The money machine

Textbooks do not usually change the world. After all, compilations of established wisdom cannot easily serve as manifestos for change. But Paul Samuelson’s textbook Economics was an exception to the rule. Samuelson revised it for over three decades from its first publication in 1948, with the eleventh edition under his sole name coming out in 1980. Four more editions, jointly by Samuelson and William Nordhaus, appeared over the next fifteen years. Although it has now been largely replaced in the classroom by other works, these tend to keep the same structure and to expound the same themes as Samuelson’s template. In effect, the Samuelson textbook has so dominated the instruction of economics that it has fixed the meaning of the subject in modern times.

The impact of Samuelson’s primer on economic thinking was nicely captured by Paul Krugman’s tribute to it in a 2011 essay, “Mr. Keynes and the Moderns.” To quote:

The brand of economics I use in my daily work . . . was largely established by Paul Samuelson back in 1948, when he published the first edition of his classic textbook. It’s an approach that combines . . . microeconomics . . . and Keynesian macroeconomics. In the Samuelsonian synthesis one must count on the government to ensure more or less full employment; only once that can be taken as given do the usual virtues of free markets come to the fore.

Plainly, the Samuelson tradition—as understood by Krugman—is against socialist revolution. It recognizes the efficiency of the free market and, by extension, endorses private property and the incentives of the capitalist system. But this endorsement is qualified by a call for activist government. In this one key respect Samuelson borrowed from Keynes, and Krugman has borrowed from Samuelson. According to all three of them, the government must use its “fiscal policy” levers—its powers over public expenditure and taxation—to manage the economy.

Krugman’s preparedness to acknowledge his intellectual debts to Samuelson is striking. He knows that most of his economically alert readers share those debts and are therefore amenable to his commentary. Krugman may not be to everyone’s taste, but his views matter. According to the website Academic Influence, he was the world’s most influential economist in the 2010s. The larger point is that, in the early twenty-first century, the economic aspects of public policy–making are Samuelsonian to a remarkable extent.

Not that Samuelson’s position went unchallenged in his lifetime. By chance both he and Milton Friedman were students at the University of Chicago in the fall of 1932, where—according to Nicholas Wapshott in his book Samuelson Friedman: The Battle Over the Free Market—they met in the recently completed Social Science Research Building.¹ In Wapshott’s words, an “intense rivalry” was evident “from the start.” The rivalry lasted the rest of their long lives. (They both died at the age of ninety-four, Friedman in 2006 and Samuelson in 2009.)

The Samuelson tradition—as understood by Krugman—is against socialist revolution.

The rivalry was partly about status in the academic pecking order, but from the late 1940s it became increasingly partisan in a doctrinal or even ideological sense. As a young man Friedman was attracted to the novel Keynesian fiscalist thinking coming from Cambridge, England. In the early 1940s he worked for two years in the U.S. Treasury, where his task was to assess how much taxes should be raised to combat inflation. His report was thoroughly Keynesian in approach. But over the next decade a drastic reassessment occurred. By the early 1950s he was persuaded that the quantity of money was crucial to the determination of national income. Much of his subsequent career was spent criticizing Keynesian macroeconomics, denigrating fiscal policy, and championing “monetary policy,” i.e., policies dealing with interests rates and the supply of money in circulation.

These questions may seem technical to non-economists, but they entailed wider political commitments. In his 1936 General Theory of Employment, Interest and Money, Keynes had advocated a “somewhat comprehensive socialisation of investment,” so that the state should be large enough that its fiscal operations could influence aggregate demand. By defending monetary policy, Friedman was rejecting this line of argument. The intellectual disagreement between Samuelson and Friedman was therefore, above all, about the size and role of the state in a modern economy.

Given this background, Nicholas Wapshott’s book could hardly have been better timed. American politics has become increasingly polarized in the twenty-first century, with such issues as the socialization of healthcare and the taxation of the rich worrying voters along the same basic divide as that between Samuelson and Friedman. More adventitious, but also fundamental, is that late 2021 and early 2022 saw a sharp increase in inflation, with the annual increase in consumer prices reaching the highest level for four decades.

The current debate on inflation is not yet as impassioned as the one in the 1970s. An even-handed and well-organized discussion of the earlier debate might help to inform today’s exchanges. Unfortunately, Wapshott’s account is one-sided and biased, being too friendly to Samuelson and mostly hostile to Friedman. Wapshott—who is not an economist by training—lacks the grasp of theory and evidence required for his conclusions to carry authority. His motive is transparent: to present the issues in binary terms and to score political points. He regards Samuelson as a center-left social-democrat angel, while seeing Friedman as a neoliberal and “right-wing” demon with Republican political sympathies. The bias is at its most unattractive in the final pages of the last chapter, which include a quote from a private letter written by the ninety-two-year-old Samuelson. Friedman is said to have had “a weird temperament” and to suffer from “gut ideologies.”

Friedman’s reputation soared through the 1960s and 1970s.

In fact, Friedman’s reputation soared through the 1960s and 1970s, as he explained that inflation is always and everywhere a monetary phenomenon. A 1963 essay by him stated firmly, “I know of no exception to the proposition that there has been a one-to-one relation between substantial rises in prices and substantial rises in the stock of money.” The essay was selected by Samuelson for a book of readings and is quoted by Wapshott. One policy conclusion is then clear, though unpalatable. If inflation has taken off to an unacceptably high number, the state—the central bank working with the government—must restrain money growth. Sure enough, the result of a monetary squeeze may be a recession. Friedman conceded this, but he also argued that no other policy would work. (Another policy message is that in a deeply depressed economy the state should boost money growth, as with operations such as “quantitative easing,” but more on this anon.)

By the late 1970s Friedman had persuaded policy-making elites in many countries that a money-growth slowdown was necessary to curb inflation. In the United States, Paul Volcker, the Federal Reserve chairman from 1979 to 1987, absorbed Friedman’s analysis and implemented an avowedly monetary program to halt inflation. In essentials the program worked. Inflation did come down and it stayed down for twenty-five years, a period of benign macroeconomic outcomes known as the Great Moderation. Volcker is today regarded as one of the Fed’s most successful leaders. Admittedly, in detail much went wrong. Friedman and Volcker squabbled and fell out. Wapshott delves into the squabbles over detail but barely notices the more significant lesson, that the defeat of inflation did pave the way for the Great Moderation.

In the policy turmoil of the 1970s and 1980s, Friedman was repeatedly at the front and center of the stage, whereas Samuelson was often a bystander. To be fair to Wapshott, he does notice that for years Samuelson limited himself to Keynesian concepts and ways of thinking. At the heart of his textbook is the “Keynesian cross” diagram, where lines for aggregate demand and supply intersect to determine national income and output. The trouble is that the notions of “aggregate demand” and “aggregate supply” are viable in this construction only if the price level is given. Samuelson nevertheless wanted to attribute inflation to “an excess in aggregate demand.”

The fuzziness of the ideas alienated policy-makers. They found Friedman’s advice more down-to-earth and useful, and sidelined Samuelson. The references to money and monetary policy changed in successive editions of Samuelson’s Economics textbook, as he tried to catch up with the data and reality. But Wapshott is repeatedly generous to Samuelson, while sneering at both Friedman’s contribution and his politics.

The fuzziness of Samuelson’s ideas alienated policy-makers.

The differences between Friedman and Samuelson are of great relevance to the latest upturn in inflation. Despite his success in the policy debates of his era, Friedman did not write a textbook. He may have convinced many of his contemporaries, but he did not have an enduring influence on future generations of students. Once a body of ideas and principles is embedded in university instruction, it becomes a vested interest of the instructors. They have their own lecture notes, examination papers, and the like. Keynesianism—or rather Samuelson’s macroeconomic views dressed up as those of Keynes—has the power of incumbency in the academic world.

The first edition of Samuelson’s Economics appeared just after the Second World War, when the United States suffered from serious inflation. In 1943 the quantity of money (broadly defined, using a measure including all bank deposits) shot up by almost 30 percent, while in 1944 and 1945 it advanced by 20 percent and 15 percent respectively. Samuelson’s textbook was published less than eighteen months after the annual increase in consumer prices had touched 20 percent. But it contained no statement about recent rates of money growth, as if these rates did not affect inflation and could legitimately be ignored by the economics profession.

Fast-forward to the spring of 2020. After the announcement of the covid medical emergency on March 13, the Federal Reserve decided on large-scale “quantitative easing,” with potentially unlimited asset purchases to stabilize financial markets and bolster economic activity. In the year to June the quantity of money rose by 26 percent, the highest annual number since 1943.

But in their analyses Fed economists were loyal to Samuelson and waffled about aggregate demand and supply. No concern was expressed about the potential inflationary consequences of the money explosion. Indeed, the minutes of the Federal Open Market Committee’s June 2020 meeting contained not a single reference to any money aggregate. Instead some fomc members were worried that not enough had been done to raise future inflation above 2 percent! Concern about deflation persisted despite the fastest money growth since the Second World War. The fomc forecast was that end-of-2021 consumer inflation would be between 1.4 and 1.7 percent, although with downside risks.

In the year to June the quantity of money rose by 26 percent.

In the last two years the Fed chair, Jerome Powell, has been asked occasionally about how he views the quantity of money and Milton Friedman. Taking his cue from the economics experts in his institution, he has been dismissive of both. Meanwhile in his New York Times column, Krugman spent nearly all of 2021 championing what he termed “Team Transitory,” the large group of economists who believed that inflation was not a problem and would not last long. Without doubt, the American debate about economic policy in the covid emergency was Keynesian in character; it was conducted almost entirely by economists who had been taught by the Samuelson textbook. In this sense Samuelson won the long-range battle of ideas, even if in his own lifetime he was usually outclassed by Friedman in their frequent polemics.

But opinion may be shifting. Inflation has climbed into the high single digits, in accordance with the “long and variable lags” between money and inflation about which Friedman so often warned. Both Powell and Krugman have admitted they were wrong. Krugman—to repeat, the world’s most influential economist—has even said that his misjudgment is “a big deal.” Wapshott’s book on Samuelson and Friedman will not match the Samuelson textbook and its fifteen editions. Nevertheless, a second edition—kinder to Friedman, and more balanced in its view on money and the economy—would be appropriate.

A Message from the Editors

Support our crucial work and join us in strengthening the bonds of civilization.

Your donation sustains our efforts to inspire joyous rediscoveries.

Show your support

This article originally appeared in The New Criterion, Volume 41 Number 2, on page 57
Copyright © 2023 The New Criterion | www.newcriterion.com
https://newcriterion.com/issues/2022/10/the-money-machine