initial part of a market process
that plays itself out within capital and resource markets; the loss of
wealth and possible increase in the natural rate is the ultimate effect
of that same market process.
The Dynamics of an Unsustainable Boom Although Friedman
does not engage in process analysis in his treatment of the interest
rate as it is affected by credit expansion, he does engage in process
analysis in his treatment of the wage rate as it is affected by
price-level inflation (Friedman, 1976, pp. 221-29). The first-round
effects consist of a discrepancy between two wage rates: the rate as
perceived by the workers and the rate as perceived by the employer. Such
a discrepancy occurs in the early phase of an inflation because the
employer immediately perceives the difference between the price he pays
for labor and the newly increased price of the one product he produces,
while workers perceive, but belatedly, the general increase in the
prices they pay for consumer goods The ultimate effect of price-level
inflation is a rising nominal wage rate, which maintains a real wage
rate—as perceived (correctly) by both employers and workers—consistent
with the natural rate of unemployment.
Friedman could have made
the claim, in connection with these labor-market dynamics, that "the
importance of the ultimate effects in comparison to the first-round
effects is an empirical question." Undoubtedly, direct empirical
testing—if data could be obtained on the differing perceptions of wage
rates—would show the ultimate effects to be dominant. But Friedman does
not dismiss his own analysis with a rhetorical question about an
empirical test. Instead, he sees the first-round effects as the initial
part of a market process that plays itself out within labor markets, and
he sees the reestablishment of the natural rate of unemployment as the
ultimate effect of that same process.
There is empirical
evidence consistent with both the Monetarist treatment of labor markets
and the Austrian treatment of credit markets. The unsustainablility of
an inflation-induced boom in labor markets and of a credit-induced boom
in capital markets is suggested by a natural rate of interest and a
natural rate of unemployment that are independent of monetary policy.
Data on inflation rates and unemployment rates for the last several
decades must be accounted for in terms of some market process through
which monetary expansion has an initial effect, but not a lasting one,
on real magnitudes. Whether the most relevant market process is one
working through labor markets or one working through credit markets is a
matter of logical consistency, plausibility, and historical
relevance.(8)
And, of course, Monetarist labor-market dynamics and Austrian
capital-market dynamics can be seen as partial, complementary accounts
of the same, more broadly conceived market process.
This comparison of
Monetarism and Austrianism in the context of the dynamics of an
unsustainable boom seems to create an alliance between these two schools
against Keynesianism. The allied account of an artificial boom that
contains the seeds of its own destruction stands in contrast to the
Keyensian account of a bust attributable to a sudden and fundamentally
unexplainable loss of confidence in the business community. But the
alliance is only a tactical one. Any theory of a boom-bust cycle is
inconsistent with Friedman's plucking model, which suggests that there
are no such cycles to be explained.
The original context in
which Friedman offered his account of the inflation-induced labor market
dynamics makes the inconsistency understandable. Friedman was not
attempting to identify a market process that fits neatly into his own
Monetarism. Instead, he was demonstrating the fallacy of a politically
popular Keynesian belief that there is a permanent trade-off between
inflation and unemployment. Based upon the empirical study done by A. W.
Phillips in the late 1950s, many Keynesians came to believe that the
inverse relationship between rising nominal wages and unemployment
constituted a menu of social choices and that policymakers should
acknowledge the preferences of the electorate by moving the economy to
the most preferred combination of inflation and unemployment.
Friedman was willing to
do battle with the Keynesian optimizers on their own turf.
Accounting for the inverse relationship in terms of a misperception of
wages, he was able to show that the alleged trade-off existed only in
the short run and therefore did not constitute a sound basis for policy
prescription. There is no evidence, however, that he considered these
labor-market dynamics to be an integral part of his own macroeconomics,
although some Monetarists, notably Edmund S. Phelps (1970), and most
textbook writers have taken them to be just that.(9)
Neither Keynesianism, as represented by ISLM analysis, nor Monetarism,
as represented by Friedman's plucking model, acknowledges the boom-bust
cycle as a part of our macroeconomic experience. Austrianism is set
apart from the other two schools in this regard. And, by adopting a
fundamentally different framework at a lower level of aggregation, the
Austrians have been able to identify the capital-market dynamics
essential to the understanding of such cycles.
A Summary Assessment: The Wicksellian Watershed and the Austrian
Sieve In the broad sweep of the history of macroeconomic
thought, the Wicksellian theme, in which there can be a temporary but
significant discrepancy between the bank rate and the natural rate of
interest, constitutes an important watershed. A significant portion of
twentieth-century macroeconomics can be categorized as variations of
this Wicksellian theme. Included indisputably in this category are
followers of Wicksell in Sweden: Gustav Cassel, Eric Lindahl, Bertil
Ohlin, and Gunner Myrdal; Wicksell-inspired theorists in Austria: Ludwig
von Mises and, following him, F. A. Hayek; and British theorists working
in the tradition of the Currency school: Ralph Hawtrey, Dennis
Robertson, and taking his cue from the Austrians, the early Lionel
Robbins. Excluded from
this category are those theorists who deny, ignore, or downplay the
Wicksellian theme, typically by adopting a level of macroeconomic
aggregation too high for that theme, in any of its variations, to
emerge. Exemplifying these theorists are Irving Fisher and, following
him, Milton Friedman. Even Don Patinkin, who draws heavily on Wicksell's
ideas about the dynamics of price-level adjustments, belongs to this
group. His chosen level of aggregation, which combines consumer goods
and investment goods into a single aggregate called commodities,
precludes from the out set any non-trivial consequence of the
discrepancy between the bank rage and the natural rate.
Axel Leijonhufvud (1981,
p. 123) bases his own interpretation of Keynes on a similar grouping of
theorists. Wicksell and Fisher are at the headwaters of two separate
traditions labeled "Saving-Investment Theories" and "Quantity Theory."
Leijonhufvud makes Keynes out to be a Wicksellian, but he does so only
by patching together a new theory with ideas taken selectively from the
Treatise and the General Theory. This interpolation
between Keynes's two books is designated "Z-theory" (Ibid., pp. 164-69).
Drawing from the first book, it allows for a natural rate of interest
from which the bank rate can diverge, and drawing from the second
book, it allows for the resulting disequilibrium to play itself out
through quantity adjustments rather than through price adjustments.
Leijonhufvud's hybrid
Keynesian theory gives play to the Wicksellian theme and fits
comfortably in the list of "Saving-Investment" theories. With the
exposition of his "Z-theory," Leijonhufvud has clearly identified
himself as a Wicksellian.(10)
To claim, however, that Keynes himself was a Wicksellian is to engage in
counter-factual doctrinal history. In the Treatise, the
discrepancy between the bank rate and the natural rate did not have a
significant effect on the saving-investment relationship; in the
General Theory, significant disturbances to the saving-investment
relationship were not attributed to a discrepancy between the two rates.
By offering his Z-theory
in support of Keynes's candidacy as a Wicksellian, Leijonhufvud tacitly
admits that Keynes had actually managed to skirt the Wicksellian idea
first on one side, then of the other. The categorization of theorists
defended in this chapter differs importantly from Leijonhufvud's in that
Keynes is transferred—on the basis of what he actually wrote—to the
other side of the Wicksellian watershed. Keynes's chosen level of
aggregation, together with his neglect of Wicksellian capital-market
dynamics, establishes an important kinship to Fisher, Friedman, and
Patinkin. Hayek's early
"Reflections on the Pure Theory of Money" might well have been entitled
"Is Keynes a Quantity Theorist?" Nearly half a century after his
critique of the Treatise, Hayek explicitly categorized "Keynes's
economics as just another branch of the centuries-old Quantity Theory
school, the school now associated with Milton Friedman" (Minard, 1979,
p. 49). Keynes, according to Hayek, "is a quantity theorist, but
modified in an even more aggregative or collectivist or macroeconomic
tendency" (Ibid.).
The Wicksellian watershed, as employed by Leijonhufvud, makes a
first-order distinction between broad categories of theories on the
basis of subject matter. In one category, the subject is saving and
investment and the market process through which these macroeconomic
magnitudes are played off against one another. In the other category,
the subject is the quantity of money and the market process through
which changes in the supply of or demand for money affect other real and
nominal macroeconomic magnitudes.
An alternative
first-order distinction, more in the spirit of Hayek's critique of
Keynes, is one based on alternative levels of macroeconomic aggregation.
The notion of a Wicksellian watershed might well be supplemented by the
notion of an Austrian sieve. In one broad category of theories, the
level of aggregation is low enough to allow for a fruitful exploration
of the Wicksellian theme. In the other category, the level of
aggregation is so high as to preclude any such exploration. Based on
their high levels of aggregation, then, both Keynesianism and Monetarism
fail to pass through the Austrian sieve. This is the meaning of Hayek's
claim that Keynes is a quantity theorist and of the corresponding claim
that Friedman is a Keynesian.
Bibliography (to be added)
Notes
1. This interpretation is almost
universally attributed to Hicks (on the basis of his early article) and
to Hansen (on the basis of his subsequent exposition). Warren Young
(1987) makes the case that, on the basis of the papers presented at the
Oxford conference in September 1936, credit for the ISLM formulation
should be shared by John Hicks, Roy Harrod, and James Meade.
2. Friedman clearly recognizes his
kinship to Keynes in terms of their fundamental approach: "I believe
that Keynes's theory is the right kind of theory in its simplicity, its
concentration of a few key magnitudes, its potential fruitfulness. I
have been led to reject it not on these grounds, but because I believe
that it has been contracted by experience" (Friedman, 1986, p. 48).
Allan H. Meltzer identifies the type of theorist that produces Keynes's
kind of theory: "Keynes was the type of theorist who developed his
theory after he had developed a sense of relative magnitudes and of the
size and frequency of changes in these magnitudes. He concentrated on
those magnitudes that changed most, often assuming that others remained
fixed for the relevant period" (Meltzer, 1988, p. 18). This method is
not as laudable as it may seem. If subtle changes in credit and capital
markets induce significant but difficult-to-perceive changes in the
economy's capital structure, then Keynes's—and Friedman's—method is much
too crude. Surely, the job of the economist is to identify market
processes even when—or especially when—the relevant market forces do not
have direct or immediate consequences for some macroeconomic
aggregate.
3. Austrian macroeconomic
relationships are spelled out in various contexts by Ludwig von Mises
(1966), F. A. Hayek, (1967), Lionel Robbins (1934), Murray Rothbard
(1970, 1983), Gerald P. O'Driscoll, Jr. (1977), and Roger Garrison
(1989, 1986).
4. The aphorism "the bigger the boom,
the bigger the bust" must be applied cautiously. The Austrian theory
links the necessary, or unavoidable, liquidation to the credit-induced
misallocations. It does not imply, as, for example, Gordon Tullock
(1987) seems to believe, that all the actual liquidation during the
Great Depression is to be explained with reference to misallocations
that characterized the previous boom. Much, if not most, of the
liquidation during the 1930s can be attributed, as Rothbard (1983)
indicates, to misguided and perverse macroeconomic and industrial
policies implemented by the Hoover and Roosevelt administrations
5. The relative emphasis on secular
unemployment, as compared to cyclical unemployment, is consistent with
Meltzer's interpretation of Keynes (Meltzer, 1988, pp. 196-210). In most
modern textbooks, involuntary unemployment is taken to mean cyclical
unemployment. In Meltzer's view, which is more faithful to the
General Theory and to Keynes's long-held beliefs about
capitalistic economies, cyclical unemployment is a minor component of
involuntary unemployment (Ibid., p. 126).
6. Although there is no explicit
reference to Hayek or other Austrian theorists in his article, the
plucking model is clearly intended as a basis for rejecting the general
category of theories which account for the boom-bust cycle.
7. It is recognized both by modern
Austrian theorists and by Wicksell's contemporaries that the equivalence
of the bank rate and the natural rate is consistent with price-level
constancy only in the special case of constant output. If the economy is
experiencing economic growth, then maintaining a saving-investment
equilibrium will put downward pressure on prices, and conversely,
maintaining price-level constancy will cause investment to run ahead of
saving.
8. An assessment of the logical
consistency, plausibility, and historical relevance of these two
perspectives on monetary dynamics is undertaken in Bellante and Garrison
(1988).
9. Friedman's Wicksell-styled analysis
of labor-market dynamics stands in direct conflict with his
fourth-listed Key Proposition of Monetarism, according to which "the
changed rate of growth of nominal income [induced by a monetary
expansion] typically shows up first in output and hardly at all in
prices" (Friedman, 1970, p. 23). In his subsequent Phillips curve
analysis, misperceived price increases precede and are the
proximate cause of increases in output. For an extended discussion of
this inconsistency, see Birch et al. (1982); for an attempt at
reconciliation, see Bellante and Garrison (1988, pp. 220-21).
10. But "Leijonhufvud the
Wicksellian" remains a puzzle to modern Austrian economists. In his
exposition of the Wicksellian theme, Leijonhufvud grafted Wicksell's
credit-market dynamics onto neoclassical capital theory and appended the
following note: "Warning! This is anachronistically put in terms of a
much later literature on neoclassical growth. Draining the
Böhm-Bawerkian capital theory from Wicksell will no doubt seem
offensively impious to some, but I do not want to burden this paper also
with those complexities" (Leijonhufvud, 1981, p. 156). Then, in his
restatement of the critical arguments, Leijonhufvud reveals his own
judgment on natters of capital theory: "Like the Austrians,...I would
emphasize the heterogeneity of capital goods and the subjectivity of
entrepreneurial demand expectations." If Leijonhufvud had
emphasized Austrian capital theory as the stage on which the Wicksellian
theme was to be played out, he would have left Keynes in the wings and
followed that theme from Wicksell to Hayek.
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