Friedman and Samuelson on the business cycle.

• Author: Hammond, J. Daniel
• Position: Report

Chicago School economists have come in for criticism since the financial crisis and so-called Great Recession began in 2007. Commentators have blamed recent problems on a laissez-faire faith in the efficacy of markets and simple rules for business-cycle policy--ideas associated with economics as taught and practiced at the University of Chicago. Events over the past four years, we are told, demonstrate the need for a restoration of Keynesian thinking about business cycles and activist government policies to keep markets from failing, However, there is another aspect of Chicago School economics that is commonly overlooked. This is the conviction that economists' understanding of the business cycle is meager in light of the knowledge necessary for activist countercyclical policy to be effective. From this comes the Chicago School concern that economists and policymakers not attempt to do something beyond their capability. Overreaching can make the problems worse.

In the public mind, Milton Friedman and Paul Samuelson represent more than any other individuals two competing schools of thought that dominated macroeconomic and business cycle debates over much of the past century. As readers of their Newsweek columns from the late 1960s into the 1980s learned, Friedman was the "conservative" Chicago economist favoring free markets, deregulation, and rules-based monetary policy. Samuelson was the "middle-of-the-road" economist, favoring regulatory oversight of markets and activist monetary and fiscal policy. Friedman was the monetarist and Samuelson the Keynesian. Friedman died in 2006, so we do not have his commentary on the current crisis. Samuelson died in 2009, and before his death spoke with journalist Nathan Gardels of his and Friedman's respective ideas and influence in light of the crisis.

Nathan Gardels: You have outlived Milton Friedman, who died in 2006. And now your Keynesian ideas have also outlived his radical free-market ideology. Is economics back to where you started?

Paul Samuelson: You are right. I am old enough to have seen the cycle come full circle. My experience is more valuable now than it "was even a year ago, since I first became actively engaged in economic policy on January 2, 1932, at the rock bottom of the Great Depression, when I was an adviser to the Federal Reserve Bank in Washington. In subsequent years, I was principal economic adviser to President-elect John F. Kennedy in 1960 and recruited the team for his Council of Economic Advisers.

I became a centrist early on. Of course, the central planning system of the socialist states we still contested with ideologically in those days was idiotic, but that didn't mean government doesn't play a critical role.

And today we see how utterly mistaken was the Milton Friedman notion that a market system can regulate itself [Samuelson 2011].

As Americans struggle in the current climate with what to believe about economic conditions and policy, it is instructive to look back at the ideas on business cycles and macroeconomic policy of these two giants of 20th century economics.

Friedman: NBER Economist

The question of how much economists know about the business cycle, and thus how much expertise they can bring to the policymaking table, including crucially their ability to forecast business conditions, was an important part of what separated Friedman's views from the mainstream over the course of his career (see Hammond 1996). A good place to begin seeing this difference is in the late 1940s, as Friedman and Anna J. Schwartz embarked on their monetary project for the National Bureau of Economic Research (NBER). Friedman's background was in statistics and to a smaller extent business cycle analysis, but he had little experience with monetary economics at the outset of their project. His two most important mentors, Arthur F. Burns and Wesley C. Mitchell, had instilled in him firm convictions of how to do economics. From Bums he learned the Marshallian approach to economics, which involved use of relatively lowbrow theory in close relation with measureable entities theory that could be used to extract useful information from data. From Mitchell Friedman learned the techniques used at the NBER to analyze business cycle data, and he also learned that constructing economic data is as important as constructing economic theory.

Friedman's early perspective on business cycle analysis is evident in his review of Jan Tinbergen's Business Cycles in the United States of America, 1919-1932. Tinbergen's book was one of the early attempts to estimate coefficients of a general equilibrium model of the business cycle, work for which he was awarded the very first Nobel Prize in Economic Science (shared with Ragnar Frisch). Tinbergen and Frisch were cited "for having developed and applied dynamic models for the analysis of economic processes" (http://nobelprize.org/nobel_prizes/economics/ laureates/1969/#). Friedman was less impressed in 1940 than the Nobel committee later was in 1969, He wrote of the estimates:

Tinbergen's results cannot be judged by ordinary tests of statistical significance. The reason is that the variables with which he winds up, the particular series measuring these variables, the leads and lags, and various other aspects of the equations besides the particular values of the parameters ... have been selected after an extensive process of trial and error because they yield high coefficients of correlation [Friedman 1940: 659].

Friedman quoted his teacher Wesley Mitchell to the effect that a statistician can take almost any pair of data series and manipulate them to obtain a high correlation coefficient between the two. What Tinbergen failed to do is to test his model with data from outside the sample that he used to estimate the coefficients. Friedman did such a test in a rudimentary form and found that the model did not explain the out-of-sample observations very well.

A decade later Friedman commented on another test of a general equilibrium business cycle model. In this case Carl Christ tested the model on out-of-sample data, as Friedman had suggested for Tinbergen. But Friedman was still not impressed with the results. He set up an alternative, and extremely simple, model in which the values of endogenous variables were predicted to be unchanged from period to period. This was in effect running a contest between a highly sophisticated model of the business cycle and "we know nothing about the business cycle." "We know nothing" won the contest! Friedman concluded that economists using the big general equilibrium "system" models were striving for something well beyond their reach. Greater progress would be made in "analysis of parts of the economy in the hope that we can find bits of order here and there and gradually combine these bits into a systematic picture of the whole (Friedman 1951: 114).

We tend to think of Friedman as a monetarist and economists on the other side of debates about business cycles as Keynesians. But the critiques we just examined were before Friedman and Schwartz began their money and business cycles project, and therefore before he was a monetarist. The position he represented was the NBER approach to business cycle analysis. His opponents in the 1940s tended to be Keynesians, but the pressing issue was not so much what one thinks are the causes and cures for the business cycle, as how one searches for answers to the question and how much is known. A good illustration of this debate is in Arthur Burns's 1946 annual report of the NBER, where Burns was director of research. Burns criticized Keynesians for presuming that they had figured out the business cycle, and for relying on theory with scant resort to economic data other than highly aggregated data. Keynesians saw compensatory fiscal policy as the solution to the cycle. Referring to the set of assumptions behind the analysis, about the shape and stability of the consumption function, the relative size of consumption effects of tax cuts and tax hikes, and so forth, Burns (1946: 11) concluded:

Although assumptions such as these may be extremely helpful at a stage in our thinking about an exceedingly complicated problem, it seems that the inferences to which they lead...