Central bankers have abandoned Milton Friedman
It is a cruel irony of fate that 2012, the year that celebrates the centennial of Milton Friedman’s birth, is the year that marks the end of his preeminence as an influence over economic policy. Since the emergence in the early 1970s of stagflation – a corrosive combination of lack of growth matched by inflation in double figures – Friedman’s dictums on the causes and cures of rising prices have been the mood music behind management of many leading economies. Since the Great Recession took hold, however, the priorities of government economists have evolved, and once more growth and employment are emerging as the prime goals of public policy.
In the 33 years since Paul Volcker was made Federal Reserve chairman by President Jimmy Carter in 1979, Friedman’s idea that inflation is the economy’s greatest danger has ruled the roost. So long as inflation is kept at around 2 percent, unemployment has been allowed to find its own level. But times have changed. At the first meeting of the Federal Reserve since Barack Obama’s re-election, Federal Reserve Chairman Ben Bernanke has made the creation of jobs a principal aim alongside keeping inflation in check.
In practice, this means interest rates will not be raised so long as unemployment remains above 6.5 percent and inflation is forecast to remain below 2.5 percent. With this tap on the tiller, Bernanke has quietly dispatched the Age of Friedman, replacing it with a policy that harks back to the Keynesian days when “full employment” was the sole target. (Technical note: In economics, “full employment” does not mean when everyone is employed; to allow for the churn as workers move among employers and other adjustments to the labor force, “full employment” is usually deemed to be when 94 percent to 97 percent of those seeking jobs are employed.)
This significant but surreptitious shift in economic policy did not make headlines in the popular press or on the nightly TV newscasts. Rupert Murdoch’s Wall Street Journal, however, which is fighting a rearguard action on behalf of “classical,” or Hayekian, economics, spotted the importance of the change. “It’s striking to see a central bank in the post-Paul Volcker era say overtly that it wants more inflation,” it wrote, before warning that “sooner or later the bill for open-ended monetary stimulus will arrive.”
Economics in the modern age, since John Maynard Keynes transformed the discipline with his “General Theory of Employment, Interest and Money” in 1936, has been a tussle among those, like Keynes, who believed unemployment to be society’s greatest scourge, and those, like Friedrich Hayek, who saw inflation as a nation’s undoing. The division can be traced to the two men’s personal experiences, with the patrician Keynes indignant that the British should suffer mass unemployment through the 1920s and 1930s and Hayek traumatized by the social decay that overtook his native Austria during the years of rampant inflation after World War One.
Keynes won that pivotal argument almost 80 years ago and ushered in the Age of Keynes ‑ 30 years of improving prosperity, unrivaled in the history of the Western world, in which “full employment” became the preeminent national goal. The reckless application of Keynesian measures – cheap money, tax cuts and large-scale public spending to stimulate the economy on borrowed money – and the failure to pay back debt when the economy was booming led to persistent high inflation. By continuing to funnel vast amounts of money into the economy at the top of the business cycle, inflation was guaranteed.
A solution to the malaise was proffered by Friedman, a Hayek devotee who, with Anna Schwartz, analyzed the causes of the Great Depression. They concluded the disaster was caused by the Federal Reserve’s attempt to choke off the effervescent commodity bubbles of the late Twenties by abruptly raising the interest rate, thereby starving the system of cash. Friedman’s belief that inflation “is always and everywhere a monetary phenomenon” led him to suggest that hyper-inflation in the Seventies could be cured by the Fed rationing the supply of money, then providing a small but predictable amount of inflation. Volcker, Carter’s Fed chairman, agreed with Friedman and under President Ronald Reagan put “monetarism” into practice. Since then, successive administrations have adopted broad monetary measures and imposed a set of rules to maintain inflation at no more than 2 percent.
Since the Great Recession, however, in the face of stubbornly high unemployment and stagnant growth – what might be called “stagployment” – government priorities have slowly altered. Ten years ago, Bernanke, Friedman’s most loyal disciple, toasted his monetarist mentor on his 90th birthday, declaring, “Regarding the Great Depression, you’re right. We [the Federal Reserve] did it. We’re very sorry. But, thanks to you, we won’t do it again.” To prevent the Great Recession turning into a second Great Depression, Bernanke has been flooding the economy with cheap money by buying back bonds in the process known as quantitative easing.
Ahile a protracted slump has been averted, Bernanke has not been thanked for his pains. Some conservatives, fearful of inflation, have harshly criticized him. During the Republican primaries, every presidential contender demanded Bernanke’s head on a plate. Had Mitt Romney won the presidency, Bernanke’s reign, set to end next year, would have been abruptly shortened and a “sound money” chairman would have been appointed. One of the most significant yet barely noticed outcomes of the election is that Bernanke can now operate without threat of dismissal.
Bernanke is not alone in promoting the importance of employment and demoting the fear of inflation. This week, Mark Carney, who in July will become governor of Britain’s central bank, the Bank of England, let it be known that he, too, was considering abandoning the 2 percent inflation target put in place by Margaret Thatcher, who was a devotee of Friedman and Hayek. Carney, who as governor of the Bank of Canada presided over his country’s swift return to growth and its healthy job creation after the Great Recession, suggested in a speech this week that to restore an economy to full health central banks should target growth as well as inflation.
There is more than economics at play here. Those who advocate targeting inflation rather than unemployment are often shills for businesses that benefit from a large permanent pool of jobless. Unemployment and the threat of being fired keep wages and salaries low and undermine labor unions’ bargaining power. But the benefit for employers comes at a high price for the rest of us. Unemployment among the young who cannot find a way onto the job ladder and those too old to find another job before retirement casts a pall over America. Cheap labor comes at the price of endless family tragedies.
Americans cannot hope to recover the prosperity they enjoyed before 2008 unless and until everyone is back to work. So long as there is a large reservoir of jobless, public spending on welfare must remain high. Once full employment is restored, a slight across-the-board rise in personal taxation can before long reduce the deficit and pay down the national debt. That is what happened in the Clinton years.
Just as interest rates will now be pegged to job creation as well as inflation, there is an argument for linking the rise in general taxation and the reduction in public spending to growth and unemployment. Such an approach may bring to an end the perennial, debilitating “fiscal cliff” and debt ceiling brinkmanship. Without such a rational device, the president and House Speaker John Boehner are resigned to replay the scene in Nicholas Ray’s Rebel Without a Cause where two teenagers play chicken, leaping out at the last minute as their cars career off a cliff. In that sorry story, only one survived.
Nicholas Wapshott’s Keynes Hayek: The Clash That Defined Modern Economics is published by W.W. Norton. Read extracts here.
PHOTO: U.S. Chairman of the Federal Reserve Ben Bernanke speaks during a news conference in Washington December 12, 2012. In an unprecedented step, the Federal Reserve said on Wednesday it would hold interest rates near zero until it hit the specific target of a 6.5 percent U.S. jobless rate, and it pledged to keep pumping more money into the economy. REUTERS/Kevin Lamarque