Kuttner vs Friedman; Hamlet Without The Prince

By Arnold Kling

"A signature Friedman debating technique is to disclaim knowledge when conversation moves into an area where the facts are at odds with his theories." -- Robert Kuttner, The American Prospect
If you want to read the debate between Robert Kuttner and Milton Friedman yourself in order to decide who won, feel free. Not taking any chances, Kuttner wrote his own evaluation, quoted above.
The subject of this article is Kuttner's column about the debate, rather than the debate itself -- Kuttner the fight judge, not Kuttner the boxer. I was particularly struck by Kuttner's statement above. Evidently, the concept of genuine humility is so foreign to Kuttner that he regards an expression of humility as a debating tactic. In a sense, that is why Kuttner belongs on the left. Contemporary liberalism without hubris is Hamlet without the Prince.
Monetarism
Kuttner reports round one as follows:
“after the stock market collapse of 2000-2001, Greenspan led the Fed to cut interest rates 12 times in a year, reducing the short-term interest rate effectively to zero.
“Greenspan opened the monetary floodgates...In short, despite Friedman’s obsession with money supply, it took a very loose monetary policy by the Fed coupled with major interventions in the banking system plus a very stimulative budget (helped along by the willingness of foreign central banks to continue lending America money) to keep the post-crash economy from sinking into deflation and deep recession. Whatever Greenspan did, he neither put the money supply on automatic pilot nor passively targeted price stability.”
Both Friedman and Kuttner believe that monetary policy after the stock market crash was constructive. The difference between the two is that Friedman argues that the Fed kept the money supply growing, while Kuttner argues that the Fed intervened to keep the money supply growing. Furthermore, he contends, because the Fed intervened, that proves that left-leaning economists, who favor government intervention, are correct.
What is the difference between keeping the money supply growing and intervening to keep the money supply growing? There is no such difference in monetary economics. In the money market, there is a relationship between the interest rate controlled by the Fed, called the Fed Funds rate, and the money supply. If a financial shock threatens to reduce money growth and the Fed wants to offset the shock, then it has to reduce the interest rate. If it refuses to "intervene" in this way, the money supply will fall below target. It could be said that Friedman has always favored "intervention" to maintain stable money growth; however, by Keynesian standards, this is a passive, noninterventionist policy rule.
Ironically, in the debate, Friedman did admit to a departure from one of the tenets of monetarism, which is that the velocity of money can be viewed as roughly constant. Instead, he suggests that the velocity of money drops when there is a stock market crash, and that it is wise to offset this drop in velocity with faster money growth. Kuttner might have done better to press Friedman on this point.
Currency Markets
Friedman, a longtime proponent of flexible exchange rates, argues that the Federal Reserve should leave foreign currency markets alone. Kuttner writes,
“If, for example, the U.S. currency tumbled in world financial markets, the Fed would be torn between a policy of tight money to stem the dollar’s fall and loose money to keep the domestic economy out of severe recession.”
Here, Kuttner is confused. If a recession were to coincide with a decline in the dollar, the causal factor would be the recession. However, that is not what Kuttner has in mind. What he appears to be contemplating is a thought-experiment in which speculators autonomously drive down the value of the dollar.
Conventional macroeconomics says that such an autonomous, speculative decline in the value of the dollar would not cause a recession. On the contrary, it would increase exports and reduce imports, and thus would be expansionary/inflationary. There is absolutely no reason to loosen the money supply under such a scenario.
On the larger point, about whether the government should allow market forces to determine the value of the dollar, economists are nearly unanimous in their support of Friedman. (The only exceptions are economists who prefer a gold standard.) Friedman believes that speculators may be mistaken, but it is difficult for governments to intervene effectively in currency markets. The overwhelming weight of empirical evidence is on his side. I do not know of any important American economist arguing for currency intervention today. (Many economists would argue for policies to influence America's savings rate, which in turn would affect the dollar. See The Balance of Saving.)
The Natural Rate of Unemployment
Kuttner writes,
“Another favorite Friedman idea was a “natural rate of unemployment” -- the rate of joblessness that would keep prices roughly stable, supposedly around 6 percent. If governments or central bankers tried to reduce unemployment below this ostensibly natural rate, inflation would result, because workers in tight labor markets could bargain for wage increases in excess of their actual productivity.
“However, the rate of unemployment that is consistent with stable prices turns out not to be a constant or knowable number, hence not a reliable target for monetary policy.”
Kuttner has apparently missed the point of the concept of a natural rate of unemployment, which is that the unemployment rate should not be a "target for monetary policy." What Friedman means by the term natural unemployment rate is the rate toward which the economy will gravitate without any attempt at activist management by government. It is because the economy will settle on this natural rate that the Fed should not intervene to manipulate unemployment. If you are not intervening to manipulate the unemployment rate, then the accuracy of your measure of the natural rate of unemployment is irrelevant. Uncertainty about the level of the natural rate is a problem only for the opponents of Friedman, who are interventionists.
Health Care and Schools
On health care and schools, Kuttner writes,
“When pressed, he [Friedman] concedes that government ought to provide ‘catastrophic’ health insurance for people who can’t afford to buy it, but as a humanitarian act of charity and not as an act of economic efficiency.
“...Friedman makes similar arguments about schooling. In his ideal world, government would cease providing, or even financing, schools entirely. ‘My ideal school system,’ he told me, ‘would be one in which parents are responsible for supporting [the education of] their children, as they are responsible for feeding and clothing them.’ He added, ‘If government has any role at all, it is solely on a humanitarian basis, for those cases of indigent families who simply cannot afford to school their child.’”
Kuttner does not address these views. Perhaps he believes that they are self-evidently wrong. For those of us who are more inclined to think that Friedman's views are self-evidently right, I wish that Kuttner had provided more argument. For example, I would concede that there are parents who do not seem to have the motivation and the means to ensure that their children are educated. So far, however, judging by the performance of schools attended by such children, the government is unable to solve the problem. However, if Kuttner has ideas for overcoming dysfunctional parents, I am ready to listen.
Uncomfortable Facts
The quote that I used at the beginning of this essay, in which Kuttner accuses Friedman of pleading ignorance to uncomfortable facts, is followed immediately by:
“For example, self-regulation obviously failed investors in the multiple insider-trading, self-dealing, and stock promotion scandals of the late 1990s that in turn led to the stock-market bubble. Insiders ripped off investors by cooking corporate books, misallocating trillions of dollars of investment capital.”
This is the first I have heard of the hypothesis that scandals caused the stock bubble. I have found many economists who think of it the other way around -- scandals seem to be a feature of the final phase of a stock bubble. Their explanations for the bubble tend to focus on investors' expectations -- for the economy, the profitability of Internet stocks, and the behavior of other investors. Many economists draw a comparison with the railroad boom 150 years earlier.
This is also the first time I have heard that corporate accounting scandals resulted in "misallocating trillions of dollars of investment capital." According the U.S. National Income Accounts, total nonresidential fixed investment in the U.S. barely tops $1 trillion per year. Kuttner is saying that more than 100 percent of one year's purchases of plant and equipment went down the toilet. If such an enormous misallocation had occurred, then productivity would have declined sharply. That is hardly the case.
In Kuttner's view, these are the "facts" of which Milton Friedman disclaimed knowledge. Was the Nobel Laureate being evasive, or overly polite?
Genuine humility is a feature of libertarian conservatism, which may be the fundamental reason that it differs from neoconservatism. If you think you have all of the answers, then it is difficult to resist passing No Child Left Behind Laws and other expressions of government hubris. Libertarian conservatives believe that we do not know enough to justify imposing our will on others through government. Supporters of activist government believe they know more than we do. I fear that they know less.
Arnold Kling is author of Learning Economics.