This is another installment in our series of profiles of leading economists from Capitalism and its Critics.
Milton Friedman was born in Brooklyn in 1912 and died in San Francisco in 2006 at age 94. He is known as the primary apostle of monetarism, which is the proposition that the core metrics of an economy—inflation, and the rates of growth and of unemployment–are determined by the growth rate of the money supply and not, as John Maynard Keynes postulated, government spending policies designed to promote or constrain economic performance. Friedman may be most famous for his 1962 book “Capitalism and Democracy.” He graduated from Rahway (NJ) High School at age 15 and earned his undergrad degree at Rutgers and later his Masters at Columbia. He would be a professor at the University of Chicago for 30 years starting in 1946.
He won the 1976 Economics Nobel and became a primary intellectual leader of the monetarist school, which rejected Keynesianism in favor of the concept that there is a “natural rate of unemployment” which no government policy can alter in the long run.
He was also famous for redrawing the conventional “Philips curve,” which graphically displayed the concept that inflation and unemployment are inversely correlated. Higher inflation could give you lower unemployment and vice versa. (A.W.H. Phillips conducted an exhaustive study of wage inflation and unemployment in the UK from 1861 to 1957–just shy of a century’s worth of data–and found a consistent inverse relationship; the lower the unemployment rate, the more aggressively firms had to raise wages to counteract scarcity. Conversely, in periods of high unemployment, potential workers are more flexible about what a threshold “acceptable” wage rate is.) Conceptually, Friedman redrew this as a vertical line, rejecting the curve’s implicit premise that a government can achieve lower unemployment if it is willing to tolerate higher inflation. (If the blip in inflation is a surprise, unemployment may temporarily drop, but the macroeconomy will soon return to its natural equilibrium, a function of the frictions and imperfections of the labor market.)
Phillips Curve (courtesy Google Gemini)
Friedman rejected the Phillips Curve paradigm. Instead, he argued that there was a “natural rate of unemployment” which was inalterable over any short to medium-term time frame. In other words, policymakers actually could not choose to trade off a low jobless rate for higher inflation or vice versa. Granted, if a nation’s central bank drastically lowered the country’s discount rate unemployment might temporarily drop assuming the business world didn’t see it coming, In his 1967 Presidential speech to the American Economic Association, Friedman posited that there was a “natural rate of unemployment” and if policymakers tried to lower that rate, inflation would accelerate. Famously, Friedman summarized this view thusly: “There is always a temporary trade-off between inflation and unemployment. There is no permanent trade-off.”
Subsequently, economists came up with the concept of “NAIRU,” or the non-accelerating inflation rate of unemployment, stipulated to mean the unemployment rate below which inflation is expected to rise or, expressed slightly differently, the equilibrium point between labor market slack and price stability. (It can change over time due to structural economic shifts, demographic changes, and labor’s bargaining power, but these changes take time and as a matter of realpolitik will not be evident over, say, a President’s term in office.) Capitalism and Freedom was, to say the least, out of step with the received wisdom on its publication in 1962. Among other things, Friedman wrote that government power was the greatest threat to freedom and questioned its role in, among other things, highway building, public education, social security, public housing, banking regulation, and even national parks. It received a cool reception.
But Friedman’s day would come. In 1965 the US inflation rate was 1.6%; by 1970 it had reached 5.8%. The famous driver of this rise was Lyndon Johnson’s surge in government spending, both to pay for the Vietnam War and to underwrite new and expensive domestic programs. As wage bills and input prices increased, corporate America passed along the rising costs in higher prices.
The Yom Kippur War of October 1973 prompted Arab oil producers to embargo oil to Western nations that supported Israel, and within months the price of crude more than tripled. Moreover, inflation and unemployment spiked up at the same time. Within two years, inflation was at 12% and unemployment above 8%. According to the conventional Philips curve this was not supposed to happen.
Clearly, a new policy framework was required, and the economic academics rose to the occasion. Specifically, they came up with the theory of “rational expectations” which swept through American economics departments “like a virus” and that at its extreme claimed that if the Fed’s commitment to eliminate inflation was sufficiently credible, inflation should fall sharply pretty much immediately. Wage negotiators would accept that if, say, the money supply growth would be limited to 3% they would adjust their claims in wage bargaining negotiations accordingly.
Understandably, this theorizing was tremendously attractive to politicians and in particular to Ronald Reagan during his failed 1976 presidential campaign and later to Margaret Thatcher. after Reagan won the 1980 campaign and moved into the White House, he appointed Friedman to a panel of outside economic advisors who met with him regularly.
You may be familiar with Isaiah Berlin’s 1953 essay “The Hedgehog and the Fox,” which is grounded in an ancient Greek fragment, “The fox knows many things, but the hedgehog knows one big thing,” to divide thinkers into two types: foxes, who pursue many ends and see the world in all its variety, and hedgehogs, who relate everything to a single, central vision or system. (In history, “hedgehogs” have included Plato and Dante, whereas “foxes” have included Aristotle and Shakespeare.) Friedman was a hedgehog; see the title of this column–inflation is “always and everywhere” caused by one and only one thing.
Now, we come to the often overlooked Hyman Minsky, a professor at Washington University St Louis. He was a liberal by nature and therefore intrinsically skeptical of Friedman’s conservatism, but he was not fundamentally an ideologue and how he developed his thinking proved prescient. (Capitalism and its Critics discusses Minsky in the chapter devoted to Friedman, as it’s intellectually dubious to discuss one without the other.)
Minsky described himself as a Financial Keynesian and studied under Joseph Schumpeter at Harvard in the early 1950s. Perhaps his most famous paper came out in 1978 and in it he presented the concept of two fundamental parallel structures in a modern economy: The business sector, which invested in buildings and capital equipment to produce things, and the banking sector which lent money to business based on expected cash flows.
Standard textbooks concentrated almost exclusively on the production side of the economy but by contrast Minsky emphasized the availability of credit and how it changes over time. Early in a business cycle, financial institutions choose to lend only to business projects where cash flows were expected to comfortably cover their financial commitments. Unfortunately, this virtuous. does not last. As the prices of assets such as stocks and real estate rise, banks and other lenders lower their credit standards and start lending to ventures that can generate enough cash to meet their interest payments but not any other financial commitments.
These types of businesses have to roll over their debts on a regular basis, at the limit, on an overnight basis. Still, we have not reached the last stage in recklessness. That is what Minsky kindly named “Ponzi finance.” This is lending on the basis of a wish and a prayer because if for any reason the supply of new credit dries up Ponzi businesses have no choice but to sell assets in order to raise the cash. This is when they typically discover that their assets cannot be sold at a price that comes anywhere near covering their debts. Asset prices collapse, and we are on the way to a financial crisis.
Sounds like 2007 / 2008, anyone?
Again, you are probably wondering what on earth this has to do with Law Land.
One of my core beliefs is in the power of stewardship. None of these transactions can come to fruition without law firms papering the deals and the relationships and the underwriting agreements. There may be no pecuniary reward in you telling your client that they are doing something foolish and strongly urging them not to do the deal. taking the legal work with it, but if reputation in the long run is your most valuable asset – it is – next time this financial mania syndrome begins to appear, you might have an internal summit conference to think about this. Financial crises can kneecap your clients–particularly those in voguish highly leveraged sectors like private credit–and take away your pipeline of future work (and your receivables) to boot.
Urging a bit of caution while the spigot is open full blast may come across as contrarian at best and self-defeating at worst. But as someone who devoted his career to advancing economic equilibrium in the long run, Milton Friedman would understand.
Bank run (image courtesy Gemini AI)
