adapted from “hayek and friedman” edward elgar companion to hayekian economics edited by r....

Adapted from “Hayek and Friedman”Edward Elgar Companion to Hayekian Economics Edited by R. Garrison and N. BarryPublished by Edward Elgar (forthcoming)

July 26, 2013

How Methods Shape Substance

Hayek and Friedman: Head to Head

The Level of Aggregation

Hayek and Friedman: Head to HeadHow Methods Shape Substance

Milton Friedman’s monetarism was based on a still higher level of aggregation. The equation of exchange MV=PQ made use of an all-inclusive output variable (Q), putting into eclipse the issue of the allocation of resources between current consumption and investment for the future. Seeing no problems emerging from the market itself, Friedman focused on the relationship between the government-controlled money supply and the overall price level.

Capital-based macroeconomics is distinguished by its propitious disaggregation, which brings into view both the problem of inter-temporal resource allocation and the potential for a market solution. F. A. Hayek showed that a coordination of saving and investment decisions could be achieved by market-governed movements in interest rates. He also recognized that this aspect of the market economy is especially vulnerable to the manipulation of interest rates by the central bank.

Keynes, Friedman, and Hayek on Aggregation:

Theorizing at a high level of aggregation, John Maynard Keynes argued that market economies perform perversely—especially the market mechanisms that are supposed to bring saving and investment into balance with one another. Seeing unemployment and resource idleness as the norm, Keynes called for countercyclical fiscal and monetary policies and ultimately for a “comprehensive socialization of investment.”

M = quantity of moneyV = velocity of moneyP = price levelQ = real GDP

Contrasting Methods


Keynes, Friedman, and Hayek on Method

“Keynes was the type of theorist who developed his theory after he had developed a sense of relative magnitudes and of the size and frequency of changes in these magnitudes.”

“He concentrated on those magnitudes that changed most, often assuming that others remained fixed for the relevant period.”

Allan Meltzer, Keynes’s Monetary Theory: A Different Interpretation (1988)

John Maynard Keynes

"We're all Keynesians now ….”

“We all use the Keynesian language and

apparatus….”

Milton Friedman as quoted in Time Magazine (1968)

“I believe that Keynes’s theory is the right kind of theory in its simplicity, its concentration on a few key magnitudes, and its potential fruitfulness.”

Milton Friedman, “Keynes’s Political Legacy,”in John Burton, ed., Keynes’s General Theory: Fifty Years On (1986)

Milton Friedman


For Hayek, then, the cause-and-effect relationship between central-bank policy during the boom and the subsequent economic downturn have a first-order claim on our attention, despite the more salient co-movements in macroeconomic magnitudes that characterize the post-crisis spiraling of the economy into deep depression.

Paraphrased from R. Garrison, “Hayek and Friedman: Head to Head,” in The Elgar Companion to Hayekian Economics (forthcoming)

“There may well exist better ‘scientific’ evidence [i.e., empirically demonstrated regularities among ‘key’ macroeconomic magnitudes] for a false theory, which will be accepted because it is more ‘scientific,’ than for a valid explanation, which is rejected because there is no significant quantitative evidence for it.”

Friedrich Hayek, “The Pretence of Knowledge,” Nobel Lecture, 1974

The role of the economist, Hayek points out [in his Pure Theory of Capital, 1941], is precisely to identify the features of the market process that are “hidden from the untrained eye.”

Friedrich Hayek


A Difference in Focus


Keynes attributes the downturn to psychological factors affecting the investment community (rather than to movements in interest rates).

“I suggest that a more typical, and often predominant, explanation of the crisis is … a sudden collapse in the marginal efficiency of capital” (G.T., 1936, p. 315)

Keynes main focus, however, is on the dynamics of the subsequent downward spiral---and on policies aimed at reversing the spiral’s direction.

John Maynard Keynes

Keynes, Friedman, and Hayek on Focus

Friedman is dismissive of the whole issue of the cause of the initial downturn in 1929, referring to it as an “ordinary,” “run-of-the mill,” “routine,” “garden-variety” recession.

His focus is on policy blunders that occurred on the heels of the downturn and on the correlation between the decrease in the money supply and the decrease in real GDP.

Milton Friedman


The correlation between movements in the money supply and movements in total output leaves no doubt as to the central issue.

Friedrich Hayek focuses on the policy-infected aspects of the boom and their implications of the boom’s sustainability.

The post-bust reallocation of labor and capital takes time, but the particular dimensions of, e.g., the Great Depression (its length and depth) are to be explained largely in terms of the policy perversities that hampered the recovery.

Friedrich Hayek

QUERY: Can we justifiably say that “The bigger the boom; the bigger the bust”?


For Hayek, the ABCT is fundamentally a theory of the unsustainable boom. Accounting for the actual depth and length of the depression that ensues requires an economic and historical account of each particular episode.

Hayek and Friedman: Head to HeadHow Methods Shape Substance: A Summary

For Friedman, the analysis of a business cycle consists almost wholly of an empirical accounting of the depression’s depth and length.

THE CASE OF THE CABBAGE-EATING MISSISSIPPI MONSTERAustrian and Chicago Methodology in Action

Suppose that in late October of 1929, a thousand-pound monster descended on Mississippi soil. It spent the next three-and-a-half years eating all the cabbages (and quite a few rabbits) between Tupelo and Pascagoula. By early March of 1933, the monster weighed four-thousand pounds.

Two investigators are sent to Mississippi to get a handle on the situation. One is from Vienna, the other is from Chicago.


The Viennese investigator asks, “Where in the world did this hideous thing come from?”

It turns out, on further investigation, that the monster was the unintended consequence of some ill-conceived government-sponsored bionics project.


The Chicagoan shows up, shoves the Austrian aside, and says, “Never mind how this thing got here, the REAL question is: How did it grow from 1000 pounds to 4000 thousand pounds? How did an ordinary, run-of-the-mill, garden-variety monster quadruple its weight in 40 months?

The Chicagoan’s answer, of course, is: it was all those cabbages. (He couldn’t get good data on the rabbits.) The correlation between cabbage consumption and weight gain of the Mississippi monster leaves no doubt as to the central issue.


QUERY: Do we suspect that data availability is what led the Chicagoan to his conclusion? And that the lack of hard data pertaining to the monster’s origins caused him to be dismissive of questions about where the thing came from?

These and related suspicions are what underlie the message in Hayek’s Nobel address on “The Pretense of Knowledge.”

.

M V = P Q

With a nearly constant velocity of money

and Output (Q) growing slowly,

the price level (P) moves with the money supply (M).

with a lag of 18-30 months.

Friedman’s Monetarism:


M V = P Qwith a lag of 18-30 months.

“Inflation is always and everywhere a monetary phenomenon.”

M V = P Q


M V = P Q

Friedman’s Monetary Rule:

Increase the money supply at a slow and steady rate to achieve long-run price-level constancy.

with a lag of 18-30 months.


M V = P QM V = P Qwith a lag of 18-30 months.

RA

TE

OF

IN

TE

RE

ST

SAVIING (S) INVESTMENT (D)

D

S+ΔM

S

But what happens within the Q aggregate as a result of the monetary injection?




Friedman declares the 1920s as the Golden Years of the Federal Reserve. He ignores interest rates during the 1920s because they didn’t change much.

That is, they didn’t pass the Keynes criterion.




But what if they should have changed---but weren’t allowed to?




But the Federal Reserve, guided by the “real-bills doctrine” met each increase in demand for credit with an increase in supply---thus keeping the interest rate from rising.

During the 1920s breakthroughs in technology increase the demand for loanable funds and put upward pressure on interest rates.




Seeing no change in interest rates, Friedman dismissed interest rates as a potential independent variable in his econometric equations.

Seeing no change in interest rates when they should have risen (because of the technological advances), Hayek was able to identify some critical “market forces hidden from the untrained eye.”

QUERY: Which view, Friedman’s or Hayek’s, is more firmly anchored in the empirical (historical) circumstances of the 1920s?

Does Keynes recognize the significance of the loanable funds market in the context of business cycles?

No. He denies that saving depends on the interest rate and he (all but) denies that investment depends on the interest rate. He jettisons the loanable-funds theory.Does Friedman recognize the significance of the loanable funds market in the context of business cycles?

No. He assumes this market is working well and so he ignores it in dealing with the key issue of the relationship between the money supply and the price level.

For him, saving is dependent only on income, and investment expenditures are based predominantly on psychological considerations, on “animal spirits.”

For him, the focus is on total output (Q, as in MV=PQ), which includes the output of both consumption goods and investment goods.

S = -a + (1-b)Y

MV = PQ

I = I0

.

THE GREAT RECESSION

Consequences of the Housing Boom

A Critical Comparison:

The Dot-Com Boom and Bust (1990s)cushioned with underlying real growth

The Housing Boom and Bust (2000s)compounded by mortgage market distortions.

The increased demand for credit puts upward pressure on interest rates.

The Fed counters the upward pressure on interest rates by “accommodating” the increase in demand for funds with an increase in supply.

The monetary expansion drives saving back to its initial level while allowing for a still-greater level of borrowing.

RA

TE

OF

IN

TE

RE

ST

SAVING (S) INVESTMENT (D)

D

S+ΔM

S

Boom and Bust: The Dot-Com Episode

In a typical cyclical episode, the boom begins as a genuine boom that reflects technological breakthroughs.

An artificial boom rides piggyback on a genuine boom.

RA

TE

OF

IN

TE

RE

ST

SAVING (S) INVESTMENT (D)

D

S +Subsidy

S

S+Subsidy+ΔM

This boom began with increasingly aggressive housing policy that increased the supply of mortgage loans.

The increased supply of credit put downward pressure on interest rates.

The Fed further increased the supply of loanable funds to avoid reduced lending in other markets (and to stimulate recovery from the dot-com bust).The artificial boom rode piggyback on the distortion of mortgage markets.

The double shift in the supply of loanable funds compounded both the downward pressure on interest rates and the excessive borrowing.

Boom and Bust: The Housing Episode

“too low for too long”

Friedman’s View of a Monetary Contraction

M V = P Q

A sharp monetary contraction puts downward pressure on P and Q.

If P is sticky downward, Q will fall dramatically.

Evidence shows that between October of 1929 and March of 1933 decreasing M was the essential (primary, dominant) cause of the decrease in Q.

The correlation between movements in the money supply and movements in total output leaves no doubt as to the central issue.



The Irony of Monetarism:

The monetary rule that allows the economy to perform at its laissez-faire best presupposes a critical piece of intervention (Regulation Q) that makes the money supply operationally definable.

Greenspan:

“We don’t know what money is, anymore.”

…which explains why the Federal Reserve switched from money-supply targeting to interest-rate targeting in the early 1980’s



Also, consider:

The velocity of money

The bank operating ratios (excess reserves)

The geographical distribution of US dollars

Friedman’s “Plucking Model”of Cyclical Movements

Vienna vs. Chicago on Monetary

Issues

Why was Milton Friedman so unreceptive to the Austrians’ capital-based theory?



Note: Q = QC + QI

but the effect of interest-rate changes on relative movements of consumption and investment and on the pattern of investment is no part of the theory.

Inflation is always and everywhere a monetary phenomenon.

But what goes on in the short-run---during that critical 18-30 months?

John Bates Clark 1847 — 1938

Clark-Knight (Black Box) Capital Theory

Frank H. Knight 1885 — 1972

Does the interest rate play any role at all within

the output aggregate?


Milton Friedman (1969 [1961]), “The Lag Effect in Monetary Policy,” in Milton Friedman, The Optimum Quantity of Money and Other Essays, Chicago: Aldine.

Friedman allows for a possible effect on interest rates:

Holders of cash will…bid up the price of assets. If the extra demand is initially directed at a particular class of assets, say, government securities, or commercial paper, or the like, the result will be to pull the prices of such assets out of line with other assets and thus widen the area into which the extra cash spills. The increased demand will spread sooner or later affecting equities, houses, durable producer goods, durable consumer goods, and so on, though not necessarily in that order…. These effects can be described as operating on “interest rates” if a more cosmopolitan [i.e., Austrian] interpretation of “interest rates” is adopted than the usual one which refers to a small range of marketable securities.

“The key feature of this process [during which interest rates are low] is that it tends to raise the prices of sources of

MAINTENANCE OF SOURCES

DO NOT OPEN

SOURCES

SERVICES

both producer and consumer services relative to the prices of the services themselves…. It therefore encourages the production of such sources and, at the same time, the direct acquisition of the services rather than of the sources. But these reactions in their turn tend to raise the prices of services relative to the prices of sources, that is, to undo the initial effects on interest rates.

MAINTENANCE OF SOURCES

DO NOT OPEN

SOURCES

SERVICES

The final result may be a rise in expenditures in all directions without any change in interest rates at all; interest rates and asset prices may simply be the conduit through which the effect of the monetary change is transmitted to expenditures without being altered at all….”

But how, then, does Friedman account for the lag

between rising M and rising P?


Friedman accounts for the 18-30 month lag:

“It may be … that monetary expansion induces someone within two or three months to contemplate building a factory; within four or five, to draw up plans; within six or seven, to get constructions started. The actual construction may take another six months and much of the effect on the income stream may

INVESTMENT

CO

NS

UM

PT

ION

18-30 m

onth la

g

Keynesia

n

spira

ling

come still later, insofar as initial goods used in construction are withdrawn from inventories and only subsequently lead to increased expenditure by suppliers.”

Gregory MankiwFormer ChairmanCouncil of Economic AdvisorsGeorge W. Bush Administration

GREG MANKIW’S BLOGRandom Observations for Students of Economics

September 16, 2006: Curious question from Mankiw:

“How can you identify my car?”

mvpy writes:

You know, I hate to spoil things, but I must say, I think Milton Friedman has a better plate. This is from an article I came across:

"Years ago, trying to find the Friedman’s apartment in San Francisco, I knew I was in the right location when I spotted a car with a license plate that read “MV = PT."

A. Delaique writes:

Milton Friedman's license plate was MV = PQ, not MV = PT. Picture here : http://gribeco.free.fr/article.php3?id_article=12

http://gribeco.free.fr/article.php3?id_article=12

mvpy writes:

You know, I hate to spoil things, but I must say, I think Milton Friedman has a better plate. This is from an article I came across:

"Years ago, trying to find the Friedman’s apartment in San Francisco, I knew I was in the right location when I spotted a car with a license plate that read “MV = PT."

A. Delaique writes:

Milton Friedman's license plate was MV = PQ, not MV = PT. Picture here : http://gribeco.free.fr/article.php3?id_article=12

Anonymous writes:

That's pretty ridiculous..

Canée writes:

I love economists.

http://gribeco.free.fr/article.php3?id_article=12

Adapted from “Hayek and Friedman”Edward Elgar Companion to Hayekian Economics Edited by R. Garrison and N. BarryPublished by Edward Elgar (forthcoming)

July 26, 2013

How Methods Shape Substance

Hayek and Friedman: Head to Head

adapted from “hayek and friedman” edward elgar companion to hayekian economics edited by r....

Documents

head slide

milton friedman keynes

level of aggregation

methods shape substance

contrasting methods

john maynard keynes

methods shape substance

keyness theory