For decades after the Great Depression, Keynesian thought dominated the economics profession. Then, within a decade and a half, it collapsed completely, discredited and disbelieved by almost all.

• What did Keynes teach about the economy?
• What was the substance of Friedman's monetarist critique?
• Where does that leave economics today?
  

James Sherk, Senior Fellow for Economics, answers these questions below in a paper that has become a resource for students of economics worldwide:

After the Second World War the Keynesian school of thought completely dominated the economics profession. When John F. Kennedy became President, he brought Keynesian economists and Keynesian policy prescriptions with him to the Oval Office. With the passage of the 1964 tax cut premised on Keynesian policies, and the subsequent economic boom that followed, Keynes’s ideas appeared to reign supreme. Yet within a decade and a half, Milton Friedman had consigned most of them to the ash heap of economic history. Keynesian orthodoxy passed from complete domination of the American economics profession in the 1960’s to near irrelevance as Friedman’s revolutionary monetarist theories and empirical research systematically demolished the Keynesian paradigm.

Before one can understand Milton Friedman’s critique of Keynesian economics, one must first understand the origin of Keynesian thought and its dominant position in economic thought during the 1950’s and 1960’s. During his years in Cambridge, John Maynard Keynes belonged to a secret society called the “Apostles.” This organization strongly opposed Victorian morality and its values. It advocated the moral superiority of homosexuality, and, until his marriage in 1925, Keynes frequently engaged in homosexual acts, even with young boys. Keynes believed in living for the moment, in doing what feels best regardless of abstract notions of right and wrong.[i] Keynes once declared that “I remain, and will always remain, an immoralist.”[ii] Prior to the Great Depression, the classical school of economics dominated the economics profession. Keynes’s ideas, based on consuming in the present and not worrying about the unpredictable future, went nowhere.

In the early years of the Depression, the classical school’s dominance continued. Many classical economists argued that, in fact, the Depression would improve the economy in the long run by wringing out bad investments, inefficiencies, and misallocations of resources. In the early 1930’s, the majority of economists derided British economist John Maynard Keynes’s publications as logically inconsistent. As the Depression wore on, with no end in sight, economists began to change their views.[iii] The continuing unemployment of one fifth to one fourth of the population could no longer be seen as a necessary economic readjustment. The classical theories fell into disrepute, and economists searched for new answers.

Into the vacuum stepped Keynes with his General Theory of Employment, Interest, and Money, published in 1936.[iv] Challenging the view that free markets are self-equilibrating, Keynes turned the economics profession on its head. Nonetheless, the economics profession did not immediately accept Keynes’s views. Keynes generally failed to convince older economists; those over the age of fifty rarely accepted his teachings. Younger economists, on the other hand, quickly warmed to his views.[v] Empirical evidence also appeared to back Keynes’s ideas – the perceived successes of the fascist and communist governments in Europe in eradicating unemployment during the 1930’s, while the capitalist economies remained mired in the Depression, and the fact that the massive government spending needed to fight the Second World War preceded the low unemployment and rising standards of living of the post-war years, provided Keynes’s theories with important support.[vi]

Although he died in 1946, Keynes’s students and converts, especially Paul Samuelson and James Tobin, continued his work. As the classical old guard retired or died off, Keynesians replaced them and filled the upper echelons of the economics profession. By the 1950’s virtually the entire economics profession accepted Keynes’s theories, deriding and ignoring dissenting proponents of free market policies.[vii] Paul Samuelson’s pivotal textbook Economics, which clarified Keynes’s doctrines and made them accessible to students, became America’s best selling economics textbook, with over 440,000 copies sold in 1964. In 1967 Samuelson became the first person to receive the Nobel Prize in economics.[viii] Keynesian thought, which emphasized consumption at the expense of savings, had very little influence on the behavior of the average American worker. However, the widespread academic acceptance of Keynes perpetuated these theories.

When Americans elected John F. Kennedy President in 1960, the Keynesian economists who dominated academia entered the highest levels of the U.S. government with him. Kennedy appointed the prominent Keynesian Walter Heller to head the President’s Council of Economic advisers, and generally followed the Keynesian advice he received. In 1963 JFK proposed a massive tax cut to, in accordance with Keynesian theories, stimulate demand and push the economy back to full employment. Following Kennedy’s assassination, President Johnson pushed the plan through congress in 1964. The results seemed to vindicate Keynes, as the economy grew and unemployment fell.[ix] Accepted by the vast majority of economists, installed in the highest levels of government authority, and seemingly vindicated by the facts, Keynesian doctrines stood at the apex of their influence in the mid 1960’s.

What, exactly, did Keynesian theories teach? One should note that economists did not settle on one interpretation of Keynes. The General Theory is a dense book that can be unclear and difficult to understand.[x] Multiple economists came up with different variations and interpretations of Keynes’s work.[xi] However, an explanation of the basic features of the orthodox model illustrates the core Keynesian ideas that Friedman critiqued.

The concept of the “marginal propensity to consume” is vital to Keynes’s theories. Keynes posited that consumption operates as a function of consumers’ current income. Workers earn their wages and then decide to spend some portion of it, saving the rest. Interest rates do not affect this decision. Regardless of the rate of interest, workers will still consume and save the same proportion of their earnings. Only the amount of income earned affects this decision. As individuals earn more money, Keynes says, their consumption as a proportion of income drops.[xii] Wealthier individuals run out of things to spend their money on, so to speak, and thus have a lower marginal propensity to consume.

Keynes does more than deny the ability of interest rates to affect savings. In his view interest rates have no substantial effects on investment either. Economists generally accept that businesses and entrepreneurs make investment decisions on the basis of the expected profitability that they believe they will earn as a return on their investment. In the Keynesian model, however, investment expenditures exhibit great instability.

Keynes’s personal experiences exerted a major influence in his formulations of theories of business investment. In 1926, Keynes predicted that “We will not have any more crashes in our time” and he invested heavily in the stock market in the 1920’s. The crash of 1929 wiped out Keynes’s savings.[xiii] This experience reinforced Keynes’s belief in the inherent unpredictability of the future, while also leading him to believe in the innate irrationality of businesses and investors.

Keynes observed that the future cannot be known with any degree of certainty, and any attempt to gauge the expected rate of return on an investment involves calculating such quantities as future costs and demand for a product. In addition to the inherent difficulties in making such calculations, Keynes believed business leaders and entrepreneurs also allow their own wishes, fears, and the reigning conventional wisdom, not just the hard facts, to influence their investment decisions. Consequently, Keynes reasoned, investors will be driven by what he termed “animal spirits,” and investment will be highly unstable.[xiv] The speculations of investors, driven by irrational feelings about the future, which may or may not have a basis in reality, drive Keynes’s economy. As “conventional wisdom” shifts from pessimistic attitudes to optimistic attitudes, and vice versa, investors make new investments or liquidate old ones. Keynes felt that this is what happened in 1929, as unreasonably pessimistic investors caused the market to crash, for no rational reason, and wiped out three quarters of his savings.[xv] These constantly shifting beliefs and hopes about future profitability, not the current rate of interest, will dominate the decision to invest. In this sense, investment is both highly erratic and autonomous.

It should be noted that economic indices such s the Consumer Confidence Index and the Business Confidence Index are derived directly from these Keynesian theories. They represent attempts to predict future economic performance on the basis of the current “levels” of optimism or pessimism of consumers and investors.

Keynes further broke from classical economics with his concept of liquidity traps. He reasoned that individuals had two primary motives for holding money, as opposed to some other asset that they could purchase. Obviously, people demand money so that they can complete transactions and as a precaution against unforeseen circumstances. Keynes also identified a second motive for holding money, what he termed speculative demand. People clearly will not purchase bonds at a low rate of interest if they expect the interest rate to rise in the near future, instead they will hold off investing until the interest rate rises. As the rate of interest dropped, Keynes theorized, increasing numbers of people would start believing that the interest rate had nowhere to go but up. At some point the rate of interest would get so low that no one would invest their money in the market at all. The low returns, coupled with the belief that interest rates would soon rise, would cause both individuals and banks to stop investing their savings. Instead they would speculate, holding their savings in cash and waiting for the rate of interest to rise before they invested in the market.[xvi] Keynes called this phenomenon of low interest rates increasing the demand for currency holdings the liquidity trap. Money gets trapped in the form of cash balances and ceases to play a role in the economy.

In Keynesian economics, these three factors, the marginal propensity to consume, autonomous and unstable investment, and liquidity traps, have serious implications for the economy. According to Keynes they mean that the economy can get stuck in an equilibrium that has permanently high unemployment. The Keynesian cross diagram illustrates this conclusion. This graph was actually invented not by Keynes, but by Paul Samuelson, who used it to clarify and illustrate Keynes’s meaning.[xvii]

The vertical axis represents national expenditures and the horizontal axis shows national income. The 45-degree line signifies all points at which national income equals national expenditures, and any stable long run equilibrium must lie along this line. Sloping upwards is the consumption function. Even when they have no income, people spend something; they dip into their savings. So even at a zero income, people still have expenditures. As their income rises, people will spend more, but not as much more as they earn in additional income. So at some point the consumption function intersects the 45-degree line. At any point to the right of this intersection people are saving more than they are spending. Some of these savings will be invested by businesses. The amount invested is completely independent of the interest rate or the amount saved. As a result the consumption and investment function is simply the consumption function shifted upwards by whatever amount of autonomous investment businesses have decided on. The economy comes to a stable equilibrium when the consumption and investment function intersects the 45-degree line.

However, Keynes believes that this equilibrium can include permanently high unemployment. The economy is said to be in a state of full employment when it employs the maximum number of people possible; when output is at its maximum. Obviously, governments find attaining full employment a desirable policy goal. This was especially true during the Great Depression, when over one fifth of the population went without jobs. Keynes believed that full employment in the economy does not naturally occur, but can be brought about by the correct government policies.

Referring to the diagram, assume that that the economy had been in a state of full employment when a wave of pessimism and “animal spirits” hit investors, driving down investment to the level shown. If individuals continued to save, as before, the excess savings would cause interest rates to drop. However, since investment decisions are unrelated to the interest rate, businesses would not invest the saved funds.

Instead the unspent savings would stick in the liquidity trap, either hoarded as cash by individuals or as reserves by banks, in both cases effectively removed from the economy. One man’s expenditures, however, represent another man’s income. The unspent savings would cause the national income to drop, and the economy would settle into a new equilibrium, below full employment. Savings are the wrench thrown in the gears of the Keynesian economic machine.[xviii] In Keynes words “the more virtuous we are, the more determinedly thrifty … the more our incomes will have to fall.[xix] Government, Keynes argues, must engage in massive spending programs to boost incomes and expenditures back to the full employment level.

Why does Keynes believe the government must take such drastic measures to restore the economy? If the amount of money effectively in the economy falls, will not prices simply deflate to take that into account? According to Keynes, this can’t happen. He claims that workers suffer from “money illusion” so that they cannot see that a nominal wage cut leaves their real wages untouched. Workers and their unions will not accept a reduction in wage rates. In the Keynesian terminology nominal wages are “sticky,” and employers cannot cut their employee’s wages.[xx] Since wages will not adjust downwards, and businesses must pay their employees the same wages they did when the nation had a much higher income, the economy will stay stuck in a recession if left to its own devices.

Keynes presents a solution to this dilemma; government must step in and increase effective demand. The government spending will boost national incomes back up to the full employment level (Consumption + Investment + Government, on the graph). The government intervention would free unspent savings and get them back into the economy, raising output and incomes. Thus, in Keynes’s paradigm, demand creates its own supply.[xxi]

The government has two possible means of increasing aggregate demand: it can use fiscal policy or monetary policy. A fiscal policy to stimulate demand would involve massive government spending without a corresponding rise in taxes; in other words, deficit spending. By issuing bonds and then spending the proceeds, the government would access the unspent savings and put them back to work in the economy. What the government chooses to spend the money on does not matter, it could even pay people to dig holes and fill them back in again. As Keynes wrote, “Pyramid-building, earthquakes, even wars may serve to increase wealth.[xxii]” The important point is that the government spends the money.

Alternatively, the government could utilize monetary policy to stimulate the economy, basically printing money to generate more demand. Keynes, however, did not believe that monetary policy would be as effective as fiscal policy. With fiscal policy the government knows the money gets spent. Printing new money would not provide the same benefit, since individuals would still hoard the new cash and banks would keep the excess reserves. In other words the new money would also get stuck in the liquidity trap.[xxiii]

However the government chooses to stimulate demand, the effects on the economy would greatly exceed the initial government expenditures. This occurs because of the “multiplier effect,” an extension of the logic of the marginal propensity to consume. When the government spends money on, for example, $10 million to catalogue every possible way Southerners cook spinach, it pays out wages to workers who had been unemployed. These workers spend a portion of their new income, which for the sake of the example will be eighty percent, and save the rest. When the newly employed workers spend this portion of their earnings they put another $8 million into the economy. The people who receive this $8 million as income also save some of their wages and spend the rest, putting another $6.4 million into the economy, and so on and so on. Eventually, in Keynes formulation, the multiplier k is equal to the reciprocal of 1 minus the marginal propensity to consume. Mathematically k = 1 / (1 – MPC).[xxiv] In this example k = 1 / (1 - 0.8) = 5. A ten million dollar government program would increase national income by fifty million dollars. Note that only consumption contributes to the multiplier effect. Savings remain unproductive bank reserves.

In the Keynesian paradigm, therefore, the economy experiences random swings in employment levels because of the “animal spirits” that afflict investors. The market will not self adjust but will remain stuck in a recession unless the government intervenes. Acting with the power of the multiplier, new government deficit spending on almost anything will increase demand and push the economy back up to full employment. This model, however, does little to explain inflation. If new money simply gets caught in liquidity traps and does not affect the economy, what causes inflation?

The answer came in the form of the Phillips curve. In 1958 A. W. Phillips analyzed the relationship between unemployment and the rate of increase of money wages in the United Kingdom between 1861 and 1957. Phillips concluded that there existed an inverse relationship between the two, that as unemployment rose the rate of increase of money wages dropped. Economists believed that the rate at which nominal wages increased corresponded closely with the inflation rate, and that the Phillips curve therefore implied a trade off between unemployment and inflation.

Keynesians quickly incorporated the new data into their existing paradigm and provided a theoretical underpinning for Phillips’ observed empirical data.[xxv] The Keynesians held that the employment rate served as a proxy for excess demand in the labor market. Falling unemployment indicated excess demand for labor, pushing wages (and prices) up at an inflationary rate. Conversely, high unemployment indicated an excessive supply of labor, and businesses would not have to raise their wage offers to attract needed workers. Keynesians argued that policy makers had a choice; they could have low inflation or low unemployment, but not both.[xxvi]

While Keynes’s theories did not influence the behavior of the average American, by the early 1960s economists had firmly ensconced the Keynesian paradigm in their profession. It provided an explanation for the failure of free market economics during the Great Depression and, perhaps more importantly, policy prescriptions to prevent future recessions. Yet within a decade and a half the monetarist counter-revolution dethroned Keynes and consigned many of his central ideas to the history books. The tireless efforts of Milton Friedman, long a prophet in the wilderness, almost single-handedly brought about this intellectual coup-de-taut.

Unlike the handful of other free market economists who opposed the dominant orthodoxy, Friedman did not attempt to storm Keynes’s Ivory Tower stronghold from the outside. Before he began his assault on Keynes, Friedman built up unimpeachable academic qualifications. The son of Jewish immigrants from Eastern Europe, Friedman’s parents worked in New York sweatshops to earn a living. Friedman worked his way through college as a waiter and a salesman, ultimately earning his Ph.D. from Columbia University in 1946 and became a full professor at the influential University of Chicago. He also won the esteemed John Bates Clark Medal just two years after Paul Samuelson had received it. In addition to operating within the academic discipline, Friedman also operated within the Keynesian structure, utilizing the Keynesian framework and language, coupled with exhaustive empirical evidence that supported his theories, to undermine Keynes’s premises and conclusions.[xxvii] However much the economics profession disagreed with him, Friedman had the standing to force his opponents to take him seriously and respond to his critiques.

Acting within the Keynesian paradigm, Friedman’s first assault against Keynes came in the late 1950’s with his development of the Permanent Income Hypothesis. In 1957 he published A Theory of the Consumption Function, a thoroughly researched empirical study of consumption data in the United States. Based on the data he analyzed, Friedman came to the conclusion that the Keynesians were dead wrong about the consumption function. People do not base their spending decisions on just their current income; instead they take into account their conception of their permanent income.[xxviii]

Friedman used the example of the spending habits of an individual over the period of a week. Such an individual’s spending habits appear bizarre if economists analyzed their consumption as a function of their current, daily, income. One day a week, on payday, the individual receives a massive amount of income, but only spends a small portion of it. The other six days of the week the individual has no income whatsoever, but continues to spend at the same rate as before. Individuals, however, do not find this bizarre at all. They regard their income as coming in a steady stream, distributed throughout the week, and act accordingly. In other words, individuals do not act on the basis of their daily income, but on the basis of their perceived permanent income.[xxix]

Consumers also know that their weekly incomes fluctuate. Economists can obtain a better understanding of consumers’ behavior by looking to the longer term. Employees know that sickness, bonuses, seasonal variations, profit sharing checks, unemployment, overtime, as well as many other unforeseeable events, will affect their current income. They allow for these disturbances when planning their spending. In good times they increase their savings and in bad times they dip into those savings. Individuals base their consumption decisions on their notion of their long term, permanent income, not the transitory fluctuations of the moment. While consumers may not consciously ascertain their permanent income level, they still do so. In making this determination, people take into account their past income, giving greater consideration to the income that they received more recently. In general, Friedman writes, individuals estimate their permanent income level based on their measured income from the past three years.[xxx]

The permanent income hypothesis has serious ramifications for Keynesian economics. If people base their consumption patterns not on their current income, but on their permanent income, the multiplier loses most of its power. Government public works programs to stimulate demand will not generate economic activity multiple times greater than the initial expenditures because the newly employed workers will recognize the transitory nature of their new income and save most of it. According to the hypothesis, the multiplier would more closely approximate a factor of one than the factor of six or seven that Keynesians had assumed. From this follows the conclusion that the economy exhibits much more stability than the Keynesians had believed, since the economy does not magnify small increases or decreases in current income into large changes in output or demand. Also, the permanent income hypothesis implies that richer individuals do not necessarily save at a higher rate than poorer individuals. This implies that the government has no need to redistribute wealth from higher income individuals to lower income individuals in order to encourage consumption.[xxxi] With one stroke Friedman weakened the core Keynesian fiscal policy recommendation of multiplier-leveraged government spending to boost aggregate demand.

Friedman did not simply present the Permanent Income Hypothesis as a theory, he backed it up with exhaustive empirical evidence. Further empirical research by such Keynesian luminaries as James Tobin and Franco Modigliani confirmed Friedman’s hypothesis.[xxxii] Friedman had not simply presented a counter argument to Keynes’s doctrine; he had supported it with unassailable facts.

Friedman did more than attack the multiplier as a means of leveraging government expenditures to expand the economy – he denied the ability of fiscal policy to affect the economy at all. Friedman argued that government spending cannot create new wealth, it can only reallocate existing wealth. Thus, Government spending does not benefit the economy.

Friedman introduced this concept, which he and other economists have termed the “crowding out effect,” in his book Capitalism and Freedom, published in 1962.[xxxiii] Suppose that the government wishes to increase demand by launching a massive new spending program. Both Keynesians and monetarists agree that it obviously does not benefit the economy if the government pays for the new spending by raising taxes – then the decrease in demand from higher taxes offsets the increase in demand from new spending. Instead, the Keynesians argue for deficit spending to increase demand. However, Friedman notes, this also fails to create new wealth. In his view the government spends more, but receives the money from the savings of private investors. These investors now have less to spend on or invest in the economy. The public works simply “crowd out” private investment. While the allocation of spending in the economy has shifted, the overall level has not.[xxxiv] There is no such thing as a free lunch; the government cannot conjure prosperity out of thin air.

Friedman backed up his criticism of fiscal policy with empirical studies. Empirical studies conducted by Friedman and his colleague David Meiselman in 1963, the Federal Reserve Bank of St. Louis in 1968, and an analysis by Friedman of the American economy during World War One, World War Two, and the Civil War support Friedman’s thesis that fiscal policy does not have a major impact on the economy. Instead, they suggested that monetary policy exerted a far greater influence on the economy.[xxxv]

Before Friedman, the Keynesian economists did not appreciate money’s awesome power over the economy. They believed that money had little impact on economic events. The pre-Keynesian classical school had taught that in an economy the relationship P*V = M*Q held true. In other words the aggregate price level multiplied by the velocity of money (the number of transactions that a unit of money is used to facilitate annually) equaled the money supply multiplied by the quantity of goods in the economy. Since classical economists held that the velocity of money and the quantity of goods in an economy did not change much in the short run, any increase in the money supply must lead to a rise in the general price level. Keynes’s doctrine of liquidity traps denied this relationship. Keynes asserted that the demand for money exhibited great instability. Speculative demand and high liquidity preferences would cause banks and individuals to hoard new cash, offsetting any increase in the money supply by the government.[xxxvi] In the Keynesian world the government could print as much money as it liked and it would not lead to inflation because individuals would decrease the rate at which they spent the money in the economy.

Friedman, on the other hand, believed in the quantity theory of money. This theory posits that any substantial increase in the supply of money will lead to a substantial rise in nominal incomes. Note that the theory does not refer to a rise in prices, only in nominal incomes. Inflation can manifest itself as both a rise in prices and as an increase in the quantity of goods produced. By using nominal income in the theory, not prices or output, Friedman included the effects of increases in both quantities. To show that an increase in the supply of money must necessarily lead to an increase in nominal incomes Friedman had to demonstrate the stability of the velocity of money. He had to show that individuals’ demand for money did not fluctuate significantly, that people did not decide to hoard large amounts of cash because they expected interest rates to rise.[xxxvii] In short, for Friedman and the quantity theory of money to be right Keynes and his suppositions of liquidity traps had to be wrong.

Friedman began demonstrating the validity of his hypothesis with a sharp departure from Keynesian thought. Keynes taught that individuals have two different reasons for demanding money: transaction and precautionary demand, and speculative demand. Friedman, on the other hand, treated money not as a consumption good but as an asset that provides a stream of services to its owner. Money serves more than two purposes and should not be shoehorned into such a limited role. Among other services, money provides its holders with security, liquidity, and convenience. People will adjust their portfolios to equalize the marginal returns they receive on their assets, including money.[xxxviii] Approaching the problem from this angle, Friedman went on to analyze what would happen if people found that they had too much money in their portfolios.

If the government expanded the money supply, the people who initially received the new money would find that they had too much money in their portfolios relative to the other assets they wished to hold, and thus that their marginal returns on their money holdings would be lower than the marginal returns they could receive from holding other assets. Consequently, they would adjust their portfolios to decrease their cash holdings and increase their holdings of other assets, such as securities, bonds, land, or other goods that they desired. The individuals from whom they purchased these assets would find themselves in exactly the same situation, and would then set about to decrease their cash balances relative to the other assets that they posses. Since one man’s expenditures represent another man’s income, the nation as a whole would find itself in a situation where people are trying to decrease their cash balances but cannot do so.[xxxix]

People keep trying unsuccessfully to spend down their surplus money, and the nation becomes a sellers market. Businesses, stores, and workers find that they can raise their prices without losing business. They charge more, but their customers will also pay more. The rising prices, though, decrease the value of individuals’ money balances in real terms. People find that their money buys less and that they require more of it to receive the same yield that they did previously. As they find that they need higher money balances than before, people cut back on their expenditures. Eventually, individuals’ marginal returns equalize, the spending spree stops, and prices even out at the new, higher level.[xl] This depicts the process, in a rather simplified form, by which Friedman theorized that an increase in the money supply leads to an increase in nominal incomes.

Unlike Keynes, Friedman did more than simply hypothesize about his theories; he went out and subjected them to empirical testing. With his co-author Anna Schwartz, Milton Friedman published two thorough and exhaustive analyses of monetary changes and their impact on the economy, A Monetary History of the United States from 1867-1960 and Monetary trends in the United States and United Kingdom. After analyzing over nine decades of empirical evidence Friedman came to several conclusions.

First, he showed that the rate of change of the money supply is closely associated with the rates of change of prices, and real and nominal income. The closest relationship is between the rate of change of the quantity of money and nominal income.[xli] Ninety years of historical evidence confirm the quantity theory of money. Governments cannot simply print cash and expect it to have no effect.

Friedman also discovered that individuals have a fairly constant demand for the amount of money they wish to hold on hand. In fact this, demand varies little between countries with comparable economic institutions or between decades. In America today, as in the America of a century ago, the average person chooses to keep approximately four weeks’ wages as cash.[xlii] This evidence supports Friedman’s view that people try to maintain a consistent real cash balance and undermines the Keynesian belief in an unstable demand for money.

Friedman also discovered that, on the whole, the velocity of money, the number of annual exchanges an average unit of money facilitates, has not changed very much. In the long term, as America has become wealthier, the velocity of money has dropped slightly, but not significantly. In the short run, the velocity of money rises slightly during an economic expansion and falls slightly during a recession.[xliii] Once again, the evidence contradicts Keynes theories. The velocity of money does not shift wildly when new money enters the economy.

Not surprisingly, then, researchers have not found evidence substantiating the existence of the theoretical liquidity trap. Neither Friedman nor anyone else has found any indication that the demand for money significantly increases as the interest rate drops. Indeed, researchers have not found any evidence that the demand curve for money changes at all at lower interest rates.[xliv] Contrary to Keynes assertions, the liquidity trap does not exist.

Friedman conclusively demonstrated the invalidity of central tenets of the Keynesian paradigm. Liquidity traps ensnaring currency existed only in Keynes’s imagination. Despite fiscal policy’s impotence, monetary policy could have a great and powerful effect upon nominal prices and incomes.

Friedman analyzed effects of changes in monetary policy and discovered that monetary policy had a far greater power to affect the economy than anyone else had previously imagined. Friedman discovered that between 1867 and 1960 the stock of money had fallen, in absolute terms, six times. These six reductions in the money supply corresponded with the six serious contractions the economy experienced during those decades. Upon further analysis Friedman concluded that the fall in the quantity of money was the cause, not the result, of the economic contractions.[xlv] Taking a look at the eighteen economic cycles after 1870, Friedman discovered that, on average:

“Peaks in the rate of change of the stock of money precede ‘reference’ peaks in the business activity by about sixteen months, and troughs in the rate of change of the stock of money precede ‘reference’ troughs by twelve months.[xlvi]”

An increase in the rate of change of the money supply precedes a boom and a decrease precedes a recession. Strong empirical evidence exists supporting Friedman’s belief that the change in the rate of growth of money causes the economic contraction or expansion, not vice versa. Before Friedman’s analysis no one had ever thought about the economy in this way. Now everyone could see the powerful impact of monetary changes.

Friedman’s analysis of the monetary history of the United States also shed new light on the cause of the most traumatic event in America’s economic history, the Great Depression. Previously, economists had believed that unfettered capitalism and free markets caused the Depression, and that government intervention had lifted America from the abyss. Economists had also believed that the Federal Reserve expanded the money supply during the crisis, to no avail. Indeed, the failure of classical economists to account for the Depression had led to the widespread acceptance of Keynes’s teachings.[xlvii] Friedman proved them all wrong, demonstrating that:

“From the cyclical peak in August 1929 to the cyclical trough in March 1933, the stock of money fell by over one third.[xlviii]”

Government failure, not market failure, caused the Great Depression. Rather than testifying to the ineffectiveness of monetary policy, the Depression provided tragic evidence of the tremendous power that money exerts on the economy.

Friedman turned the conventional Keynesian beliefs about monetary policy on their head. Painstaking and thorough empirical research demonstrated the stability of the demand for money, the relative constancy of the velocity of money, and the non-existence of liquidity traps. The experience of the past century proved that a substantial increase in the quantity of money leads to a substantial increase in nominal incomes. The quantity theory of money supplanted Keynes’s unsupported monetary hypothesizing. Slowing the growth of the money supply causes recessions while expanding its growth too rapidly invariably leads to inflation. Keynes erred. What, then, of the orthodox Keynesian belief in the Phillips curve and the existence of a trade off between inflation and unemployment?

Keynesians accepted the Phillips curve trade off between unemployment and inflation. They believed that policy makers could choose to lower one of these variables, but only at the expense of raising the other. In the late 1960s reality interfered with the Phillips curve – unemployment and inflation both rose simultaneously.[xlix] Keynesian economists could not explain this phenomenon, but Friedman could.

In his 1967 presidential address to the American Economic Association, Friedman rejected the notion that economies faced a long run trade off between unemployment and inflation.[l] In the short run, however, such a relationship does hold. The Keynesians had forgotten to include the effect that individuals’ expectations play in the economy. People work to obtain real buying power, not any set level of nominal wages. In the short run, when the government starts expanding the money supply, or increasing the rate at which the money supply expands, people expect a relatively stable price level. Consequently, businesses and workers misinterpret their rising nominal incomes as increases in the demand for their services and expand their output. Businesses will hire more employees and employees will work longer because they believe their real incomes have increased.[li] In the short run, an unanticipated expansion of the money supply does lead to lower unemployment.

In the long run, the expansion of the money supply causes prices to rise, diminishing the value of the workers’ nominal money wages. Employees find that their higher money wages do not purchase any more in real terms than their previous, lower, wages. If people believe that the price increases will go away in time, they will hold off on asking for wage increases. Eventually, though, individuals will realize that the higher prices are permanent and will demand a compensatory increase in their wages. They now expect inflation and act accordingly. Facing higher labor costs, firms must cut back on their total employment. Firms may also find that projects that had been profitable at the lower real wage level cannot turn a profit once wages rise to counteract the inflation, and must therefore be abandoned.[lii] In the long run, then, employment will drop back down to its previous levels, quite probably accompanied by a recession. In order to get employment back up to the level of the inflationary boom the monetary authorities would have to increase the money supply again, by a greater amount than the economic actors had anticipated.

Rather than facing just one Phillips curve, Friedman wrote, policy makers must take peoples’ expectations into account and deal with a series of short run Phillips curves, each associated with a different level of anticipated inflation. In the short run, the government can decrease unemployment by inflating, but in the long run inflation does not affect the quantity of employment in the economy. Friedman termed this the Natural Rate Hypothesis, that in the long run the economy faces a natural level of unemployment that cannot be permanently altered by monetary changes. [liii] If the government wants to lower the natural rate of unemployment it must make real, structural changes in the economy, such as de-regulating or lowering the minimum wage, not inflating the money supply.

The theoretical and empirical case for the vertical long run Phillips curve proved so strong that by 1972 the majority of those in the economics profession accepted it.[liv] Again Friedman exposed the shortcomings of Keynesian theories. Monetary policy wields great economic power, but governments cannot use it to push the economy permanently beyond its natural limits.

Even if, as the Keynesians contend, the government did possess the power to conduct “counter cyclical” economic policy to stimulate the economy during recessionary periods and restrain it during booms, could the government use that power effectively? Milton Friedman argued strongly that it could not. At every stage in its actions to stabilize the economy the government faces unavoidable time lags and delays.

First, the government will likely face a lag in recognizing the onset of a recession or a boom. The commerce department takes several months to gather the statistics for each quarter. Once the statistics have been collected policy makers usually have a difficult time interpreting them.[lv] The data rarely indicates a recession until after it has been underway for some time.

Secondly, it takes time for the government to act once it recognizes a problem in the economy that requires stabilization. A bill must work its way through Congress and receive the President’s signature to become law. The Open Market Committee must meet and agree upon a course of action before the Federal Reserve can change monetary policy.[lvi] All this takes time.

Once the government has recognized and taken action to fix a problem in the economy, the policy change will take time to influence the market. This can be the longest and most variable lag of all. It takes between twelve and eighteen months for the economy to feel the effects of a change in monetary policy. Furthermore, the effects of policy changes do not concentrate all at once but spread out over time. Some parts of the change could act in the right direction at the right time only to be followed by effects much later and in the wrong direction.[lvii] Policy makers cannot accurately know how long it will take until the new policies impact the market.

As a result of these unavoidable delays in the effectiveness of government action, Friedman believes that countercyclical stabilization policies are a fool’s errand. Instead of acting to mitigate economic cycles, they will probably act to reinforce the cycle. Stimulus meant to combat a recession would likely arrive once the recession had ended and an expansionary period had begun. Similarly, restraining actions during a boom would probably arrive after the boom had ended and a recession had arrived. Friedman demonstrated mathematically that in order to cut the variations of the business cycle in half government policy would have to operate in the right direct at the right time approximately seventy percent of the time, an extremely unlikely occurrence.[lviii] The government does not possess perfect knowledge. It cannot hope to know, one to two years in advance, when and how much stabilization the market requires. Governments cannot effectively implement Keynesian countercyclical policies.

Economists, like all people, hesitate to discard long held beliefs. Friedman’s theoretical dismemberment of the Keynesian model did not mean that the majority of economists abandoned Keynesian thought. It would take more than Friedman’s attacks, it would take clear empirical proof to sway the balance of opinion among economists to Friedman’s side. The economy did not take long to provide such proof. In the mid 1960s the Federal Reserve expanded the money supply, resulting in inflation. Keynesians attributed the inflation to expansionary budget deficits. The Keynesians in the Johnson administration took no notice when the Federal Reserve stopped pumping new cash into the market in 1966. Friedman, on the other hand, predicted both a decline in inflation and a recession. While not technically a recession, economic growth ground to a halt in 1967. In 1968-9 the Federal budget ran a surplus. Keynesians predicted higher unemployment and lower inflation. Friedman ignored the budget and looked to a massive increase in the money supply to conclude that inflation would rise significantly. Once again events proved Friedman right and the Keynesians wrong.[lix] As the sixties ended and the seventies began America experienced both high unemployment and high inflation. Keynesian theories did not square with the evidence economists faced.

As the evidence weighed in against Keynes, Friedman’s stature in the economics profession rose. In 1967, as more economists grasped the importance of monetary policy, he was elected president of the American Economic Association. In 1976 Sweden’s Royal Academy awarded Friedman the Nobel Prize in economics.[lx]

Eventually, the economics profession abandoned a great deal of the Keynesian paradigm. While, despite Friedman’s critiques, many economists clung to a belief in the power of government to stabilize the economy, Keynesians yielded on almost every other point. They accepted that government could create instability in the market and that monetary policy played a significant role in the business cycle. Post-Keynesians contended that the multiplier still existed, but that it operated on a much smaller level than previously believed. Economists nearly unanimously accepted Friedman’s natural rate of unemployment and the non-existence of the Phillips curve. Finally, although the post-Keynesian economists did not accept Friedman’s argument that inflation was always a monetary phenomenon, they acknowledged that it usually was.[lxi] Successive editions of Samuelson’s Economics demonstrate the scope of the monetarist victory. By 1973, Samuelson admitted that monetary policy had an important role in the economy. In the 1995 edition of his textbook, he conceded not only the importance of monetary policy but also the ineffectiveness of fiscal policy.[lxii] Since the late 1970’s Friedman’s theories have persuaded most Western monetary authorities to curtail the rate of growth of the money supply, causing inflation to fall dramatically throughout Europe and North America.[lxiii] Despite a lingering sympathy towards government intervention, by and large Friedman’s ideas won the day.

In the inexplicable tumult of the Great Depression Keynes’s theories supplied the answers that economists lacked. The consumption function, autonomous investment, liquidity traps, sticky wages, the multiplier, and the Phillips curve appeared to provide an explanation for the persistent depression and tools to ensure that America would never have to face another recession. As reality dashed the Keynesian theories in the 1960s and 1970s economists came to accept Milton Friedman’s monetarist counter paradigm. The permanent income hypothesis, inherent weaknesses of fiscal policy, the quantity theory of money, the natural rate hypothesis, and the inescapable lags facing government stabilization policies eviscerated the theoretical underpinnings of Keynesian orthodoxy. While the advocates of government intervention have not abandoned their attempts to expand the state, they can no longer use Keynes’s theories to advance their cause. .

[i] The Making of Modern Economics, Page 324.

[ii] Ibid, Pg. 325

[iii] Ibid, Page 320.

[iv] Ibid, Page 331.

[v] A Modern Guide to Macroeconomics, Pg. 62.

[vi] The Making of Modern Economics, Pgs. 347-9.

[vii] The Making of Modern Economics, Pg. 390.

[viii] Ibid, Pgs. 352-7.

[ix] The Unraveling of America, Pgs. 45-52.

[x] The Making of Modern Economics, Pgs. 331-2.

[xi] A Modern Guide to Macroeconomics, Page 74.

[xii] Ibid, Pg. 65.

[xiii] The Making of Modern Macroeconomics, Pgs. 327-29.

[xiv] A Modern Guide to Macroeconomics, Pg. 64.

[xv] The Making of Modern Macroeconomics, Pg. 338.

[xvi] Monetarism and the Demise of Keynesian Economics, Pages 43-44.

[xvii] The Making of Modern Economics, Pages 358-62.

[xviii] The Making of Modern Economics, Pages 361-3.

[xix] The General Theory of Employment, Interest, and Money, Page 111.

[xx] Monetarism and the Demise of Keynesian Economics, Pg. 52.

[xxi] A Modern Guide to Macroeconomics, Pages 72-3.

[xxii] The General Theory of Employment, Interest, and Money, Page 129.

[xxiii] The Making of Modern Economics, Page 346.

[xxiv] Ibid, Page 346-7.

[xxv] A Modern Guide to Macroeconomics, Pages 146-7.

[xxvi] Ibid, Pgs. 148-52.

[xxvii] The Making of Modern Economics, Pgs. 384, 398-9.

[xxviii] Milton Friedman: Economics in Theory and Practice, Pgs. 201-2.

[xxix] Milton Friedman: A Guide to his Economic Thought, Page 104.

[xxx] Ibid, Pgs. 104-5.

[xxxi] The Making of Modern Economics, Pg. 400.

[xxxii] Ibid, Pg. 400.

[xxxiii] Ibid, Pg. 403.

[xxxiv] Milton Friedman: A Guide to his Economic Thought, Pages 164-6.

[xxxv] Ibid, Pgs. 171-4.

[xxxvi] A Modern Guide to Macroeconomics, Pg. 138.

[xxxvii] Milton Friedman: A Guide to his Economic Thought, Pgs. 54-6.

[xxxviii] A Modern Guide to Macroeconomics, Pg. 139.

[xxxix] Milton Friedman: A Guide to his Economic Thought, Pg. 54.

[xl] Ibid, Pgs. 38-9.

[xli] Ibid, Pg. 93.

[xlii] Ibid, Pg. 37.

[xliii] Ibid, Pg. 93.

[xliv] A Modern Guide to Macroeconomics, Page 141.

[xlv] Ibid, Pgs. 142-3.

[xlvi] Milton Friedman: A Guide to his Economic Thought, Pgs. 150-1.

[xlvii] A Modern Guide to Macroeconomics, Pgs. 401-2.

[xlviii] A Monetary History of the United States 1867-1960, Pg. 299.

[xlix] A Modern Guide to Macroeconomics, Pg. 152.

[l] The Making of Modern Economics, Pg. 404.

[li] A Modern Guide to Macroeconomics, Pgs. 153-5.

[lii] Milton Friedman: A Guide to his Economic Thought, Pgs. 134-5.

[liii] Ibid, Pgs. 136-140.

[liv] A Modern Guide to Macroeconomics, Pg. 157.

[lv] Milton Friedman: A Guide to his Economic Thought, Pg. 159.

[lvi] Ibid, Pg. 159.

[lvii] Ibid, Pgs. 159-60.

[lviii] Ibid, Pgs. 158-60.

[lix] The Unraveling of America, Pgs. 166-74.

[lx] The Making of Modern Economics, Pgs. 392-4.

[lxi] The Unraveling of America, Pgs. 178-9.

62 The Making of Modern Economics, Pgs. 392-3.

63 The Making of Modern Economics, Pgs. 409.

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