Stephen King: Oxford dons' bête noire who laid down economic bedrock

Keynesians weren't willing to ditch the ideological baggage of stop-go policies
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When I went up to Oxford in the early 1980s, his name was dirt. The university economics faculty was, to say the least, less than enthusiastic about his teachings. Most of the tutors were Keynesians of one sort or another, with a few Marxists thrown in for good measure. Few were interested in his thoughts on control of the money supply, the benefits of free enterprise or the need for small government. Yet Milton Friedman, who died last week, will be remembered as an economic colossus of the late 20th century.

At the time, Oxford didn't much like Friedman because Friedman, in turn, was a friend of Margaret Thatcher's and Oxford certainly wasn't Thatcherite. Friedman wasn't her biggest economic influence - that accolade went to Friedrich Hayek, the Austrian economist - but he was strongly associated with key features of the Thatcher government, notably its attempts to bring down inflation through control of the money supply and, simultaneously, its desire to rein back public spending.

The Oxford dons' unwillingness to embrace Friedman's ideas reflected a powerful ideological divide. Keynesians weren't stupid. They recognised that the so-called Keynesian stop-go policies of the 1960s had failed. But they weren't prepared to ditch the ideological baggage that had supported those policies in the first place. Keynesians believed in a strong form of market failure. They argued that, left to their own devices, markets could generate persistently high rates of unemployment. They also trusted governments to know how and when to intervene to remove this market failure.

By the late 1960s, it appeared that the Keynesians had won the debate. Indeed, in 1971, President Nixon declared that "we are all Keynesians now". Friedman, though, had already put the arguments in place to support the later monetarist revolution. Alongside Edmund Phelps, he argued against a trade-off between unemployment and inflation: attempts to lower unemployment through, for example, higher government spending would lead to rising inflation expectations, higher wage claims and, hence, no reduction in unemployment at all.

But his approach wasn't restricted to the wearing of Thatcherite hair shirts. He also argued that the Great Depression in the 1930s stemmed in part from the Federal Reserve's failure to inject sufficient liquidity into the US economy at the time.

From these observations, he was able to put together the monetarist critique of the Keynesian post-war consensus. The first strand was the importance of control of the money supply, to avoid both inflationary booms and depressionary busts. The second strand was the significance of small government. This reflected both his belief in personal liberty and his doubts about the effectiveness of government intervention. Indeed, a weak form of the monetarist critique held that while, in theory, governments could intervene to stabilise economic activity, they wouldn't be able to do so in practice because they would get both timing and magnitude wrong: from this perspective, governments were more likely than markets to fail at the macro level.

These arguments became more powerful in the 1970s. The Bretton Woods system of fixed exchange rates broke down, leaving countries without nominal anchors for inflation expectations. The 1973 Arab oil embargo triggered a particularly brutal increase in price pressures. Collective bargaining encouraged aggressive increases in pay. And, against many of the predictions of unreconstructed Keynesians, unemployment started to rise. The Keynesian response - the imposition in the UK of incomes policies - made things still worse, as markets stopped functioning and the price mechanism completely broke down. With strangulated growth, rampant inflation and unacceptably high unemployment, it was time for a change.

But the change didn't begin with Margaret Thatcher. Money supply targeting, the hallmark of monetarist policies, was introduced by Dennis Healey, the Labour Chancellor of the Exchequer, in 1977, two years before Mrs T set foot in Downing Street. Jim Callaghan, the Prime Minister at the time, famously said: "We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked ... by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step." Friedman had won the debate.

So if both Labour and the Tories were willing to accept Freidman-esque monetarist orthodoxy, why were the Oxford dons so critical? Other than their distaste for Thatcherite policies, their concerns were, I think, focused on the remarkable simplicity of Friedman's monetarist arguments. In other areas - notably his work on consumer spending and the so-called permanent income hypothesis - Friedman had become part of the mainstream of economics. His monetarist convictions, though, were more questionable.

First, there was an issue of definition. Which monetary aggregate was the best measure of "money"? No one really knew. Second, there was an issue of control. Friedman thought central banks should control the quantity of money and leave its price - the interest rate - to be determined by the market. In practice, though, this proved near-enough impossible, and it wasn't long before central banks went back to their old interest rate-setting ways, much to Friedman's irritation. Third, there was an issue of stability. Charles Goodhart, the eminent monetary economist, noted that "any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes", which certainly proved a problem for those who thought Sterling M3 was the answer to the world's economic problems.

Indeed, Goodhart's Law, as it's now called, revealed an inconsistency in Friedman's approach. His belief in monetarism suggested a predictable, if not stable, relationship between money supply and nominal GDP. Yet his belief in free markets suggested that the relationship might always be undermined through financial innovation.

And so it has proved. As the 1980s progressed, so central banks slowly abandoned monetary targets, replacing them with exchange rate targets, inflation targets and, in the case of the Federal Reserve under Alan Greenspan, an eclectic risk management approach. The Oxford dons were partly right: the monetarist approach was too simplistic and those adhering rigidly to its doctrines may have allowed their economies to suffer excessive pain.

Despite this, I suspect Friedman's reputation will, deservedly, remain extraordinarily high. After all, his espousal of free market principles has dominated economic discourse for decades now. His belief in sound money - whether reflected in a money supply target or, these days, in an inflation target - is now shared by virtually all central banks. And his influence on both Ronald Reagan and Margaret Thatcher helped shape the world we now live in.

Yet his legacy won't go unchallenged. Free markets have contributed hugely to gains in global output in recent years, but government intervention, for good or bad, is on the increase, in dealing with the environment, in "protecting" the interests of voters at the expense of foreigners or in dealing with the implications of globalisation for income and wealth distribution. Friedman's ideas formed part of the bedrock of developments in the late 20th century. With growing worries about market failures, some of this bedrock is now being chipped away.

Stephen King is managing director of economics at HSBC