Tuesday, 15 August 2006

Friedman's Lessons for Europe

Milton Friedman – Nobel economist, arch-monetarist, barely five feet tall but still utterly ebullient – turned 94 this month. His thinking has a lot to tell Europeans about how to run their governments and their economies.

It was Friedman who knocked the stuffing out of Keynesianism – the postwar consensus shared by almost all economists, that governments could guarantee stable growth through cheap credit and a few tweaks to the tax system. In fact, it delivered worldwide stagflation.

That, said Friedman, was because the Keynesians had forgotten the importance of money – the stuff we hold in our pockets, cash registers, and bank accounts. Like anything else, the more there is of it, the less it is worth. And the more money the government mints and prints, the less it will buy. In other words, you get inflation.

Maybe European governments have actually learnt that lesson, after the double-digit inflation of the 1970s and beyond. Keynes left monetary policy for dead, but Friedman singlehandedly revived it as the foundation of economic management. The Bundesbank’s management of the D-Mark provided a fine example of monetary stability and its benefits. Britain did well after monetary policy was handed over to the Bank of England, replacing short-termist political control by a clear long-term inflation target. And the euro too was left to a European Central Bank to insulate it from day-to-day political interference.

Friedman’s message got through. Money is a powerful tool, if a blunt one. The aim should be long-term stability – Keynesian-style “fine tuning” attempts just make things worse.

But inflation is not dead. Politicians enjoy it too much. And that, says Friedman, is the problem: inflation is like a drug. Expand things, and your economy booms. People rush out to spend, and businesses expand to capture their custom. But soon, prices are rising and nobody is any better off. Businesses scale back, and unemployment climbs again. So politicians inject another dose of inflation. And another, and another. Until prices become entirely dysfunctional.

And politicians also enjoy having grand designs. Like the euro. But Friedman is deeply skeptical. He successfully campaigned for floating exchange rates to replace the postwar system of fixed exchange rates. Another Keynes legacy, that simply concealed the real market pressures underlying the value of currencies. Pressures built up until crisis devaluations or revaluations became inevitable. Hardly a stable system.

Likewise, the euro conceals real pressures within the euro area. Some regions have inflation, others are in the doldrums: one monetary policy does not fit all. The euro leaves countries no way to adjust to these pressures.

To Friedman, trying to control any price is a mistake, whether it is the price of a currency or the price of housing. Indeed, back in 1946 he showed how government efforts to keep rents low and “affordable” simply caused landlords to withdraw from the housing market, unable to make a decent return on their property. Far from helping poorer families, rent controls meant that they could not find a home at all, or would have to live in overcrowded accommodation because of the shortage.

Indeed, Friedman taught us that in most cases, the market could do better than governments – a theme he and his wife Rose expounded with verve in their book and TV series Free to Choose. We vote for our politicians only every few years, and are presented with a whole package of policies. But the market allocates goods smoothly across the planet, on the basis of our daily decisions on what individual items to buy or not to buy.

So to Friedman, the more than we can transfer from government to the market, the better. Like welfare, where he advocated a negative income tax – giving needy families cash rather than government-run services, so they can be players in the same markets as anyone else, and benefit from the same competition and choice. Or education, where Friedman was an early advocate of vouchers. No need for state-run schools, just give parents a check which they can use to buy an education at any school, public or private. The Netherlands and Denmark have had versions of this idea for some time, and it is now expanding rapidly in Sweden and being mooted in other European countries.

Governments might have some useful role, says Friedman, but it is small. Most of what they do has the opposite effect of what they intended. They are the main source of monopoly power, for example: but big business is good at exploiting this so that regulations supposedly “in the public interest” actually end up making life tougher for their smaller competitors.

We need less of this, not more. But at least Friedman’s ideas have informed and galvanized a whole generation of critics of overblown government, like him.

So there is hope yet. Even for Europe.

By Eamonn Butler
The author is Director of the Adam Smith Institute.