The Forgotten Case Against Milton Friedman

Thomas Palley

In 1967, Milton Friedman launched a counterrevolution in economics that overturned the Keynesian theory of inflation. Three years later, economist James Tobin issued a powerful theoretical rebuttal — but in the economics mainstream, it’s been all but forgotten.

Economists Milton Friedman (L) and James Tobin (R). (Bettmann / Hulton Archive via Getty Images)

Interview by
Seth Ackerman

Milton Friedman revolutionized macroeconomics with his 1967 presidential speech to the American Economics Association (AEA), which presented a theory of the so-called natural rate of unemployment for the first time. That speech, which played a major role in discrediting the brand of Keynesianism that prevailed in postwar liberal economic policy thinking, remains one of the most frequently cited papers in all of economics.

Much less well remembered is the rebuttal to Friedman’s ideas issued by another future Nobel Laureate economist in another AEA presidential address, four years later: Yale University’s James Tobin. Tobin’s dueling theory of inflation held out the possibility of an alternative path for economics and macroeconomic policy, but it has seldom received the same recognition, or the same scholarly interest.

Jacobin’s Seth Ackerman spoke with Thomas Palley, coeditor of the Review of Keynesian Economics and former AFL-CIO assistant director of public policy, about why Tobin’s inflation theory matters today, and why the issue of inflation continues to perplex both the economics mainstream and the Left.

Seth Ackerman

You have always been a critic of economics orthodoxy. A few weeks ago I interviewed James Forder, who wrote a book I’m a big fan of — I’m sure you know it — called Macroeconomics and the Phillips Curve Myth.

In that book, Forder exposes as a myth the story everyone is told about inflation in the 1960s and 1970s: about how a blinkered, Keynesian-dominated economics profession had this very naïve view of inflation and didn’t understand the importance of inflation expectations in determining inflation, and as a result they let inflation get out of control.

What’s interesting to me is that the supposedly “naive” view that is alleged to have been so widespread in the ’60s is actually not so different — in its conclusions — from your own view.

Over the years you have developed a theoretical basis for the view that there is a potentially stable trade-off between unemployment and inflation that policy makers can exploit. In other words, policy makers can choose to have somewhat higher inflation and somewhat lower unemployment, or they can choose the opposite sort of policy, and either one can potentially be a stable policy choice.

I want to ask you about those ideas, but first I’d like to hear your take on what the economics establishment currently says about inflation, and why you disagree with it.

Thomas Palley

Well, the first thing to note about inflation is that there are many different kinds of inflation. They all have different logics and different effects, and that’s something that is not taught in textbooks but ought to be. It’s also something that the economics profession doesn’t really get, or at least does not emphasize sufficiently.

I distinguish between six major kinds of inflation. One is demand-pull inflation, which is the story of “too much money chasing too few goods” — that’s the nutshell way of talking about it.

A second form of inflation is conflict inflation, which is conflict between capital and labor over the distribution of income.

A third form of inflation is supply-side inflation, which concerns global commodity price shocks. Here, the classic example is the OPEC oil price shocks of the 1970s.

A fourth form of inflation is imported inflation, when inflation is caused by exchange-rate depreciation and a rise in the price of imports — and I suppose to the extent that our current inflation is supply-chain inflation, it could be interpreted as fitting in this category.

The fifth form of inflation is what I call high inflation. This is often associated with large budget deficits and dysfunctional politics where a government needs funding, but it can’t get it together to fund itself with appropriate taxation, so budget deficits are the way they do it, which produces inflation.

Lastly, the sixth form of inflation is hyperinflation, which is a rare event. It’s usually associated with wars in which the supply side of the economy has been destroyed, or with failed states or kleptocratic governments that have destroyed the conditions for doing business.

The Phillips curve is about demand-pull inflation. The controversies raised by Milton Friedman were about the Phillips curve, which means that they are about demand-pull inflation.

The orthodox story that is told today is that there’s a temporary, short-run, negative trade-off between unemployment and inflation — or at least that the economy generates a pattern of outcomes in the short run that looks like such a trade-off. But if policy makers try and exploit that trade-off, it will crumble, and they will be forced to go back to what is called the natural rate of unemployment — only now with a higher inflation rate than before and no reduction in unemployment.

Basically, that view is the legacy of Milton Friedman. Though I am critical of the Friedman view, I still think he made an important contribution. He focused on the issues that were at stake, which are: how are wages set, what is the role of inflation expectations, and is there a systematic trade-off between inflation and unemployment that can inform policy, especially monetary policy. He did a service by framing the argument. The problem is that I think Friedman came out on the wrong side of that argument.

Seth Ackerman

How so?

Thomas Palley

Well, I think there is such a thing as a systematic Phillips curve. And if James Forder thinks there isn’t, I would disagree with him. Now, I am aware of Forder’s argument that Friedman engaged in some strawman rhetoric. But Friedman’s challenge was basically reasonable. Why do I say that? Well, if you go back to the early 1960s, there was a widespread belief that there was a systematic trade-off between inflation and unemployment that policy could use. People believed in the “structural Phillips curve.” Friedman questioned the long-run existence of that trade-off using very conventional economic theory.

Now, he also said that economists had forgotten about inflation expectations. And that’s where the strawman argument creeps in, because economists certainly were aware of inflation expectations, and they were also aware that expectations could shift the Phillips curve. That’s very clear in the famous 1960 article by Paul Samuelson and Robert Solow. If you read it, they do talk about inflation expectations being important, and how changing inflation expectations would eventually affect the position of the Phillips curve.

That said, economists had not fully worked through the logic and implications of that, and that’s what Friedman did. So, to repeat, Friedman showed that when you used conventional theory and you added inflation expectations and took them seriously, the Phillips curve would slowly dissolve if policy makers tried to take advantage of it. Instead of getting lower unemployment with higher inflation, in the end you would just get higher inflation and unemployment would return to its so-called natural rate regardless.

Seth Ackerman

It sounds like what you’re saying is that if you believe in a stable long-run unemployment-inflation trade-off, it doesn’t necessarily imply that you don’t understand the role of inflation expectations. Whereas Forder perhaps too easily leaves an impression that one automatically implies the other.

Thomas Palley

Yes. Friedman’s work clearly did shake things up: economists did believe that there was a policy-exploitable trade-off, and that’s why what he said was so controversial. So my read on Friedman is that he overstated the claim that economists were unaware of inflation expectations, but on the other hand — and this is what’s important — he showed that if you used conventional economic theory about how wages are set, you didn’t get the Phillips curve that economists were working with.

So he showed that their macroeconomics was inconsistent with their own theory. And the logic is very simple. Conventional theory says that wages are set to balance the labor market and ensure full employment. If you follow that logic through, if policy tries to overstimulate the economy beyond the point of full employment, then wages will just rise faster to restore the balance, and you just end up at the natural rate of unemployment again, but now with persistent higher inflation. I don’t think economists had really pieced that all together.

Now, this is where Friedman gets lucky. In 1967 he makes this argument about the Phillips curve dissolving. And then lo and behold, it suddenly starts to dissolve. The Phillips curve that people had been watching in the early 1960s, which was a very nice curve that seemed to offer some very palatable policy trade-offs, suddenly began to dissolve — it started to become steeper and to move.

And one reason was surely because of inflation expectations kicking in. But there were also other reasons. And that’s why I made those comments about different kinds of inflation. So, for example, income-distribution conflict kicked in. The 1960s and early 1970s were increasingly a period of conflict between capital and labor over the profit share.

And then in the late 1960s and early 1970s, you had a commodity price boom, which was followed by the huge OPEC oil price shocks. Those supply shocks also had the effect of amplifying the conflict inflation.

Under those circumstances, the Phillips curve essentially dissolved, because inflation was being determined by so many factors. And that dissolution was taken as proof that Friedman was right.

Now, here’s the twist. As I interpret it, the economics profession willingly went along with the story that Friedman was right. And there’s a reason for that. Friedman had based his case on conventional theory. And the economics profession is not in the business of challenging conventional theory. In fact, the exact opposite is true. It’s in the business of defending conventional theory.

The Phillips curve was always an observed empirical relationship, a statistically fitted relationship. The challenge was always going to be to provide a theoretical explanation of that observed relationship. Friedman showed that economic theory didn’t have an explanation that supported a policy trade-off and that, therefore, there was need for new theory. The Left didn’t have a theory either, even though it wanted to believe that the trade-off existed. All the Left had was a conflict theory of inflation. And that’s where James Tobin comes in.

Seth Ackerman

Right. So what was Tobin’s intervention in the inflation debate?

Thomas Palley

Tobin was the one economist who tackled the problem and really looked for a new theoretical explanation. And I have to say, I was a graduate student at Yale and took his macroeconomics class, and his work has deeply informed my own thinking.

Tobin’s basic idea is that we need to think of the economy as consisting of many sectors, or what you might think of as many small economies that are aggregated together into a national economy. Each sector is being hit by random disturbances. Demand and spending are shifting between these sectors. And this is going on all the time. At any moment, some sectors are at full employment, and others are below full employment.

Tobin realized that inflation might be a way of helping the economy rebalance faster. This is the vision he lays out very clearly in his AEA presidential address in 1971.

The problem is that sectors below full employment have a hard time rebalancing, because there’s resistance to wage cuts — and for very good reasons. I’ve written about this. First, employers are always looking to cut wages no matter what the conditions are. That’s a fundamental piece of the structure of capitalism. So how can you trust an employer who says, “I need to cut wages because business conditions are bad?” How is a worker going to be able to trust that? Employment is a very conflicted relationship, and as a result it’s hard to push wage cuts through, even if they are needed. Second, workers are debtors. For instance, most of us have mortgages, so wage cuts increase the burden of debts, and they’re going to be resisted for that reason.

The secret sauce is to increase demand everywhere. That restores full employment in sectors that have unemployment, but it causes inflation in sectors already at full employment. And that’s where you begin to get the possibility of a trade-off. The more demand you throw in, the more sectors will be at full employment, the faster inflation will be — but also fewer sectors will have unemployment because they’ve adjusted faster back to full employment.

Seth Ackerman

But then the obvious question is, why wouldn’t Friedman’s story about inflation expectations kick in at that point? People see higher prices, that gets incorporated into wage bargains, and inflation just keeps accelerating.

Thomas Palley

Well, that’s exactly right. Tobin never quite figured out how to answer that. And I would say I regard that as being my small contribution here. What you can say is that in sectors with unemployment, workers know full well what the inflation rate is. They’re not fooled. They can open a newspaper, they watch TV, and they’ll get the inflation rate. But if you’re in a depressed sector, you may decide to settle for slightly less of a wage increase. You won’t be fully compensated for inflation, and thereby you’ll effectively take a small wage cut relative to the rest of the economy. Meanwhile, the sectors at full employment will fully incorporate inflation expectations.

The key is recognizing that the degree to which sectors incorporate expected inflation in their wage settlement will depend on local conditions. You get less feed-through of inflation expectations in depressed sectors, and you get full feed-through of inflation expectations in sectors at full employment.

One way you might illustrate this is the metaphor of elevators and escalators. Mainstream economists think of labor markets as being like elevators. You have a shock to the local labor market. The next period, the local labor market resets wages, and it quickly goes back to full employment. So the labor market is like an elevator. An elevator shoots back up to full employment — quick adjustment.

The implicit Tobin view is that labor markets are like escalators. You have a shock; the local labor market then slowly adjusts back to full employment. Faster demand growth is a way of speeding up the escalator so that you get to full employment sooner. But the cost is inflation in those labor markets elsewhere that are already at full employment.

Of course, for economic theory the issue is to precisely identify that argument and show how it works, which is where technical modeling enters and gets tricky. That took time, and that’s part of the tragedy. Tobin was very quick out of the gate in 1971 with a counter to Friedman’s argument in his presidential address. But the precise argument and formal modeling of it took a lot longer. And by then, the economics profession had sort of moved on and was not in a mood for listening.

Seth Ackerman

So far have you managed to interest other economists in this kind of research program?

Thomas Palley

No, they’re not interested in my particular argument, but they have picked up on a related argument by George Akerlof and his coauthors.

One thing I will say on this point is that one of the great pities is that progressives never really embraced Tobin and his view of the economy. Because if you take the approach that I do, where there have to be different theories of inflation to describe different types of inflation, his thinking fills a gap in their thinking. It provides an explanation of the Phillips curve trade-off, which most progressives believe in but lack an explanation of.

However, progressives in the 1970s and 1980s did not join with Tobin. In my view there are two reasons for that. One reason is that Tobin was quite mainstream in his thinking on some aspects of economic theory, especially income distribution. He believed in the neoclassical marginal productivity theory of income distribution — which I don’t believe in, by the way — which contributed to suspicion and rejection of Tobin by the Left. A second reason is that the Left insists on seeing all inflation in developed economies as conflict inflation. The Left tends not to appreciate different types of inflation, and that’s also been a cause of difference between me and my progressive colleagues.

Seth Ackerman

How do you see the current inflation situation?

Thomas Palley

If I had been at the Fed in 2022, I would also have been voting for raising interest rates. In my view, it’s not just inflation that warranted higher interest rates. An even more important reason was asset-price bubbles and house-price inflation. Asset-price bubbles end in busts, and asset-price inflation is a very unfair way to distribute the fruits of economic activity. It’s not a good way to run an economy, and it’s not good for working families.

I’ve worked in Washington for over twenty-five years, and I’ve never yet come across a progressive who has argued for raising interest rates. I think that may be because progressives always view inflation as conflict inflation, which makes them against raising interest rates. In conflict inflation raising rates is tacitly siding with employers. In contrast, I carry in the back of my mind many theories of inflation, and one of them is Tobin’s Phillips curve theory. Given that, I’m much more open to the possibility that an increase in interest rates can be needed to tame excess demand. I think that is relevant to current conditions, along with the asset-price bubble problem.

Seth Ackerman

Yet you also advocate a higher inflation target.

Thomas Palley

Yes. We may need to tame inflation and we may also need a higher inflation target. That is not inconsistent. In my own work, I talk of the “backward bending Phillips curve,” which generates an optimal rate of inflation that I call the minimum-unemployment rate of inflation or MURI — the rate of inflation that will deliver the minimum unemployment rate. I think that is what policy should aim for. And I would say it’s somewhere between 3 percent and 6 percent. That’s quite a wide range, but we can take a midpoint, say around 4 to 5 percent.

If you push inflation above 5 percent, it’s quite likely that your Phillips curve is going to start bending backward, and you’re going to lose some of the benefits of inflation. The precise level is something that you’d only find out by experimentation. But a long time ago I did a short empirical paper that basically tried to make the argument. What I found was that the duration of spells of unemployment declined with higher inflation, which is proof of the escalator at work. If inflation is speeding up the escalator, unemployment spells will be shorter because you get to the top faster.

One of the ironies of the moment is that, in my view, we’re in the inflation sweet spot but we’re trying to push it below the sweet spot.

Seth Ackerman

So your views may have coincided with Larry Summers’s views at some earlier point, but at this point, where he really wants to see the labor market get a lot more slack, that’s where you depart from him.

Thomas Palley

Yes, exactly. Unfortunately, I often find myself caught between sides on these issues. I think Larry Summers was right on the need to get going and raise interest rates — though also for additional reasons than those that he gave. But now he’s in danger of being wrong by pushing too far.

Conversely, progressives were wrong in opposing interest rate increases in 2022. But at some stage they will be right if the Fed persists with raising rates — and I have to say, at 5 percent I begin to get a bit anxious. Right now, there’s good reason for an interest-rate pause.