capitalism

196 Friedman, Milton (1912–2006)
Friedman’s methodological position, adopted by most
of his colleagues at Chicago and eventually a good portion
of the profession, laid the groundwork for important
empirical work and elegant mathematical modeling that
have helped economists better understand the world. It
also placed the Chicago School squarely in opposition to
the Austrian School, whose proponents embraced many of
the same promarket positions as Friedman, but who
argued that economists must base their work on a set of
assumptions that can be demonstrated to be logically correct.
Moreover, the Austrians argued that much empirical
work was of limited value because social scientists cannot
model human behavior in the same way that physical scientists
model their objects of study. One can say, for
instance, that a price control will lead to a shortage, but
the magnitude of that shortage will be difficult, if not
impossible, to predict.
Friedman considered his A Theory of the Consumption
Function, published in 1957, as his “best purely scientific
contribution” to economics. In it, he argues for the “permanent
income hypothesis,” which maintains that people
make consumption decisions based on the permanent component
of their income stream, not on transitory components.
In short, people are forward-looking and act based on
long-term income prospects. This hypothesis has several
implications. First, people tend to smooth their consumption
over their lifetimes. For instance, young people with
high future earning power may rationally accumulate debt
early in life, knowing that they will be able to pay it off as
their incomes increase. Second, tax cuts may not spur consumption
if the public believes those cuts to be only temporary.
The permanent income hypothesis has become one of
the cornerstones of modern macroeconomics.
Although Friedman considered A Theory of the
Consumption Function to be his most significant contribution,
his work in the area of monetary theory was surely his
most influential. Inflation, Friedman famously argued, was
“always and everywhere a monetary phenomenon.” It is not
fundamentally caused by unions demanding higher wages
for their members, thus increasing labor costs and the
prices of goods. Nor is it a product of companies wielding
expansive market power and charging monopolistic prices.
Instead, it is caused by too much money chasing too few
goods. Central banks, Friedman concluded, should focus
narrowly on maintaining price stability and adopt rules that
would ensure such an outcome.
In 1963, Friedman, with Anna J. Schwartz, published
A Monetary History of the United States, 1867-1960. The
book spanned almost a century of monetary history, but
its most important section dealt with what the authors
called “the great contraction.” Friedman and Schwartz
argued that the Great Depression was not caused by the
failings of the market system. Rather, they maintained,
the Federal Reserve had pursued a monetary policy that
was excessively tight and that had led to a sharp decline
in economic activity. A Monetary History was a rare
scholarly achievement: It has had great influence among
both the economics profession and policymakers.
In his 1967 presidential address to the American
Economic Association, Friedman questioned the theoretical
and empirical validity of the “Phillips curve,” a statistical
relationship that purportedly demonstrated a permanent
tradeoff between unemployment and inflation. This tradeoff
implied a set of choices for society. If you wanted greater
employment, you simply had to increase the money supply.
That in turn would produce higher inflation, which might be
acceptable given current circumstances. Conversely, if inflation
became too high, one could simply tighten the money
supply and accept more unemployment. Not surprisingly,
these ideas were popular with activist policymakers.
Friedman challenged these conclusions, arguing that the
tradeoff between unemployment and inflation was temporary
and resulted only from unanticipated changes in
inflation. The public, he claimed, was unlikely to be systematically
fooled, and policymakers could not easily manipulate
the economy. He later recalled,
As employers and workers caught on to what was happening,
any trade-off would disappear. I introduced the concept
of a “natural rate of unemployment” to which the
level of unemployment would tend whatever the rate of
inflation once economic agents came to expect that rate of
inflation. To keep unemployment below the natural level
requires not simply inflation, but accelerating inflation.
Friedman’s argument was later refined and expanded by
economists Edward Prescott and Finn Kydland, and it
would become increasingly accepted as stagflation gripped
the American economy in the 1970s.
While Friedman was engaged in technical economic
research at the highest levels, he also took an active
interest in public-policy issues. In 1962, he published
Capitalism and Freedom, the product of a series of lectures
he gave at Wabash College in 1956. Although directed at a
general audience, the book contains sophisticated and
sometimes technical arguments for a number of free-market
proposals, all presented in clear and accessible prose. For
instance, Friedman called for the establishment of unilateral
free trade and flexible exchange rates, introduced the
idea of school vouchers, and argued for the privatization of
social security. Also, as the title of the book
suggests, Friedman argued that economic freedom is a
necessary prerequisite for political freedom, a proposition
that has been criticized by many political scientists. In
Capitalism and Freedom, Friedman made it clear that he
believed some state involvement was necessary if a stable
and prosperous society were to function. “The consistent
liberal is not an anarchist,” he wrote. Yet he later rejected