Quarterly esssays (in English and French) on the theme "Querying economic orthodoxy"

No. 57 - September 2012

What’s wrong with Milton Friedman’s economics?


Underlying most arguments for a free market is a mistaken assumption that free markets and freedom are one and the same thing. They are not.
Howard Schwartz, What Color Tie Do You Vote For, see www.freedomandcapitalism.com 

A standard-bearer for laisser-faire

Milton Friedman (1912 – 2006), the celebrated University of Chicago economist, is enormously admired in his own profession. Ben Bernanke, Governor of the US Federal Reserve, whose wisdom, erudition and practical leadership of the Fed in very difficult times command respect, said in 2002 that among economic scholars, Friedman has no peer.1 Paul Krugman, hardly the warmest friend of free-market economics, wrote in 2007 that I regard him as a great economist and a great man.2 Others’ enthusiasm is less restrained.

Since I am not writing primarily for professional economists, I am not going to discuss here Friedman’s technical, academic texts on economic theory. But apart from his academic research, Friedman produced a vast quantity of essentially propagandist writings, which have been very widely read and have had much influence on economic policies in the USA, in Europe, in Latin America and elsewhere. In my view, there is much that is wrong with the ideas put forward in Friedman’s popular free-market evangelism, and these ideas have had many harmful consequences.    

For many years Friedman led the ‘conservative’ assault upon the mixed-economy strategies that prevailed in the mid-twentieth century. He explicitly favored a return to nineteenth-century laisser-faire.

We find a very clear and simple exposition of his project in a lecture he gave in Singapore in 1981, entitled The Invisible Hand in obvious reference to Adam Smith. Here he sets out his belief that the great worldwide movement towards free-market capitalism, that began with the eighteenth-century classical economists – Smith, Ricardo, Turgot and others – was and is the only true path to human progress.

He describes this global trend in euphoric terms. For example: in 1867, when the Meiji restoration occurred, the new men who ruled Japan were automatically ‘infected’, as some would say, or ‘affected’, as I would say, by this trend in opinion.3 Note the word automatically. The epidemic was irresistible; everyone caught the bug.

Yet, he continues, by the late nineteenth century, though laisser-faire apparently dominated policy and had been highly successful, the trend of opinion in the world was turning the other way. Fabian socialism was on the rise. Dicey4 dates the turn in opinion as occurring in Britain around 1880 to 1890. However, the new trend did not have any appreciable effect on policy until the early twentieth century.5

This last sentence is far from accurate. In Britain, Acts of Parliament regulating conditions of work in factories and mines were passed throughout the nineteenth century; there were ten such Acts between 1802 and 1891, and though the earlier ones were ineffective, the later Acts did indeed bite. Labor unions were legalized by the Trade Union Act 1871.    

Friedman, like other modern free-marketeers, declines to recognize the fact that the opponents of laisser-faire had a case. He barely mentions the exorbitant inequalities, the miserable condition of the working classes, the wrenching instabilities, that tarnished the ‘glories’ of the first free-market revolution. For him, the ‘counter-revolution’ that began in the second half of the nineteenth century was simply a perverse event that should never have happened.

Stuck in the eighteenth century

Friedman continues: the major problems which face us…are inflation and slow economic growth.6 Like others of his kind, he appears to recognize no limits to a strategy of endless expansion. Elsewhere he ridicules the Club of Rome report Limits of Growth (1972): they said we have to adjust our sights, we must recognize that there are limits to growth…This approach is completely wrong.7 Furthermore, from an economic point of view, oil is not an exhaustible resource…we are not going to have a worldwide shortage of energy.8

Classical economics, which claimed that free markets would open the gates to a rosy future of perpetual (if not continuous) growth, was born in an age when world population was still well below one billion. Demographers estimate a total of around 720 million in 1750, when Smith was preparing to write his Wealth of Nations. His world was one-tenth as populous as ours. In those days, there was no serious danger of exhaustion of natural resources.      

But today, the ‘neoclassical’ economics of Friedman and his countless followers is still stuck in the eighteenth century. It is still implicitly based on assumptions that were realistic 250 years ago, such as: a small human race that does not make unsustainable demands on the earth’s resources; an economy of small businesses, each owned and managed by a few individuals; and high natural barriers to competition, due to slow and costly transport and communications.

Friedman was a prolific writer and speaker who pontificated on a wide range of economic issues. Here we shall look at five of the most important.

Monetary policy

Friedman is best known – or most notorious – for his theory of monetarism, which for practical purposes is based on two main propositions:

Inflation is caused solely by excessive growth in the supply of money (that is, banknotes and coin in circulation plus customers’ deposits with banks); thus, inflation is always and everywhere a monetary phenomenon.9

Therefore, government should ensure that money supply always increases at a slow and steady rate; this strategy will ensure economic stability with little or no inflation.

Central banks are supposed to regulate the supply of money through their interaction with commercial banks, which ‘create’ money by lending to customers. A central bank may instruct the banks under its supervision to increase their lending by no more than, say, 5% a year; but this kind of direct credit control is now out of favour. A more usual method today is to require the banks to put some of their money into reserve deposits with the central bank; this limits the banks’ capacity to lend. Another tactic is to sell government bonds to the banks, again mopping up some of their cash and thus restraining their lending. Yet another method is to raise the central bank’s interest rate ('base rate'); commercial banks then follow suit by raising their own rates. This, it is hoped, will discourage bank customers from borrowing, and thus restrain money supply growth. 

In the early eighties, Britain and the USA suffered very rapid inflation, due partly to sharp price rises for oil and other commodities, partly to aggressive pay demands by labour unions. But, according to Friedman, this inflation could only be due to untamed money supply growth. So the British and American governments were persuaded to attempt rigorous control of the money supply.

O dear! there goes another of those theories that sound clever, but do not work in practice. It proved impossible to keep the money supply on a smooth, gently rising, path as Friedman demanded. In the first place, it was difficult to agree upon what actually is the money supply. Is it simply (as some argue) only the notes and coin in circulation? Or does it include current accounts with banks? Or deposit accounts too? With banks only, or do building societies and other savings institutions count?   

Monetary mayhem

In America, there was a mushroom-like growth in new forms of making payments and new instruments for circumventing the Fed’s policy – through the invention of money substitutes of all kinds, like ‘NOW’ accounts and money-market funds, the transfer of business to non-member banks or to branches of foreign banks, and so on.10 Money supply growth, inhibited in the main commercial banks, popped up in other places. Trying to control the total supply was like treading barefoot on an eel.

The central banks’ clumsy attempts at regulation produced mayhem. Interest rates and government bond yields rose to absurd levels and fluctuated wildly. I well remember buying, in 1981, US Treasury bonds that gave returns of around 15%! Meanwhile, inflation stayed far too high. To cope with this, governments did something that Friedman did not approve; they tightened their budgets sharply, leading to very deep recession.

This nasty experience led to deep disillusion with Friedmanite monetary policy. Friedman himself, in a well-publicized press interview, at least had the decency to admit his error: the use of quantity of money as a regulator has not been a success. I’m not sure I would as of today push it as hard as I once did.11

Since the mid-eighties, governments have given up trying to hit money supply targets. Instead, they try (largely by adjusting bank base rates) to keep inflation down to low target levels. This method, though far from perfect, is clearly better than Friedman’s fad.          

Consumption and savings

Personal incomes are either spent (on consumption), or saved (put aside or invested). Keynes held that there is a simple and stable relationship between spending and saving: as incomes rise, the proportion saved increases. So, savings rise faster than incomes, making more capital available for investment (though it will not necessarily be invested; it might simply be kept in the bank). Conversely, if incomes fall, savings will fall back even faster.

If Keynes is right, then it should be a simple matter for government to regulate the economy by adjusting tax rates. In an inflationary boom, it can jack up the rate of income tax, leaving us with less current income. Spending will then drop, choking off the boom; and savings will diminish even more. There will be less capital available for house purchase; so, if a house price bubble is part of the boom, we can expect the bubble to deflate, or even burst.

Friedman disagreed with Keynes. He argued that, in deciding how much to spend and how much to invest, we consider our ‘permanent’ or long-term income. On this theory, transient changes in income have little effect on spending. Windfalls or temporary gains are usually saved, not spent. Likewise, faced with a tax hike, we will not prune our spending. We will expect that, since higher taxes are politically unpopular, the government will cut the rate back as soon as it can; the higher immediate tax charge will have little effect on our long-term ‘permanent’ income. So, why tighten our belts?

This argument, grandly known in the trade as the permanent income hypothesis, is regarded by Friedman’s admirers as one of his best pieces of theory. In practice, in the world of scarce and precarious employments that Friedmanite policies have given us, the notion of permanent income may perhaps seem a little fanciful. However, if governments are persuaded to accept the theory, there are very real practical implications. For it means that there is no point in bothering with tax policy as a regulator; it will not work.

Friedman’s theory thus supports the view that the only way to regulate the economy, or to restrain inflation, is by the use of monetary policy, as described above. Friedman, like other libertarians, wanted taxes kept as low as possible and disliked attempts by government to regulate anything. However, he argued, should regulation be unavoidable, it should be done only through monetary policy. British former prime minister Edward Heath accused Nigel Lawson, Margaret Thatcher’s finance minister, of following this advice; he aptly called it playing golf with one club.     

In the present recession, when governments find themselves obliged to raise tax rates to trim their excessive deficits, we must hope that Friedman was right in arguing that higher taxes will not make us aggravate the recession by spending less. Evidence to date does not encourage optimism on that point. But at least we are having the good sense to keep interest rates very low, and to make  some efforts to increase the money supply.

Friedman and freedom

Like other libertarians, Friedman favored a strictly negative concept of freedom. Political freedom means the absence of coercion of a man by his fellow-men12 says he, reminding us of Hayek’s view: liberty is the absence of restraint and constraint13 by the will of others. Both Friedman and Hayek insist that, so long as we individuals are not obstructed by other people (including those people who govern us), we are free.

Defined in this way, freedom has no moral implications; it is amoral. Friedman leaves us in no doubt about that: freedom has nothing to say about what an individual does with his freedom.14  

What is wrong with that definition? After all, it is obvious that too much restraint (prohibition from doing things) or too much constraint (compulsion to do things) can impair our freedom. Nevertheless, the libertarian conception of freedom is, in my view, far too narrow and seriously inadequate. There are many other obstacles to the attainment of freedom.

A person may lack freedom because he is constrained by forces other than the will of other people; by impersonal forces.  Most of us, surely, would say that a mountaineer who finds himself accidentally trapped in a crevasse, from which he cannot escape by his own efforts, is not free so long as he remains in that position. Hayek, however, disagreed. He claimed that the trapped climber is still free (or not unfree), since he has not been willfully confined by anyone else.15 That statement is logically correct, given Hayek’s conception of freedom, but it strongly suggests that this conception is perverse.

This narrow, negative concept of freedom is not just a curiosity of Hayek’s and Friedman’s economic theories. It has nasty practical consequences. For in free-market economics, market forces are considered to be always impersonal. It follows that they cannot damage our freedom. Since libertarians regard individual 'freedom' as far more important than anything else, they do not care about the harm that impersonal market forces may inflict upon us. Unemployment, inadequate pay, excessive hours of work or unhealthy working conditions? These do not reduce our freedom, so why complain about them? 

A person may also lack freedom because he is ‘enslaved’ by his own bad habits or vices. This idea is fundamental in Christian moral theology; the New Testament speaks of the slavery of sin and uses the word redemption (which originally meant buying a slave out of bondage) to mean forgiveness and purification. On this view, freedom is the opposite of sin. It is not simply lack of restriction; it is a positive moral quality achieved through the pursuit of virtue; there is no true freedom except in the service of what of good and just,16 as the Catholic catechism puts it. Or, as the theologian Bernard Häring has it, in essence freedom is the power to do good; the power to do evil is not of its essence.17 Here is a far richer and fuller understanding of freedom than the economists’ negative freedom, that has nothing to say about what one does with it.

For a more secular, but compatible, description of this ‘positive’ freedom, we may turn to the Indian economist Amartya Sen, who writes that increasing human ‘capabilities’ must play an essential role in the promotion of individual freedom…a socially responsible conception of individual freedom includes both positive and negative liberties.18

Libertarians, with their amoral notion of freedom, fail to understand that, if we want to be truly free, we must all strive for moral goodness. They think freedom can be achieved simply by demolishing constraints and cutting back the powers of government. It does not occur to them that regulations designed to prevent misbehaviour may actually help us to be more free, by keeping us in the paths of righteousness. Try a practical example from our troubled financial world: in the pre-libertarian age, tightly-regulated bankers were not allowed to use their banks’ capital to support unproductive and dangerous speculative trading. That meant that more capital was available to support good banking, i.e. lending to sound, productive businesses.       

It may seem paradoxical, but it is true: constraints that do indeed reduce our negative freedom, may nonetheless increase our positive freedom (power to do good).

Underlying most arguments against the free market is a lack of belief in freedom itself,19 says Friedman. This sounds plausible, but it drastically oversimplifies the issue. For freedom can mean many different things. I agree entirely that underlying my arguments against the free market is a lack of belief in Friedman’s negative concept of freedom.20 But I prefer to believe in a different concept of freedom.

Social responsibilities of business

One of Friedman’s most controversial doctrines appears both in Capitalism and Freedom and in a famous New York Times article:21 few trends could so thoroughly undermine the very foundations of our free society as the acceptance by corporate officials of a social responsibility other than to make as much money for their stockholders as possible.22  Friedman argued that a company has no right to divert any of its earned profits to ‘social’ or ‘public good’ purposes. Nor is it entitled to reduce its profits by running its business in ways considered to be socially virtuous, though not the most profitable.

According to Friedman, a business should earn as much profit as it possibly and lawfully can, and distribute as much in dividends as it can, after retaining what is necessary for the maintenance and furtherance of the enterprise. It should be left to the stockholders to spend part of their dividends for the public good, should they wish to do so.

Friedman argues as follows: if a corporate executive decides, for example, to do more than the law requires to make his factory cause less pollution, then he is spending stockholders’ money in a way that is not advantageous to them, unless they happen to live near his factory. He is ‘taxing’ them for an ulterior end decided by himself, spending someone else’s money for a general social interest.22 Friedman argues that only government, elected by the people as a whole, has the right to do that.

His argument is paradoxical. A company that, in order to maximize its profits, spends as little as it can get away with on pollution avoidance, is penalizing society as a whole for the benefit of its own stockholders. That is unacceptable; but, according to Friedman, it is the duty of the government, not the company, to solve the problem by tightening up anti-pollution regulations, or by taxing the company in proportion to the pollution it causes.      
Friedman’s position is thus an open invitation to wholesale state regulation of business,23 as social scientist Daniel Liechty has observed. Yet Friedman detested state regulation of business! Here we have a radical self-contradiction. Liechty offers a convincing response: when a business community acts spontaneously and uncoercedly with a policy directed towards taking its social responsibilities seriously…this is a distinctively anti-socialist policy. That is to say, it keeps the need for state regulation and control to a minimum, and therefore keeps the bugbear of socialism at bay.

In conditions of untrammeled competition, such as Friedman and other libertarians demand, companies can scarcely afford to behave in a civilized and socially responsible fashion. That is a strong argument against the pursuit of maximum competition. Indeed, if it is true that the sole duty of company managers is to maximize profits, then in the pursuit of their duty they should collude with their competitors to keep prices high. But, for libertarians, that is a capital sin; and they call for draconian regulation by government to prevent it!

Freedom of contract

Friedman emphasized the importance of freedom of contract; in his ideal market economy, individuals are effectively free to enter or not enter into any particular exchange, so that every transaction is strictly voluntary.24 He disapproved of most restrictions on the ability of individuals or companies to contract freely with each other, listing specifically (among other things):25

         Minimum prices for farm products

         Tariffs or quotas on international trade

         Rent controls

         Minimum wage rates

         Obligatory state pension schemes

         Post Office monopoly

This principle of free contract is clearly the bedrock of free-market or laisser-faire economics: it means in practice that every legal person (individual or corporate body) should be free to enter into any contract with any other legal person, provided both parties agree voluntarily to the terms of the contract.

Thus, you must be allowed to enter into whatsoever contract you please with anybody, or any company, provided you can persuade the other party to accept it, or vice versa; even if the contract is unfair to the party you are dealing with, or unfair to you, or immoral, or annoying to your neighbors, or damaging to the environment.

The basic problem with this doctrine is, of course, unequal bargaining power. A contract between a labourer and a big corporation is clearly a bargain between parties of very unequal strength, so it may well be unfair to the labourer; likewise, a deal between a small coffee-planter and a multinational agribusiness, or an individual tenant and a dominant landlord. Libertarians simply assume that a free market will enable bargains like these to be struck on terms that are acceptable to all parties concerned. Friedman argues that free competition on both sides makes this possible: the employee is protected from coercion by [any particular] employer because of other employers for whom he can work.26 This, clearly, is just another theory that too often fails to work in practice.

For, as the Canadian political theorist Crawford Macpherson observed, the contract one enters into is not strictly voluntary unless one has the freedom not to enter into any exchange at all.27 An employer may be free not to engage any more workers, if he cannot do so on terms that seem fair to him; he may choose not to expand his business, so that he will not need any more workers. The worker, however, is not free not to take a job with anyone – unless unemployment benefits are generous and unconditional! They are no longer so, if or where they ever were. As Macpherson remarks, the labour force does not have a choice as to whether to put its labour in the market or not.28

Macpherson also argues that generous welfare provisions can, in fact, give workers greater freedom, because they reduce the urgent need to work and make it easier for a worker to turn down a job that does not provide adequate rewards.  But libertarian economists are not interested in that kind of freedom. Though they may try to disguise it with their theoretical arguments, in reality what they want is (for capitalists) more freedom from regulation, and (for workers) less freedom to earn a decent living.

A plausible, well-promoted ideology

It is paradoxical that Friedman, whose theories have so often proved disappointing when applied in practice, should have attracted such admiration, even veneration, within and beyond his own profession. But this kind of paradox is not so uncommon. One is reminded of the situation in architecture, where Le Corbusier and other champions of the ‘international style’ continue to be revered by their profession, even though their buildings are widely disliked, or indeed hated; and even though many of those buildings have proved so unserviceable that they have had to be demolished long before the end of their expected lifespan.

What this illustrates is simply that the promotion of a plausible ideology, however flawed, by a forceful and charismatic personality is a winning formula; winning, that is, for the ideology’s devotees, but often damaging for everyone else. Other twentieth-century examples of this principle are not far to seek.

It is scarcely an exaggeration to say that the modern gurus of libertarian economics – Friedman, Mises, Hayek, and their followers – were and are all basically intellectual McCarthyites, motivated by a visceral hatred of communism and, by association, of all forms of socialism. Their virulent loathing has driven them to embrace with uncritical enthusiasm the opposite doctrine. But it was the vices of nineteenth-century laisser-faire that inspired communism and socialism in the first place!

Classical economics, from its very beginnings, has erred in its over-reliance on the theory that self-interested actions by individuals combine to yield the best outcome for all; in its over-emphasis on benefit for ourselves as consumers and investors, at the expense of ourselves as workers; in its complacent acceptance of exorbitant inequalities; in its blindness to the noxious effects of unrestrained competition.

Moreover, free-market economics, obsessed with enhancing labor productivity (producing more with less human work), has always relied on growth in output to keep us, or most of us, employed. In the past, when world population was much smaller, persistent all-round growth in production and consumption was a tolerable prospect; today it is no longer so.

It is time for us to realize that Friedman’s libertarian capitalism is a philosophy that is contrary to the best interests of most people. And that it is also incompatible with sustainable long-term economic strategy.

ANGUS SIBLEY (postmaster@equilibrium-economicum.net) is the author of The 'poisoned spring' of economic libertarianism (PAX ROMANA, 2011); see link.

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1 Remarks by Governor Ben S. Bernanke on Milton Friedman’s 90th birthday, University of Chicago, 8th November 2002.

2 Paul Krugman, Who was Milton Friedman? in New York Review of Books, 15th February 2007.  

3 Friedman, The Invisible Hand in economics and politics (Institute of Southeast Asia Studies, Singapore, 1981), page 3.

4 Albert Venn Dicey (1835 – 1922), a famous expert on British constitutional law.                        

5 Friedman, The Invisible Hand, page 3.

6 Ibid., page 16.

7 Friedman, The Energy Crisis (1978), reprinted in Bright Prospects, Dismal Performance (Horton, Sun Lakes (Arizona), 1983), page 143.

8 Ibid., pages 144 and 152.
9 Friedman, Inflation: Causes and Consequences (Asia Publishing House, New York, 1963).
10 Nicholas Kaldor, How Monetarism Failed in Challenge (Sharp, Armonk (New York), May/June 1985), reprinted in Milton Friedman, Critical Assessments (Routledge, London, 1987), vol. IV, pages 102ff.

11 Friedman, interview with Simon London, Financial Times Magazine, 7th June 2003.

12 Friedman, Capitalism and Freedom (University of Chicago Press, 1962), chap. 1.

13 Friedrich von Hayek, The Constitution of Liberty (Routledge & Kegan Paul, London, 1960), chap. 1.

14 Friedman,  Capitalism and Freedom, chap. 1.

15 Hayek, The Constitution of Liberty,chap. 1.

16 Catechism of the Catholic Church (Vatican, 1992), para. 1733.

17 Bernard Häring CSSR, The Law of Christ [Das Gesetz Christi, 1954], trans. Kaiser (Mercier, Cork, 1961), vol. I, chap. 4.

18 Amartya Sen, L’économie est une science morale (La Découverte, Paris, 1999), part I (pages 65 and 71).

19 Friedman, Capitalism and Freedom, chap. 1.

20 This does not mean that I lack belief in the fact that inappropriate or excessive restrictions can impair our freedom. It means that I believe that freedom is far more than mere lack of restriction.

21 Friedman, The Social Responsibility of Business is to Increase its Profits in New York Times Magazine, September 13th, 1970.

22 Friedman, Capiialism and Freedom, chap. 8.

23 Daniel Liechty (State University of Illinois), On the Social Responsibilities of Business: Contra Milton Friedman in Management Decision (Emerald Group, Bradford, England), vol. 23 (4) (1985); reprinted in Milton Friedman, Critical Assessments, loc. cit. supra, vol. IV,
pages 199 ff.

24 Friedman, Capitalism and Freedom¸ chap. 1.

25 Ibid., chap. 2.

26 Ibid.¸ chap. 1.

27 Crawford Brough Macpherson (1911 – 1987), professor of political economy, University of Toronto, Elegant Tombstones: a Note on Friedman’s Freedom in Canadian Journal of Political Science (March 1968), reprinted in Milton Friedman, Critical Assessments, loc. cit. supra, vol. I, pages 354ff. Macpherson opposed the culture of ‘possessive individualism’. The phrase elegant tombstones is quoted from Friedman, Capitalism and Freedom¸ chap. 10.

28 Macpherson, ibid.