Uneasy Money

After blowing off some steam about Milton Friedman in my previous post, thereby antagonizing a sizable segment of my readership, and after realizing that I had been guilty of a couple of memory lapses in citing sources that I was relying on, I thought that I should go back and consult some of the relevant primary sources. So I looked up Friedman’s 1966 article “Interest Rates and the Demand for Money” published in the Journal of Law and Economics in which he denied that he had ever asserted that the demand for money did not depend on the rate of interest and that the empirical magnitude of the elasticity of money demand with respect to the interest rate was not important unless it approached the very high elasticity associated with the Keynesian liquidity trap. I also took a look at Friedman’s reply to Don Patinkin essay “Friedman on the Quantity Theory and Keynesian Economics” in Milton Friedman’s Monetary Framework: A Debate with his Critics.

Perhaps on another occasion, I will offer some comments on Friedman and the interest elasticity of the demand for money, but, for now, I will focus on Friedman’s reply to Patinkin, which is most relevant to my previous post. Patinkin’s essay, entitled, “Friedman on the Quantity Theory and Keynesian Economics,” charged that Friedman had repackaged the Keynesian theory as a quantity theory and tried to sell it with a Chicago oral tradition label stuck on the package. That’s an overstatement of a far more sophisticated argument than my one sentence summary can do justice to, but it captures the polemical gist of Patinkin’s argument, an argument that he had made previously in a paper, “The Chicago Tradition, the Quantity Theory, and Friedman” published in the Journal of Money, Credit and Banking which Harry Johnson relied on in his 1970 Richard T. Ely lecture, “The Keynesian Revolution and the Monetarist Counterrevolution.” Friedman took personal offense at what he regarded as attacks on his scholarly integrity in those papers, and his irritation (to put it mildly) with Patinkin is plainly in evidence in his reply to Patinkin. Much, but not all, of my criticism of Friedman stems from my memory of the two papers by Patinkin and Johnson.

Now to give Friedman his due – and to reiterate what I have already said a number of times, Friedman was a great economist and you can learn a lot by reading his arguments carefully because he was a very skillful applied theorist — he makes a number of effective responses to Patinkin’s accusation that he was merely peddling a disguised version of Keynesianism under the banners of the quantity theory and the Chicago oral tradition. These are basically the same arguments that Scott Sumner used in the post that he wrote defending Friedman against my recycling of the Patinkin/Johnson criticism.

First, like earlier quantity theorists, and unlike Keynes in the General Theory, Friedman assumed that the price level is determined (not, as in the GT, somehow fixed exogenously) by the demand for money and the supply (effectively under the complete discretionary control of the monetary authority) of money.

Second, because differences between the demand for money and the supply of money (in nominal terms) are equilibrated primarily by changes in the price level (not, as in the GT, by changes in the rate of interest), the link between monetary policy and the economy that Friedman focused on was the price level not the rate of interest.

Third, Friedman did not deny that the demand for money was affected by the rate of interest, but he maintained that monetary policy would become ineffective only under conditions of a liquidity trap, which was therefore, in Friedman’s view, the chief theoretical innovation of the General Theory, but one which, on empirical grounds, Friedman flatly rejected.

So if I were to restate Patinkin’s objection in somewhat different terms, I would say that Friedman, in 1956 and in later expositions, described the quantity theory as a theory of the demand for money, which as a historical matter is a travesty, because the quantity theory was around for centuries before the concept of a demand for money was even articulated, but the theory of the demand for money that Friedman described was, in fact, very much influenced by the Keynesian theory of liquidity preference, an influence not mentioned by Friedman in 1956 but acknowledged in later expositions. Friedman explained away this failure by saying that Keynes was merely adding to a theory of the demand for money that had been evolving at Cambridge since Marshall’s day, and that the novel element in the General Theory, absolute liquidity preference, was empirically unsupported. That characterization of Keynes’s theory of liquidity preference strikes me as being ungenerous, but both Friedman and Patinkin neglected to point out that Keynes erroneously thought that his theory of liquidity preference was actually a complete theory of the rate of interest that displaced the real theory of interest.

So, my take on the dispute between Friedman and Patinkin is that Patinkin was right that Friedman did not sufficiently acknowledge the extent to which he was indebted to Keynes for the theory of the demand for money that he erroneously identified with the quantity theory of money. On the other hand, because Friedman explicitly allowed for the price level to be determined within his model, he avoided the Keynesian liquidity-preference relationship between the quantity of money and the rate of interest, allowing the real rate of interest to be determined by real factors not liquidity preference. In some sense, Friedman may have exaggerated the conceptual differences between himself and the Keynesians, but, by making a strategic assumption that the price level responds to changes in the quantity of money, Friedman minimized the effect of changes in the quantity of money on interest rates, except via changes in price level expectations.

But, having granted Friedman partial exoneration of the charge that he was a crypto-Keynesian, I want to explore a bit more carefully Friedman’s remarkable defense against the accusation by Patinkin and Johnson that he invented a non-existent Chicago oral tradition under whose name he could present his quasi-Keynesian theory of the demand for money. Friedman began his response to Patinkin with the following expression of outrage.

Patinkin . . . and Johnson criticize me for linking my work to a “Chicago tradition” rather than recognizing that, as they see it, my work is Keynesian. In the course of their criticism, they give a highly misleading impression of the Chicago tradition. . . .

Whether I conveyed the flavor of that tradition or not, there was such a tradition; it was significantly different from the quantity theory tradition that prevailed at other institutions of learning, notably the London School of Economics; that Chicago tradition had a great deal to do with the differential impact of Keynes’s General Theory on economists at Chicago and elsewhere; and it was responsible for the maintenance of interest in the quantity theory at Chicago. (Friedman’s Monetary Framework p. 158 )

Note the reference to the London School of Economics, as if LSE in the 1930s was in any way notable for its quantity theory tradition. There were to be sure monetary theorists of some distinction working at the LSE in the 1930s, but their relationship to the quantity theory was, at best, remote.

Friedman elaborates on this tidbit a few pages later, recalling that in the late 1940s or early 1950s he once debated Abba Lerner at a seminar at the University of Chicago. Despite agreeing with each other about many issues, Friedman recalled that they were in sharp disagreement about the Keynesian Revolution, Lerner being an avid Keynesian, and Friedman being opposed. The reason for their very different reaction to the Keynesian Revolution, Friedman conjectured, was that Lerner had been trained at the London School of Economics “where the dominant view was that the depression was an inevitable result of the prior boom, that it was deepened by the attempts ot prevent prices and wages from falling and firms from going bankrupt, that the monetary authorities had brought on the depression by inflationary policies before the crash and had prolonged it by ‘easy money’ policies thereafter; that the only sound policy was to let the depression run its course, bring down money costs, and eliminate the weak and unsound firms.” For someone trained in such a view, Friedman suggested, the Keynesian program would seem very attractive. Friedman continued:

It was the London School (really Austrian) view that I referred to in my “Restatement” when I spoke of “the atrophied and rigid caricature [of the quantity theory] that is so frequently described by the proponents of the new income-expenditure approach – and with some justice, to judge by much of the literature on policy that was spawned by the quantity theorists.”

The intellectual climate at Chicago had been wholly different. My teachers regarded the depression as largely the product of misguided government policy – or at least greatly intensified by such policies. They blamed the monetary and fiscal authorities for permitting banks to fail and the quantity of deposits to decline. Far from preaching the need to let deflation and bankruptcy run their course, they issued repeated pronouncements calling for governmental action to stem the deflation. . . .

It was this view the the quantity theory that I referred to in my “Restatement” as “a more subtle and relevant version, one in which the quantity theory was connected and integrated with general price theory and became a flexible and sensitive tool for interpreting movements in aggregate economic activity and for developing relevant policy prescriptions.” (pp. 162-63)

After quoting at length from a talk Jacob Viner gave in 1933 calling for monetary expansion, Friedman winds up with this gem.

What, in the field of interpretation and policy, did Keynes have to offer those of us who learned their economics at a Chicago filled with these views? Can anyone who knows my work read Viner’s comments and not see the direct links between them and Anna Schwartz’s and my Monetary History or between them and the empirical Studies in the Quantity Theory of Money? Indeed, as I have read Viner’s talk for purposes of this paper, I have myself been amazed to discover how precisely it foreshadows the main thesis of our Monetary History for the depression period, and have been embarrassed that we made no reference to it in our account. Can you find any similar link between [Lionel] Robbins’s [of LSE] comments [in his book The Great Depression] and our work? (p. 167)

So what is the evidence that Friedman provides to counter the scandalous accusation by Patinkin and Johnson that Friedman invented a Chicago oral tradition of the quantity theory? (And don’t forget: the quantity theory is a theory of the demand for money) Well, it’s that, at the London School of Economics, there were a bunch of guys who had crazy views about just allowing the Great Depression to run its course, and those guys were quantity theorists, which is why Keynes had to start a revolution to get rid of them all, but at Chicago, they didn’t allow any of those guys to spout their crazy ideas in the first place, so we didn’t need any damn Keynesian revolution.

Good grief! Is there a single word that makes sense? To begin with those detestable guys at LSE were Austrians, as Friedman acknowledges. What he didn’t say, or didn’t know, is that Austrians, either by self-description or by any reasonable definition of the term, are not quantity theorists. So the idea that there was anything special about the Chicago quantity theory as opposed to any other species of the quantity theory is total humbug.

But hold on, it only gets worse. Friedman holds up Jacob Viner as an exemplar of the Chicago quantity theory oral tradition. Jacob Viner was a superb economist, a magnificent scholar, and a legendary teacher for whom I have the utmost admiration, and I am sure that Friedman learned a lot from him at Chicago, But isn’t it strange that Friedman writes: “as I have read Viner’s talk for purposes of this paper, I have myself been amazed to discover how precisely it foreshadows the main thesis of our Monetary History for the depression period, and have been embarrassed that we made no reference to it in our account.” OMG! This is the oral tradition that exerted such a powerful influence on Friedman and his fellow students? Viner explains how to get out of the depression in 1933, and in 1971 Friedman is “amazed to discover” how precisely Viner’s talk foreshadowed the main thesis of his explanation of the Great Depression? That sounds more like a subliminal tradition than an oral tradition.

Responding to Patinkin’s charge that his theory of the demand for money – remember the quantity theory, according to Friedman is a theory of the demand for money — is largely derived from Keynes, Friedman plays a word game.

Is everything in the General Theory Keynesian? Obviously yes, in the trivial sense that the words were set down on paper by John Maynard Keynes. Obviously no, in the more important sense that the term Keynesian has come to refer to a theory of short-term economic change – or a way of analyzing such change – presented in the General Theory and distinctively different from the theory that preceded it. To take a noncontroversial example: in his chapter 20 on “The Employment Function” and elsewhere, Keynes uses the law of diminishing returns to conclude that an increase of employment requires a decline in real-wage rates. Clearly that does not make the “law of diminishing returns” Keynesian or justify describing the “analytical framework” of someone who embodies the law of diminishing returns in his theoretical structure as Keynesian.

In just the same sense, I maintain that Keynes’s discussion of the demand curve for money in the General Theory is for the most part a continuation of earlier quantity theory approaches, improved and refined but not basically modified. As evidence, I shall cite Keynes’s own writings in the Tract on Monetary Reform – long before he became a Keynesian in the present sense. (p. 168)

There are two problems with this line of defense. First, the analogy to the law of diminishing returns would have been appropriate only if Keynes had played a major role in the discovery of the law of diminishing returns just as, on Friedman’s own admission, he played a major role in discovering the theory of liquidity preference. Second, it is, to say the least, debatable to what extent “Keynes’s discussion of the demand curve for money was merely a continuation of earlier quantity theory approaches, improved and refined but not basically modified.” But there is no basis at all for the suggestion that a Chicago oral tradition was the least bit implicated in those earlier quantity theory approaches. So Friedman’s invocation of a Chicago oral tradition was completely fanciful.

This post has gone on too long already. I have more to say about Friedman’s discussion of the relationship between money, price levels, and interest rates. But that will have to wait till next time.