Milton Friedman versus the Rothbardians: An Empirical Test

0:00Basically, in the last 50 years since the publication of Rothbard's formulation of a business cycle theory and his analysis of the Great Depression, there's been a really amounting recognition and respect from mainstream economists who are increasingly challenging this sort of orthodox Friedman-Schwartz explanation of the Great Depression. We see this in a couple of papers, for example, in the Journal of Political Economy, Ohanian and Cole challenged the idea that the New Deal had anything to do with getting us out of the Depression. And then later on, in the Journal of Economic Theory, another very high-level journal, Ohanian alone wrote an article called, Who or What Caused the Great Depression?

0:45And he cited Rothbard, he took the Rothbardian view that, in fact, It was rigidity in labor markets that caused it. He explicitly rejected the Friedman-Schwartz view that it was a monetary failure. He said it was a failure of labor markets, not a failure of the Fed in this particular case. And then, of course, we know that many financial economists, practitioners, commentators have also been using the Rothbardian formulation of Austrian Business Cycle Theory going forward in the last decade or more to explain events as they unfolded leading up to the bursting of the housing bubble and then the financial meltdown. So in the first part of my paper I go through a number of different people I've used Rothbard. In fact I'm Brendan Brown who's here with with us also use Rothbard's America's Great Depression in some of his analysis of the Great Depression in his book, The Global Curse of the Federal Reserve.

1:56So I found the paradox and that was that some contemporary Austrian economists have recently criticized Rothbard as a greatly inferior monetary economist to Friedman. Let's take one example, George Selgin, and I'm not completely being fair to George here, but he's never fair to me, so, because it was on a blog, he's a free banker who has strong Austrian inclinations, he harshly compared Rothbard to Friedman in an online article blog in 2011, and he said as a monetary economist Rothbard was mediocre to bad, his version of the Austrian cycle theory was naive, containing about a dozen auxiliary all of which are patently false. Milton will always seem to me the bigger man as well as the better monetary economist.

2:46So I didn't want to really refute that. I wanted to have some fun with it. And refuted in sort of a different way. And it struck me that you could really test Selgen's assertion. Now, the test I proposed to conduct, or that I did conduct, does not really involve specific quantitative predictions Predictions

3:36People who pretty closely follow him, including myself, Mark Thornton, and there are others, made predictions about what the pattern of the unfolding of these events would look like. And that's what I did then was to talk about pattern prediction. So let me just give you a little bit about pattern prediction. Now this concept was made famous by Friedrich Hayek, okay. So I went back and I began to look and it turned out that it was actually first articulated about 30 years before Hayek wrote by Lionel Robbins in his brilliant essay on the nature and significance of economic science. He really first formulated the concept and he actually used the terminology of pattern prediction.

4:25Let me just give you a few quotes from Robbins just to give you a flavor of what pattern predictions If the given situation conforms to a certain pattern, certain other features must also be present, for their presence must be deducible from the pattern originally postulated. The analytical method is simply a way of discovering the necessary consequences of complex collocations of facts, consequences whose counterpart in reality is not so immediately discernible as a counterpart of the original postulates. Granted the correspondence of its original assumptions and the facts, its conclusions are inevitable and inescapable. It is this inevitability of economic analysis that gives it its very considerable prognostic value.

5:12Those are his words. Robbins went on to point out that while economics cannot predict changes in valuations and technical facts, once the pattern of such data has been ascertained, It can draw inevitable conclusions as to their implications, and if the data remain unchanged, it can draw inevitable conclusions as to their implications. Now Robinson can see that when there's a very small change in the data, an exogenous change, a tariff on one single item in the economy, that can certainly not show up in the later data, that can certainly be hidden by other exogenous changes that may take place in the interim before the full consequences of the tariff have unfolded.

6:01And he said, for example, wages could have fallen, in which case the price of the article that had a tariff placed on it may not actually show up in the data. However, he went on to something very interesting. He says there are certain broad changes, usually involving many lines of expenditure or production at once. Where a knowledge of implications is a very firm basis for conjectures of strong probability. This is particularly the case in the sphere of monetary phenomena. According to Robbins, pattern predictions relating to the later phase of business cycle, cycle, based on data revealing that the first phase is already in progress, falls into the category of what he called conjectures of strong probability, explained Robbins. It becomes more and more clear, for purely analytical reasons, that once the signs of a major boom in trade have made their appearance, the coming of slump and depression is almost certain.

6:56So now he's saying that this is not a Ceteris Paribus prediction. I mean, this is a prediction in the data. Although when it will come and how long it will last are not matters which are predictable since they depend on human volitions appearing after the indications and questions have appeared. Mises sharpened Robin's formulation of the concept of pattern prediction. According to Mises, economics provides the indispensable means of ascertaining whether government interventions of various types have succeeded in achieving the goals they were aiming at. That is, whether the predictions of the supporters of the interventions have come to pass. For the aims of the interventionists, you know, it surprised me in thinking this through, are invariably articulated as a specific pattern of economic activity that will diverge from that which the unhampered market would bring about.

7:50All interventionist measures are therefore based on implicit pattern predictions. Now, Mises doesn't say that in those words, those are my words, but he has an insight into that. So, in tracing out the effects of any actual government intervention, therefore, the deductive economist is in effect enunciating a prediction of an alternative pattern of economic interactions that will inevitably emerge once the interventionist policy has been implemented. And Mises goes on to say that because of human valuations and volitions, these can only be qualitative, not quantitative. So he forcefully states the claim for the predictive value of economic science. Quote, economics can predict the effects to be expected from resorting to definite measures of economic policies.

8:37It can answer the question of whether a definite policy is able to attain the ends aimed at. And if the answer is in the negative, what its real effects will be. But of course, this prediction can only be qualitative, it cannot be quantitative, because there are no constant relations between the factors and the effects concerned. The practical value of economics is to be seen in this neatly circumscribed power of predicting the outcome of definite measures. Mises is saying, this is not a Cerebus Paribus prediction, this is a prediction that you will see configured in the data. In fact, Mises goes a little bit further than that and he says, I'm paraphrasing him, for Mises then, pattern predictions refer to qualitative configuration of objective economic data which could not be detected without prior economic analysis and indeed whose very conception is dependent on economic theory.

9:34Let me give you an example. An increase in the federal minimum wage to $9, which is now being bandied about per hour or from the current $7.25 per hour which we assume to be above the equilibrium wage will lead to an increased surplus of unskilled labor reflected in greater unemployment or decrease in its non-wage benefits or both. This pattern prediction is theory-dependent in the sense that the very phenomenon of an excess supply of labor specified by the theory could not be even apprehended without it, okay, is specified by the theory and could would not even be apprehended without it, let alone detected in the complex objective data. So the very prediction of the pattern, you can't even know what the pattern would be like without prior analysis.

10:21So the empirical stuff comes afterwards. Okay, let's get to Friedman. Friedman treated the relationship between money and prices as aggregative and mechanical. He focused narrowly on the effect that a change in total quantity of money would have on a unitary variable that he called the price level, which can be measured in a myriad of ways, which we won't get into. But this yields a definition of inflation that refers exclusively to the general movements of prices and completely ignores other more important effects of changes in the money supply. These effects include artificially depressed interest rates, a distorted structure of relative prices, the falsification of entrepreneurs, profit and wealth calculations, all of which lead to asset bubbles, malinvestments, overconsumption and financial crises.

11:14So because of Friedman's defective analytical economics, his pattern predictions are going to be incorrect. So what I did was go back to 2002 and found articles written by Milton Friedman and he was still very lucid at that time. at that time, in every year from 2002 to 2006, and even one that was published posthumously the day after he passed away. And he completely misses the whole pattern of the bubble and the housing bubble, the run-up in financial prices and so on. He thinks the economy is Now, in my paper, you know, I have, as I said, one or two articles in which he makes these claims for each year, but let me skip, in the interest of time, to a remarkable interview that he gave to Charlie Rose on public television in December of 2005, and let me quote from that.

12:19covered a broad range of topics including the performance of the Fed under Alan Greenspan. Friedman gave no indication even at this late date that he had a clue that monetary policy had stimulated a dangerous housing bubble or that a bubble even existed. By this time the money supply had expanded by two trillion dollars or about one billion Friedman effusively praised Alan Greenspan and gave his approval to the Fed's recent monetary policy.

13:11The interview is worth quoting at length because it demonstrates how very bad monetary theory, how bad analysis, gives rise to wildly inaccurate interpretations of the economy's performance. Not just interpretations, but pattern predictions. Note how Friedman is almost monomaniacal in his focus on price stability, in what I'm about to read, and how this drives his entire appraisal of the state of the U.S. economy. Okay, so now I'm going to quote Milton Friedman. The United States is at the peak of its performance in its history. There has never been a time in the United States when we have had the state of prosperity, its level and its spread that we have had in the last ten or fifteen years. There has never been a fifteen year period in which there has been so little fluctuation in prices and inflation. Inflation has stayed around two or three percent or less for the last fifteen years. I mean this is it, that's It's unprecedented. I certainly do give credit to Alan Greenspan for that. I think monetary

14:12policy is primarily responsible for it. Charlie Rose, you think that Alan Greenspan was the greatest Federal Reserve chairman ever? I don't know if that was the inflection but I like to make it. Milton Friedman, there has been no chairman since the founding of the Fed who has anything like as good an outcome. Because he took the containing of inflation as a Chief Task of the Fed. Let me put it this way. In the first 75 years of its existence, the Fed on the average was a major negative feature in the economy. We never would have had the Great Depression if there hadn't been a Fed. Since then, since 1982 or 1983, the Fed has been a beneficiary, and I mean to say benefactor there, for the economy.

14:58So that I had never, or I had very seldom, anything good to say about the Fed before the 1980s. Since Alan Greenspan took over, I have very little but good to say, and by the way in some of the earlier articles that I looked at between 2004 and 2002 and 2005, Friedman goes on, makes comments that we don't even need his quantity rule anymore. He actually abandons, he forsakes his quantity rule because the Fed has now under Alan Greenspan figured out the correct thermostat by which to adjust changes in velocity, to adjust the The Money Supply to Chains and Velocity. So let me continue with the interview.

15:46I think his successor is a very able man, and he, like Greenspan, takes keeping stable prices as the major function of the Fed. And I have a good deal of confidence that he will continue in Alan Greenspan's path. You can make a good argument that the Fed overdid easing money a little, and that must be a reference to when they push rates down to one or two percent. One percent. That they kept the fed funds rate at one or two percent a little too long and you know that it's a natural tendency that you overdo things. You almost never go right along on a stable path like this and he makes his hand go straight up. He says it waves a little bit. He says you go up, you go too far and it's a little hard to calibrate but that was Greenspan's genius. He could calibrate everything. He was willing to abandon the quantity rule for the Greenspan rule.

16:40Posthumously, the day after he died, November 17, 2006, an article that he had written came out in the Wall Street Journal, Why Money Matters. In this, Friedman compared three episodes of monetary policy which he called, using positivist jargon, a major natural experiment. And the The natural experiment was to compare the United States economy in the 1920s, the Japanese economy in the 1990s, and then the U.S. economy in the 1990s also, when we had the tech bubble. So what he says is, the conclusion that Friedman drew from this natural experiment was that the highly expansionary monetary policy that the Fed pursued after the 1990s boom caused allowed the U.S. recession of 2000-2001 to be very mild and allowed the U.S. economy to avoid a 1930s style Great Depression or a 1990s style Japanese Great Recession.

17:44Now this article vividly illustrates the reason for Friedman's stunning failure to recognize the housing and stock market bubbles that were very clearly evident and peaking by 2006. For Friedman did not give the slightest indication that he viewed the rapid growth in the money supply as a major factor driving the boom phases of the three episodes. Rather, he concluded, and I quote, monetary policy played a role in these three earlier booms, but only a supporting role. Technological change appears to be a major player. This conclusion perfectly exemplifies the mindset of price stabilizers like Friedman and his mentor Fisher, who he called the greatest American economist who ever lived. Since there was very little change in some arbitrarily selected price index in the US in the 1920s and 1990s, and in Japan in the 1980s, well then, monetary policy could not have been the cause of the boom.

18:38In the last section, so Friedman made no, his predictions of how the economy would continue under Greenspan, his pattern prediction, was devastatingly, blatantly, abysmally bad, okay, wrong. And then in the last section of my paper, I rehearse some of the predictions that were made by the Rothbardians, which Mark has written an article on, I sort of went over it. And I had also discovered that in 2004, in an article, I had sort of talked about the housing bubble and predicted that it would blow up, okay? And I'm just a guy who teaches at Pace University, I'm not Milton Friedman, so it's not me, it's just a good analytical economics that Austrian economics is that I think permits us to make these non-quantitative pattern predictions that Robbins and Mises talked about Mises talked about, and also Rothbard has a long section which I quote in my paper on pattern predictions. He does not use the term though. So I'll stop here and take any questions.