Why Milton Friedman's Theory of Inflation is Fundamentally Unsound
Do you live in a world where machines last forever, there's no debt, and nothing ever changes?
There’s been a lot of talk and debate about inflation and hyperinflation recently, including fights over what causes it. In the U.S., there are insane debates about tariffs, and whether they would cause inflation. As an import tax paid by Americans, it is driving up prices, but Trump’s defenders have denied it by citing Milton Friedman’s textbook definition of inflation, which Friedman argued was only ever caused by government.
There needs to be a much better debate and more clarity about all of this, because Milton Friedman’s explanation - which makes a kind of intuitive sense in conversation, makes no sense whatsoever when you look under the hood.
White House Senior Trade Counselor-designate Peter Navarro: said
Inflation is a monetary phenomenon, where we run a Federal Reserve that prints too much money, and they do that to accommodate fiscal irresponsibility.”
This is the dominant belief in the U.S. and around the world. Robert Reich, the former secretary of Labour under Bill Clinton, who often praises Bernie Sanders basically agreed with Navarro on the idea that fiscal government spending causes inflation last October. Reich said that “Trump’s unforgivable failure to contain COVID as well as other advanced countries did required massive government expenditures that fueled inflation.” (Emphasis mine).
As Matt Stoller wrote at his substack about monopolies, “Big”
Aside from some antitrust-focused analysts and MMT folks, the economics establishment have argued that the whole premise that market power is relevant to pricing is silly. Even Adam Tooze, the economic historian who tends to take the more progressive side of the economics world, dismissed the notion. The more mainstream you get, the more harshly the idea is dismissed.
It’s particularly odd, because the way that Friedman describes inflation as working - doesn’t even accurately describe the basic way that governments run deficits. Friedman is saying that when a government runs a deficit, they are increasing the money supply, and that is what causes inflation.
The idea that increasing the money supply is what leads to inflation feels right.
If have a certain amount of money that has a certain total value. you can think of it as a fraction - that the total value of the economy is on top, and the total number of dollars is on the bottom.
it feels like basic math: you just divide all the stuff by the all the money. If there’s more money but the same stuff, it must be worth less. Or if you had wine, it’s like you’re diluting it.
There are many, many reasons why this simple and intuitive model is not accurate, and also why it has nothing to do with government deficits.
Deficit spending does not involve an increase in the money supply at all. It is an increase in the amount of money the government is putting into the private sector above what it is taking in in taxes.
A government can have identical consecutive budgets, spending the same amount. It can be balanced one year, and in deficit the next just because revenues are down, but the exact same amount of money is being spent. It’s not an increase in the money supply at all. Even if the government is increasing the budget, there is no increase in the money supply. Investors will place their money - which already existed - with the government, for safekeeping and security.
New money is not being created by the central bank to support the deficits.
What is even more confusing is that what economists call “money printing,” perhaps typically for economists, does not mean that governments are creating new currency or money. What they are talking about here is about commercial banks extending new credit, when central banks lower interest rates. It’s private credit that is being extended in the form of loans, credit cards, mortgages.
This creation of new private credit does increase the total money supply, but not with government-issued fiat currency. It is not part of any elected government’s fiscal stimulus, debt or deficit that politicians have a say in and vote on. The decision is entirely up to appointed central bankers, who are independent.
Banks are regulated in such a way that they can extend credit based on certain constraints, like their reserves, and interest rates. Interest rates are proportional to risk: low risk means low interest rates, and high risk means high.
Lower interest rates bend the curve of assumed risk, and results in a large amount of lower quality credit being extended that penetrates much more deeply into the economy. The focus for lenders is how much a person can pay on a monthly basis to support their debt. When interest rates drop, the same monthly payment can service much more debt. Lowering interest rates by 1% can increase the price of a $375,000 house by $50,000. Banks will be willing to extend credit to people who did not previously qualify, while everyone who did already qualify is eligible to borrow much more. When interest rates are near zero, people treat it as “free money” except it’s being used to drive up and speculate on the price of existing assets.
That is the “money printing” side of it, and it is inflationary, but not only is the credit money being extended entirely private, it drives a series of inflationary pressures, starting with the price of property, which creates pressure on wages. Corporations that are already established will take advantage of the ultra-low interest rates, not to invest in the creation of new value, but the purchase of existing value: mergers, acquisition and the ever greater concentration of ownership, which translates to pricing power, oligopoly and monopoly.
This is all quite blatantly obvious. There’s no question of the role of cartels and corporate networks colluding to drive and hold up prices, through deliberate hoarding and restriction of supply, including of essentials that underpin entire economies - energy and property - land - which are both essential to survival - never mind prosperity.
Inflation is invariably linked with crisis, and it creates a collective hoarding response that pits people against each other, because panic buying can be met with panic hoarding - as well as people taking advantage of a situation.
Surges in inflation being a conflict phenomenon are being supported by theory:
In April 2023, Guido Lorenzoni and Iva ́n Werning wrote a paper, “Inflation is Conflict” Eckhart Hein wrote a Post-Keynesian perspective “Inflation is always and everywhere ... a conflict phenomenon: post-Keynesian inflation theory and energy price driven conflict inflation.”
There’s a notable paper from 1977 by Robert Rowthorn.
Conflict means uncertainty, and uncertainty raises costs, as well as opportunities for exploitative profit-taking.
This is not a new observation: it is written in Sun-Tzu’s The Art of War:
“Where the army is, prices are high; when prices rise, the wealth of the people is exhausted. When wealth is exhausted the peasantry will be afflicted with urgent exactions.”
Chia Lin: … Where troops are gathered the price of every commodity goes up because everyone covets the extraordinary profits to be made.
That was 2,500 years ago, but coveting extraordinary profits has never gone out of style. OPEC+ with Saudi Arabia and Russia - are a blatantly obvious example - a cartel that controls the price of oil by deliberately colluding and choosing to restrict production. That was one of the major reasons for ultra-high gas prices and oil profits and inflation in 2022-2023.
As Matt Stoller has reported, in the U.S., investigations into abuse of monopoly power shows that alleged price-fixing in the oil industry was responsible for 27% of all inflation in 2021, that for U.S. rents between 2020 and 2024, up to a quarter of the inflation is due to price-fixing.
Matt Stoller wrote:
“The monetarist view is perfectly encapsulated by Friedman’s remark that “inflation is always and everywhere a monetary phenomenon.” According to this view, the principal factor underlying inflation has little to do with things like labor, materials costs, or consumer demand. Instead, it is all about the supply of money.”
In fact, the specifics of Friedman’s argument are notable because of the restrictions he has to impose on the economy in order for his logic to work:
Steve Keen writes in his new book, that for Friedman to make his argument required him to invent,
“a fictional world in which, given his assumptions, government money printing was the only possible cause of inflation.
[Friedman writes : ] “Let us start with a stationary society in which there are (1) a constant population with (2) given tastes, (3) a fixed volume of physical resources, and (4) a given state of the arts ... (7) Any capital goods which exist are infinitely durable, cannot be reproduced or used up, and require no maintenance ... (8) these capital goods ... cannot be bought and sold. (9) Lending or borrowing is prohibited ... (12) All money consists of strict fiat money, i.e., pieces of paper, each labelled "This is one dollar." (13) To begin with, there are a fixed number of pieces of paper, say, 1,000...
Let us suppose that these conditions have been in existence long enough for the society to have reached state of equilibrium. Relative prices are determined by the solution of a system of Walrasian equations. Absolute prices are determined by the level of cash balances desired relative to income ... Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky... (Friedman 1969, pp. 2-4)”
[Keen] If you accept these assumptions, then the only conclusion you can reach is that money creation by the government —"helicopter money"-causes inflation. But these assumptions leave out critical aspects of the real world. Lending and borrowing exists, so there are two sources of domestic money creation, not just one. Population is changing, as are physical resources and technology. Capital goods can be produced, and they do wear out. The economy is never in equilibrium.
Friedman’s theory depends on conditions that describe a world completely unlike our own. It is not just fictional, it’s static: It’s describes a world where nothing wears out, needs maintenance, breaks down, without innovation, decay or risk. It’s rigid and inflexible.
It’s also a world without agency or individuals making decisions or taking strategic risks for gain.
It should be recognized as obvious that inflation is part of a fear response to a crisis and uncertainty. There are technical definitions of uncertainty that are important, but there are two ways we can think of uncertainty.
One is as missing information, but another useful way of thinking about it is about how much control you have over an outcome. How certain are you that you can that you can shape an outcome of an event? Your ability to control an outcome is what real power actually is, as an individual.
Large scale crises - disasters, war, financial breakdowns, outbreaks of infectious disease - have the effect of increasing both kinds of uncertainty across the entire social and economic landscape. There are events with global impact - global oil prices, global financial crises, global pandemics, global conflicts.
That real increase in uncertainty means we have less certain knowledge and less certain control. It is not just a matter of “confidence” - it directly affects people’s capacity to control an outcome. This directly affects bargaining power between buyer and seller. The seller, who has what the buyer needs, has the upper hand.
This is much closer to what Adam Smith described in the Wealth of Nations, when he talked about collusion to increase prices. “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”
What is missing from neoclassical economics, above all, is the idea of uncertainty. It is true, in a very real sense, that there are limits to both human knowledge and the human capacity to guarantee a given outcome.
This is arguably the most serious failure of the entire neoclassical economic project: instead of dealing with uncertainty by incorporating it into their formulas, they try to banish uncertainty by excluding it.
“The idea of rational expectations was first developed by American economist John F. Muth in 1961. However, it was popularized by economists Robert Lucas and T. Sargent in the 1970s and was widely used in microeconomics as part of the new classical revolution.
The theory states the following assumptions:
With rational expectations, people always learn from past mistakes.
Forecasts are unbiased, and people use all the available information and economic theories to make decisions.
People understand how the economy works and how government policies alter macroeconomic variables such as price level, level of unemployment, and aggregate output.
This runs contrary to all historic evidence. The evergreen classic “Extraordinary Popular Delusions and the Madness of Crowds” by Charles MacKay covers centuries of manias where the broad mass of a community are seized by manias. Stock market bubbles in the 1600s and 1700s mass delusions, wars, witch hunts and panics.
However, on a deep level, what is missing from neoclassical economic models is that fundamental uncertainty that is an escapable part of human existence.
There’s no small irony in the fact that the theory of “Rational expectations” is both irrational and fails to grapple with the consequences of expectations.
It is not just that human beings are not rational; it is not just that we make terrible decisions, or that we fail to learn from our mistakes. It’s that expectations are about looking forward in time with the hope of a desired outcome that has not yet come to pass.
The reality of human existence - including economic decisions is that we live in time; we don’t know everything, and we don’t control everything.
Those two forms of uncertainty are fundamentally inescapable. Anything less than total knowledge and total control means there is some uncertainty. Even total knowledge of the current moment is not enough to be certain, because we do not have total knowledge of the future.
Even knowledge of things that are inevitable - like death - are only partially certain.
The reality of what this means for human beings, especially when they are making economic decisions, is because there is always some uncertainty - so human beings as economic actors can only have partial knowledge, and partial control.
Every choice involves taking a risk.
Every economic actor is deploying strategies and taking risks in the hope of a reward
Because of the lack of information and control, no strategy is ever totally risk-free, and some efforts will succeed and reap benefits, and others will fail and result in a loss.
Even with a lottery, where it is certain that someone will win, but it is not certain who it will be.
Success or failure are contingent on many factors, but the likelihood and distribution of success or failure is directly related to the risk involved.
Opponents may execute counter-strategies that can either neutralize your efforts or put you over the top.
While we are talking about the macroeconomy, it is not just one on one interactions: you have many people taking risks.
For an individual or organization to take a risk, they are constrained not just in the resources they have to take a risk with, but their ability to absorb a loss if the risk fails. Just as it may be possible for a small risk to have an unexpected and large payoff, the costs of failure may also be catastrophic. Individuals of limited means, for example, might have $5,000 in savings that they could place on a high-risk investment that could earn them $100,000, but unable to bear the loss.
Someone with $1,000,000 in savings can take such a risk because they can easily bear the loss: what is high-risk for some is lower risk for others. Capacity to take a risk and bear losses is unequal.
The population distribution of those payoffs is directly linked to the level of risk being taken. The probability distribution of a high-risk investment is that most investors will lose, and a few will win big.
If I were to say that this is clearly a matter of chance, there are many people who will object, and say that people who are wealthy work hard, create jobs, take personal risks and are deserving of their success.
This may well be true, but it doesn’t change the fact that the payoff on a high-risk investment, is by its very definition, unlikely to happen to a specific person: that’s what makes it high-risk. Most people will lose, and very few will win, especially in financial transactions, which are zero-sum.
High-risk investments will not work to spread the wealth for everyone. They will, by their very nature, concentrate wealth in the hands of a few, because high risk means most people will lose and a very few will win. This is one of the reasons that, despite the idea that the best way to accrue value on the stock market is to “buy and hold” for years, the greatest fortunes are made and lost on single days of tremendous volatility.
Once an individual has accumulated enough surplus to bear a loss, you can afford to continue making high-risk, high-reward bets: in fact, you have so much surplus that you can not only control rewards, but shift the amount of risk in the game.
It is also common for people to refer to the incidence of hyperinflation in Germany as an example of money printing by government - which is completely incorrect. It was not the government at all - it was the central bank had been privatized and was allowing banks to print their own money, and they did.
Inflation is not being caused by fiscal stimulus, nor is fiscal spending being supported by a monetary stimulus.
If it is the case, as I believe it to be, that price inflation is caused by collusion and uncertainty, than the solution is to disrupt the collusion and reduce the uncertainty. That can mean breaking up or regulating monopolies and oligopolies, requiring greater competition in order to provide better choice.
We are not in an inflation crisis: inflation is a painful signal of uncertainty and problems in the economy.
It also has to be emphasized that Friedman and the neoclassical’s obsession with inflation has nothing to do with concern over the cost of the “basket of goods” that consumers buy, and everything to do with intervening in the market to prevent the value of existing assets from going down, even when those assets are massively overpriced.
Inflation can be seen as a signal that the economy is in crisis - like an alarm going off. The problem with monetary policy for the last 50 years is that, the effect of the anti-inflationary policies of central banks has been to suppress the signal, instead of responding to the alarm. It amounts to five decades of hitting the snooze button and postponing the crisis.
What’s more, the consequences of those monetary policies - lowering interest rates, massively expanding the supply of credit, and quantitative easing, are aimed at preventing asset bubbles from collapsing, and continuing to expand them instead.
Friedman and the neoclassical economists crafted policies that go beyond investor protection, to active investor protectionism.
Inflation is a sign something is wrong that needs to be addressed - very likely high debt levels, and too much ownership and income in too few hands, so people outside that privileged group have fewer and fewer opportunities.
Instead of addressing the cause of the inflation, central banks have been suppressing the warning signal for 50 years, but especially since the “Greenspan Put” of 1987, when Federal Reserve Chair Alan Greenspan effectively bailed out Wall Street.
In a 2001 paper, Marcus Miller, Paul Weller & Lei Zhang argued that
“investors in the US had come to expect that the Federal Reserve would take decisive action to prevent the stock market from falling -- but not to stop it rising: and were confident that the intervention would succeed. Two key examples of the Fed’s ability to prevent market crashes are the prompt action taken to limit “market break” of 1987 and to alleviate the “liquidity crunch” of 1998, in both cases by cutting interest rates and pumping in liquidity.”
Preventing the stock market from falling, but not to stop it rising effectively means that central banks are choosing to intervene to keep assets artificially high in a crisis.
However, the reality of risk-taking is that once the real-world results become a reality, there are real benefits and payoffs, and real losses and costs. They are not theoretical.
Ironically, these federal reserve “Puts” are justified by the neoclassical claim that the market and capitalists do a better job of allocating resources than government, even as a branch of government is altering policy and making funds available to investors whose risks went sour.
People have described American capitalism as “privatizing gains and socializing losses,” or “socialism for capitalists, and the free market for everyone else.” These interventions protect investors and banks - but the losses and costs remain, and the burden is shifted elsewhere.
These central bank interventions in the U.S., Canada, and around the world, have now amounted to trillions of dollars in support for investors, and have created the current economic and political crisis we are all living in: the massive concentration of wealth; asset bubbles, affordable housing crisis, a lack of investment in productive industry, all of it inflated with excess low-grade private debt.
The link between stability, instability, uncertainty, risk and it has real distributional consequences. Chaotic volatility - including inflation, hyperinflation is bad for the vast majority of participants in the economy, who will lose, while a very few will gain enormous sums.
In Hamlet, Shakespeare writes “There’s a divinity that shapes our ends, Rough-hew them how we will,” and that is the nature of probability. We do have the capacity to influence outcomes, and some have more capacity than others.
Inflation is being caused by collusion and by uncertainty and conflict, and the housing and affordability crisis is driven by central banks, interest rates and people looking to make the greatest amount they can from mortgages.
What this also means, however, is that fiscal stimulus that reduces uncertainty will have the effect of reducing inflation; so does debt restrucuring, and injections of equity to “prime the pump” and create stability and an economy where the costs and benefits of risk-taking are better shared, not just due to government taxation or redistribution, but due to having a private economy that make it more likely for more people to succeed.
That takes an economy that is based in reality, and making the most of what we do know, and what we can control, while being conscious of what we don’t.
-30-
Thank god for this analysis and explanation. Excellent and essential stuff. Cheers!
Milton Friedman was all the rage when I began college in the Reagan revolution of the early 80’s. I read most his books as supply side economics (Voodoo economics for some) became the mantra in government and business. Even back then in my early 20’s I remember thinking there was something awfully simple about his writings along with his wife.