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January 30, 1999

Mr. Market

Nobel laureate and Hoover fellow Milton Friedman evaluates Alan Greenspan’s job performance, analyzes the role of the International Monetary Fund in the Asian financial meltdown, and explains how to fix Social Security—all in less than three thousand words.


EPSTEIN In what ways has free-market capitalism won victories over the past few decades? In what ways, if any, has it suffered defeats?
FRIEDMAN The one way in which free-market capitalism has really won a victory is in terms of rhetoric. You no longer hear the talk about the superiority of Japan, Inc., let alone the centralized system of communism. The area in which it is questionable whether much has been gained is the area of practice. Governments of the West today have larger government spending relative to the national income than they did twenty or thirty years ago. In every practical respect, the economy of the United States and the economy of most Western countries is less free market today than it was forty or fifty years ago.

EPSTEIN But what about all the recent achievements in the area of deregulation?
FRIEDMAN What has happened is that there has been deregulation of economic controls: the elimination of the Interstate Commerce Commission, the deregulation of railroads and the airlines. But there has been an increase in regulations that don’t have a strictly economic purpose but are socially oriented, such as the Environmental Protection Agency.

EPSTEIN Do you disagree with those who would credit the EPA with the widespread improvement in our air and water?
FRIEDMAN What deserves credit for the improvements in the environment before the EPA? What explains the fact that the places where pollution is worst is in places like Russia and East Europe, where you had a government fully in charge of avoiding pollution? The fact is that in many cases the EPA has done more harm than good. I am not an expert on that subject. I can’t give you detailed chapter and verse. But I believe it is a statement that would get a lot of support from people who know what is going on.

EPSTEIN Let me put the abstract environmental argument for regulation to you. A factory will pollute a river if it doesn’t own that river and if indeed nobody owns that river. But there is harm if it does pollute that river. Therefore the regulator has to do something to prevent it or to minimize it.
FRIEDMAN Therefore there is a problem. The next question is whether there is a way of resolving that problem that doesn’t cost more than it is worth. In many cases there is no way of resolving the problem that doesn’t introduce equal problems, and in almost all other cases such problems are better solved by imposing pollution fees. The argument against what the EPA has been doing is mostly that it has insisted on using command-and-control regulations rather than price mechanisms. In recent years there has been some introduction of price mechanisms, such as in the selling of the rights to emit pollutants into the air. And that is the right direction in which to move. But you can go much further.

EPSTEIN But you do agree in principle with the idea that, at least from one perspective, we are talking about how a regulator could impose a price mechanism to correct for that harm.
FRIEDMAN In some cases there is market failure. But it has to be balanced against government failure. It does not follow that, for every market failure, there is a governmental answer. And it does not follow that, for every government failure, there is a market answer. You have to look at both sides. I am not an anarchist. I believe we do need a government. But I believe we need one that is far more limited than the one we have now. I do not believe there are many activities of the government that come under the rubric that you are bringing in. If you look at the way government spends the money, the major expenditures are for entitlements.

EPSTEIN How would you evaluate the progress of the move to, in Clinton’s words, end welfare as we know it?
FRIEDMAN We have gone a short distance to ending welfare as we know it. We continue to pour out billions of dollars with the effect of adding to the burden of poverty rather than reducing it.

EPSTEIN Would you still favor a negative income tax that would put an income floor under everyone?
FRIEDMAN I favor a negative income tax if and only if it is a substitute for all other welfare programs. I do not favor a negative income tax being tacked on to and in addition to the other programs. As so often happens, you have the problem of how do we get from where we are to where we would like to be? In my ideal world there would be no negative income tax. It would be a world in which the great bulk of people are able to earn their living in the market and in which there are private charitable organizations that help those who cannot. But we are not at that world and we can’t go to that world overnight.

We have through our welfare programs essentially assumed responsibility for the lives of a large number of people. It is unconscionable simply to dump them in the street overnight. It is tempting to say you should completely end welfare, period. But you can’t do that.

EPSTEIN Let’s shift to the move to privatize Social Security. Would you like to see the United States replicate what happened in Chile?
FRIEDMAN Here again you have the problem of going from where you are to where you would like to be. Social Security, as we call it, is a combination of two separate programs, neither of which would have a chance of being enacted on its own. One program is a program of a flat-rate tax on wages up to a maximum: a regressive tax imposed at one of the worst places in the economic structure, where it introduces a gap between what the worker receives and what it costs the employer. You cannot conceive of that tax being enacted by itself as part of a financing program. The second component is a system of payments of subsidies, which, again, I cannot believe could have been enacted by itself. It is a system in which the amount a person receives depends on a whole variety of circumstances, some of which may be relevant and some of which may not be relevant to what you would like to have a subsidy program do. But you would never enact a subsidy program in which the largest subsidies go to the people who have earned the highest incomes. Yet when you tie the two together you have a sacred cow. I have always said it is one of the greatest marketing miracles of this century.

Can you explain to me how you justify saying to somebody who has AIDS and is scheduled to die at the age of fifty or forty, “We have to take 15 percent of your income and save it for your old age?” Not all people have the same requirements with respect to their retirement. The implicit assumption that nobody would save for his own old age if he wasn’t forced to seems to me utterly wrong. The whole drive toward Social Security was biased by the experience of the Great Depression. Prior to the Great Depression this wasn’t a major problem.

EPSTEIN What’s your solution?
FRIEDMAN My preferred solution would be one of meeting all the obligations you have currently entered into under Social Security—we made promises and contracts with people, and we ought to live up to all of them—and then abolishing the whole system. But that is not going to happen. And the second best will be a move in the direction of Chile toward private investment accounts. One of the things I dislike about the current proposals is the idea of requiring people to do it. I don’t see any difficulty in designing a scheme that would be nonmandatory. In fact, I did so in 1972 in the course of a debate with Wilbur Cohen, who was then the head of the Social Security Administration.

EPSTEIN You could probably pull that proposal off the shelf right now and tell us how it was going to work.
FRIEDMAN Sure, it is all in print. But you and I are wasting our time on that. That isn’t what is going to happen.

EPSTEIN I don’t imagine full privatization is going to happen, either.
FRIEDMAN Yes, it is. I believe it is. This area is one of the few on which I am really optimistic because the financial considerations are driving it in that direction and because there are three things that I think are going to make it happen: One is the financial disaster in the Social Security system we’re headed toward if we don’t do something. Second is the change in the fraction of the population that holds equities. And third is the widespread belief on the part of the younger generation that Social Security is not going to be there for them.

EPSTEIN Let’s get to the current situation in the economy at the moment. How good a job has Alan Greenspan been doing?
FRIEDMAN I think he has been doing a splendid job so far.

EPSTEIN What has been splendid about it?
FRIEDMAN On average, we’ve had the lowest and least variable rate of monetary growth since he has been in office of any comparable period in the past. But Alan would be the first to object that he didn’t do everything all by himself.

EPSTEIN If you were in charge, what would you do that’s different?
FRIEDMAN My ideal is to eliminate the Federal Reserve. So I don’t like to speculate what I would do if I were running it.

EPSTEIN You would resign.
FRIEDMAN That is right. I might. Or I would not accept the job in the first place. I think Greenspan has had a very difficult period in which to work because of the changes in the financial system, including the growth of mutual funds, the relationship between monetary growth on the one hand and income and price growth on the other. So there has been a real problem of trying to distinguish between those changes in velocity that had to be worried about and those that did not. And on the whole, he seems to have done a very good job of threading his way through those difficulties.

EPSTEIN With respect to your saying you would not want to see a central bank, you long ago proposed that we simply pursue a policy of steady growth in a particular monetary aggregate. But wouldn’t that require a central bank to implement?
FRIEDMAN Yes, but I would substitute a computer for it, not a central bank. All you would have to do is have it buy or sell X dollars of securities. It is purely a technical matter.

EPSTEIN The year-to-date growth in M2 has run 6.2 percent and the monetary target is 1–5 percent at the moment. So it is 1 percent above its target. Similarly, M3 is running 7.7 percent year to date, compared with the 6 percent maximum target. So you must be critical of Mr. Greenspan or the central bank for not reining in money growth. If it has those targets, it is certainly not achieving them.
FRIEDMAN I believe we are in danger of an uptick in inflation because of that. And I do believe it is desirable to bring those monetary growth rates down. But the problem is, I am not in favor of using the federal funds rate as a monetary instrument. I don’t like operating through interest rates. So it does seem to me that the Federal Reserve should be engaging in open-market operations designed to hold the rate of monetary growth down a little. It should be slowing monetary growth.

EPSTEIN And it can do it without hiking the interest rate?
FRIEDMAN That is the problem. I don’t know that it can. But if it can’t, then it ought to let the interest rate do whatever it is going to do.

EPSTEIN It seems you are giving Alan Greenspan qualified praise because you are suggesting that, even if you did believe in the institution, then the best way to run the Fed is to target a monetary aggregate rather than a fed funds rate.
FRIEDMAN No, I think circumstances do make a difference. I think there is no doubt that, from 1992 to 1995, around there, there was a very sharp uptick in the velocity of M2 and that targeting money supply at that time in a rigid fashion would not have been a good thing to do.

EPSTEIN You are saying, in effect, that the relationship between the money supply and nominal gross domestic product broke down. The old rules no longer held.
FRIEDMAN It has always been a very loose relationship.

EPSTEIN But it became much looser.
FRIEDMAN Right.

EPSTEIN To the point that you would have abandoned—
FRIEDMAN I don’t know what I would have done. I am not going to speculate on that. I only say in retrospect that Greenspan did the right thing in abandoning primary reliance on M2 during that period. Whether I would have had the sense to do that or not, I don’t know.

EPSTEIN Then he did the right thing at the time. But how about now?
FRIEDMAN Now he is worrying about the problem. As you know from his various testimony, he has said that he is concerned about monetary growth and the relationship between money and income.

EPSTEIN Do you think the European Monetary Union will be a success?
FRIEDMAN I hope so, but I am very dubious.

EPSTEIN Why so?
FRIEDMAN Because the European Union is not an appropriate area for a single currency. There are some cases where a single currency is desirable and some where it is not. It is most desirable where you have countries that speak the same language, that have movement of people among them, and that have some system of adjusting asymmetric effects on the different parts of the country. The United States is a good area for a common currency, for all those reasons.

But Europe is the opposite in all these respects. Its inhabitants speak different languages, have different customs. And there is limited mobility between countries. The exchange rate between different currencies was a mechanism by which they could adjust to shocks that hit them asymmetrically—that hit one area differently from another. The Europeans have, in effect, entered into a gamble in which they have thrown away that adjustment mechanism. It may work out all right. But on the whole, I think the odds are that it will be a source of great trouble.

EPSTEIN What kind of trouble?
FRIEDMAN The trouble will not be for all of them. Some among them will be affected by developments that would have called in the past for a depreciation of their currency. But given that they are locked into a single currency, the alternative will be a recession.

EPSTEIN To what extent do you think the Asian debacle demonstates that free-market capitalism, and in particular the free flow of currencies, is not the right way to go?
FRIEDMAN It doesn’t demonstrate it at all. Quite the opposite. The problem in Asia was that you did not have free flow of currency. You had pegged exchange rates. You find over and over again that a pegged exchange rate plus a central bank is a recipe for trouble—whether you are dealing with Great Britain in the 1950s and 1960s or whether you are dealing with Britain and Italy and the others in 1993, when you had the big problem with the exchange-rate mechanism, or whether you are dealing with Argentina, Israel, Chile, or Mexico, you name it. It is hard to name any country that has had the combination of a pegged exchange rate plus a central bank that has not sooner or later gotten into trouble. Can you name one case?

EPSTEIN No.
FRIEDMAN I guess you would have to say France has done pretty well over the last fifteen or twenty years. But France earlier got into trouble. The point is that pegging an exchange rate is a governmental price-fixing measure, no different from pegging the price of wheat or the price of anything else. The central bank in all of these countries is a government agency. And the two together are even more lethal in the presence of the International Monetary Fund. If the Asian problem is evidence of anything, it is why you ought to get rid of the—

EPSTEIN And you would get rid of the IMF today?
FRIEDMAN The IMF was created for one purpose and one purpose only. In 1944 or 1945, it was created to supervise, to run, a system of fixed exchange rates among a specified number of countries. That system was really officially declared dead in 1973. So in the ordinary and reasonable course of events you would think the IMF would disappear. But there is nothing so permanent as a government agency, especially if it is international. So the IMF, instead of disappearing, went into a different business. It went into the business of providing advice and counseling. But unlike private consulting agencies, which charge people for their services, the IMF not only didn’t charge—it brought subsidies. So it was very popular as a consulting agency. And it gradually changed from being an overseer of short-term balance-of-payments problems to being a junior World Bank and a lender of last resort. And in the process, in my opinion, it has done tremendous harm.

EPSTEIN How much harm?
FRIEDMAN I do not believe there would have been an East Asian crisis if there had been no IMF. Take the case of Thailand. The fact that Thailand had a pegged exchange rate with respect to the United States and the fact that the IMF was around there encouraging it to have a pegged exchange rate at that time meant that lenders elsewhere underrated the exchange-rate risk.

EPSTEIN And the fact that Thailand has a central bank?
FRIEDMAN Yes! Three factors—IMF, pegged exchange rate, and discretionary central bank—set the stage for investments that were not economically justified. Let’s suppose for a moment that you had two of those, a central bank and the IMF, but with a floating exchange rate. Under those circumstances, a gradual decline in the baht would have fed information around the world that Thailand’s currency wasn’t really worth as much as people had been thinking. And it would have affected investor behavior. But what is really needed to change the situation in the Far East is for Japan to start pulling itself out of recession.

EPSTEIN How should it go about doing that?
FRIEDMAN By expanding its money supply. People will say, “But how can it expand the money supply when the discount rate is only 0.5 percent and the long-term bond rate is around 1.2 percent?” The answer is that a central bank can buy up government securities. It can keep on buying them. It doesn’t matter whether the interest rate is 1.2 percent or 1.1 percent or 1 percent. If it buys those securities, it will increase the monetary base. It will increase the reserves in the commercial banks. It will do more in the short run to help Japan resolve its banking crisis than any short-term reforms.

EPSTEIN You don’t see any role for fiscal policy that would take the form of running budget deficits?
FRIEDMAN I see a role for fiscal policy from a supply-side point of view; that is, cutting high marginal tax rates will increase incentives on the supply side. But I don’t see any role for it from the demand side. Indeed, it is not easy to find any case in which fiscal policy has worked in the absence of monetary policy.

EPSTEIN You don’t think there are cases in which you have what has been described as a liquidity trap—a loss in business confidence such that business will be timid about investing?
FRIEDMAN Oh, sure. But that doesn’t mean that increasing the money supply won’t have an effect. It may be that it will have a much smaller effect than at other times. But it will still have an effect.

EPSTEIN One wouldn’t say that there isn’t an important role for monetary policy. But the standard argument is that, where business confidence is at a low, if the government steps into the capital markets and borrows, the recovery will happen sooner.
FRIEDMAN No. It will delay recovery. If the government steps in and borrows, that reduces the funds available for investment. It doesn’t add to it. What you are saying is not that it comes in and borrows but that it also spends the money. All right. That is the same as if the borrowed money had been spent by someone else. I don’t doubt that you could set up a hypothetical case of the climate you are describing. What I am saying to you is that I think you will have an almost impossible time finding any example in practice.

EPSTEIN You were acquainted with the Austrian economist Friedrich Hayek and also are familiar with the work of Ludwig von Mises and his American disciple, Murray Rothbard. When you were talking about bad investments, you were alluding to Austrian business-cycle theory. A certain concept that has pretty much gone into our parlance and understanding fits in with what you said about what happened in Asia. There can be times and conditions in which the stage can be set for malinvestment that leads to recession.
FRIEDMAN That is a very general statement that has very little content. I think the Austrian business-cycle theory has done the world a great deal of harm. If you go back to the 1930s, which is a key point, here you had the Austrians sitting in London, Hayek and Lionel Robbins, and saying you just have to let the bottom drop out of the world. You’ve just got to let it cure itself. You can’t do anything about it. You will only make it worse. You have Rothbard saying it was a great mistake not to let the whole banking system collapse. I think by encouraging that kind of do-nothing policy both in Britain and in the United States, they did harm.

EPSTEIN Would you make a similar statement about John Maynard Keynes and the Keynesians?
FRIEDMAN That is also true of them. Thanks to the Keynesians, we had the stagflation of the 1970s. You never would have had stagflation if it hadn’t been for the full-employment policies coming out of the Keynesian revolution. So both the Austrians and the Keynesians did a good deal of harm. But both of them, I would say, added to our understanding of business cycles. Only I don’t think there are business cycles.

EPSTEIN You can’t add too much to your understanding of something that doesn’t exist. But getting back to your analysis of Asia, you talked about certain necessary conditions for the creation of a situation in which malinvestment occurred. Is that a fair summary of what you said?
FRIEDMAN I am not sure I like to refer to it as malinvestment.

EPSTEIN I think you called it economically unjustified.
FRIEDMAN The problem is the following one: I don’t like to use the word malinvestment as a synonym for monetary disequilibrium. What you created in those countries was a situation of monetary disequilibrium, where the internal value of the currency was not equal to its external value. That in turn encourages an economic structure within the country that is not viable. And one aspect of that is malinvestment.

EPSTEIN You would want a monetary expansion in these countries?
FRIEDMAN At least not a monetary contraction. But everybody would be much better off if you could get the IMF out of it. How can you justify the American taxpayer bailing out the New York banker who made a loan to Korea? How do you justify that?

EPSTEIN You would not have wanted the Clinton-Rubin bailout in Mexico?
FRIEDMAN Of course not.

EPSTEIN And you think the Mexican economy would be better off if it had never occurred?
FRIEDMAN Sure. Certainly no worse off. However, some bankers in New York would be a lot worse off. And they should be. If you are going to get the profits, you have to take the losses. I have always said the essence of a free-market system, which tends to be called a profit-and-loss system, is that the loss component is more important than the profit component. You need the discipline of the loss in order to keep the system going.

EPSTEIN Thank you, Dr. Friedman.


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Milton Friedman, recipient of the 1976 Nobel Memorial Prize for economic science, was a senior research fellow at the Hoover Institution from 1977 to 2006. He passed away on Nov. 16, 2006. He was also the Paul Snowden Russell Distinguished Service Professor Emeritus of Economics at the University of Chicago, where he taught from 1946 to 1976, and a member of the research staff of the National Bureau of Economic Research from 1937 to 1981.


Reprinted from Barron’s, August 24, 1998. © 1998 Dow Jones & Company, Inc. All rights reserved. Photographs: Copyright 1998/Barbara Ries.

Available from the Hoover Press is The Essence of Friedman, a volume of essays by the Nobel laureate economist. To order, call 800-935-2882.