“The Business Cycle Largely a ‘Dance of the Dollar’” (1923) Set the Model for the “Purely Monetary” Theory of the Business Cycle

In keeping with this outlook, Irving Fisher wrote a famous article in 1923, “The Business Cycle Largely a ‘Dance of the Dollar’”—recently cited favorably by Friedman—which set the model for the Chicagoite “purely monetary” theory of the business cycle. In this simplistic view, the business cycle is supposed to be merely a “dance,” in other words, an essentially random and causally unconnected series of ups and downs in the “price level.” The business cycle, in short, is random and needless variations in the aggregate level of prices. Therefore, since the free market gives rise to this random “dance,” the cure for the business cycle is for the government to take measures to stabilize the price level, to keep that level constant. This became the aim of the Chicago School of the 1930s, and remains Milton Friedman’s goal as well. 

Why is a stable price level supposed to be an ethical idea, to be attained even by the use of governmental coercion? The Friedmanites simply take the goal as self-evident and scarcely in need of reasoned argument. But Fisher’s original groundwork was a total misunderstanding of the nature of money, and of the names of various currency units. In reality, as most nineteenth century economists knew full well, these names (dollar, pound, franc, etc.) were not somehow realities in themselves, but were simply names for units of weight of gold or silver. It was these commodities, arising in the free market, that were the genuine moneys; the names, and the paper money and bank money, were simply claims for payment in gold or silver. But Irving Fisher refused to recognize the true nature of money, or the proper function of the gold standard, or the name of a currency as a unit of weight in gold. Inst4ead, he held these names of paper money substitutes issued by the various governments to be absolute, to be money. The function of this “money” was to “measure” values. Therefore, Fisher deemed it necessary to keep the purchasing power of currency, or the price level, constant. 

This quixotic goal of a stable price level contrasts with the nineteenth-century economic view—and with the subsequent Austrian School. They hailed the results of the unhampered market, of laissez faire capitalism, in invariably bringing about a steadily falling price level. For without the intervention of government, productivity and the supply of goods tends always to increase, causing a decline in prices. Thus, in the first half of the nineteenth century—the “Industrial Revolution”—prices tended to fall steadily, thus raising the real wage rates even without an increase of wages in money terms. We can see this steady price decline bringing the benefits of higher living standards to all consumers, in such examples as TV sets falling from $2000 when first put on the market to about $100 for a far better set. And this in a period of galloping inflation. 

—Murray N. Rothbard, “Milton Friedman Unraveled,” Journal of Libertarian Studies 16, no. 4 (Fall 2002): 46-47.

The Key Problem with Friedman’s Fisherine Approach Is the Same Orthodox Separation of the Micro and Macro Spheres

The third major feature of the New Deal program was proto-Keynesian: the planning of the “macro” sphere by the government in order to iron out the business cycle. In his approach to the entire area of money and the business cycle—an area on which unfortunately Friedman has concentrated most of his efforts—Friedman harks back not only to the Chicagoans, but, like them, to Yale economist Irving Fisher, who was the Establishment economist from the 1900s through the 1920s. Friedman, indeed, has openly hailed Fisher as the “greatest economist of the twentieth century,” and when one reads Friedman’s writings, one often gets the impression of reading Fisher all over again, dressed up, of course, in a good deal more mathematical and statistical mumbo-jumbo. Economists and the press, for example, have been hailing Friedman’s recent “discovery” that interest rates tend to rise as prices rise, adding an inflation premium to keep the “real” rate of interest the same; this ignores the fact that Fisher had pointed this out at the turn of the twentieth century. 

But the key problem with Friedman’s Fisherine approach is the same orthodox separation of the micro and macro spheres that played havoc with his views on taxation. For Fisher believed, again, that on the one hand there is a world of individual prices determined by supply and demand, but on the other hand there is an aggregate “price level” determined by the supply of money and its velocity of turnover, and never the twain do meet. The aggregate, macro, sphere is supposed to be the fit subject of government planning and manipulation, again supposedly without affecting or interfering with the micro area of individual prices.

—Murray N. Rothbard, “Milton Friedman Unraveled,” Journal of Libertarian Studies 16, no. 4 (Fall 2002): 45-46.

Friedman and Schwartz’s Case That the Demand for Money (the Inverse of Velocity) Is Constant Is Statistical Legerdemain (a Sleight of Hand)

For many years I [Joseph T. Salerno]—and other Austrians—have had to endure charges by monetarists that Murray Rothbard fudged the data to increase monetary growth rates during the 1920s in order to portray it as an inflationary decade. As I argued in an exchange with eminent monetary historian Richard Timberlake these allegations are baseless. So, now it is with delicious irony that I draw your attention to an explosive article by three econometricians thoroughly debunking the empirical claim made by Milton Friedman and Anna Schwartz that the velocity of money in the U.S. has exhibited long-run stability for more than a century leading up to 1975. 

Neil Ericsson, David Hendry, and Stedman Hood argue that dubious “data adjustment” in Friedman and Schwartz’s empirical models “dramatically reduced apparent movement of the velocity of circulation of money and . . . adversely affected the constancy and fit of his estimated money demand models.” In other words, Friedman and Schwartz’s empirical case that the demand for money (the inverse of velocity) is constant, which Friedman and Schwartz painstakingly elaborated in three statistical tomes published from 1963 to 1982 and which is the linchpin of monetarism, has been exposed as statistical legerdemain. 

Friedman and Schwartz adjusted the raw data to account for: 1. the sudden onset of rapid developments of financial instruments and institutions in the U.S. economy compared to the U.K. economy; and 2. short-run fluctuations in velocity associated with business cycles. In adjusting for “changing financial sophistication,” Ericsson et al. point out, Friedman and Schwartz added a linear trend of 2.5% on money supply observations prior to 1903, but made no trend adjustment at all to the data after that year. In the process, they “adjusted” the money stock for 1867 from its raw or unadjusted value of $1.28 billion to $3.15 billion. This is a phantom increase of 246% on the observed money stock! The result of this trend adjustment was to substantially suppress the effect of the precipitous decline in observed velocity of more than 50% from the early 1870s to 1903 on its variability over the entire period studied (1867-1975). Thus although the adjustment applies to only 30% of the period studied, it accounts for almost 75% of the total variance of velocity.

—Joseph T. Salerno, “Milton Friedman Debunked—by Econometricians,” Mises Wire, entry posted May 12, 2017, https://mises.org/wire/milton-friedman-debunked-econometricians (accessed April 16, 2021).

The Parallels between the Myth of the Laissez-Faire Hoover and the Myth of the Do-Nothing Fed Are Striking

In addition to the myth of the laissez-faire Herbert Hoover, another popular theory of the Great Depression blames the do-nothing Federal Reserve. Ironically, this interpretation comes, not from Big Government critics of the free market, but instead from none other than Milton Friedman and his monetarist followers. Just as modern-day Keynesians urge the government to “avoid the mistakes of Hoover” by running up massive deficits, so too do modern monetarists urge the Fed to “avoid the mistakes of the Depression” by injecting massive amounts of reserves into the banking system. 

The parallels between the myth of the laissez-faire Hoover and the myth of the do-nothing Fed are striking. Just as Hoover engaged in unprecedented “stimulus” through his fiscal policies, so too did the Fed—starting immediately after the stock market crash in 1929—engage in unprecedented “easy money” policies. Because the massive budget deficits eventually forced Hoover to reverse course and raise taxes (in 1932), modern Keynesians say Hoover didn’t borrow-and-spend enough. Similarly, because a gold outflow from the country eventually forced the Fed to reverse course and tighten the money supply (in late 1931), the monetarists say the Fed didn’t inflate enough. But in both cases, the question remains: If budget deficits and cheap money were the right medicine, why was the Depression still getting worse, two years into these unprecedented fiscal and monetary remedies?

—Robert P. Murphy, “Did the Tightwad Fed’s Deflation Cause the Great Depression?” in The Politically Incorrect Guide to the Great Depression and the New Deal (Washington, DC: Regnery Publishing, 2009), 63-64.

New Keynesian Views on Monetary Theory and Policy Are More Fallacious Than Those of Their Predecessors

The essential fallacy of John Maynard Keynes and his early disciples was to cultivate the monetary equivalent of alchemy. They believed that paper money was a suitable means to alleviate the fundamental economic problem of scarcity. The printing press was, at any rate under certain plausible conditions of duress, a substitute for hard work and savings and cutting prices. 

The self-styled new Keynesians have not at all abandoned this fallacy and they therefore do not differ in any essential respect from the old Keynesians, in spite of the pains they take to distinguish themselves from the latter. The new Keynesian recommendation for monetary policy is to “stabilize the growth of aggregate demand.” In plain language this means that the monetary authorities should never stop flooding the economy with paper money. Recognizably, this is the core tenet of the old Keynesian monetary program, which in itself had been nothing but even older fallacies clothed in the new language of aggregate analysis. 

In many respects, new Keynesian views on monetary theory and policy seem to be even more fallacious than those of their predecessors. Whereas Keynes and his immediate followers were still trained in the old-fashioned art of economic reasoning, the new Keynesians are macro economic purebreds. Their expertise lies more or less exclusively in the field of modeling. As with the macroeconomics profession in general, they are devoted to a positivistic methodology, putting all their energies into modeling quantitative relationships among things that are the result of human action, rather than into the analysis of human action itself. Not surprisingly, therefore, their “science” of the economy resembles a hotchpotch of educated guesswork, conventions, and fictions, all designed to make the problems under consideration amenable to mathematical treatment. 

—Jörg Guido Hülsmann, “New Keynesian Monetary Views: A Comment,” Quarterly Journal of Austrian Economics 6, no. 4 (Winter 2003): 73.

The Textbook Rendition of the Short-Run Phillips Curve Dynamics Clashes with the Empirical Record and with a Fundamental Proposition of Monetarism

Textbook writers and even many self-identified monetarists have taken this short-run/long-run Phillips curve analysis to be the monetarists’ account of the market mechanisms that cause a money-induced boom to go bust. Much more plausibly, however, Friedman’s presidential address was intended only as immanent criticism of the views held by his Keynesian-oriented contemporaries. Many saw the Keynes-inspired downward-sloping Phillips curve as an enduring trade-off between inflation and unemployment, a virtual menu of policy choice for left-leaning politicians willing to put up with inflation in order to reduce unemployment and for right-leaning politicians willing to put up with unemployment in order to reduce inflation. Friedman’s message was simply that there is no long-run trade-off. 

The common textbook rendition of the short-run Phillips curve dynamics actually clashes both with the empirical record and with a fundamental proposition of monetarism. The low unemployment rate during the boom depends on wage rates lagging behind rising output prices. This sequence would mean that real wage rates are relatively low during the boom. But the notion of low real wages during credit-induced booms has no empirical support. (In the Austrian view, the artificially cheap credit increases investment, increases the demand for labor, and hence increases the real wage rate. In fact, the higher real wages are in large part responsible for the political popularity of credit-induced booms). 

Not long after Friedman offered his criticism of the Phillips curve as a menu of choice, he set out ten fundamental propositions of monetarism, which included the proposition that a monetary expansion causes quantities (output and, as a virtual prerequisite, employment) to increase first and prices only later. With this sequence, of course, it cannot be the rising prices that, being differentially perceived by employers and employees, are responsible for increased employment and output. Friedman actually finessed the issue of “quantities then prices” versus “prices then quantities” in his presidential address, portraying the latter as an extra boost during a later phase of the adjustment process. But it was exclusively the “prices then quantities” sequence that became the standard textbook version, formalized by Robert E. Lucas Jr. as a monetary misperception theory of the business cycle. In any case, the “quantities then prices” understanding, which Friedman favored, is evidently not strong enough to show up in his highly aggregative monetarist framework as an empirically verifiable boom-bust sequence.

—Roger W. Garrison, review of Alchemists of Loss: How Modern Finance and Government Regulation Crashed the Financial System, by Kevin Dowd and Martin Hutchinson, The Independent Review: A Journal of Political Economy 16, no. 3 (Winter 2011/2012): 444-445.

Irresponsible Monetary Policy Eventually Leads to an Increase in the Natural Rate of Unemployment

As Bellante and Garrison (1988) remind us, Friedman acknowledges that irresponsible monetary policy would eventually lead to an increase in the natural rate of unemployment. Two of Friedman’s papers (1976 and 1977) suggested the potential existence of a positively sloped Phillips curve. But in neither case did Friedman reconsider his model of dynamic monetary theory in light of his empirical work. 

In his Nobel lecture, Friedman acknowledged that additional research was needed to resolve the inconsistency between the monetarist Phillips curve and empirical data. He anticipated that this “third stage” of the research into the relationship between inflation and unemployment would only be successful if a way was found to incorporate political factors:

In recent years, higher inflation has often been accompanied by higher not lower unemployment, especially for periods of several years in length. A simple statistical Phillips curve for such periods seems to be positively sloped, not vertical. The third stage is directed at accommodating this apparent empirical phenomenon. To do so, I suspect that it will have to include in the analysis the interdependence of economic experience and political developments. It will have to treat at least some political phenomena not as independent variables—as exogenous variables in econometric jargon—but as themselves determined by economic events—as endogenous variables [. . .]. The third stage will, I believe, be greatly influenced by a third major development—the application of economic analysis to political behavior, a field in which pioneering work has also been done by Stigler and Becker as well as by Kenneth Arrow, Duncan Black, Anthony Downs, James Buchanan, Gordon Tullock, and others. (1977, p. 470)

In my doctoral thesis (Ravier, 2010), I called this “Friedman’s dilemma” because Friedman observed an empirical reality his own analytical framework was unable to explain. Friedman observes a positively sloped Phillips curve and a long-term effect of monetary stimulus which is not neutral in real terms. Both are inconsistent with his own theories. Instead he provides evidence confirming the work of Robert Lucas (1973) and, more recently, William Niskanen (2002). Robert Mulligan (2011) has demonstrated the connection between Niskanen’s article and Austrian business cycle theory.

—Adrián O. Ravier, “Dynamic Monetary Theory and the Phillips Curve with a Positive Slope,” Quarterly Journal of Austrian Economics 16, no. 2 (Summer 2013): 172-173.