Economics Makes Strange Bedfellows

Milton Friedman opposed Dub's Amazing Iraqi Adventure. However, he waffles on an exit strategery. The late George Aiken (R-VT) had it right during the Vietnam debacle: "Declare victory and go home." If this is (fair & balanced) cant, so be it.

[x New Perspectives Quarterly]
Free Markets and the End of History

Milton Friedman, 93, was awarded the Nobel Prize for Economics in 1976. His monetarist and laissez-faire ideas have been profoundly influential in the past several decades with leading political figures from Margaret Thatcher to Ronald Reagan. In late November, NPQ editor Nathan Gardels spoke with Friedman at his hilltop San Francisco apartment with panoramic views across the San Francisco Bay to the Golden Gate Bridge.

NPQ | You’ve seen a lot in your long life and thought about the big issues. What is on your mind these days?

Milton Friedman | The big issue is whether the United States will succeed in its venture of reshaping the Middle East. It is not clear to me that using military force is the way to do it. We should not have gone into Iraq. But we have. At the moment, the most pressing issue, therefore, is to make sure that effort is completed in a satisfactory way.

There is no doubt that America’s stature in the world—in large part due to the attraction and promotion of our liberal freedoms—has been eroded as a result of Iraq. However, if Iraq emerges in the end as a self-governing country that is not a threat to anybody, that will have a favorable effect on the Middle East in general. The end result then would be to increase the prestige of the US. But that is not the case now. The effect so far has been the other way.

NPQ | The so-called “old Europe” of France, Germany and Italy has been stagnating with high levels of unemployment. Germany—one of the last bastions of the Cold War Keynesian welfare state—now has a conservative leader, Angela Merkel.

What should be done to get Germany, and by extension old Europe, back on track?

Friedman | They all ought to imitate Margaret Thatcher and Ronald Reagan; free markets in short.

Germany’s problem, in part, is that it went into the euro at the wrong exchange rate that overvalued the deutsche mark. So you have a situation in the eurozone where Ireland has inflation and rapid expansion while Germany and France have stalled and had the difficulties of adjusting.

The euro is going to be a big source of problems, not a source of help. The euro has no precedent. To the best of my knowledge, there has never been a monetary union, putting out a fiat currency, composed of independent states.

There have been unions based on gold or silver, but not on fiat money—money tempted to inflate—put out by politically independent entities.

At the moment, of course, Germany cannot get out of the euro. What it has to do, therefore, is make the economy more flexible—to eliminate the restrictions on prices, on wages and on employment; in short, the regulations that keep 10 percent of the German workforce unemployed. This is far more urgent than it would otherwise be if Germany were not in the euro.

This set of policies would open up the German potential. After all, Germany has a very able and productive workforce. It has high-quality products that are valued all over the world. It has every opportunity to be a productive, growing state. It just has to give its entrepreneurs a chance. It has to let them make money, hire and fire, and act like entrepreneurs.

Instead, what you have as a result of past policies is that German entrepreneurs go outside of Germany for many of their activities. They are investing abroad instead of at home because there isn’t the openness, fluidity and opportunity they find outside their borders.

NPQ | British Prime Minister Tony Blair argues there is a “third way”—for example, flexible labor markets without hire-and-fire American-style. This, he argues, is more suitable to the “European social model” with its enduring concern with social justice. Is there an in-between way, or must it be all or nothing?

Friedman | I don’t think there is a third way. But it is true that a competitive market is not the whole of society. A great deal depends on the qualities of the population and the nation in how they organize the non-market aspects of society.

NPQ | Perhaps the Scandinavian countries are a model to look at. They are high-tax but also high-employment societies. And they have freed up their labor markets much more than in Italy, France or Germany.

Friedman | Though it is not as true now as it used to be with the influx of immigration, the Scandinavian countries have a very small, homogeneous population. That enables them to get away with a good deal they couldn’t otherwise get away with.

What works for Sweden wouldn’t work for France or Germany or Italy. In a small state, you can reach outside for many of your activities. In a homogeneous culture, they are willing to pay higher taxes in order to achieve commonly held goals. But “common goals” are much harder to come by in larger, more heterogeneous populations.

The great virtue of a free market is that it enables people who hate each other, or who are from vastly different religious or ethnic backgrounds, to cooperate economically. Government intervention can’t do that. Politics exacerbates and magnifies differences.

NPQ | The inflation rate in America as well as globally remains historically low, even as oil prices skyrocket. Why?

Friedman | Inflation is a monetary phenomenon. It is made by or stopped by the central bank. There has been no similar period in history like the last 15 years in which you’ve had little fluctuation in the price level. No matter what else happens, this will maintain as long as the US Federal Reserve maintains strict monetary policy and control of the money supply.

The same thing is true in Europe. The ECB (European Central Bank) has held down the rate of monetary growth. So there have been stable prices. The pressures in Europe, however, will be much stronger than in the US. The main pressure is to print money and be more expansive in order to promote employment.

What the ECB does really depends on whether Germany and France and Italy will back it. Italy may well be the main problem. It has benefited most from the euro by having been able to get the euro interest rate instead of what otherwise would have been its own. That would be much higher because Italy has been accumulating so much debt. In the past, Italy has inflated away its debt. The virtue of the euro is that Italy can’t do it alone. A tight ECB policy wouldn’t permit that to happen again.

In this sense, the euro is good for Europe. But only if there is flexibility all around. The problem is that, in a world of floating exchange rates, as Italy was before the euro, if one country is subjected to a shock which requires it to cut wages, it cannot do so with a modern kind of control and regulation system. It is much easier to do it by letting the exchange rate change. Only one price has to change, instead of many.

But now, in the euro, that option is taken away. The only alternative if a state has to adjust to a shock is to let internal prices vary. It has to let wages go down, if necessary. It has to let internal interest rates go up, if necessary.

NPQ | The US Treasury debt is held mainly by China, Japan and South Korea. Is the huge foreign balance of payments deficit a problem for the US and world economy?

Friedman | I don’t think so. It may well be a statistical mirage. If you look at the balance sheet, the US is heavily in debt. If you look at the income account—the amount of interest the US pays abroad—it is almost exactly equal to the amount of interest that it receives from abroad. American assets held abroad are earning a higher rate of return than foreign assets held here.

That is understandable because what is most attractive about the US to people and countries with wealth is that it can provide security, insurance really, against political instability. Nobody is afraid that the money they place in the US is at risk of expropriation or of in some other way being taken away. For this safety, the wealth holders of the world are willing to accept a lower rate of return. US assets abroad, in contrast, are riskier and thus yield a higher rate of return.

This explains why there is a rough balance in real terms. It is not clear there really is a debt. It looks like the imbalance concerns are misleading. It doesn’t worry me a bit that China and Japan hold so much US debt. In a way, it seems foolish for them to do it because they get lower returns than they might elsewhere. But that is their business.

NPQ | By pegging their currencies to the dollar, haven’t China and Japan de facto established what is in essence “Bretton Woods II”—that is, a stable new currency regime among most of the world’s largest trading partners?

Friedman | Yes, for the moment, this is sort of true. But they are not really committed to it. The Chinese currency is starting to appreciate. The Japanese currency has moved quite a lot.

China’s productive system draws upon the other East Asian countries to a great extent. It buys from Japan and Korea and others. So, the volume of trade is much larger than the net amount being exported from China. China needs substantial reserves to finance all that.

NPQ | Does the large US fiscal deficit worry you?

Friedman | Not at all. It is the spending that got us there that worries me. If the US government spends 40 percent of the nation’s income, as it does through either borrowing or taxes, that income is not available for people to spend. The deficit is an indirect method of taxation. Of course, politicians prefer to borrow instead of tax because then someone down the road has to deal with the consequences.

If anything, at the moment, the large deficit has a positive effect of holding down further spending. In that sense, it is a good thing. But it is not a good thing if produced by more spending.

NPQ | China has registered tremendous growth since 1979 through what might be called a “market Leninist” model, or an “authoritarian free-market system” like the Pinochet government you advised in Chile. Can this model last?

Friedman | No. The same thing will happen in China that happened in Chile. Political freedom will ultimately break out of its shackles. Tiananmen Square was only the first episode. It is headed for a series of Tiananmen Squares. It cannot continue to develop privately and at the same time maintain its authoritarian character politically. It is headed for a clash. Sooner or later, one or the other will give.

If they don’t free up the political side, its economic growth will come to an end—while it is still at a very low level.

The situation is not all bleak. Personal freedom has grown greatly within China, and that will provoke ever more points of conflict between the individual and state. There is a new generation that is educated and travels abroad. It knows firsthand the alternatives out there. So, the authoritarian character is softening somewhat.

Hong Kong is the bellwether. If the Chinese stick to their agreement to let Hong Kong go its own path, then China will also go that way. If they don’t, that is a very bad sign. I’m optimistic.

NPQ | What impact has the Internet had on freedom and markets?

Friedman | It has had a tremendous effect. Look at what has happened in China. People can talk to each other, and the government, despite its best efforts, can’t control it.

The Internet also moves us closer to “perfect information” on markets. Individuals and companies alike can buy and sell across borders and jurisdictions wherever they find the best match of supply and demand. Undoubtedly it has reduced the possibilities of taxation. Why should I buy something here if I can buy it from a company in Japan or England or Brazil with a lower tax?

The Internet is the most effective instrument we have for globalization.

NPQ | So you see the march of liberty and free markets going forward into the 21st century, not taking a detour backward in China or elsewhere?

Friedman | Yes. The world as a whole has more or less embraced freedom. Socialism, in the traditional sense, meant government ownership and operation of the means of production. Outside of North Korea and a couple of other spots, no one in the world today would define socialism that way. That will never come back. The fall of the Berlin Wall did more for the progress of freedom than all of the books written by myself or Friedrich Hayek or others.

Socialism today has only come to mean government extraction of income from the haves and giving it to the have-nots. It is about the transfer of income, not ownership. That is still around.

NPQ | Might the state make a comeback, though, because of a new set of realities: demographics, the environment and the combination of inequality and democratization?

The rich-country populations are growing old. With the rise of the individual and demise of the family, the state will be called upon to ensure health care and pension security. With the scientific consensus on climate change, there will inevitably be demands for more state regulation on the environment. The spread of global free markets has also meant rising inequality. Inevitably, as democracy also spreads, the majority who are less well off will demand transfers from the wealthy to address social injustice.

Friedman | Sure, the state might come back. The only reason free markets have a ghost of a chance is that they are so much more efficient than any other form of organization. When you argue for free markets, you are arguing against the trend. When something goes wrong, the natural tendency is to say, “By God, we need to pass a law and do something.”

The argument for the free market is a complicated and sophisticated one and depends on demonstration of secondary effects. I have confidence market efficiency will win out. But there is no doubt that the problems you raise are all there. And there is no doubt there will be tremendous pressure to pull in the government as the answer.

At the end of World War II, government spending was 15–20 percent of national income. Then it went up dramatically so that by 1980 it hit 40 percent largely because of programs ranging from Medicare to environmental regulation to Social Security. From 1980 until 2005, it has remained static. We haven’t beaten the tendency or rolled it back. We’ve just stopped the growth. This is an argument that supports your thesis, I’m afraid.

On aging societies, there is no reason why a country that has a lot of old people can’t be prosperous if, during their working lives, individuals provide for their retirement. The only reason there is a crisis about Social Security in the US and pensions in Europe and Japan is that you cannot maintain a “Ponzi” scheme indefinitely. We have collected from today’s young to pay today’s old and counted on tomorrow’s young to keep doing so. That was a fine scheme as long as the number of young people was rising faster than old people. When that ratio comes to an end, such a system also has to end. It all would have been much better if individuals saved for their own old age.

Why is it that private insurance companies are not in trouble because people are getting older? Aren’t they subject to the same demographics? The difference is that they’ve accumulated a fund, not a pay-in, pay-out system.

NPQ | Even in the free market US, President Bush, at the height of his power, couldn’t convince the American public to move toward privatizing Social Security.

Friedman | There is no doubt this aging issue will test the argument over the efficiency of the market versus political demands for government to step in.

On the question of whether inequality of the market might lead the less-well-off democratic majority to push for state control, I’m not so sure. The important issue is not how much inequality there is but how much opportunity there is for individuals to get out of the bottom classes and into the top. If there is enough movement upward, people will accept the efficiency of the markets. If you have opportunity, there is a great tolerance for inequality. That has been the saving grace of the American system.

In the US, the problem now is primary and secondary education. We’ve had such an increase in inequality because a quarter of American kids don’t finish high school! In the current world, with the skills needed, those dropouts are condemned to being members of the underclass. In my view, this is a fault of the American school system, which is a government monopoly.

NPQ | With globalization, are we seeing the freest world economy we’ve ever seen?

Friedman | Oh no. We had much freer trade in the 19th century. We have much less globalization now than we did then.

Will we go ahead back to this freedom of the 19th century? I don’t know. We have a freer world because of the collapse of the Soviet Union and the changes in China. Those two have been the main contributors to freedom in our time. The countries that have risen and separated out as a result of the collapse of the Soviet Union are, on the whole, following freer economic policies. Most of these states have freer government and less restrictions on trade.

This free-market base will likely expand from there by example to others not so free. Everyone, everywhere, now understands that the road to success for underdeveloped countries is freer markets and globalization.

NPQ | In the end, your ideas have triumphed over Marx and Keynes. Is this, then, the end of the road for economic thought? Is there anything more to say than free markets are the most efficient way to organize a society? Is it the “end of history,” as Francis Fukuyama put it?

Friedman | Oh no. “Free markets” is a very general term. There are all sorts of problems that will emerge. Free markets work best when the transaction between two individuals affects only those individuals. But that isn’t the fact. The fact is that, most often, a transaction between you and me affects a third party. That is the source of all problems for government. That is the source of all pollution problems, of the inequality problem. There are some good economists like Gary Becker and Bob Lucas who are working on these issues. This reality ensures that the end of history will never come.

Copyright © 2006 Center for the Study of Democratic Institutions

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