Saving the Friedman Legacy

Just when all the financial excitement was beginning, Paul Krugman wrote an article for the New York Review of Books entitled ‘Who was Milton Friedman?’ Was he the economists’ economist, profound theorist, universally admired by professional economists? Or was he the simplistic ideologue, populariser and propagandist of monetarism and the free market doctrine, whose ideas proved unworkable in practice and whose intellectual honesty was at least questionable? Krugman’s answer was that Friedman was both of these.

The problem with this dichotomy was that Friedman, the simplistic populariser, gained huge credibility from Friedman, the profound theorist. And his intellectual dishonesty was evident in his populist exploitation of that credibility. For example, on 1st September, 1976, Friedman, addressed the Institute of Economic Affairs in London. The title of his talk was ‘The Road to Economic Freedom: The Steps from Here to There’. His prescription for Britain was the ’shock treatment’ of low flat rate taxes and wholesale privatisation, both of which a few years later the Thatcher government implemented.

His justification for privatising the provision of education and healthcare was simplistic in the extreme:
‘There is a sort of empirical generalisation that it costs the state twice as much to do anything as it costs private enterprise, whatever it is.’

Friedman didn’t actually have any data to support this contention, but added that, ‘My son once called my attention to this generalisation, and it is amazing how accurate it is.’

His argument for flat rate taxation was similarly limited.

Adam Smith had suggested
‘It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.’

Friedman simply said he could not see any justification for progressive taxation.

‘The personal income tax structure which seems best to me is a flat rate (23.5%) on income above an exemption.’

He provided no evidence of any analysis to support 23.5% as the flat rate tax for the British economy, leaving its apparent precision to suggest such analysis did exist. His stature as profound theorist, confirmed that year as winner of the Nobel Memorial prize for economic sciences, meant he did not have to offer evidence to lend credibility to his populist sound-bites. Friedman appeared content to exploit that facility to its fullest extent. Moreover, any ordinary economist challenging him would have risked professional suicide. At the Institute of Economic Affairs, such confrontation would have been unthinkable.

Friedman’s impact on the Anglo-American world has been greater than any economist since Keynes. Moreover his free market perspective still dominates Anglo-American political thinking despite, as Krugman pointed out, his ideas having proved unworkable in practice.

Friedman completed Capitalism and Freedom in 1962, when the world appeared to be divided between the two philosophies of socialism, most of which had in practice become totalitarian, and the free enterprise society which was arguably democratic. At that time it was uncertain that ‘our free society’ would prevail. Friedman and colleagues at Chicago and his Austrian predecessors, shared the commitment to free markets and the unreasonable belief that any step towards social democracy, no matter how small, would lead ultimately and inevitably, to a full-on totalitarian communist state. He may have imagined that progressive taxation was just such a step.

Friedman’s early public association was with monetarism. His belief in monetary policy sprang directly from the commitment to free markets. Government’s role in stimulating an economy in recession should be focused on feeding in the requisite liquidity. The markets would automatically allocate its use to the most efficient and effective applications. He rejected the alternative, tax and spend fiscal policies, because they would involve government interventions in specific public spending projects with all their assumed inefficiencies and political biases, inevitably involving government as market regulators, bureaucratic authors of endless enterprise stifling red tape, leading ultimately to the totalitarian socialist state.

Both Thatcher and Reagan pursued monetarist policies for the first few years of their administrations and found they didn’t work. Friedman himself subsequently expressed his disappointment at the result of the monetarist experiment.

Curiously, that failure did not dissuade the current generation of ‘madmen in authority’ from a monetarist approach to dealing with the 2007-8 crisis. Through quantitative easing government has pumped hundreds of billions of taxpayers’ money into the UK economy to stimulate growth. It did so by funding banks, but the banks were reluctant to pass the money on because they needed to rebuild their own balance sheets, having themselves made such a mess of them. So quantitative easing had negligible impact on real business and real jobs. That was exactly as Irving Fisher had indicated as far back as 1911: if money doesn’t circulate, pouring more in will have no effect on the economy. It was what J K Galbraith had referred to as trying to push the economy with a piece of string.

Nevertheless, at the end of 2008 the approach was argued by Friedman’s fellow Chicago School economist, Robert Lucas, with a more or less standard free market argument:
‘There is no other way that so much cash could have been put into the system as fast. It entails no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These seem to me important virtues.’

Lucas ignored the fact that it also had no beneficial impact on the real economy.

Regarding privatization and low flat rate taxes, both have been implemented in the UK. Friedman had claimed that low, flat rate taxes would remove the impetus for tax payers to avoid and evade payment. After his ideas were implemented, he expressed himself as disappointed that the extra money from lower taxes, put into the pockets of the wealthy, was used to achieve ever more sophisticated ways of avoidance and evasion.

Analysis of privatization, which lies way beyond the current objective, confirms that no convincing general case has been made. Friedman’s doubling of private costs for public performance is clearly way off the mark. Public services companies such as Serco, 4GS, Sodexo, Interserve and the rest, though adept at winning contracts for privatised services, are not always so effective at running them and not infrequently produce quite shocking stories of incompetence and profiteering.

Friedman is, of course, far from unique in subscribing to policies that don’t work in practice. The core of the problem is the idea of self-interest maximising economic man, a concept so inadequate as to require the added gravitas of reference as homo economicus. Economic models of what is referred to as ‘the firm’ are no less implausible. The utterly trivial notion of a profit maximizing production function, for example, requires a multitude of totally unrealistic assumptions that have to be made to make even that abstraction internally consistent so that calculus can be applied.

Over the past few decades economics has progressed further into mathematical fantasy. Kay has pointed out the hugely improbable assumptions that have to be made to ground Lucas’s highly influential dynamic stochastic general equilibrium model. The primary aim of contemporary economics is to build models that can be computerised and be capable of being run to a solution. Lucas credits the contribution of earlier ‘attempts to deal theoretically’ with monetary issues by Hayek, Keynes and contemporaries. However, he notes their inability to calculate the predictions of their own theories without the ‘equipment of modern mathematical economics’. An alternative view might be that those earlier economists were fortunate not to have been seduced by the ‘equipment of modern mathematical economics’ and therefore had to depend, at least to some extent, on observed reality and common sense.

For contemporary economics, practical reality is not a serious consideration. Friedman himself argued that realism was unimportant; what mattered was the ability to predict. But when the Queen asked why economists had not predicted the 2007-8 crisis, the response from Lucas was that the crisis was not predicted because economic theory predicts that such events are unpredictable. This apparently contemptuous rejection of any responsibility for being of practical use, is an essential feature of Friedman’s ‘profound theory’.

A further strand of Friedmanite theory can be traced back to the following much cited assertion in Capitalism and Freedom:
‘Few trends could so thoroughly undermine the very foundations of our free society than the acceptance by corporate officials of a social responsibility other than to make as much money for their stockholders as possible.’

Friedman clearly regarded ‘corporate officials’ exercising social responsibility as one of those steps towards social democracy which would lead inevitably to totalitarian communism. Though that possibility no longer exists, the argument has had, and is still having, a huge and damaging impact. It has justified the extraction of value from the real economy for the benefit of investors and the destruction of real economy jobs. Fox and Lorsch noted a ‘multi-trillion dollar transfer of cash from US corporations to their shareholders over the past 10 years.’ The City of London has achieved similar disinvestment. Also over the past decade the number of public companies in the UK has almost halved and declined by 38% in the United States. Similarly, the number of Initial Public Offerings (IPOs) has declined by over two thirds, and in the case of small and medium sized enterprises (SMEs) on which the hopes for an innovative high tec future rests, by more than 80%.

Still today most company directors believe, or claim to believe, the Friedman line, that it is their legal duty to do what they can to maximise the wealth of shareholders. That duty is foundational to the many codes of practice relating to corporate governance, from the first, the 1992 Cadbury code, which argued that

’shareholders, as owners of the company, elect the directors to run the business on their behalf and hold them accountable for its progress. The issue for corporate governance is how to strengthen the accountability of boards of directors to shareholders.’

Institutions, such as the Confederation of British Industry and the Business Round Table in the United States, endorse and promote this belief. Influential magazines such as The Economist, and think tanks such as the Institute of Economic Affairs, actively propagate the idea. It is the often unstated, but almost invariably active, assumption behind finance and business reporting in the press and broadcast media. The general belief is that shareholder primacy is what capitalism is all about.

Moreover, a July 2013 report on business education confirms it is still taught by business school faculty, as confirmed by Insead professor Craig Smith:
‘Students come in with a more rounded view of what managers are supposed to do, but when they go out, they think it??s all about maximising shareholder value.’

But it is all based on falsehood. When Friedman made his assertion it was completely without legal or theoretical foundation. Economists did subsequently develop a theory to justify shareholder primacy, an unconvincing and dishonest speculation which became accepted dogma referred to as agency theory, a deliberate misapplication of the legal principal : agent relationship.

Academic economists developed the theory to pretend the public company had no legal existence. In a frequently cited paper, Jensen and Meckling defined the firm as a ‘legal fiction’. Since it was a fiction, the totally false claim was made that the directors and executives were agents of the shareholders and therefore bound to act at all times in the shareholders’ best interests.

But the company is not a legal fiction; it is a legal fact. That is its whole point. Company directors are appointed as the agents of the company. Their contracts of employment and service agreements are with the company, not shareholders, and are specific about the requirement to act in the best interests of the company at all times. Since 1844, company law has been clear about directors’ duties to the company and its long term prosperity and also to have regard to the interests of all stakeholders. Nowhere in the world is there a legal statute which confirms company directors as the agents of shareholders. And despite it being the mainstream belief, a review of case law found only one item providing any support, back in 1919, and that was so weak it has only ever been cited once.

So Friedman’s statement about the responsibilities of corporate officials is untrue. It fits his free market fixation, but at the time it was made Friedman must have known it was an existential lie. Corporate officials do not have a responsibility to make as much money as possible for stockholders; and they do have moral responsibilities, as Friedman himself subsequently admitted. Those moral responsibilities include concerns for issues such as justice, fairness and sustainability, all of which are threatened by the naked pursuit of the Friedmanite objective of maximising shareholder wealth.

Friedman was right about one thing in the real world. The economy carries on surviving the incompetent assaults of economists and politicians. This is not because of the magic of markets, but because of the continuing efforts of the mass of people needing to earn a sufficient living. Competitive markets no doubt contribute to that robustness, but markets suffer a natural tendency to concentrate and, in the absence of effective regulation, to become ever more monopolistic and subject to fixing and abuse: a very real problem that Friedman never faced up to.

Friedman’s legacy then is of profound theory largely without practical value. Attempts to use that theory for practical purposes have invariably failed. So, his legacy should be to be taught, rather like in the past Latin was taught, as training of the mind. His legacy should be maintained and respected in the groves of academe, honoured by such as Robert Lucas.

But it would seem reckless to retain it as a guide to policy making.

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