Paul Krugman: Who Was Milton Friedman?

I don't want to push the religious analogy too far. Economic theory at least aspires to be science, not theology; it is concerned with earth, not heaven. Keynesian theory initially prevailed because it did a far better job than classical orthodoxy of making sense of the world around us, and Friedman's critique of Keynes became so influential largely because he correctly identified Keynesianism's weak points. And just to be clear: although this essay argues that Friedman was wrong on some issues, and sometimes seemed less than honest with his readers, I regard him as a great economist and a great man.

Milton Friedman played three roles in the intellectual life of the twentieth century. There was Friedman the economist's economist, who wrote technical, more or less apolitical analyses of consumer behavior and inflation. There was Friedman the policy entrepreneur, who spent decades campaigning on behalf of the policy known as monetarism—finally seeing the Federal Reserve and the Bank of England adopt his doctrine at the end of the 1970s, only to abandon it as unworkable a few years later. Finally, there was Friedman the ideologue, the great popularizer of free-market doctrine.

Did the same man play all these roles? Yes and no. All three roles were informed by Friedman's faith in the classical verities of free-market economics. Moreover, Friedman's effectiveness as a popularizer and propagandist rested in part on his well-deserved reputation as a profound economic theorist. But there's an important difference between the rigor of his work as a professional economist and the looser, sometimes questionable logic of his pronouncements as a public intellectual. While Friedman's theoretical work is universally admired by professional economists, there's much more ambivalence about his policy pronouncements and especially his popularizing....

Keynes didn't make an all-out assault on Economic Man, but he often resorted to plausible psychological theorizing rather than careful analysis of what a rational decision-maker would do. Business decisions were driven by "animal spirits," consumer decisions by a psychological tendency to spend some but not all of any increase in income, wage settlements by a sense of fairness, and so on.

But was it really a good idea to diminish the role of Economic Man that much? No, said Friedman, who argued in his 1953 essay "The Methodology of Positive Economics" that economic theories should be judged not by their psychological realism but by their ability to predict behavior. And Friedman's two greatest triumphs as an economic theorist came from applying the hypothesis of rational behavior to questions other economists had thought beyond its reach.

In his 1957 book A Theory of the Consumption Function—not exactly a crowd-pleasing title, but an important topic—Friedman argued that the best way to make sense of saving and spending was not, as Keynes had done, to resort to loose psychological theorizing, but rather to think of individuals as making rational plans about how to spend their wealth over their lifetimes. This wasn't necessarily an anti-Keynesian idea—in fact, the great Keynesian economist Franco Modigliani simultaneously and independently made a similar case, with even more care in thinking about rational behavior, in work with Albert Ando. But it did mark a return to classical ways of thinking—and it worked. The details are a bit technical, but Friedman's "permanent income hypothesis" and the Ando-Modigliani "life cycle model" resolved several apparent paradoxes about the relationship between income and spending, and remain the foundations of how economists think about spending and saving to this day.

Friedman's work on consumption behavior would, in itself, have made his academic reputation. An even bigger triumph, however, came from his application of Economic Man theorizing to inflation. In 1958 the New Zealand–born economist A.W. Phillips pointed out that there was a historical correlation between unemployment and inflation, with high inflation associated with low unemployment and vice versa. For a time, economists treated this correlation as if it were a reliable and stable relationship. This led to serious discussion about which point on the "Phillips curve" the government should choose. For example, should the United States accept a higher inflation rate in order to achieve a lower unemployment rate?

In 1967, however, Friedman gave a presidential address to the American Economic Association in which he argued that the correlation between inflation and unemployment, even thought it was visible in the data, did not represent a true trade-off, at least not in the long run. "There is," he said, "always a temporary trade-off between inflation and unemployment; there is no permanent trade-off." In other words, if policymakers were to try to keep unemployment low through a policy of generating higher inflation, they would achieve only temporary success. According to Friedman, unemployment would eventually rise again, even as inflation remained high. The economy would, in other words, suffer the condition Paul Samuelson would later dub "stagflation."

How did Friedman reach this conclusion? (Edmund S. Phelps, who was awarded the Nobel Memorial Prize in economics this year, simultaneously and independently arrived at the same result.) As in the case of his work on consumer behavior, Friedman applied the idea of rational behavior. He argued that after a sustained period of inflation, people would build expectations of future inflation into their decisions, nullifying any positive effects of inflation on employment. For example, one reason inflation may lead to higher employment is that hiring more workers becomes profitable when prices rise faster than wages. But once workers understand that the purchasing power of their wages will be eroded by inflation, they will demand higher wage settlements in advance, so that wages keep up with prices. As a result, after inflation has gone on for a while, it will no longer deliver the original boost to employment. In fact, there will be a rise in unemployment if inflation falls short of expectations.

At the time Friedman and Phelps propounded their ideas, the United States had little experience with sustained inflation. So this was truly a prediction rather than an attempt to explain the past. In the 1970s, how-ever, persistent inflation provided a test of the Friedman-Phelps hypothesis. Sure enough, the historical correlation between inflation and unemployment broke down in just the way Friedman and Phelps had predicted: in the 1970s, as the inflation rate rose into double digits, the unemployment rate was as high or higher than in the stable-price years of the 1950s and 1960s. Inflation was eventually brought under control in the 1980s, but only after a painful period of extremely high unemployment, the worst since the Great Depression.

By predicting the phenomenon of stagflation in advance, Friedman and Phelps achieved one of the great triumphs of postwar economics. This triumph, more than anything else, confirmed Milton Friedman's status as a great economist's economist, whatever one may think of his other roles...