THE ECONOMY'S NEW CLOTHES: Milton Friedman on the New Economy

Friday, March 10, 2000
Former Hoover fellow and Nobel laureate Milton Friedman.

Internet technologies are transforming the way we communicate and do business. But, are we, as some claim, in the midst of the "long boom," a new era of unparalleled prosperity driven by unprecedented technological change or are we merely enjoying a bull market that has yet to begin its inevitable correction? What does the current economic boom have in common with the "Roaring Twenties" and how can we avoid an economic contraction as severe as the Great Depression?

Recorded on Friday, March 10, 2000

Peter Robinson: Welcome to "Uncommon Knowledge." I'm Peter Robinson. Our show today: the New Economy. Consider this: a prosperous America, consumer confidence soaring. The stock market setting one new record after another. And the entire economy seeming to be driven by one new technology: the automobile.

That's right, I'm talking about the 1920s when, if you were a baron of Wall Street, there was a good chance you'd be driven around in a Lincoln Town Car like this one, or if you were a more ordinary American, that you would drive yourself around in a Model T like this.

Many of the nation's leading economists thought the boom would go on indefinitely, failing to predict the Crash of 1929, which of course led to the Great Depression.

Now to today. Once again, the nation is prosperous. Consumer confidence is soaring. The stock market is setting one new record after another. And the entire economy seems driven by one new technology: the dot, as in dot com, as in the Internet.

The question is, of course, how many parallels there are between today and the Roaring '20s. Will our boom end as badly as that boom? Or are we in a genuinely new economy with changed economic rules?

With us to discuss the new economy, the one of the most important economists of the 20th Century, Nobel laureate Milton Friedman.

The Economy's New Clothes

Is the economic future that we see taking shape around us, the new information economy, so discontinuous with the past that it does indeed represent a new economy?

Milton Friedman: I think not. If you go back to the 1920s, when you had essentially the same phenomenon. What are the things that people say about the new economy now? It's a big technological development.

Peter Robinson: Right.

Milton Friedman: In the 1920s the big technological development was in automobiles and electricity. In the middle of the '20s there were dozens of IPOs of automobile companies almost every year coming out. There were hundreds of automobile companies started, of which only a small number, of course, survived.

The second thing that people say is well, now, we have a good monetary policy. We don't have to worry about inflation. In the 1920s you had exactly the same argument. Because the Federal Reserve which had been established in '14 had started to learn how to run things, and from 1923 to 1928 it did an extremely good job and prices were very stable.

Peter Robinson: From 1923 to '28, so there were five golden years.

Milton Friedman: Right, prices were very stable. People talk about the change in the industrial composition, all the mergers and so on. It was a big merger movement in the 1920s. Indeed, Irving Fisher who was the greatest economist of the time, gave a talk the night before Bloody Thursday or whatever the day was in '29, in which he talked about all of these elements.

Every single element in there you can find in today's, in which he included in talking about how the stock market was in for a long good run. He lost his shirt on it. But he was a great economist, and in a way, I don't think he was wrong. Because you would not have had the terrible debacle if the Federal Reserve hadn't behaved very badly. And it never occurred to him that the Federal Reserve would behave that badly.

Peter Robinson: Well, we better go into that for a moment. So the Great Depression was the fault of the Fed?

Milton Friedman: That's right. Now the stock market--I'm not saying that the stock market collapse was the fault of the Fed.

Peter Robinson: That was a genuine bubble.

Milton Friedman: The Fed may have contributed to it, but it was primarily a genuine bubble. And it was a bubble that was stimulated, a boom, the boom market of the 20s was stimulated by exactly the same kind of forces that have been stimulating our present bull market, technological development--

Peter Robinson: So there were real change--real changes in the economy, that were indeed impressive--

Milton Friedman: That's right.

Peter Robinson: They were objectively taking place; that wasn't nonsense. But the bubble--now you'd better actually define what you mean by a bubble?

Milton Friedman: I don't know that I want to talk about a bubble. I want to talk about a bull market that gets very high and then is reversed and comes down again.

We've had three comparable bull markets since the '20s. We've had the '20s in the United States, we've had the '80s in Japan, and the '90s in the United States. And if you pluck them one on top of the other they almost coincide, they have exactly the same pattern.

So if this is new, the '80s was new, if that was new, the '20s are new.

Peter Robinson: So we're inching our way toward the edge of the precipice?

Milton Friedman: No, that's a different question. What happens after--no doubt such a bull market tends to overshoot. By how much and when, those are much more difficult questions. And especially by how much, because that partly depends on what happens after the bull market breaks.

In the United States, in the three years after the bull market broke--

Peter Robinson: In '29.

Milton Friedman: '29, from '29 to '32 or '33, the Federal Reserve permitted or forced the stock of money to go down by a third. For every $100 in existence in money--I'm now talking about bank deposits and currency in your pocket--for every $100 in existence in 1929, there were only $67 in 1933.

And as a result, when that collapsed, I think it was a decline of 80 percent.

Peter Robinson: The Great Depression was a long time ago. Haven't we learned a thing or two about managing the economy since?

Shocking the System

Between 1890 and 1945 the United States experienced seven contractions, three of five percent, two of ten percent and one of almost 15 percent. Yet since 1945 we have experienced just one contraction of a mere three percent, and today in the so-called new economy, we find ourselves in the midst of an 18-year expansion that has been marred by only one mild recession.

So the business cycle is becoming less important?

Milton Friedman: No. I've always questioned whether there is such a thing, really, as a business cycle. What you have is an economy which is subject to shocks from time to time. And a shock comes along which knocks the economy down, and then it recovers. But the idea that there are regular intervals, regular size, I think that is not supported by the--I have no doubt whatsoever that to a large extent past recessions were produced by mistaken monetary management; that they were not natural in the economy, that they did not have to occur; but you had a situation in which the monetary authorities--this is particularly after the Federal Reserve was established--followed a policy of tending sort of a stop-go policy. They were late in reacting to changes in the economy, and when they acted, they acted too strongly.

And even the Fed has learned from experience. And I believe that the performance of the Fed under Mr. Greenspan has been better than any prior chairman. You may know personally I'm in favor of abolishing the Fed.

Peter Robinson: Yes, I know. I know. I'm going to get to that.

Milton Friedman: I would rather substitute a computer for it.

Peter Robinson: The business cycle is one of those phrases that is almost incantatory, people say it over and over again, and so I assume there must be a business cycle. Now I hear you saying that you're not sure that such a thing even exists.

Milton Friedman: If you want to see a real cycle, think of a seasonal cycle.

Peter Robinson: Right.

Milton Friedman: That's an event. It's warm in the summer, it's cold in the winter, you grow food in the summer, you don't grow it in the winter.

Peter Robinson: Predictable, regularity.

Milton Friedman: So you have a real cycle predictor, that would be a real honest-to-God cycle.

Peter Robinson: All right.

Milton Friedman: Now the image of the business cycle that people have had is that there are reactions in the economy of a similar kind which tend to run with reasonably regular frequency.

Now for one time, to give an example, one favored theory at a time was the so-called sun spot theory. There are spots on the sun which have a physical cycle, 10-year cycle roughly. And that does affect the fertility of crops on the earth. It affects the growing conditions. And Stanley [Jevins], an English economists in the 19th Century correlated, the movements in agricultural output with the movements in the sun, and argued that that was a cause of a business cycle. That would be a real honest-to-God cycle.

Peter Robinson: Right.

Milton Friedman: And people had been searching for some other mechanism. But what I think is really going on is a very different thing. I think that you have a reaction mechanism in the economy. The image I've always had is, think of a piece of wood up here with an elastic band glued onto the bottom of it. And every now and then something comes along that plucks it down. For example, you get the shock of the oil embargo.

Peter Robinson: You're talking about the '70s.

Milton Friedman: In the '70s. That knocks it down, and that creates a recession. And then there is a reaction mechanism within the economy, which you can understand, that it takes time for what happens then to have its full effect. Some things react immediately. Some things react later. And that reaction mechanism means that we'll take a reasonably predictable amount of time for the economy to react back to there, and get back up to that board up there which defines its long term path.

And similarly there might be something that pulls it up. All of a sudden, you've got a war in which in order to finance it, they print a lot of money, it causes inflation, that produces a temporary boom, and then you react down to it.

So the image I have is of an economy which is subject to shocks from time to time, and which reacts to those shocks in a rather predictable manner, with a predictable reaction mechanism in it.

Now we've been very fortunate since--let's see, the '70s, you had a serious recession, as a result, I believe, of the shock of the oil embargo.

Now right now we've been very fortunate that we haven't had--the one major shock we had in the period since then was the Asian crisis. It was the collapse of the Asian countries. But that Asian crisis was both favorable and unfavorable for us. It was unfavorable in the sense of a financial disturbances that developed; but it was favorable in that it lowered commodity prices--

Peter Robinson: Suddenly Korean cars became less expensive.

Milton Friedman: Favorable to manufacturers, and also, because it caused people all over the world to be concerned about the safety of their assets. It was favorable to our financial markets; it produced an inflow of foreign funds--

Peter Robinson: To the safety of the American markets? I see.

Milton Friedman: Right. So because it had these opposite effects, it did not produce a serious recession in the United States.

Peter Robinson: Are the high growth rates of the past few years sustainable?

Bull Durable

It used to be a rule of thumb that the economy would grow at about 2.5, three percent a year was a good year. Now listen to these growth rates: 1996, 3.7 percent; '97, 4.5 percent; '98, 4.3 percent; '99, 4.1 percent.

Question about the so-called new economy: have we achieved a new permanently higher growth rate?

Milton Friedman: Five years is not a very long basis for a permanently higher--you undoubtedly have had rapid rates of growth, and I think there is no doubt that they derive from these technological developments in computers and the information industry. But that's a process of getting up to a new higher level. And once you get there, you won't grow any faster than you ever did before.

See, there's a big difference between a permanently higher growth rate, like this--

Peter Robinson: Right, you're changing the slope of the line.

Milton Friedman: And changing where that board is. See, the board is there, and now you've had developments which enable you from the same resources to get a larger output. So you're having the board shift from here, it's up here. And in the process of the shift we'll have a rapid growth for a few years until you get there, and then the growth rate will slow down, even though you stay up there.

Peter Robinson: So you'd expect it to settle back down to 2.5 percent, 3 percent, in that range?

Milton Friedman: Well, all we know is that for the last 100-150 years, it's been of the order of 2 to 2-1/2 percent.

Peter Robinson: All right, now let me ask you this. Why? That sounds like a rule of the universe. 100-150 years. All kinds of different economic regime, the agrarian regime, then we go through the industrial revolution, and now you're suggesting into this new information economy, and it's still 2.5 percent a year?

Milton Friedman: I don't know that it's 2.5 percent a year. But that average is an average of a lot of different numbers. These 4.5 percent numbers go into it. The zero numbers for awhile go into it.

Peter Robinson: There's variability around that.

Milton Friedman: So it's just a pure statistical fact that on the average it's been around 2, 2-1/2 percent. So unless you tell me something that will make it very different--see, don't misunderstand me, the benefits from the technological change are permanent. You have the whole level of the economy is higher than it otherwise would be. And that's going to stay there. I don't mean there won't be some dips and so on, but it'll stay there. But the effect on the rate of growth is temporary.

Peter Robinson: Now related to this question of whether we've achieved a higher rate of productivity is, have we achieved a new lower rate of unemployment?

Milton Friedman: What the average level of unemployment that you can maintain, what I define as a natural rate of unemployment, depends on the circumstances of the period. If you have a world in which you have very strong trade unions, lots of wage rigidities and fixed rates, you have high rates of unemployment, as in Germany, or in Europe in general today, where rates of unemployment have just come down to 10 percent in Germany. And that's a result of having a very rigid wage system, where it's very hard to fire anybody, so people don't want to hire anybody; and in which wages are fixed by union agreements and so on.

On the other hand, if you have a more flexible economy, and unions have become much less important in the United States, then the natural rate of unemployment on the average going to be lower.

Peter Robinson: We have a much more fluid wage and labor market.

Milton Friedman: We do. And what's more, you have all sorts of developments in the way of part-time employment, temporary employment agencies, and information is more readily available. It's easier to find out what jobs there are, where they are--

Peter Robinson: Here, the Internet is directly at play.

Milton Friedman: Absolutely. I think the Internet--as I say, the Internet has been a major factor. I think it will have tremendous effect, but on the level where we'll be, not on the permanent rate of growth.

Peter Robinson: The information economy has driven the stock market to one new high after another. Has the bull market gone too far?

(Not So) Tiny Bubbles

Peter Robinson: Now this is Milton Friedman in 1998, quote: I have believed for some time now that the stock market was in a bubble. When you uttered those words the Dow was at about 6,500.

Milton Friedman: I was wrong. I was wrong at that time.

Peter Robinson: But if you wait long enough you'll be right? So what do you believe about the market today, the equities market today, in the United States?

Milton Friedman: I think they are in a--

Peter Robinson: Now, you resist using the term "bubble". Why is that? You don't like that term?

Milton Friedman: Well, because it's very hard--you know you only recognize a bubble after the event, not before. And we'll find out later whether it's a bubble.

Peter Robinson: What do people mean when they say bubble?

Milton Friedman: What they mean by a bubble, they mean that the levels of the stock market prices cannot be justified by the likely real earnings of the companies whose stocks are being valued. The rise in the market averages has been produced by a very small number of companies.

Peter Robinson: The telecoms and the Internet stocks.

Milton Friedman: Right, it's a two-tier market. And the high tech market is in a bubble.

Peter Robinson: Do you want to call it the new economy market and the old economy?

Milton Friedman: If you want to call it the new economy market, I don't mind. The newer economy market. But we know what we're talking about, we're talking about, as you say, the high tech, the telecom.

Peter Robinson: Okay. Now, 1920--excuse me, 1929, the bubble burst. Equity markets in this country collapsed 80 percent.

Milton Friedman: Now, hold on, go slowly. In 1929 when it burst, they did not collapse 80 percent. It was 80 percent over the course of the next three years. In fact by early 1930, the market had almost recovered from the collapse in October.

Peter Robinson: So let me rephrase it then. From peak to trough, recognizing that some years elapsed, but from peak to trough the equity market fell 80 percent--

Milton Friedman: The reason I think I emphasize this is because I believe if the Federal Reserve had followed correct policy, the bottom of the market would have come in '30 or '31 rather than '33, and would have been nothing like 80 percent below what it was.

Peter Robinson: So you're anticipating my question. So from '29 to '33 we drop 80 percent. In Japan when the bubble bursts, the equity market drops about half. Now the bubble bursts sometime here in the United States--

Milton Friedman: We'll have to see what the Federal Reserve does afterwards.

Peter Robinson: What should it do?

Milton Friedman: What it should do--

Peter Robinson: Note to Alan Greenspan.

Milton Friedman: Alan Greenspan doesn't need a note. He understands monetary affairs every bit as much as I do. But I will tell you what he will do. Not what he should do, but what he will do, is exactly what he did in 1988, '87, when you had the stock market decline, the big decline.

Peter Robinson: Right about 25 percent in a couple of days.

Milton Friedman: That's right. He poured in money. He had the Federal Reserve follow a very easy money policy. And that's what he will do again if the market tanks. Not indefinitely, but for a time, to give it some cushion.

Peter Robinson: The Fed knows now, we know now, what to do in the case of a serious fall.

Milton Friedman: Well, when I say, we know what to do, I don't mean to suggest it's an easy and obvious thing. How much? How rapidly? When do you overdo it? Do you move the economy into--see, you have to be careful. You don't want to restart the bubble.

Peter Robinson: So this is not like having a computer all set up to do it and all you have to do is push the button. This is complicated tricky business.

Milton Friedman: My computer set-up instead of the Fed would be for the long term purpose, and would eliminate all of this fine-tuning, we'd have none of this. We'd simply have the quantity of money go up regularly, day by day, week by week.

Peter Robinson: Even in the event of a market fall-off? You would make no adjustment?

Milton Friedman: No adjustment. Because adjustments--there are times when the adjustment is desired and good. But if you look over the record of the Federal Reserve over its whole history, its done harm more often than its done good. There are only a few periods--'23 to '28, as it happens is one of them, and the recent few years is another. But if you tally the number of years in which they behaved in a way that I would score as excellent, or in a way which I would score as terrible, the terrible years greatly outnumber the excellent years.

The price you pay for a big depression like '29 to '33 cannot be redeemed by softening the effect of the '87 stock market collapse.

Peter Robinson: Final question: are Alan Greenspan and the Federal Reserve doing the job they ought to do.

How Greenspan Is My Rally

Given that we are in--at least one tier of the equity market is in a bubble, in your judgment Alan Greenspan is the man you'd like to have in charge of all the levers? He's likely to do as good a job as anybody?

Milton Friedman: Well, I don't think--let me make it clear, it's not Alan Greenspan's business, it's not the Federal Reserve System's business, to try to control the stock market prices.

Peter Robinson: So he was engaging in a no-no when he said a couple of years that the equities markets showed, quote, irrational exuberance.

Milton Friedman: He should not have said that. Absolutely. That was a mistake. The business of the Fed is to keep prices stable, general prices, not stock market prices, but the prices you pay for bread and for milk and for cars and for coats and for hats and shoes. The average of all prices, general price level; that's its business, and its one and only business. And it has no business trying to affect the stock market.

But in order to prevent inflation, in order to keep stable prices, given that it has the power and the duty, it will have to react to changes in the stock market. But it shouldn't try to determine what the stock market is.

Peter Robinson: The consensus among traders and investors and business journalists right now is that the Fed is raising interest rates, and that Alan--with a purpose in mind. And that Alan Greenspan is doing everything but wiggle his ears to signal to the markets that he is serious, that he believes the equities markets are over-valued, and he wants to cool this thing off and bring it down.

Do you believe that's a correct reading of his actions?

Milton Friedman: No, I don't.

Peter Robinson: You don't?

Milton Friedman: I think that that's an understandable reading of his actions, but I don't think it's correct. Because what he has been stressing is not the market; what he has been stressing is what he believes is--that the demand for output is increasing faster than the sustainable rate at which it can be increased. That's the point he's stressing.

Peter Robinson: And part of the demand is the capital gain, right?

Milton Friedman: Part of the demand is arising out of the capital gains.

Peter Robinson: So the equities markets play a role there.

Milton Friedman: Play a role in adding to the demand for goods and services. And his concern is that unless--if that continues, it will produce higher prices over the whole range of goods and services. And there is some evidence that there is a little pickup of inflation. I think he is correct to be worried about that.

I think if you look at what's been happening to total monetary growth, it's been too high to be sustainable over a long period, and it's appropriate for him to try to bring it down.

Peter Robinson: Let me ask a final question, then, on this new economy. Is it a characteristic of this new emerging economy that the Fed is losing a certain element of control? Here's what I mean. That interest rates go up, and what we've seen in the markets in the last couple of weeks is that the Dow goes down and the NASDAQ takes off, because investors calculate that the older industries represented in the Dow will be affected by increases in interest rates. But the high tech industries, which are not as reliant on bank money, won't be. So we shift capital from a place where the Fed does seem to have control, to the NASDAQ, the new stocks, where it doesn't have control, and Alan Greenspan is a frustrated and a sad man.

Milton Friedman: The Federal Reserve has never had control of the stock market. But it has as much control over the economy as a whole, over the monetary growth of the economy as a whole, as it ever had. Nothing in this new economy that in anyway at all reduces the powers of the Fed.

Now of course when I say that, I think that the market enormously overestimated the powers of the Fed, that they attribute to Greenspan a capacity to fine-tune anything in the world that he does not have. And that's a source of danger, because what affects price level is partly what people expect the price level to be; price expectations.

And at the moment there is so much confidence in Greenspan's handling of the economy--

Peter Robinson: Leave it to Alan.

Milton Friedman: Right, that people are forming price expectations that it is very hard to see as realistic.

Peter Robinson: Milton Friedman, thank you very much.

What a relief. Milton Friedman believes the equity markets are over-valued, but when the markets come to their senses, the Federal Reserve will behave better today than it did in 1929.

In other words, the dot com economy will not go the way of the Model T. I'm Peter Robinson, thanks for joining us.