Responding to a beggar, W. C. Fields quipped: “Sorry, my good man, but all my available funds are tied up in cash.” To Keynes, this would be a problem not just for the beggar; by keeping wealth “tied up” in cash or in checking accounts, he would say that Fields was helping to deepen the Depression.
Since his view was that stingy misers perpetuated the Depression, Keynes advocated government spending to lift consumption. To Keynesians, the national economy is like an automobile. The accelerator pedal is marked “higher government spending / lower taxes”; the brake is marked “lower government spending / higher taxes.” A government that drives deftly and carefully can bring economic growth and stable prices.
This chapter tells the story of an intellectual movement that attacks the Keynesian model by asserting that (1) governments are usually lousy drivers, and (2) the economy’s brake and accelerator have little to do with fiscal policy. This movement, called monetarism, admits that the economy does have an accelerator and a brake, but insists that the accelerator should be marked “higher money supply” and the brake “lower money supply.” The monetarists also disagree with the Keynesians about who sits in the driver’s seat. According to the Keynesians, Congress, which authorizes spending and taxes, is the driver. In contrast, the monetarists portray the Federal Reserve Board, which oversees the banking industry, as the driver.
A titanic struggle took place between Keynesians and monetarists from the 1950s through the 1970s. Led by Milton Friedman, Karl Brunner, and Allan Meltzer, the monetarists were initially greeted with derision, even though their intellectual forefathers included Locke, Hume, Mill, and Ricardo. But as they kept producing cogent studies and courageous graduate students, they wore down Keynesian opposition and earned more respect and prominence until finally, during the Carter administration, Congress required the Federal Reserve to take the monetarist arguments seriously, and the chairman of the Federal Reserve Board decided to follow monetarist advice.
Where does the struggle stand today? It’s a tie. We will see that the federal government treats the national economy as an automobile with four pedals—two accelerators and two brakes! Remember poor Harry Truman begging for a one-handed economist. Today’s leaders seem to be stuck with four-footed economists. To make matters worse, the pedals don’t seem as potent as the strict monetarists and orthodox Keynesians had promised.
To understand today’s macroeconomics, we must trace the course of the Keynesian-monetarist battles and learn how the monetarist model operates. This requires us to learn a bit about banking and the Federal Reserve Board. Some of the concepts may seem tricky at first, but the effort necessary to understand them is worthwhile, for the story of how the monetarist theories earned respect is one of the fascinating epics in contemporary intellectual history.
Monetarists accuse Keynes of ignoring money and the money supply, which sounds absurd. After all, how could a man who made a fortune in stocks and commodities and who revolutionized macroeconomics ignore money? That would be like accusing Melville of ignoring whales. Surely, monetarists have something in mind other than the everyday idea of money.
What is money? Anything can be money, including shells and beads; cigarettes often serve as money in prisons. In today’s macroeconomic lingo, we follow the Federal Reserve Board definitions of money supply. The most popular measure is called M1 and equals (1) the amount of currency held outside the banks plus (2) the amount of funds in checking accounts (“demand deposits”) at commercial banks. (Note that corporate stocks and bonds are not considered money. Broader measurements of the money supply include less-liquid assets such as savings accounts and money market mutual funds.)
Why would anyone be foolish enough to argue about the money supply? The more money, the merrier, right? Wrong. In slapstick movies, bumbling gangsters drop suitcases filled with bills, and bystanders dive past one another hoping to grab a few. The bystanders always smile, and the bad guys wail. Why do economists cry with the gangsters? A problem does not arise when just a few suitcases burst open. But if lots of luggage were to suddenly flood a town with bills, inflation might follow. If the amount of money overwhelms the capacity to produce goods, consumers, with more money to spend, bid up prices. The town is no wealthier than it was before; more bills do not bring a higher standard of living any more than if everyone added two zeroes to his or her salary. Remember that wealth is measured by the goods and services it can buy, not by numerals. Since one U.S. dollar can buy thousands of pesos, a Colombian millionaire might be considered poor compared with a low-income American. Giving all the Colombians suitcases packed with pesos would not help. More paper does not bring more merriment.
What’s the correct money supply level? The easy answer: enough to buy all the goods produced, so that full employment is reached without a rise in prices. But the easy answer avoids the crucial question. How much money should be in circulation in order to have full employment and stable prices? To answer this question, we must know how fast people spend the money they receive. Do people tend to hold on to their money for a long time before spending it, or do they spend money quickly? How fast does money change hands and circulate through the economy? If money moves quickly, the country does not need as much as it would if people were to leave it lying around in their sock drawers for months before spending it. Academic careers and national economies hinge on this simple issue. The rate at which the money stock turns over each year is called the velocity of money. Economists compare this with GDP and speak of the income velocity of money, V. Thus, V equals the level of GDP divided by the money supply.
For example, if the GDP is $24 trillion and the money supply is $12 trillion, V must equal 2. If money turns over two times during the year, on any particular day people are holding about six months’ worth of income (in the form of currency or checking accounts).
Why is this important? How could anyone debate this with anything but gentlemanly insouciance? If velocity is stable, and if the central bank can control the money supply, the government has a powerful tool with which to speed up or slow down the economy. The accelerator and brake pedals marked “money supply” directly control the engine. If velocity is unstable, however—if people vacillate between holding a lot and holding little of their funds in currency and checking accounts—controlling the money supply is not very helpful, and the accelerator becomes unhinged.
To simplify the sides in the battle, monetarists believe that velocity is stable, while Keynesians see it as unstable. No wonder monetarists tap the money supply as the most powerful pedal in the government’s car, while Keynesians exalt fiscal policy, and a rigid subset of Keynesians see monetary policy as being no more important to the engine than a windshield wiper.
Before exploring the history of monetarism and the evidence for and against it, we must first summarize how the Federal Reserve Board manipulates the money supply. Three tools are most important. First, the Fed controls the percentage of deposits that banks are permitted to lend (the reserve ratio). Assume that the Fed sets the reserve ratio at 20 percent, so banks can lend 80 percent of the money deposited with them. Then assume that our friend Chris deposits $10 in a checking account. This counts in the money supply. (Remember, the money supply equals checking accounts plus currency.) If Lynn now borrows $8 from the same bank, the money supply rises by $8. If she deposits the $8 in a checking account, and Brad borrows $6.40, the money supply rises further, by $6.40. Now, if the Fed tells banks they may lend only 75 percent rather than 80 percent of their deposits, the banks will have to call in some of their loans, which shrinks the money supply. The more banks lend, the larger the money supply.
Second, the Fed sometimes lends funds to banks. By raising the interest rate on these loans (the discount rate), the Fed discourages banks from lending and reins in the money supply.
Third, and most important, the Fed buys and sells government securities (open-market operations). The public, including corporations and individuals, holds about 20 trillion dollars’ worth of government bonds, which pay interest to holders each year. To understand this tool requires concentration, and it helps to use visual aids. Take out a dollar bill and a piece of paper. Mark the paper “BOND.” Designate one end of the table “Public,” the other “Fed.” Remember, bills held by the Fed are not considered part of the money supply. If the Fed wants to expand the money supply, it can buy bonds from the public. By buying, the Fed receives a bond (which is not part of the money supply) and gives the seller a check (or dollar bills) in return. When the check is cashed or deposited, it becomes part of the money supply. (When it was held by the Fed, it was not considered part of the money supply.) In contrast, if the Fed sells a bond to an individual or institution, it receives a check (or dollar bills) drawn on an individual’s account. The money supply contracts, for the bond that the seller receives is not money, whereas the funds that the Fed receives cease to be money once the Fed owns them.
Even before the Federal Reserve System was set up in 1913, classical and neoclassical economists outlined the impact of changes in the money supply. Yale professor Irving Fisher took a crucial step forward in 1911 by deriving a simple mathematical framework from John Stuart Mill’s analysis. One popular version of the “quantity theory” is MV = PQ. This simple equation allows us to understand a great deal about the monetarist critique. First, recall that M is the money supply and V is velocity. PQ represents nominal GDP (P is the price level, and Q is the amount of goods and services produced, which is the real GDP). No one disputes this equation. By definition, the amount of money multiplied by the number of times it changes hands equals the nominal value of goods and services purchased. But economists can argue endlessly about the behavior of these variables.
The most crude caricature of monetarism contends as follows: (1) velocity is constant; (2) the amount of goods and services that can be produced is fixed in the short run; therefore, (3) if the Fed raises the money supply by 5 percent, we will see a 5 percent rise in prices. The crude quantity theory essentially erases V and Q from the equation and concludes that any change in M will be felt only in P.
Even this cartoon has some merit, though, especially in explaining hyperinflation. The German Weimar Republic presents the model case. Between 1921 and 1924, the printing presses worked full speed, blasting the money supply into the stratosphere. It did not just double, triple, or quadruple. It rose by more than 25 trillion percent! The price index followed, soaring in a year and a half from 1 to 200 million. Everyone was a billionaire! And nearly every millionaire was hungry. Closets burst with bills while cupboards were bare. In America, Samuel Goldwyn said that “an oral contract is not worth the paper it’s printed on.” In Germany, money wasn’t worth the paper it was printed on. The German economy was destroyed. In recent years, Venezuela joined the hyperinflation club, reaching a 10 million percent annual pace in 2019. Middle-class citizens found themselves scavenging through dumpsters for food, and 10 percent of the population fled the country. Though Venezuela sits atop the world’s largest oil reserves, a corrupt government skimmed the wealth from the people and tried to compensate by handing out worthless pieces of paper currency.1 The moral here is that cheap money does not come easy.
Modern quantity theorists, monetarists, claim that their intellectual forefathers were too humble about money. In the short run, money can sway not just prices but also economic activity. In the long run, however, a change in the money supply changes only prices. The monetarists also add an anti-Keynesian tenet: government spending will not affect prices or output unless the money supply also changes. Only money matters.
We have three important tasks here: First, we must see why monetarists sound so arrogantly confident about money. Second, we must see why Keynesians speak so flippantly about money. Third, we must see why monetarists speak flippantly about government spending. After that, we can examine how the debate stands today.
Let’s look at the transmission mechanism that directly links the money supply with GDP. Assume that the monetarists are right: velocity is stable. If the Federal Reserve increases the money supply by buying bonds, it places more money in the hands of the sellers. But people want to maintain a stable level of money holdings. According to monetarists, people hold money mostly for daily transactions. Since they now have extra money, they will spend it on goods, services, and real assets. GDP climbs.
If the Federal Reserve instead touches the brake and sells bonds, people have less money. Since they want to maintain a stable level of money, they cut back spending, slowing GDP.
Essentially, monetary policy plays with the liquidity of the public. Provided people persistently desire a stable level of liquidity, monetary policy can predictably and powerfully affect GDP. The Federal Reserve can toy with the public to promote different levels of spending.
How could Keynes and his followers disagree with this model? Ironically, Keynes once believed it. Even more ironic, the foremost monetarist since World War II, Milton Friedman, once did not. Keynes started as a monetarist and matured into a Keynesian. Friedman started as a Keynesian and matured into a monetarist. His friends may have nicknamed Keynes “Snout” when he was young, but neither he nor Friedman was born pigheaded.
Let’s follow Keynes’s turn from monetarist principles. Part of the Cambridge oral tradition that Keynes imbibed was the “Cambridge Equation,” as taught by Marshall. This equation operated similarly to Fisher’s model. According to Keynes, Marshall “always taught” that the demand for money was measured by “‘the average stock of command over commodities which each person cares to keep in ready form.’”2 During the German hyperinflation, Keynes stressed the power of the quantity theory in his Tract on Monetary Reform, which demonstrated how rapid inflation, encouraging people to spend money at a faster rate, forced prices up even further. By the time of the General Theory, however, the Great Depression convinced Keynes that monetary policy was impotent.
The chief target of Keynes’s criticism was velocity. Why assume that velocity is stable? So what if the central bank raises the money supply and liquidity? Why assume that people will spend the extra money? Maybe they will keep it under their mattresses. If they do, lower velocity would offset higher money. GDP would still flounder. Keynes thought this particularly possible in a depression. Whereas quantity theorists maintained that people hold money for daily purchases and perhaps for “rainy days,” Keynes introduced a third motive, “speculative.” People may hold extra liquidity just to speculate in stock and bond markets. If interest rates bounce about, speculative demand for money will also bounce. Thus, even if the money supply rises, the desire to hoard may rise also.
In a letter to President Roosevelt, Keynes presented a clever metaphor while scoffing at monetary forces: “Some people seem to infer . . . that output and income can be raised by increasing the quantity of money. But this is like trying to get fat by buying a larger belt. In the United States today your belt is plenty big enough for your belly.”3
Keynes not only insulted the power of money; he and his followers depicted a different transmission mechanism for money. Monetary policy does not work directly through consumption, but through interest rates and investment, they suggested. Two long, treacherous leaps must be taken if the economy is to feel anything from monetary maneuvering. If the Fed raises the money supply, people must not hoard (step one). Even if people do spend the money, according to Keynesians, they may purchase stocks and bonds—financial assets rather than real assets. This will lower interest rates. Only if businesses or households borrow from banks and then buy goods and services will GDP budge (step two). While waiting for these two big, risky steps, many monetarists could fall into the gorge below.
Strides in the reverse direction are just as long and perilous. If the Fed shrinks the money supply, people may not care that they have less cash in their sock drawers. Even if they do respond by selling off financial assets (which raises interest rates), borrowers may not be discouraged by higher borrowing costs (if, for example, they are obligated to continue a building project). GDP could continue to hum along.
In sum, the Keynesian critique cuts deepest when (1) velocity or money demand is fickle, and (2) borrowers do not care about interest rates.
Friedman laments that Keynes’s influence “led to a temporary eclipse of the quantity theory of money and perhaps to an all-time low in the amount of economic research and writing devoted to monetary theory and analysis. . . . It became a widely accepted view that money does not matter, or, at any rate, that it does not matter very much.”4
The eclipse even shaded Friedman’s early views. Despite his graduate studies at the University of Chicago, a long-standing home for Keynes critics, a young Friedman penned a 1942 article on inflation that scarcely mentioned monetary forces. Eleven years later, the article appeared in his book Essays in Positive Economics, together with seven new paragraphs. Friedman explained the additions: “As I trust the new material makes clear, the omission from that version of monetary effects is a serious error which is not excused but may perhaps be explained by the prevailing Keynesian temper of the times.”5
No one was better suited by temperament or intellect to lead the monetarist counterrevolution. A ferocious debater who argued his case so forcefully that he unnerved academic opponents, Milton Friedman was not intimidated by conventional wisdom. On the eve of the counterrevolution, his diminutive physical appearance matched his professional stature. Galbraith recalls that during the 1950s and 1960s, anyone who “dwelled too persistently” on the role of the money supply was considered a “crank.” Through his courage of heart and brilliance of mind, Friedman’s professional stature grew, earning him a Nobel Prize in 1976 and Galbraith’s recognition of him as “perhaps the most influential economic figure of the second half of the twentieth century.”6
Friedman considered himself a lucky man and named an autobiographical work about himself and his wife, Rose, Two Lucky People. He was born broke in Brooklyn in 1912, his Austro-Hungarian immigrant parents toiling in sweatshops. A few years later, they crossed the river to Rahway, New Jersey, a place best known for its state prison. His mother, Sarah, opened a small clothing store, while his father, Jeno, peddled wares and did odd jobs around town. Young Milton and his three sisters did not grow up in luxury, but times got even tougher when their father died during Milton’s senior year in high school. How could he consider himself lucky? Because he was born in a free country. To get through Rutgers University, he waited tables and worked as a store clerk, meanwhile earning a scholarship. At Rutgers he first studied mathematics and accounting. A high school teacher had inspired him to see the beauty in math by comparing the Pythagorean theorem to Keats’s “Ode on a Grecian Urn.” Then Milton discovered economics—and not a moment too soon. Economics needed some help, for he entered the university in 1929, just as the stock market crash was breaking apart modern capitalism like an urn that had toppled off a high shelf.
Under Rutgers professor Arthur Burns, later a Federal Reserve Board chairman, Milton learned the orthodoxies of the classical economists. He moved on to graduate school at the University of Chicago, where he was lucky enough to have a professor who seated students alphabetically, putting him in a seat next to a young woman named Rose Director. Though their marriage lasted sixty-eight years, somehow Milton seemed to suggest that had he been born Milton Zuckerman, he would not have found his bride.
Milton Friedman was short (about a foot and a half shorter than Keynes), but he was sure. There’s an old adage that one should “punch up, not down”—that is, pick fights with those of higher social stature. (National Public Radio once asked me to recommend an opponent I should face in a debate on the economy. I suggested that they ask Nobel laureate Joseph Stiglitz, chairman of the president’s Council of Economic Advisers. Stiglitz agreed, and we had a mostly genial discussion.7) Friedman picked his first fight as a graduate student in his early twenties with some pretty famous foes. He sent an article to Keynes’s Economic Journal criticizing Pigou’s elasticity-of-demand calculation. Keynes rejected the article, siding with Pigou, though Keynes would soon savage Pigou in The General Theory. Instead of in the Economic Journal, Friedman’s article and Pigou’s rebuttal were published in the Quarterly Journal of Economics. Then in another battle, Friedman wrote a book that showed the American Medical Association propping up doctors’ wages by keeping out competition. The association found advanced galleys of the book and protested, demanding the publisher cancel the book. The publisher refused, and Friedman’s career as a fearless analyst was born. Friedman argued that in “all professions . . . aristocratic, or at least restrictive movement had taken hold,” hurting consumers and propping up barriers to entry for new competitors. In 1900 only 4 percent of the labor force worked as “professionals,” but by mid-century states had passed more than 1,200 statutes for jobs as diverse as physicians and embalmers.8 From cradle to grave, Americans passed through the hands of licensed professionals.
During World War II, Friedman worked for the government as a statistician, attempting to apply mathematics to the testing of metals. He learned that theoretical models must be linked with empirical testing. At one point, he designed on paper a superstrong metal alloy for jet engines. Econometric tests yielded very robust results. Friedman marched into the chemists’ laboratory with his winning formula. He boasted that his turbine blade could spin for two hundred hours without a rupture. They followed his recipe and produced a metal with all the strength of a ripe banana. He learned not to trust theoretical statistics without real testing.
After the war, the bespectacled Friedman began teaching at the University of Chicago. He admired Keynes’s work. Even after smashing many Keynesian ideas, Friedman continued to generously laud the Englishman, calling him both a great economist and a great man. Friedman’s intellectual generosity was a constant trademark, just as notable as his ferocity in debate. But smash he did.
In a series of pathbreaking studies, Friedman salvaged the quantity theory from Keynes’s attack. Keynes left only one dusty, disreputable escape path open: Friedman would have to show that the private sector was stable. Velocity and consumption must not undulate like the hips of a Hawaiian hula dancer for monetarism to make sense.
In 1956, at a time when Keynesians dominated academia, Friedman published a set of essays that improved and tested the quantity theory of money. Instead of just tying money to prices, Friedman aimed at redefining the demand for money (the reciprocal of velocity). Demand for money is stable, he submitted, because it depends on long-term factors such as health, education, and the income an individual expects over a lifetime. Since these do not wildly waver, velocity does not. Keynes slighted long-term influences.9
The next year Friedman turned to consumption. The simple Keynesian model assumed that as current income rose and fell, so did consumption. If income fell in a particular year, people would spend less. This seems obvious on the face of it. Again, though, Friedman advocated a longer view. After all, a man who receives his paycheck on Fridays does not starve all week and feast all weekend. Rather, he maintains a steady flow of consumption because he holds expectations about long-run income. Friedman’s Permanent Income Hypothesis posits a smooth path, veering only when expectations about future income flows change. Consumers will not let a bad week or month or year alter their patterns. They will simply use up some of their savings. In an exceptionally good year, they will just save more. Only if they perceive a major shift will they alter their course.10
Friedman was not alone in pointing to long-run concerns. Franco Modigliani, a Keynesian and 1985 Nobel laureate, performed similar studies at this time on a Life-Cycle Hypothesis with similar results.11
The prime conclusion of Friedman’s work? Consumption is impressively stable.
If Friedman and Modigliani are right, temporary government policies have only weak effects on the private economy. How can we test this? A highly successful 1964 tax cut boosted consumption and sent the economy roaring ahead. Since the program slashed payroll tax rates, consumers viewed it as permanent. In 1968 the Johnson administration feared inflation and deficits resulting from Vietnam War expenses and burgeoning social spending. Congress passed an explicitly temporary tax surcharge to slow the economy. Sure enough, consumers responded not by spending less, but by drawing more from their savings in order to maintain their high consumption levels. In 1975, a temporary tax rebate also proved ineffective. Again, in 2001, a $600-per-couple tax rebate proved far less powerful than cutting tax rates.
Temporary policies have failed outside the United States as well. The Japanese Ministry of Finance tried to pump up consumer buying during the mid-1990s with temporary tax cuts, which did nothing but annoy the recipients. Families were so angry at the government for permanently raising sales taxes that they thought a temporary income tax cut was a chintzy concession. Instead of spending the money, they simply put it in the bank. Japan scrolled through more than a half dozen prime ministers during the long-lasting recession of the 1990s.
Although Friedman designed supporting theories for monetarist claims, he soon required empirical, historical studies to answer critics who ranged from the skeptical to the mocking. Friedman had long held the philosophical position that the true test of a theory is whether it correctly predicts events. Elegant molds are wrong if they are useless in the real world, he maintained. In 1963, he and Anna J. Schwartz released a massive report, A Monetary History of the United States, 1867–1960.12 Friedman knew that the strongest case for Keynesians was the Great Depression. He wasted little time before declaring that the Depression testified to the power of monetary policy, not, as Keynes believed, to its impotence. In other words, he stole the best witness from the Keynesians. Between 1929 and 1933 the quantity of money had plunged by one-third, and the Federal Reserve did not even publish this data. Friedman and Schwartz pointed fingers at the Federal Reserve Board, which had refused to provide liquidity to banks when panic-stricken customers banged on doors demanding their deposits. A little support from the Fed would have instilled a lot of confidence among customers, they said.
In sum, A Monetary History claimed that monetary mischief accompanied every severe recession and every significant inflation over the past century. There were no Keynesian recessions or inflations. One by-product of Friedman’s work was to deflect blame for inflation from the usual suspects, like labor unions.
As Friedman and other monetarists such as Meltzer and Brunner chipped away at the Keynesian orthodoxy, the Keynesian response varied. Some Keynesians countered with their own studies, some admitted that monetarists had a point, and others continued to laugh. At a conference in the late 1960s, Robert Solow of MIT commented on a Friedman paper: “Another difference between Milton and myself is that everything reminds Milton of the money supply; well, everything reminds me of sex, but I try to keep it out of my papers.”
As the 1960s progressed, though, monetarism gained more strength, for velocity was showing a remarkably stable pattern. In fact, during the three decades following 1948, velocity behaved predictably, growing at just over 3 percent per year. The crusade that Friedman had fought with just a few believers seemed to be getting divine help.
After proving the power of money and breathing new life into the quantity theory, monetarists sought to challenge the Keynesian claim that government spending could spur the economy. To slay this dragon, they needed to show that the Keynesian multiplier was nil.
Monetarists announced that Keynes dodged the big question: Where does money for fiscal spending come from? If the money supply stays constant and the government spends money, somebody else must have less to spend. There’s no such thing as a free lunch. If Congress raises taxes to pay for programs, consumers cannot buy as much. If Congress borrows money by selling Treasury bonds to the public, businesses cannot borrow as much for investment. Interest rates rise and investment falls. Government spending must crowd out private spending. Keynes’s elementary multiplier ignores this.
Keynesians cannot deny that crowding out takes place. But, they counter, crowding out does not completely offset government spending, especially during recessions. The real issue is the extent of crowding out. In the 1990s, a model sympathetic to Keynes’s, from Data Resources, estimated a multiplier of about 1.6 the first year of government stimulus but steadily dropping after that. And recently, the evidence for Keynes’s model has grown more meager. During the 2008 Great Recession, President Obama nudged Congress to pass a stimulus plan that included $340 billion in new federal spending. A postmortem by Valerie Ramey of the University of California, San Diego, concluded that such spending probably generated less than $340 billion in GDP growth.13 In retrospect, it is striking that in The General Theory, Keynes used a multiplier example ten times greater than current estimates.14 In 2020, the trillion-dollar emergency package in response to the coronavirus didn’t aim to spur spending (in fact, the government had closed down most shops) but instead aimed to give families enough cash to limp along until it was safe to come out of their homes.
The stagflation of the 1970s made Milton Friedman frustrated, but it also made him famous. In December 1967, he delivered an address to the American Economic Association in which he contended that higher inflation could not spur more jobs. This seemed kooky to listeners who were reading or even writing typical textbooks. But a few years later, economists would reread his speech and realize that Friedman had left unerasable skid marks on the history of economic thought.15 In the 1960s and 1970s, undergraduates were taught that “everyone” knew that more jobs could be created, if only society would allow slightly higher inflation. This tradeoff seemed documented by a curve named for the New Zealand economist A. W. Phillips. Under the Phillips curve analysis, if you were not willing to tolerate a little more inflation in exchange for more jobs, you were not just stupid but miserly. Friedman did not buy it. He showed, along with future Nobel laureate Edmund Phelps of Columbia, that if government tried to “buy” more jobs by unleashing inflation, it would only get higher prices. In fact, inflation might even destroy jobs. The 1970s stagflation proved a disaster for U.S. households but a ringing endorsement for Friedman’s analytical powers. Lawrence Summers, the eminent economist and former Treasury secretary, recalled that Milton Friedman had been a “devil figure” to his family of progressive, Keynesian economists. But between the time Summers was an undergraduate in the early 1970s and a young professor a decade later, “Friedman’s heresies had become the orthodoxy,” and Friedman was no longer a demon but a man whom Summers looked to with “great admiration.”16
Imagine that you are Milton Friedman. You have just demonstrated that money not only talks, but that it walks and runs the economy along. The next step would be to persuade the Federal Reserve Board to raise the money supply in recessions and to lower it when inflation appears imminent, right? When business seems slow, you would point to the printing presses and shout to the Fed governors, “Don’t just stand there! Do something!” Not our Milton. Instead he shouts, “Just stand there!”
With perhaps uncustomary humility, Friedman claims that economists do not know enough about monetary policy to manipulate it wisely. Sometimes it takes six months before monetary policy affects nominal GDP, and sometimes two years. The Fed usually hurts the economy when it tries to fine-tune, because it cannot know how long the lag will be. In 1968 the Fed feared a recession. It pressed down hard on the monetary accelerator. But the economy did not feel the effects until after the downturn had passed. The result was high inflation, for the effects came during the recovery. In 1974 the Fed slammed on the monetary brakes to halt inflation. A recession followed in 1975. When Gerald Ford jumped into the driver’s seat at the White House, he cleverly accepted the automobile metaphor and told Congress to restrain its high expectations, for he was “not a Lincoln but a Ford.” Wise advice, since the economy poked along like an Edsel.
Friedman’s advice that the Fed not react to economic news sounds like Admiral Hyman Rickover’s advice when he grew weary of Pentagon bumbling. The Pentagon should split into three divisions, he stated. The first division should do all the work. The second and third should spend all day writing longhand letters to each other. Even with this plan, the Pentagon would work harder than Friedman wants the Fed to work.
Friedmanites propose that the Fed be replaced with a robot that would delicately press the monetary accelerator at a fixed growth rate regardless of economic conditions. Whether 3, 4, or 5 percent, a constant growth would erase a major source of instability, the caprice of the Federal Reserve. If the economy dips, the constant addition of liquidity would feed spending. During upswings, inflationary sparks would not have enough fuel to inflame.
What a difference from Brookings Institution economist Arthur Okun’s confident hyperactivist Keynesian position of the 1960s! The 1962 Economic Report of the President did not stop at combatting inflation or recession. Sophisticated economists would fine-tune the national economy. Fiscal policies would smooth out an ever-growing prosperity:
Insufficient demand means unemployment. . . . Excessive demand means inflation. . . . Stabilization does not mean a mere leveling off of peaks and troughs in production and employment. . . . It means minimizing deviations from a rising trend.17
While no honest economist could write such braggadocio today, most economists disagree with Friedman’s monetary rule. Their motto: To err is human, but to really foul things up takes a computer. Even if Friedman is right and velocity appears stable over a long period, it certainly deviates in the short term. If velocity falls for several months while money continues on a fixed trend, the economy will tumble. Perhaps not for long, but jobs do hinge on the Fed’s performance in those instances. The tough questions regarding an activist Fed remain unresolved: How long does it take for the Fed to detect velocity swings (“recognition lag”)? How long does it take for its action to affect the economy (“impact lag”)? Does the Fed know what it should do?
In academia, victory comes when your peers get bigger laughs pointing at your critics than at you. By the late 1970s the monetarists moved from being the butt of jokes to the head of the class. Central banks throughout the world began closely monitoring the money supply. German central bankers at the Bundesbank became orthodox monetarists and in 1999, with the introduction of the euro, prodded the new European Central Bank to follow their tradition. Mainstream economics absorbed many monetarist propositions and shed its flippancy about money and its worship of fiscal forces. Economists can no longer be cleanly bisected into monetarist and Keynesian camps. Recall Richard Nixon’s remark “We are all Keynesians now.” Even Friedman admitted that Nixon was right, with reservations, of course. The intellectual cycle has come around again, for Modigliani has confessed, “We are all monetarists now,” with reservations, of course.
The 1985 edition of Samuelson’s Economics, written with William Nordhaus, conceded that “early Keynesianism has benefited from ‘the rediscovery of money.’ Money definitely matters. In their early enthusiasm about the role of fiscal policy, many Keynesians unjustifiably downgraded the role of money.” Samuelson and Nordhaus did not mention the names of any perpetrators.18
A perhaps apocryphal story illustrates the point: A successful businessman visited his old economics professor. While chatting, the former student noticed an exam on the professor’s desk and began reading. Shocked, he announced, “This is the same exam you gave me fifteen years ago! Aren’t you afraid the students are just going to track down old tests?” The professor laughed. “No, that’s okay. I do keep the same questions. It’s the answers I change each year.”
Having persuaded Modigliani and Samuelson that money matters a great deal, by 1981 the monetarists were singing “Who’s got the last laugh now?” from the old Gershwin tune.
But the monetarists soon stopped singing. Margaret Thatcher in Great Britain and Ronald Reagan in the United States urged the central banks to follow a monetarist anti-inflation path, cutting the money supply and ignoring a rise in interest rates. Sure enough, inflation dropped at an impressive rate, falling in the United States from more than 12 percent in 1980 to less than 4 percent in 1982. Few economists had expected money to work so forcefully. As forecast, however, a severe recession accompanied that (since at first monetary policy alters output and prices, not just prices, as it does in the long run). Unemployment in the United States topped 10 percent and began declining only in 1983. To wring inflation from an economy is not fun.
Monetarists believe that the Federal Reserve took too crude a course, slamming the monetary brakes too hard. Furthermore, they assert that the Fed under chairman Paul Volcker allowed the money supply to swing wildly. But even monetarists admit that a more gradual policy would still have induced a recession.
If the anti-inflation course proved the power of money, why aren’t monetarists still whistling a happy tune? Why did the counterrevolution not end in an unambiguous shutout? Well, a funny thing happened on the way to economic recovery. Remember the hub of monetarism, stable velocity? Just as monetarists reached exalted status, people began reexamining their sock drawers. From 1948 to 1981, velocity maintained a steady 3.4 percent growth each year. Suddenly, in 1982 the sock drawers filled up. Velocity plummeted by nearly 5 percent. From 1982 to 1988, the course of velocity was thoroughly confusing. If velocity falls, and the money supply does not grow at a higher rate, GDP must fall also.
How did the Federal Reserve respond to the collapse of velocity? Far from following a monetary rule of 3 or 4 percent growth, the Fed stomped on the monetary accelerator. Ignoring a target of 3 to 8 percent growth, the Fed launched M1 to more than 15 percent during 1986 to offset tumbling velocity.
A fixed monetary rule in 1986 might have been disastrous. Even Beryl Sprinkel, a Friedman protégé and the first orthodox monetarist to chair the Council of Economic Advisers, admitted in the 1987 Economic Report of the President:
In the context of moderate real growth, very low inflation, and falling inflation expectations and given the uncertainty about the behavior of velocity, the de-emphasis of M1 in favor of other variables . . . appears to have been an appropriate judgment. . . . No evidence suggests that the Federal Reserve has erred on the side of monetary restriction.19
The Thatcher government also jumped on the monetary pedal in the face of lower velocity. Rather than using a fixed mechanism, many central banks today track a rule-of-thumb equation known as the Taylor Rule, named after Stanford’s John Taylor, a friend of Friedman’s and a former colleague of mine at the White House. The Taylor Rule says that central banks should adjust short-term interest rates by weighing two different gaps: (1) the gap between actual inflation and target inflation, and (2) the gap between actual GDP and target GDP. Let’s say, for example, that the economy has been weak but now is heating up, and inflation is crawling higher. The rule tells the Fed to hoist up interest rates by one half a percentage point if (a) inflation goes up by one point or (b) GDP gets one point closer to its potential. Former Federal Reserve chair Ben Bernanke kept close tabs on the Taylor Rule during his reign from 2006 to 2014, but concluded that, like all equations, it had flaws in practice: “I don’t think we’ll be replacing the FOMC [Federal Open Market Committee] with robots anytime soon. I certainly hope not.”20
During the 1990s and 2000s, velocity took a wild, round-trip flight, first jumping unexpectedly and then plunging hard and fast. No one knows whether velocity will return to a stable pattern. Several hypotheses have been advanced to account for the drop. Friedman and other monetarists explained that the dramatic fall in inflation and interest rates in the 1980s and 1990s reduced velocity. Since the deregulation of banking in the 1990s, people are keeping more assets in interest-bearing checking accounts and can zap funds instantaneously through PayPal, Venmo, and their competitors. Because such accounts hold more money, velocity falls. Some tests show, however, that velocity would have fallen despite such innovations. In addition, housing refinance tools have given home owners a new source of liquidity. To paraphrase Churchill, velocity has become a riddle wrapped in a mystery inside an enigma. And it is getting the last laugh. Despite fickle velocity, central banks throughout the world agree that either a soaring or a collapsing money supply should sound loud alarms. In a speech honoring Friedman’s ninetieth birthday in 2002, Ben Bernanke, on behalf of the Federal Reserve, toasted Friedman and apologized for failing to heed his principles and letting the money supply crash during the Great Depression: “You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”21 No doubt, Bernanke thought that his toast was a gentle gesture to an elder warrior and that his words would fade with the last sip of champagne that evening. In 2006, Friedman died of heart failure. Two years later, the world’s financial system shattered, money supply growth dropped, 15.4 million Americans were thrown out of work, and a puffy-eyed Bernanke was living on trail mix, spending twenty hours a day trying to live up to his promise to Friedman.
During the late 1990s and early 2000s, the global real estate market had inflated into a thin-skinned bubble, as governments encouraged banks to lend money to home buyers who weren’t safe bets, while banks stopped asking buyers for substantial down payments. In 1995, for example, the U.S. Department of Housing and Urban Development required government-chartered firms like Fannie Mae and Freddie Mac to buy riskier mortgages from banks in order to boost the homeownership rate. Since the banks were going to unload the risky mortgages anyway, lending officers did not bother to vet the loans as carefully as they should have. Some home buyers received mortgages without even showing their tax returns (others received “NINJA loans”: meaning, “no income, no jobs, no assets”). By 2006, one in four California mortgages was considered subprime, and home prices had doubled within the prior five years. Borrowers got more access to more credit, with less reason to worry about paying it back. Economists call this a “moral hazard” problem, while laypeople call it a lack of “skin in the game.” When the bubble popped in 2008, banks went, well, bankrupt, and Wall Street’s 160-year-old brokerage house Lehman Brothers evaporated, sparking panic selling and a nearly 60 percent dive in the S&P 500 stock index. (The name Lehman Brothers became infamous, even appearing in the kids’ cartoon movie Despicable Me as the predecessor to the “Bank of Evil.”) To survive the crisis, Bernanke, himself a scholar of the Great Depression, yanked out his Friedman playbook and slashed interest rates from 5 percent to nearly zero. Other central banks followed, with the Bank of England cutting rates to their lowest since the founding of the bank in 1694. The U.S. Treasury Department forced banks to accept government loans so they would have enough capital to endure the downturn. But even those steps were not enough. With interest rates near zero, many skeptics said that the Fed had run out of policy bullets and could do no more. At that point, Bernanke deployed a rarely used tool outlined by Friedman known as QE. Up until the Great Recession, most well-read people would have identified QE as a British cruise ship named after the queen. Bernanke applied monetarist thinking and directed the Fed to buy up mortgages and bonds, injecting massive sums of money into the hands of sellers. The technique was called quantitative easing, or QE. By 2010, the Fed had gobbled up more than $2 trillion worth of securities, equal to about 15 percent of the size of the entire economy. Critics denounced the Fed, claiming it would spark hyperinflation and a disintegrating U.S. dollar. It did neither. By forcing money into the economy, the Federal Reserve avoided another Great Depression. In September 2009, U.S. GDP turned positive again, though it took four more years for housing prices to bounce back to prior levels. What kind of recovery was this?
Amid the financial and economic drama in 2008, I began citing an old name from the past and argued on National Public Radio that the economy would enjoy not a Keynesian recovery, but a Pigouvian recovery, named for Keynes’s discarded, insulted colleague.22 Pigou died in 1959 and could not put up much of a fight for his ideas even in his prime. After a ringing start as a youthful star professor, the final forty years of his career had been a slow decrescendo, deafened by the pounding, hypnotic drumbeat of Maynard Keynes. The son of a distinguished army officer whose wedding was described as “royal” by the local newspaper, Pigou was born in 1877 and grew up in a privileged household. He was, like other eldest sons in the family, sent to the tony Harrow School, where he won academic and athletic prizes and was described as a “god among mortals,” a remarkable achievement considering that one of his schoolmates, who took home the fencing prize, also achieved some success.23 The schoolmate’s name was Winston Churchill. Arthur grew to be tall, fair-haired, and ramrod straight, at least in his posture and moral positioning. He studied with Cambridge’s leading political economists, and at age thirty was elected to take over Marshall’s coveted professorship. Pigou worshipped his mentor’s textbook. New economics books were not particularly appealing; he’d rather lead vigorous young men on hiking treks across the Alps. His students noted his quick ability to switch from a weighty equation to a “hair brained spree” and back again to grave matters if Keynes stepped into the room.24 Pigou absorbed the reigning sexism of the day and had a reputation for favoring male students over females, and scoffing at politicians and foreigners, including Americans. But he made many exceptions. He worked closely with his younger colleague Joan Robinson, supported her faculty promotion, touted her writings, and invited her to convalesce at his lakeside cottage after a nervous breakdown. He would also let former students honeymoon at his picturesque cottage.25 When World War I broke out, Pigou was stranded in Zermatt, Switzerland. His brother was a Royal Navy man and rose to the rank of captain. While Keynes ended up at the Treasury, Pigou declared himself a pacifist and found himself driving an ambulance near the front lines, perhaps near such notables as Ernest Hemingway and Ray Kroc, founder of McDonald’s. Pigou was a conscientious objector to killing, but not an objector to saving lives. He was as focused on moral philosophy as he was on downward-sloping demand curves, and he published essays titled “The Ethics of Nietzsche” and “The Ethics of the Gospels.” During the war, he wrote an article in the Nation warning that a crushed Germany might regroup and rearm to lodge an even bigger battle ahead. Though his prediction of a second war was later reflected in Keynes’s Economic Consequences of the Peace, critics ripped Pigou for cowardice and Germanophilia. Seared by the reaction, he learned to stay quiet about politics. He was no coward, though, and earned ribbons and medals for civilian valor. After the war he would take those awards and bestow them on the young men who had hiked with him, recognizing their service in hill walking and “distinguished incompetence.”26
When Keynes released The General Theory in 1936, Pigou was struggling with cardiac issues, which could not have been helped by the public mauling of his ideas and his work. Repeating his name throughout the text, Keynes made Pigou the poster child for old-fashioned, fuddy-duddy economists who could not grasp his new paradigm. Reeling from the arrows, Pigou said that Keynes imagined himself to be an Einstein (note the “General” Theory), except Einstein did not dismissively smirk at Isaac Newton and call his followers “a bunch of incompetent bunglers.”27 For the next thirty years, Pigou grew more elusive and more reclusive. But silently in his own little corner of his King’s College room, Pigou persisted. Something niggled at him.
In early 2009, in the midst of the Great Recession, I flew to Cambridge as a visiting fellow to dig into the Pigou story. After a petition and intervention from Alfred Marshall’s Cambridge college, St. John’s, I received permission from the King’s College librarian to access Pigou’s private papers. As I entered the oaky rooms and flipped through dusty manuscripts, I quickly learned a few things about the man. First, he was very private. Second, he ordered his papers burned after his death. Third, he was notorious for indecipherable penmanship. I looked down at the jots on his papers and thought, Alan Turing couldn’t break this code! Still, I was able to gather bits from the work he tried to do to fend off Keynes, if not in a quick rebuttal, then in the long run.
In 1941, after a reclusive stretch, Pigou finally came forth with the secret to solving the 2008 Great Recession. Around the time Lehman Brothers imploded, headlines blared about crashing commodity prices, including oil and food. Many economists warned that falling prices would bring on a Greater Depression. After all, the world suffered slumping commodity prices in the 1930s. Pigou had another take. He argued that falling prices can potentially make us feel wealthier because our savings can buy more. If our savings are worth more, we have a “greater sense of power, sense of security.”28 If shoppers feel as if they have more buying power, they can lead the country out of recession. An automobile owner might feel better if he swerves into his local gasoline station and sees a posted price starting with a $2 handle instead of a $4 handle, for example. During 2009, collapsing gasoline and home heating oil prices were pumping more than $300 billion of extra buying power into the pockets of Americans, roughly $300 per month for a typical family. Cheaper turkeys and chickens were flocking their way to supermarkets, too. Meanwhile, Amazon was offering free shipping, and nearly everything seemed to be on sale, except the Lincoln Bedroom at the White House (though possibly to large political contributors). The Pigou Effect basically takes the money supply and divides it by the price level. With Bernanke printing more money and prices falling, the consumer might have the wherewithal to defeat recession. Unfortunately, this Pigou Effect flopped in the early 1930s. Keynes announced, “Ding-dong, the free market is dead,” and Pigou’s theory slumped into a corner of our dusty textbooks.
But why did the Pigou Effect fail ninety years ago? Because central bankers yanked the electrical cord out of their printing presses and sat on their hands. During the 1930s, both the money supply and the price level dove into a sinkhole. In the United States, the money supply shrank by 30 percent, as 40 percent of banks bolted their doors. This was the sin that Bernanke apologized to Friedman for. With Bernanke at the helm, though, the Pigou Effect had a chance.
When enough people begin bargain-hunting, you can start hunting for a Pigouvian recovery. By spring 2009, the Housing Affordability Index was soaring, restaurant owners began reporting the strongest sales in a year, and the jobless rate in half America’s states, including New York, California, and Texas, was drifting downward. In the U.K., like the suspect glimpse of a possibly extinct ivory-billed woodpecker, newspapers tentatively reported sightings of home sellers “gazumping”—nudging up their asking prices after receiving an informal offer from a buyer.29 By the end of 2009, the U.S. growth rate leaped to a 5 percent pace.
Pigou finally had his moment, in the long run. If we were to give a prize for the greatest comeback in the history of economic thought, the tall, shy hiker once stranded on Zermatt would win it, not just for his Pigou Effect but also for his work on externalities that inspires the virtual Pigou Club based at Harvard today.
Since Keynes’s death, the world has witnessed an enriching intellectual struggle. The persistent hammering by Milton Friedman kept alive a tradition that reached back centuries. Mainstream economics can neither deny its past nor refuse all Keynes’s innovations. Federal Reserve economists closely monitor both M2 and the Keynesian concept of potential GDP in a way that has been described as “putting Keynes’s head on Milton Friedman’s body.”
In the previous chapter, we asked whether Keynes would choose to study economics today. Here we may ask whether Keynes would have remained purely a Keynesian if he had lived to see the research and resurgence of the monetarists. Given his pragmatic, piercing mind, he would surely admit that some of the fundamental things apply, as time goes by.
The generations of bright economists who followed Friedman and Samuelson, including luminaries such as Martin Feldstein, Michael Boskin, Greg Mankiw, Paul Krugman, and Lawrence Summers, have been spared the bloody Keynesian-monetarist debate. They all find a role for both monetary and fiscal policy.
Rather than wrangle over policies that try to control aggregate demand, they have turned to the question of aggregate supply, asking how the federal government can induce firms to lift productivity. Higher productivity translates into a higher standard of living. But rising productivity requires rising investment in plants, equipment, research, and education. American economists aligned with both major political parties have blamed imprudent tax policies for sluggish productivity growth.30
Most of these economists carefully distinguish themselves from the zealous pamphleteers and politicians of the early 1980s whom Herbert Stein called “punk supply-siders,” some of whom promised that income tax cuts would unleash such a tremendous burst of economic activity that tax revenues would quickly and automatically rise. The Laffer curve, named for the cocktail-napkin sketch of University of Southern California economist Arthur Laffer, illustrates that high tax rates could dampen activity and, ultimately, tax revenue. If, for instance, a government placed a 100 percent tax on an extra hour’s income, would an individual have much reason to work that last hour? Actor Michael Caine moved from London to Los Angeles in the 1970s to avoid an 83 percent tax on his next movie. He boarded the plane after hearing the incoming chancellor of the exchequer’s speech about squeezing the rich “till the pips squeak.” Instead of 83 percent, the British Treasury got nothing from the actor, until Margaret Thatcher cut taxes and he moved back home.31 While the argument was sometimes exaggerated—most people do not have the choices of an Academy Award winner who starred in The Man Who Would Be King—the infectious enthusiasm of the supply-siders inspired economists to push harder in their research on the ill effects of high taxes and low savings rates on the economy.
Edward Prescott, a 2004 Nobel laureate, contends that high tax rates explain why the French, Germans, and Italians spend so much time relaxing at coffee bars and spas. He finds that western Europeans “work one-third less than North Americans and Japanese,” because France, Germany, and Italy tax collectors take 60 percent of their income, while Americans, Canadians, and Japanese tax labor at 40 percent. He points out that during the early 1970s, French used to work nearly 50 percent harder—but their marginal tax rate was far less.32
Even those economists who disdain supply-siders oppose a return to the 70 percent tax bracket of 1980 (or the 91 percent marginal tax rate of the early 1960s!), which inspired people to avoid taxes through gimmicks, shelters, and loopholes. During the last half of the 1980s, more than fifty countries cut their top rates, including such bastions of egalitarianism as Sweden and Australia. (Lebanon was one of two that hiked rates. Did it not have enough trouble?) When President Clinton persuaded Congress to raise taxes on the rich, he meant moving the top rate from 33 percent to 39.6 percent. Despite campaign rhetoric denouncing the 1980s as a giveaway to country-clubbers, he did not suggest returning the rate to the 70 percent that welcomed Ronald Reagan when he moved into the White House. Note also that while Clinton pushed up tax rates in the United States, he spent seven years urging the Japanese government to slash its income taxes in order to resuscitate its rather lifeless economy.
President George W. Bush reversed the Clinton tax hikes, and the push-pull between politicians continued with Presidents Obama and Trump reversing and squawking at their predecessors. Nonetheless, several prominent Democratic governors have made a point of cutting taxes in their states, beefing up their supply-side bona fides. Corporate tax rates have also been part of the debate. Obama’s chief economist, Jason Furman of Harvard, stated in 2014 that after the Reagan reforms in the 1980s, peer countries “leapfrogged over the United States leaving us with the dubious distinction of having the highest corporate tax rate in the world.”33 Furman and Obama proposed snipping U.S. business tax rates, though Trump took rates down further than his predecessor’s target.
Taxes will always be with us, pulling and pushing us through business and personal decisions. No one is immune. In 1998, Mick Jagger canceled the British leg of the Rolling Stones “Bridges to Babylon” world tour, complaining that the British laws would levy a $19 million tax on his band if they played on British soil. By playing a single concert in the United Kingdom, the Rolling Stones would have been forced to pay taxes on all the income they earned from their foreign concerts, too. If instead they stayed away from their home turf, they would escape British taxes. So they did, disappointing 350,000 fans. Jagger did not hide behind a publicist, by the way. He explained his economic decisions to the press cogently, as you would expect from someone who attended the London School of Economics in the early 1960s.
More recently, I would argue that the so-called gig economy is a strong supply-side force. For the past ten years, like characters in a Samuel Beckett play, Wall Street, Main Street, and the Federal Reserve have been waiting for inflation to bubble up. Several forces have been tamping it down, and one of them is a supply-side shock. What is a positive supply-side shock? Consider a simple story. Let’s say that you live in a remote village that gets its fuel from a single oil well. Then a neighbor, call him Jed Clampett, fires a shotgun while hunting varmints, and as a result, up from the ground comes bubbling crude. Suddenly, the village has twice as much oil, and the price will go down. Now, what happens if this same type of phenomenon (not the varmint-hunting) erupts in other sectors?
College economics students learn about the “production function,” a simple formula showing that output is a function of land, labor, capital, and technology. The more inputs, the more stuff people can create. The Internet and globalization are effectively increasing the magnitude of these factors. Wait a minute, how can we have more land? Are we talking about reclamation, China building new islands in the sea, or fourteenth-century Holland diking up swamps, which inspired the adage “God created the world, but the Dutch created the Netherlands”? No, we are talking about companies like Airbnb that take idle rooms and dump them onto the market. This effectively increases the supply of land available and curbs the price of vacations. Airbnb, which boasts more than 7 million listings worldwide, has increased the number of available vacation rooms by more than 25 percent in U.S. cities.
With that massive influx, the hotel industry’s favorite measures, average daily rates and revenue per available room, have lagged GDP growth. In 2019 Marriott announced it was going head-to-head with Airbnb by launching a home-rental business.
How can physical capital magically grow? It’s not magic, but upstarts like Dozr and Yard Club have boosted the supply of equipment by creating a kind of Uber for earthmovers and dump trucks. We used to see yellow Caterpillar trucks sitting idle at construction sites awaiting the start of some scheduled task. Now those trucks are available to work elsewhere during off-hours. Steamrollers don’t complain to the union foreman if they work more than fourteen hours. We have more capital because existing capital is used more intensively.
The Internet, through financial technologies and software firms like Square, PayPal, and Salesforce, fosters a freer flow of funds and a faster connection among buyers and sellers. Former Fed chair Bernanke has pointed to a gush of global savings that slosh across borders. Consumers play a role when equipped with handy tools from online platforms. Amazon’s nifty feature “Customers who viewed this item also viewed” teaches buyers to consider substitutes when they are shopping for an item. Without leaving the garage and without expending a dime on search fees, a shopper looking for, say, a Honeywell portable air conditioner that costs $500 may discover a Black & Decker that will do the job at $470. By increasing the visible supply of alternatives, Amazon’s feature tamps down prices paid. Research by Obama’s former Council of Economic Advisers chair Austan Goolsbee and Peter Klenow found that online inflation is 1 percent lower than the standard consumer price index calculation.34
These forces do not explain the entire story, because inflation is, as Milton Friedman taught, a monetary event. The strong dollar, up by 20 percent between 2014 and 2020, made foreign goods appear cheaper to Americans and created a hurdle for domestic firms that try to raise prices. Further, the destruction of wealth during the Great Recession spurred households to rebuild their balance sheets, pushing up the saving rate to about 7.5 percent, twice the pre-crisis level, and reducing the velocity of money circulating in the economy. Taken together, the supply-side shocks might have dampened inflation by about 1.5 percent. That 1.5 percent makes an enormous difference, because sleepy inflation allowed the Fed to keep interest rates low, which supported stock market prices and, combined with generous depreciation rules, prodded firms to invest in even better equipment and technology, which lifted productivity. That is why U.S. workers finally began to see wage gains.
This supply-side shock is not a deliberate government plan like President Reagan’s individual tax cuts in 1981. It is more like Jed Clampett’s well-timed buckshot. But it is potent and helps the overall standard of living to bubble up.
We are all Keynesians now, thanks to Keynes. We are all monetarists now, thanks to Friedman. We all care about supply, thanks to the gig worker next store. And we are all eclectics now, thanks to a turbulent world.
Milton Friedman’s sparring went beyond monetary debates. While free market economists are sometimes derided for lacking compassion, Friedman proposed a “negative income tax” back in 1962 to help poor people and to replace the convoluted welfare system. His design inspired today’s Earned Income Tax Credit. In international economics, Friedman committed heresy, arguing in 1953 that exchange rates should float, rather than be fixed by governments. Now trillions of dollars trade each day in foreign exchange and global bonds markets, pressuring governments and central banks to act more efficiently. In the years before his death, in 2006, at the age of ninety-four, Milton and Rose Friedman together argued vigorously in favor of creating competition among schools by offering parents the freedom to choose schools, thereby replacing the monopoly of local schools.
Milton Friedman’s proudest moment, beyond the Nobel Prize, beyond the theoretical and empirical triumphs, came in 1970. The subject had little to do with the economy: It was the military, which drafted hundreds of thousands of young Americans to a bloody war in Vietnam. President Nixon appointed Friedman to a commission that would consider whether to scrap the draft and replace it with an all-volunteer force. At the outset, the commission was evenly split between supporters and opponents of a volunteer army. Army General William Westmoreland grimly testified that he did not want to command an army of mercenaries. Friedman stopped him: “General, would you rather command an army of slaves?” Westmoreland drew himself up, his steely eyes and bronze oak-leaf clusters flashing, and declared to the bespectacled Friedman, “I don’t like to hear our patriotic draftees referred to as slaves.” Friedman replied, “I don’t like to hear our patriotic volunteers referred to as mercenaries. But if they are mercenaries, then I, sir, am a mercenary professor, and you, sir, are a mercenary general; we are served by mercenary physicians, we use a mercenary lawyer, and we get our meat from a mercenary butcher.” Friedman recalled, “That was the last that we heard from the general about mercenaries.”35 Like the dissident, persistent juror in the play Twelve Angry Men, Friedman brought forth from the commission a unanimous vote for the volunteer army, and for freedom.