Jeremy Siegel, Ph.D. The Future for Investors

Milton Friedman, who received the Nobel Prize in Economics in 1976, died November 16 at the age of 94. His legacy is measured not only by his voluminous scientific and popular writings but by the number of students and scholars whom he influenced.

I was one of them. I was honored to be a colleague of Milton Friedman at the University of Chicago from 1972 through 1976. My first academic position at Chicago’s Graduate School of Business coincided with Milton’s last four years at the university and I remained in close contact when Milton and his wife, Rose, moved to San Francisco.

My enthusiasm for Friedman’s ideas came well before I met him. My undergraduate years at Columbia University corresponded with the U.S. military buildup in Vietnam and I opposed both the war and the draft that allowed the government to obtain cheap manpower. Yet most anti-war activists were against the capitalist system and free markets, which I strongly supported.

I found my political home when I read Friedman’s Capitalism and Freedom, which was published in 1962. I became a libertarian economist: a strong believer in free markets, individual responsibility, and a minimum of government intervention and controls.

Macroeconomics

My macroeconomics education at Columbia and MIT had been “Keynesian,” and, since Keynes wrote during the Great Depression, not much was said about inflation. But in the late 1960s and 1970s, inflation became a serious problem that Keynesian economics did not adequately address. Friedman filled that void by stressing the role of money in causing the inflationary process, a classical theory that had been lost during the Keynesian Revolution.

I recall listening to Friedman’s Presidential Address to the American Economic Association delivered in Chicago in 1967 where he stressed the evils of creeping inflation. He asserted that the trade-off between inflation and unemployment – embodied in the famous “Phillip’s Curve” relationship that was taught to economic students – was only a temporary phenomenon. Once inflationary expectations were taken into account, the Phillip’s Curve disappeared and in the long run rising inflation caused rising unemployment.

Friedman also addressed monetary policy. He stated that what was important for the Federal Reserve was the real, after inflation rate of interest not the market, or nominal rate of interest. This was a notion that the great American economist Irving Fisher had noted over 60 years earlier but was ignored by Fed policy makers. Friedman said that the Fed would have to abandon interest rate and start controlling the quantity of the money if it wanted to control the rate of inflation.

Friedman’s recommendations were adopted more than a decade later when Paul Volcker took over the helm of the Federal Reserve in 1979. It took two painful years of tight money and very high interest rates to slay the inflationary dragon, but the stage was set for two decades of falling inflation and rising economic growth.

Preventing Depression

Friedman’s massive work with Anna Schwartz, The Monetary History of the United States, had the most important impact on monetary policy. The key chapter in this tome is “The Great Contraction,” in which Friedman showed how the Federal Reserve bungled its mandate to stabilize the banking system after the stock market collapse.

Friedman didn’t deny that the stock crash of October, 1929 caused an economic slowdown. But the real culprit that caused the Great Depression was the collapse of the banking system caused by the failure of the Federal Reserve to stabilize the supply of credit.

Friedman showed that the Fed did have the power to expand credit, but was afraid to do so since the Fed governors were worried about re-igniting the speculation that brought about the stock market boom for which they were roundly blamed. They failed to realize the disastrous implications of the collapse of the financial system.

History has confirmed Friedman’s conclusions. After the stock market plunged a record 22% on October 19, 1987, Greenspan flooded the system with credit and stated that he was ready to lend money to any financial institution that was experiencing difficulties. The same promise was made after 9-11. This calmed the financial markets and sharply reduced the impact of the stock market on economic activity.

Friedman’s influence had international reach. The Bank of Japan maintained the integrity of its banking system after the Japanese bubble collapsed in the early 1990s. The 80% decline in the Japanese stock prices and real estate values that took place between 1990 and 2002 did not trigger a financial panic or depression since the Bank of Japan maintained the liquidity its financial system.

Friedman’s Impact

Friedman’s research changed the way economists viewed the cause of the Great Depression. Marxists claimed the Great Depression was the result of the increasing instability of the capitalist system, while Keynes claimed that the economic collapse was caused by the decline in investment driven by “the animal spirits of entrepreneurs.”

But Milton Friedman convincingly showed that there was no inherent flaw in the capitalist system. It was the Fed’s failure to save the banking system that led to the Great Depression. Had Friedman not revealed the faults of the early central bankers, it is unlikely that modern central banks would have achieved the success they enjoy today.

It has often been said that Keynes saved capitalism by showing politicians a way out of the Great Depression by expanding the role of government within the framework of a capitalist economy. But Friedman did Keynes one better. He showed that we can prevent a Depression and avoid inflation by exercising proper monetary control without expanding the government’s power and controls.

Friedman demonstrated that individual liberty and free markets within a stable monetary framework lead to the highest level of prosperity. We have lost a great man, but his imprint on monetary policy and free societies everywhere will last for generations.