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October 03 2009| Filed Under Currencies, Economics, Financial Theory, Forex,
Forex Theory, Forex-Beginner, Futures
Milton Friedman and John Maynard Keynes are as integral to the story of
economics as Adam Smith and Karl Marx. What Keynes wrought, Friedman undid, and
supporters of the free market are deeply in debt to this Chicago school
academic for his effort. In this article, we will look at the life and
contributions of Milton Friedman. (To learn more about these great economic
thinkers, read our related article The History Of Economic Thought.)
The Father of Income Tax Withholding
Milton Friedman was born in Brooklyn in 1912, one of four children born to
Jewish immigrants. He studied at Rutgers University, Chicago University and
Columbia, focusing on mathematics and economics. During his Ph.D., WWII broke
out and Friedman took a break to work for the Treasury Department. He was part
of a think tank that brought about income tax withholding as a "temporary"
measure to help fund the war. Though he never questioned the necessity of it in
wartime, Friedman later regretted having forced withholding on Americans.
Friedman was appalled when the government made the emergency measure a
permanent part of its peacetime taxation. (Learn how Milton Friedman's
monetarist views shaped economic policy after World War II, read Monetarism:
Printing Money To Curb Inflation.)
First Blood - Attacking the Keynesian Assumptions
Friedman continued his studies after the war and began to show his free-market
colors in a time of Keynesian domination. Taking up a teaching post at the
University of Chicago, Friedman wrote free-market analysis of the damage done
by rent controls and monopolistic practices in the medical profession. In 1957,
Friedman launched his first direct attack against Keynesian thinking with "A
Theory of the Consumption Function" - an attack on one of the assumptions of
Keynes' model. (Learn more about Keynes' models and policies in Giants Of
Finance: John Maynard Keynes.)
Keynesians support short-term solutions to spur consumer spending and the
economy. The idea is that by giving a temporary tax break like a stimulus
check, the government can spur spending without giving up future tax revenues
by making a meaningful tax cut in short, the government gets to have its cake
(economic recovery) and eat it too (maintain future taxes). Friedman took on
this idea and analyzed actual empirical evidence. This was in contrast to
Keynes and his followers who rarely did actual empirical studies.
Friedman showed that people adjusted their annual spending habits in response
to real changes in their lifetime income, not temporary changes to their
current income. In practice, this means that something concrete like a raise
may prompt a family to spend more, but a short-lived boost from a stimulus
check will not. This was the first crack in the Keynesian framework, but it was
quickly followed by further attacks on the many dubious assumptions underlying
the theory. (Find out how tax breaks can help the economy in our frequently
asked question How do government-issued stimulus checks affect the economy?)
Friend of Investors and Savers
Instead of trying to boost the economy by trying to fool consumers, Friedman
believed the same ends could be met by minimizing government involvement. This
would be achieved by lessening taxes in the long term and ceasing inflationary
policies. Inflation, Friedman pointed out, was just another attempt to fool
consumers into thinking they were earning more, when the corresponding rise in
the cost of living was actually canceling out any gains in wages. Friedman and
the other economists at the Chicago school led attack after attack on concepts
like the Keynesian multiplier and the damage of saving.
Friedman took issue with the Keynesian multiplier because it gave any form of
government spending - even debt spending - a superior rating over private
investment. Friedman pointed out that the more the government borrows to spend,
the more pressure there is to inflate the currency to meet the payments in the
future. Furthermore, government spending crowds out private investors who will
sit on their capital when the government is paying for everything. Friedman
argued that, at best, the multiplier was unjustified and the implications of
government deficit spending needed to be looked at in a broader sense to
measure the true impact.
Friedman Makes a Depressing Discovery
In his book, "A Monetary History of the United States" (1963), Milton Friedman
and his coauthor Anna Schwartz showed how it was monetary policy, and not a
failure of free market capitalism, that led to the Great Depression. Friedman
surveyed almost a century of monetary policy during crashes, booms, recessions
and depressions, and came to the conclusion that the Fed was a main cause of
the depression because it shrunk the money supply by over a third between 1929
and 1933. This contraction turned a crash, something the U.S. had bounced back
from many times before, into an extended depression. The connection was never
made before because no figures on money supply were published until after
Friedman and Schwartz's book. (Learn more about the Great Depression in What
Caused The Great Depression? and The Great Depression (1929) section of our
Crashes Special Feature.)
Free Market Hero and Hard Money Advocate
Friedman began to focus more and more on the role of money in the economy.
Originally, he supported a gold standard to check inflation and prevent bank
runs, but he moved toward a hard money policy where the amount of money in
circulation would increase at the same pace as the nation's economic growth. He
believed this would be a sufficient check to keep governments from printing as
much money as they pleased, while still increasing the money supply enough to
allow growth to continue. In 1962, Friedman's book "Capitalism and Freedom" set
him up in the academic and public arenas as one of the rare defenders of free
market capitalism.
"Capitalism and Freedom" espoused the free-market solutions to many problems
and caught a lot of attention for proposing a negative income tax for people
under a certain income and school vouchers to improve the education system.
Friedman also wrote a regular column in Newsweek to explain both free-market
principles and his monetary stance. In the 1980s, Friedman took his defense of
the free market onto the airwaves with a PBS show called "Free to Choose"
followed by a book of the same title that arguably made him the most famous
economist alive.
Friedman Advocates for Currency Trading
In keeping with his opposition to Keynesian thinking, Milton Friedman took an
active dislike to the Bretton Woods Agreement, an attempt to fix currencies
rather than let them float in free-market fashion. In 1967, Friedman was
positive that the British pound was overvalued and attempted to sell it short.
He was refused by all the Chicago banks he called and vented his indignation in
his Newsweek column, laying out the necessity of floating currencies for both
public futures and a currency trading markets.
Friedman's articles inspired Leo Melamed of the Chicago Mercantile Exchange to
push for the creation of a forex market in 1972. Melamed consulted with
Friedman about the probability of Bretton Woods falling apart - an event the
viability of the new markets depended on. As Friedman assured Melamed, the
Bretton Woods agreement collapsed and one currency after another was given over
to float. The currency market is now the largest in the world, and is much more
efficient than arbitrary pegging. (Learn the basics of the forex market by
reading Getting Started In Forex.)
Stagflation and the Rise of Monetarism
Before his public success in the 1980s, Friedman had already gained
considerable clout in economic circles. When the Keynesian system buckled under
stagflation in the 1970s, academics began to take Friedman's anti-inflation,
hard money policies much more seriously. Monetarism started to eclipse
Keynesian solutions. Friedman and other Chicago School economists became
economic advisors to many governments. Collectively, they urged policies for
hard money and small government, a throwback to the days of Adam Smith. (Read
Stagflation, 1970s Style to learn more about how Milton Friedman's monetarist
theory helped bring the U.S. out of the economic doldrums.)
Friedman and the Chicago school garnered several Nobel Memorial Prizes in
Economic Sciences for their work in dismantling the most damaging Keynesian
concepts, but Friedman said himself in a 1998 speech, "We have gained on the
level of rhetoric, lost on the level of practice." By this he meant that
academic circles had accepted free market principles as superior to Keynesian
thinking, but governments were still enamored with Keynes. According to critics
of Keynesianism, Keynesian economics is attractive to governments because it
justifies even their most wasteful projects and excuses the bureaucratic
excesses of big government. Friedman and his colleagues brought another
alternative to big government, but felt that few governments were willing to
give up the reins. (To learn more about the Nobel Memorial Prize in Economic
Sciences, read Nobel Winners Are Economic Prizes.)
Nobel End
Milton Friedman came to the forefront of economics at a time when free market
economists were in short supply. At every opportunity, Friedman argued
passionately against government intervention and in favor of the free market. A
firm believer in freedom, both in the markets and in personal life, Friedman
was a member of the Mont Pelerin Society and later served as its president. He
allowed that free market capitalism may not be the perfect solution, but
asserted that it was by far the best out of all the alternatives known to us
today.
Friedman's awards and recognition are numerous, including his 1976 Nobel
Memorial Prize, but the highest praise is that he continued to toil tirelessly
defending freedom and debating all comers right up to his death in 2006.
Countries like India and China that took Friedman's message to heart and, many
believe they are now reaping the economic benefits as a result. Friedman's free
market ideals provided a new way of looking at the economy and offered
alternative ways for countries to build and maintain strong economies.
by Andrew Beattie
Andrew Beattie has spent most of his career writing, editing and managing Web
content in all its many forms. He is especially interested in the future of
search and the application of analytics to the business world. In addition to
being a long-time contributor to Investopedia.com, Andrew has been working on
ForexDictionary.com.