Milton Friedman: "I Think the Austrian Business-Cycle Theory Has Done the World a Great Deal of Harm"

This is from a 1998 interview with Milton Friedman:

EPSTEIN You were acquainted with the Austrian economist Friedrich Hayek and also are familiar with the work of Ludwig von Mises and his American disciple, Murray Rothbard. When you were talking about bad investments, you were alluding to Austrian business-cycle theory. A certain concept that has pretty much gone into our parlance and understanding fits in with what you said about what happened in Asia. There can be times and conditions in which the stage can be set for malinvestment that leads to recession.

FRIEDMAN That is a very general statement that has very little content. I think the Austrian business-cycle theory has done the world a great deal of harm. If you go back to the 1930s, which is a key point, here you had the Austrians sitting in London, Hayek and Lionel Robbins, and saying you just have to let the bottom drop out of the world. You’ve just got to let it cure itself. You can’t do anything about it. You will only make it worse. You have Rothbard saying it was a great mistake not to let the whole banking system collapse. I think by encouraging that kind of do-nothing policy both in Britain and in the United States, they did harm.

Comments

[Spectator]

"let the bottom drop out of the world" indeed.

This disingenuous remark from Friedman stems from professional jealousy. Keynes had a better turn of phrase in dismissing his rivals, notably Hayek.

But that's just it. Economics has been about shallow debates based on flimsy assumptions, backed by a boatload of spurious math. May the better debater win. May the sharpest wit lead us all. Elsewhere, I've seen the praise for Friedman's debating skills like that is all that matters. No wonder Keynes is still top dog in this make-believe science.

The tragedy is how many huge mistakes are made based on the assumption this is a science.

[anne]

Though it may take a few moments to understand, this curious approach to economics when things are not as they should be, which is always, is to complain that things are not as they should be, so allow things to get worse so that they may get better by getting worse :)

[Robert]

Forgive my ignorance, but if both Keynes and Friedman are essentially on the same page saying "doing something is better than doing nothing" in response to severe aggregate demand shocks, perhaps someone (a monetarist, perhaps) can enlighten me as to the rhetorical explanation of why printing money and throwing it at people via the banking system, with all the intermediation and moral hazard that it entails, is superior to printing money (again on the public's account) and via using the State to purchase and invest in "useful things" on the public's behalf. In the latter at least there are long-lived assets & benefitsaccruing to the public interest(whether tangible or intangible) to offset the liability resulting from intervention. Last time I checked, the Golden Gate bridge, the Hoover Dam, and the TVA were still performing admirably.

I will sguess there are arguments about freedom, choice, perceived efficiency of allocative decisions of the market, etc. but are any of these really borne out in hard evidence, even before taking account of implicit subsidies to owners of assets and debtors from neg. real rates or positive externalities related to promoting greater social welfare? I am sure I've mangled some arguments here, but further discussion (from both points of view) would be illuminating....

[Robert]

I believe that bailing out banks and people upside-down in mortgage debt is rewarding the bad actors while punishing people who avoided debt and saved. My particular focus is on the banks, which in recent years have been handing out loans to a lot of people who really shouldn't be having them. They deserve at the very least to go bankrupt, if not criminal charges for their executives (though it being perfectly legal to act as they are makes the latter a little hard to implement).

If one remembers right, it was a long, long time after the great depression before carrying debt became fashionable again or that banks would issue the kind of loans last seen in 1929. On the other hand, our stock market bubble ending in 2000 was replaced almost immediately by a housing bubble today because we bailed out overleveraged people with a round of credit expansion. Anybody holding savings accounts or short term investments has more or less consistently lost money to inflation.

If we inflate our way out everything, people very quickly catch on and leverage up on all sorts of inflation-protected things like houses and stocks. This is extremely harmful for our long term success as a nation as it diverts massive resources to whatever the fad of the year is and away from productive investments.

[AZ Cowboy]

Oops, let me fix that for you:
Though it may take an entire lifetime to understand, this approach to economics when things are not as they should be, which is due to the grand Keynesian experiment, is to stop artificially manipulating the economy.

[anne]

Mild, mild inflation is just the point of a healthy economy and just the point for why we must invest and invest intelligently. The only instance of deflation in a developed economy since 1945 is Japan, and this episode is too little studied and understood. Mild inflation has been fine since the Depression, and we should count on it.

[Winslow R.]

Az Cowboy wrote:

"is to stop artificially manipulating the economy."

*'Survival of the fittest?' Would any domestic cow survive without a cowboy? Should we stop artificially manipulating cows for the betterment of us all?

Robert wrote:

"If we inflate our way out everything, people very quickly catch on and leverage up on all sorts of inflation-protected things like houses and stocks. This is extremely harmful for our long term success as a nation as it diverts massive resources to whatever the fad of the year is and away from productive investments."

*I usually agree with you, perhaps we have a misunderstanding. Are houses and stocks a bad thing to put resources into? 'Saving' money is harmful to our long-term success because it idles real and financial resources, investing money creates 'real wealth'.

[Bruce Wilder]

Of course, in the answer to the next interview question, Friedman is back in form:
". . .both the Austrians and the Keynesians did a good deal of harm. But both of them, I would say, added to our understanding of business cycles. Only I don’t think there are business cycles."

You want to see him foam at the mouth, though, I am told the name, "DeWitt Clinton", works better, even, than "Keynes".

[Robert]

Anne...
Mild inflation may be tolerable. But your assertion is rather incomplete without further qualification such as "mild inflation in-fact (as it exists now), is perhaps tolerable, so long as it is unaccompanied by asset bubbles or other forms of potential inflationary fuel that could reasonably be expected to fan inflationary fires in the future".

Yet this precisely seems to be the case at the moment where, as a result of the large build-up of dollar reserves at foreign central banks, and the continued chasms of deficit in our fiscal, trade, & CA's and public & private deferred liabilities. Yet policy makers, and administration apologists such as Laffer, appear to not only deny the very existence of the threat, but turn it upside down, and say, "it's GOOD and exists because we're so great".

One could further argue, rather honestly, that with the productivity gains modernity has brought, and the economic enfranchisement of great swathes of humanity, that there should be downward pressure on both wages (and prices), and we in the OECD should be experiencing mild deflation that shouldn't be pernicious at all since for the majority, real wages might reasonably fall slower than prices.

The only benefit of inflation is the political expediency that money illusion creates with respect to demagogues and those who are not able to distinguish between "nominal" aqnd "real".

[dryfly]

"Only I don’t think there are business cycles."

Spoken like a lifelong resident of the ivory tower. He probably believes in Santa Claus but not business cycles.

Okay maybe 'they' aren't 'business cycles'... maybe they are 'ducks'... you know quacks like a business cycle, walks like a business cycle, looks like a business cycle... but its really just a duck.

[anne]

Japanese wages fortunately proved sticky during the deflation, so workers gained from lower prices even though wages did not rise, however the deflation went along with limited growth, rising loss of employment, and limited investment.

I am reluctant to worry especially about asset prices, and prefer that monetary policy be geared to general price increases, however I may well change my mind here.

[Yartrebo]

"*I usually agree with you, perhaps we have a misunderstanding. Are houses and stocks a bad thing to put resources into? 'Saving' money is harmful to our long-term success because it idles real and financial resources, investing money creates 'real wealth'."
- Winslow R

First a little clarification. I think there's another Robert who posts frequently, so I'm going to use the name Yartrebo from now on. Sorry if it caused any confusion.

Building housing when we have a huge glut and plenty of it goes empty or underutilized is a monumental waste of resources. If there truly is a glut of capital goods (and there isn't as commodity prices are very strong), then investment into renewable energy would make much more sense than into mostly useless housing. Investments to improve the efficiency of housing would be money well spent by decreasing utilities and maintainance, but this is generally not the case.

The problem with internal debt isn't so much the effect on GNP, which is a wash (debtor has extra money to spend/invest, but lender has less - which is reversed as the debt is paid), but an economy with a lot of debt is very leveraged and thus much more volatile. They also have worse GINI scores as consumer and government debt is a transfer payment from poor to rich.

Before the housing boom, virtually everyone had a roof over their head, and an awfully good one by international standards. Mortgage payments were reasonable, even at substantial interest rates that would encourage savings. Now, even at low rates mortgage debt can be crippling because of the size of the transactions and since housing needs were already more than met, society has gained little from the waste of funds and raw materials. And we will keep paying for it for years to come due to higher utility and maintainance consumption. It's classic supply-side constraints. Houses can only be built so fast, so adding more debt to the mix only drives prices and real inflation upwards. If housing could be built faster, it would draw resources from other sectors, like power plants, railroads, ships, furniture, automobiles, and anything else needing building materials and energy as major ingredients. Inflation would just be shifted to general inflation instead of housing-specific inflation.

And we probably (I don't have the figures) have more homeless now than before, because it's more expensive to buy housing or rent housing than before.

[Tom]

Herbert Hoover and FDR were big fans of Hayek. Ludwig von Mises was Roosevelt's personal advisor. FDR's do nothing policies, influenced by Hayek and Mises, were the cause of the depths of the Great Depression. Ha, Ha, Ha... that's a good one Milton.

[anne]

Franklin Roosevelt was elected in November 1932, which was in the depths of the Depression. The approach to fiscal policy was changed from the time Roosevelt entered the White House.

[Lord]

I wonder if we would even have inflation but for the wars we have fought. We have paid for them via inflation. If the Austrians could figure out how to fight a modern war without inflation, then the following depression could be prevented. Otherwise we will just have to live with some inflation if we continue to war.

[Yartrebo]

Having limited war without inflation is easy. Jack taxes up to divert personal consumption and comporate investment into weapons production. The only problem is then people will realize just how costly even a small war really is.

[donna]

You can't pick and choose the parts of Austrian economics you want to prove or disprove anything. It isn't about letting the bottom fall out, it's about not trying to regulate the money supply at all and letting it respond naturally to the market instead of forcing the economy into unnatural states.

[dave iverson]

Ok. We learn that Friedman hates Hayek, von Mises, Robbins, AMD Keynes. He also hates J.K. Galbraith. He also hates the FED. My question is what does Friedman like? What might he advocate? I know that Friedman advocates for "rules" in terms of rates of growth of the money supply instead of "authority" (i.e. the FED). (Drawn from Friedman's Capitalism and Freedom)

So, in this how does Friedman differ from Hayek? Both seem to say: Set up the rules and let freedom of choice prevail! Don't try to fine tune the system!

I admit my ignorance and think I ought to dig deeper into this, particularly since my last post over at my site suggests that I do believe in market cycles. It is titled Not Necessarily Out of the Depression Cycle.

I also believe in some of what all the "greats" that Friedman dismisses believed. I think they were seeing only parts of greater wholes, as was Friedman, as do we all.

[Tom]

Anne,

Let's look at how fiscal policy changed after FDR was elected. According to the "Historical Statitics of the United States, Colonial Times to 1970", series F66, Government Purchases of Goods and Services measured in billions of 1958 dollars:

1929 - 22.0; 1930 - 24.3; 1931 - 25.4; 1932 - 24.2; 1933 - 23.3; 1934 - 26.6; 1935 - 27.0; 1936 - 31.8.

The four year average for Hoover vs Roosevelt went from 24.0 to 27.2. In my view, that is hardly a dramatic shift in government spending.

[jm]

anne,

The reason why the Japanese deflation has been so seemingly benign has been that the government has suppressed the yen/dollar exchange rate by massive interference in the markets, both by direct buying of US securities and indirect support of "yen carry trade" operations through the ZIRP (sero interest rate policy).

The result has been massive loss of purchasing power by the entire Japanese citizenry. Thus, even though the average level of intelligence is significantly higher in Japan than in the US, and the Japanese work much longer hours*, the real standard of living is significantly lower. Since sacrificing wealth by exchange rate manipulation spreads the losses somewhat evenly across society, the impact is obscured.

[jm]

The asterisk above was to have connected to a note pointing out that the official working-hours statistics that show Americans working longer hours than Japanese are pure fiction. A very large fraction of working hours in Japan, for both white and blue collar employees, are off the clock (like at WalMart, but even worse). In Japan this is called "sabisu zangyou" (free overtime).

[cm]

jm: In the US, most white-collar and grey-collar employees, and quite a few blue-collar "supervisors" are in the "exempt" category where the concept of overtime does not even apply. Their work is always off the clock.

But I grant you that the work is often not as "efficient" as it is made out to be. That is, while people often work long hours, the intensity of the work is not necessarily very exacting. But nevertheless your lifetime goes by.

[Alex Grey]

The opinions of the three main camps (Austrian, Neo-Classical and Keynesian) go to the heart of economic policy today (by the way I am in the Keynesian camp or left of this). Robbins was following the Austrian logic to its logical conclusion which viewed recessions as a "natural" part of the business cycle: the Depression of the 1930s was the result of the boom of the 1920s and that the disinvestment that took place in the 1930s was as important to economic growth as the investment boom of the 1920s - cycles of investment and disinvestment are the hallmark of capitalism and it is the two together that give it its power to improve living standards (right out of Schumpeter). Hayek apparently broke rank with the Austrian School orthodoxy in arguing that the boom of the 1920s was abnormal and was caused by inappropriate monetary policy hence implicitly the Great Depression was caused by government bungling in the 1920s (for lack of a better world). The Neo-Classical (Friedmanite) view of the Great Depression was that the investment bubble of the 1920s had nothing to do with the Depression that followed but that government bungling (this time in the early days of the Depression) turned a "normal" recession into the Great Depression. The Keynesian view recognized that the boom of the 1920s was the cause of the Great Depression (like the Austrian School orthodoxy) but saw that monetary policy alone could not stabilise the economy - it neither caused the 1920s boom (debunking Hayek) nor could it stabilise the economy during the Great Depression (hence the Friedmanite view is also wrong). Interestingly, Irving Fisher has the best explanation for what distinguishes the Great Depression - deflation of asset prices caused by the process of debt-deflation. The Friedmanite school recognized this as a key process, however they were wrong about its causes and I think they will be proved wrong about its solvability (i.e. Bernanke’s helicopter money strategy will fail). Asset deflation is what causes the Keynesian liquidity trap not rigid wages. I like the theories of Minsky about financial booms and busts being exacerbated over time by a continual process of financial innovation. In this perspective, the Great Depression can actually be seen as the natural course of the business cycle in capitalist economies essentially turbocharged by financial innovation. Hence the Austrian School were not entirely wrong - only they pointed to an aspect of the logical contradiction of capitalism - that it is an unstable or "exploding" system. My guess though is that asset market effects over time become so large because of financial innovation leads to an explosion of bit assets and asset prices driven that in a major downturn debt deflation will swamp even Keynesian fiscal policy and individuals will experience broad swings in standard of living over the business cycle (My joke: no wonder economists are studying chaos theory). The reason we haven’t seen this yet is because of Kalecki’s observation that Keynesian policy is ever undone after recession leading to a build-up of government debt and higher inflation. The result is that central banks move more aggressively to raise interest rates earlier in the upswing because of higher imbedded inflation (think of the 1970s). However the attack on Keynesianism has re-established the pre-Keynesian world with all its attendant problems amplified by financial innovation. In a way the three schools all are correct in their own way though the Keynesian is the most correct and the Friedmanite the least - the crucial bit is how you fit things together. In light of this background Friedman's opinion becomes very interesting indeed.

[Johnny G]

The two theories would be equal in wisdom if the Keynesian theory did not have force and thrift subtracting from it.