An initial ‘Keynesian illness’? Friedman on taxation and the inflationary gap

An initial ‘Keynesian illness’? Friedman on taxation and the inflationary gap Abstract This paper examines Friedman’s writings in the years 1941–43 and compares them with those after the war with a view to assessing differences and similarities. Albeit a first assessment, Friedman’s claim that he was suffering from a ‘Keynesian illness’ in his ‘Washington phase’ appears to have been less ‘serious’ and deep than he himself feared, although he was to some extent influenced by the ‘prevailing Keynesian temper of the time’. 1. Introduction Friedman pointed out1 that his contributions in the years 1941–43 to the revision of the tax system prepared by the Division of Tax Research of the US Treasury Department had a distinct ‘Keynesian flavour’. As he wrote after rereading one of his statements made in 1942 before the US Congress, ‘I had completely forgotten how thoroughly Keynesian I then was. I was apparently cured, or some would say corrupted, shortly after the end of the war’ (cf. Friedman and Friedman, 1998, p. 113). Only scant literature and debate exists on Friedman’s initial alleged ‘Keynesian illness’, although it shows a first step in his views on price inflation before his restatement of the quantity theory of money. This work intends to be a first attempt to bridge this void by reconstructing Friedman’s activity in the period 1941–43,2 as well as the general cultural climate at the time. Section 2 is devoted to analysing Friedman’s works on the ‘inflationary gap’, whereas Sections 3 and 4 assess their alleged ‘Keynesian flavour’. I then go on in Section 5 to analyse Friedman’s writings on the spending tax, which are also central to evaluating his activity in his Washington phase. Finally, in Section 6, the content of Friedman’s writings in the years 1941–43 is compared with that after the war with a view to assessing differences and similarities. Albeit a first assessment, his initial ‘Keynesian illness’ appears to have been less ‘serious’ and deep than Friedman himself feared. Before I begin, a clarification regarding the meaning ascribed here to the terms ‘Keynesian theory’ or ‘Keynesian policies’ is required. In order to evaluate Friedman’s claim that his own work had an initial ‘Keynesian flavour’ and obtain a sharper comparison with his subsequent monetarist approach, we will consider as Keynesian ‘elements of the new message’ of Keynes that were neglected ‘by the IS-LM model’ (Laidler, 1999, p. 4) but not by the Cambridge economists nearest to Keynes, and Lerner and Hansen in the USA. In particular, in addition to the intrinsic monetary nature of the market economies, two features which Friedman himself eventually deemed as properly Keynesian3 will be considered. The first is the possibility of a persistent under-utilization of resources arising from a lack of effective demand, with the related point that an increase in the money-wage ratio will not necessarily lead to a rise in aggregate demand. Second, on a methodological plane, I will consider as Keynesian a non-simultaneous determination of equilibrium in the money market on the one hand, and in the commodity market on the other, namely a ‘linear’ causal chain running from the former to the latter market which, contrary to Hicks’s and Modigliani’s interpretation of The General Theory, Keynes himself seems to have followed as a first step in his analysis (see, e.g., Keynes, [1936] 1971–89, chapters 14, 18, 21; Keynes, 1937, p. 251; Pasinetti, 1974; see also below, p. 9). 2. The debate on the inflationary gap In the period 1941–43, the American economy was moving fast towards a condition of full employment of resources due to the huge increase in war expenditure (cf. Crum et al., 1942; Fellner, 1942; Rees, 1959). The short-term danger therefore became inflation rather than a shortfall in effective demand, also because shortages in basic commodities were rapidly increasing. As Eccles (1941A, p. 1284) already stressed in 1941, when the utilization of productive capacity was nevertheless still at 70%, ‘(t)oday our problem is to curb consumer demand and purchasing power so that they will not divert too much of our productive capacity to the manufacture of nonessentials …’. How to cut private demand and avoid price inflation therefore became at the heart of economic debates, with a broad consensus, however, that in conditions of full employment an excess of the nominal aggregate demand on aggregate supply could be ‘closed’ by means of taxation, direct price controls4 and the rationing of consumer goods (see, e.g., Eccles, 1941B; Koopmans, 1942, p. 53; Henderson, 1941; Morgenthau, 1941; Smithies, 1942). Friedman himself, in his statement made to the Ways and Means Committee of the House of Representatives in May 1942, while pointing out that ‘(t)he pressure to spend would be great enough … to break through any price control and rationing plan that could be devised without using a policing force so large as to constitute a serious drain on man power for industry and the armed forces’ (Friedman, 1942A, pp. 1–2), maintained that (t)axation is not, however, the only method being employed to combat inflation. Price control and rationing, control of consumers’ credit, reduction in governmental spending, and war bond campaigns are the most important other methods that are now being employed. But just as it does not seem feasible to prevent inflation by taxation alone, so these other methods cannot be relied upon in the absence of additional taxes. (Friedman, 1942A, p. 2) The issues on which there was no consensus were, on the other hand, those on the effects of price inflation, the relative efficacy of the above-mentioned various possible measures to prevent it, and in this respect, the amount of taxes needed to close the ‘inflationary gap’, namely the difference between the expected expenditures and the value of goods expected to be available. In particular, the estimates of the amount of taxes needed to prevent inflation differed markedly. For instance, those advanced in October 1941 by Friedman, Mack and Shoup in a preliminary mimeographed report entitled ‘Amount of Taxes needed in June 1942 to Avert Inflation’ were greater than those advanced by OPA economists who forecasted no serious inflation problem until the fiscal year 1944.5 Friedman’s writings on these matters are crucial in evaluating his view on price inflation and income determination during his ‘Washington phase’. Friedman here clearly distinguished between a cost-pull and demand-pull type of inflation. With respect to the former, he noted that you can move along an increasing aggregate supply curve or you can have a shift in that curve. Thus Friedman (1943B, pp. 4–5, my emphasis) wrote6 that ‘(a)lthough time rates of wages remain unaltered’ there may be ‘a rise in labor cost per unit, and possibly in other unit costs also’. Otherwise costs can rise ‘because the agents of production arbitrarily raise the price of their services by concerted action’. In both cases: taxation is no cure …. Whether the result were an increased money flow supported by an expansible credit system, or a decreased volume of production, or both, would depend in part on the tax policy that was adopted; but the rise in prices would be present in any case, in the absence of subsidies combined with rationing. Friedman contrasted this case of cost inflation with that of a price rise ‘touched off by something other than a rise in money costs’. The latter arises when: (c)onsumers, for whatever reason, increase their spending, or the supply of goods and services available declines, or there is a combination of both. As a result, dealers find that they can raise their selling prices without having goods pile up on their shelves. Indeed, according to Friedman (1943B, pp. 4–5, my emphasis), at the beginning of the war effort, an increase in aggregate demand would not necessarily lead to a rise in prices since there would probably be constant unit costs of production and ‘the absolute amount of consumer goods and services may increase as idle resources are utilized’. Nevertheless, ‘soon the scarcities become more general’ and there will be a stage in which ‘total output and total money income stabilize’. At this point, the rise in prices will become a necessity owing to ‘the decline in consumer goods as more production is devoted to war’. Such a rise will produce ‘windfall profits, at least in the first instance’, and in this respect ‘it differs from the price rise caused by increased difficulty of production’. Friedman refers to the former kind of inflation arising from ‘money income’ expanding ‘more than in proportion to income-earning activity’ as ‘atomistic inflation’ or ‘deficit-induced inflation’, citing A. C. Pigou (1941, pp. 439 and 442) as his main reference. 3. An initial Keynesian flavour? If the missing reference to Keynes in these works of Friedman, unlike those of Koopmans, Hansen, Harris and other American economists of the time when analysing the causes and impact of price increases, may appear striking, the analysis sketched out above contrasts to a great extent with Friedman’s subsequent view on the determinants of the price level and its changes over time. For instance, as in Hansen (1941, p. 171), Friedman pointed out that no general statement can be made about the effects on prices of an increasing public debt. Moreover, in his writings in the period 1941–43, there is no reference to what Hansen (1944, p. 39) called ‘a hangover from a crude quantity theory of money’, that is, that an increase in the income stream due to a rise in the quantity of money and/or in its circular velocity automatically resolves in a rise in the general price level with no effect on relative prices and the real income.7 Furthermore, unlike in his writings related to the restatement of the quantity theory of money (see e.g. Friedman, 1969, p. 172), Friedman did not now seem to consider the trade unions as affecting the general level of prices only in very short periods, while having no direct role (when not influencing money supply) in explaining its ample fluctuations or its long-run movements. Even if trade union action was to lead to ‘a decreased volume of production’ and therefore to labour unemployment, there is in fact still no reference in Friedman’s 1941–43 works to a forthcoming fall in money wages due to the pressure of competition in the labour market. Conversely, in the above quotations from Friedman (1943B), he even referred to the possibility of ‘an expansible credit system’, and thus, at least to some extent, to an endogenous money supply.8 In the next section, I will outline some elements that already distinguished Friedman’s position from a Keynesian one in the period 1941–43. However, a Keynesian flavour in his early writings on price inflation undoubtedly appears also when analysing what he called ‘atomistic’ or ‘deficit-induced’ inflation. On the one hand, Friedman, as mentioned above, not only maintained that such inflation cannot arise if there are ‘idle resources’, but he seemed also to suggest that labour unemployment (other than frictional) can be, in actual fact, a normal phenomenon (see again Friedman, 1943B, pp. 4–5). On the other hand, when considering a situation of full employment, as in wartime, he pointed out that if there is inconsistency at an initial price level between expenditure and the value of goods available for sale, it could be resolved by an increase in prices that raises ‘the ratio of saving to spending, or the ratio of tax revenue to spending, or both’ (Friedman, 1942D, p. 8; see also Friedman, 1942C, p. 316). He thus wrote: a price change does not involve merely a revaluation of goods and of incomes. Because of frictions and lags, price changes lead to a redistribution of incomes and to a change in spending-saving relationships. The initial increase in income from a rise in prices is likely to be concentrated in the hands of recipients of profits, a group that tends to receive fluctuating income and that is accordingly predisposed to save a disproportionately large part of any increase in income. Moreover, the receipt and spending of incomes are not simultaneous. All along the line, it takes time for recipients of higher incomes to readjust their spending patterns; it also takes time to make competitive readjustments of resource prices. (Friedman, 1943B, p. 11, my emphasis; see also idem, 1942D, pp. 7–8)9 Such a change in income distribution as a way of closing the ‘inflationary gap’ by raising the ratio of saving to spending is similar to what was put forward by Keynes in his works ‘Social Consequences of Changes in the Value of Money’ ([1923] 2010) and ‘How to Pay for the War’ ([1940A] 1971–89), in which Keynes,10 after considering the inability of voluntary savings to close the gap, advocated the need to obtain a ‘forced saving’ by means of a ‘deferred wage’ allocated in public bonds instead of by means of an inflationary process leading to an income redistribution that was unfavourable to the labourers (or at least to the less organized workers). On the other hand, at least temporarily, changes in distribution as a consequence of price inflation in conditions of full employment were usually admitted at the time on both empirical and theoretical grounds,11 and Friedman clearly shared such ideas. Like Hart (1942), Koopmans (1942) and Smithies (1942), Friedman thus saw the required fall in consumption in real terms as being achieved by wages lagging behind prices and leading to an increase in savings, as well as by the ‘illusion behaviour’ of income receivers who based their spending behaviour on the assumption that current prices and income remain stable. Moreover, Friedman also seemed to refer to the fact that ‘capital losses’ inflicted by inflation are taken into account when planning current expenditure. Two conclusions can therefore already be advanced at this stage. The first is that in the years 1941–43 the only ‘methods of avoiding inflation’ which Friedman mentioned ‘in addition to taxation’ were ‘price control and rationing’ (Friedman and Friedman, 1998, p. 112), whereas he did not even mention ‘money’ or ‘monetary policy’. Second, due perhaps to the influence of ‘How to Pay for the War’ or to that of Keynes’s Treatise on Money and the works on ‘forced savings’ of Hayek, Pigou and Robertson12 (all debated in Chicago in the 1930s), in his ‘Washington phase’ Friedman emphasized that price inflation would have real effects in the form of changes in relative prices and income distribution. Except for a case outlined below (see pp. 8–9), at no stage do we find any clear argument concerning money neutrality,13 nor any analysis of the determinants of the demand for money on which he will then found his restatement of the quantity theory of money (cf. Friedman, 1956). In this respect, the real effects arising from price inflation we detect in his 1941–43 writings should not be confused with those sometimes put forward by Friedman in terms of changes in the rate of inflation probably affecting capital accumulation by changing the desired real quantity of money and the allocation of wealth to the various activities. However, a difference from his subsequent works also appears when his calculations of the ‘inflationary gap’ and the amount of taxation needed to prevent inflation are analysed. When dealing with the inflationary gap, Friedman, like Keynes ([1941] 1971–89, vol. 22, pp. 291–92), stressed that at any given time there must be ‘momentary equilibrium’ between aggregate demand and supply since the income of the public must always ‘be equal to the sum of taxes plus consumption plus savings’. Furthermore, like Keynes, Friedman pointed out that the equilibrium to be maintained needed appropriate changes to be made in prices and in saving habits by placing obstacles in the way of consumption and so on. Thus he stressed that, while ‘(i)n retrospect, there can be no gap’, in prospect ‘there may well be a gap’ (Friedman, 1943C, p. 131). The ex ante inflationary gap could be closed with taxation rather than inflation and, according to Friedman, two methods were used to estimate the required amount of taxation. The first was that adopted by Angell (1941), who estimated the expansion in spending on the basis of the historical relation between changes in the stock of money and changes in income. The second method, adopted by Gilbert and Perlo (1942), referred to the historical relation between investment and the national income. In both cases, the estimates of the expansion of aggregate demand were then compared with the estimated possible increases in output in order to determine the probable degree of price change (Friedman, 1943C, pp. 114–15). In this respect, three elements characterized Friedman’s position, all attesting the influence of the ‘Keynesian temper of the times’. First, the estimate method he used is similar to the second one mentioned above. He compared the expected increase in the real output and in war expenditure in order to obtain the expected available civilian output. In order to obtain the consequent amount of decrease in the civilian aggregate demand needed to prevent inflation, he then subtracted the change in civilian demand that would occur if no new anti-inflationary measures were adopted from the (calculated) available civilian output. This latter change was estimated on the basis of the expected changes in the component parts of capital formation and in the propensity to consume assuming that disposable income and prices were the same as they were on the initial date. The second element worth noting is that in his estimates Friedman (like Hansen, Samuelson and others at the time) linked the expected changes in capital formation to the expected changes in consumer spending, whereas he did not mention any influence of the rate of interest on the amount of investments. Thus he wrote: capital formation probably has some tendency to decline if an increase in consumer spending slackens appreciably. Though this result is not to be counted on invariably, it seemed to deserve some consideration in the present analysis. (Friedman, 1943B, p. 42)14 Finally, and more importantly, Friedman refuted Angell’s method of estimating the expansion in spending on the basis of the relation between changes in the stock of money and changes in income when given the marginal circular velocity of money (i.e., the ratio between a change in national income from one year to the next and the associated change in the stock of money). On the one hand, Friedman rejected taking the government deficit as equivalent to an increase in the stock of money since it would mean assuming that the stock of money does not change for any other reason and stressed that ‘(a) change in the deficit as a result of taxes levied solely on high incomes’ may have a very different effect on spending ‘from an equal change in the deficit as a result of taxes levied on very low incomes’ (Friedman, 1943C, pp. 117–18). On the other hand, Friedman noted that Angell’s estimates were based on historical data which showed the actual changes in the stock of money, making no explicit allowance for the reactivation of formerly idle money as a way of financing the government deficit. This procedure ‘implicitly assumes a constant relation between the changes in the total-stock of money and the amount of reactivation of formerly idle money’ which, according to Friedman (1943C, pp. 117–18), was not supported by the data. In particular, the data did not support the conclusion that ‘the marginal circular velocity of money may be considered as fairly stable’. 4. Some elements of a traditional view on income and price determination Here Friedman was apparently rejecting a year-to-year explanation of income changes on the basis of a ‘rude’ quantity theory of money—an explanation which, though only in part, was supported by Fisher at the time,15 but not, for instance, by Simons, who had outlined that the circular velocity of money can change even abruptly during the cycle (Simons, 1936, pp. 5–6). However, Friedman (1943C, p. 119, my emphasis) also pointed out that the data used by Angell may be adequate for studying the average circular velocity of money or the relation between long-period changes in national income and the stock of money. Hence, on the whole, he already seems to share elements of the ‘Chicago tradition’ that afterwards were to characterize his monetary analysis where money will usually appear to be neutral in the long run, even if not in the short run (see e.g. Friedman, 1982, p. 60 and 1987, p. 250).16 Although there are no other traces in his ‘Washington period’ writings of the idea that the equilibrium of the money market can be reached by making changes in the price level given the real income and a stable desired quantity of money in real terms, the context of the above quotation reveals to us a causal chain which in the long run goes from changes in the nominal supply of money to changes in money income thanks to an (average) stable circular velocity of money.17 We thus begin to find a first element of a ‘traditional’ determination of income and prices which may help to explain Friedman’s ‘conversion’ from a Keynesian approach after the war. This is not, however, an isolated element and shows us that Friedman was still largely shaping his thinking in the period 1941–43. He thus maintained that a ‘monetary veil exists that obscures and at times conceals the physical realities of the economic system’ (Friedman, 1943A, p. 50, my emphasis), which clearly contrasted with Keynes’s emphasis on the intrinsic monetary nature of the economic relations in the market economies that led him to construct a ‘monetary theory of production’ (cf. Keynes, [1933] 1971–89, vol. 29, pp. 81–82). Moreover, when analysing the effects of cost-push inflation, as has already been seen (see pages 3–4), Friedman stated that it will lead to ‘a decreased volume of production’ unless ‘an increased money flow supported by an expansible credit system’ occurs. Quite mechanically, cost-push inflation could therefore easily be transformed into being temporary in character unless it is followed by an expansion in the quantity of money.18 Finally, when discussing the estimates by OPA economists of the inflationary gap, Friedman rightly observed that in a changing world their hypothesis ‘that ex ante saving next year is equal to ex post saving this year’ has ‘little basis in either theory or fact’. However, after simplifying the analysis by assuming an unchanged disposable income in calculating the inflationary gap, he further stated in response to Salant (1942) that the breakdown of the inflationary gap ‘among broad classes of output’ is impossible19 since ‘(t)he composition of the gap is determinate only at specified relative prices for different classes of goods’ and ‘it can be anything at all if relative prices are permitted to vary’ (Friedman, 1942C, p. 319, my emphasis). At least on theoretical grounds, if not in practice, Friedman thus stressed the existence of a strict relation between relative prices and outputs (namely, a strong, definite reaction of the latter to price changes), probably influenced by his previous works on the demand curves of commodities (see, e.g., Friedman, 1935), or by the works of Knight and Schultz, who had taught Friedman in the 1930s and kept the general equilibrium analysis alive in Chicago. In this way, he differs from a Keynesian approach since Keynes certainly never emphasized the effects of changes in relative prices on the composition of output. While in fact admitting in Chapter 20 of The General Theory that changes in the aggregate demand might lead to changes in relative prices and the composition of production, as a first necessary step in the analysis he considered output composition as given when determining real income.20 More precisely, in view of the uncertain effects of the changes in relative prices and the rate of interest on consumption and the propensity to save, Keynes made extensive reference to social and institutional factors (as well as to the different income levels earned by workers and the capitalist class) in determining the composition of output and the propensities to consume of the different groups of society (see, e.g., Keynes, [1936] 1971–89, vol. 7, Chapter 8). He also saw those factors as being relatively stable and given when determining the amount of employment on the basis of the income multiplier and autonomous demand.21 To sum up, Friedman’s analysis of the inflationary gap undoubtedly contained many Keynesian elements, but also traces of a traditional approach. Indeed, his observation (put forward when analysing ‘how the fraction of resources used to produce goods not available for current consumption adjusts to the fraction of income that individuals wish to save’) according to which ‘(n)o judgement is intended on the crucial issue separating the Keynesians and anti-Keynesians as to whether there is an automatic tendency for such an adjustment to be made at a level of full employment’ (Friedman, 1943A, note 2) also appears to move in that traditional direction if we simply consider the ‘prevailing Keynesian temper of the time’ (Friedman, 1953, p. 253). 5. The spending tax proposal Although in a different domain, a break with a Keynesian approach emerges even when we examine Friedman’s proposal of the spending tax as a measure of avoiding inflation.22 In ‘How to Pay for the War’, Keynes proposed a plan of compulsory savings to avoid inflation since the entire cost of the war could not be covered by taxation. According to him, ‘(b)y such a plan … the wage and salary earner can consume as much as before and in addition have money over in the bank for his future benefit and security, which would belong otherwise to the capitalist class’ (Keynes, [1940A] 1971–89, vol. 9, p. 375). More precisely, the plan would have avoided the ‘machinery of war finance’ operating ‘by the rise in price diverting real purchasing power away from the consumer to the profit-earning class, who in turn will transfer a large part of these profits to the Treasury’, which would have meant that at the end of the war it is the profit-earning class which owns, in the shape of holdings in the national war debt, a claim on future production; while the wage-earning class, in spite of the extra-work done, owns nothing, having lost the right to consume now and having gained no rights to consume hereafter. (Keynes, [1941] 1971–89, vol. 22, p. 145) The plan was debated in the USA, and an appeal for its adoption appeared in 194123 arguing that combining compulsory lending with taxation was the method of war finance ‘best suited to satisfy the requirements of equity’ (cf. Fellner, 1942, p. 11). The plan was on the other hand opposed by those who feared that compulsion would kill the ‘voluntary spirit’ and to some extent by the trade unions which were suspicious of the simultaneous request to stabilize wages. During the summer of 1942, however, the US Treasury developed a different proposal for a spending tax as a supplement to the income tax and presented it to the Senate Finance Committee in September 1942. Whereas Keynes had considered such a tax as theoretically sound but impossible in practice, perhaps heeding Pigou’s warning of the likelihood that the upper classes and savers would thus escape taxation to a great extent (cf. Kaldor, 1955, p. 12), the direct reference for the Treasury’s proposal was Fisher’s (1942) works on a progressive spending tax. Indeed, the Treasury’s proposal combined Keynes’s plan and the spending tax, using spending as the basis for extracting funds from the public and treating some of the funds raised as compulsory savings instead of taxes. The proposal was thus received as a plan for enforced savings24 and opposed by the Finance Committee and the financial community (see NYT, 1, 4, 5, 6, 7, and 8 September 1942).25 Also, due to the fact that it was presented so late in the tax hearings that the plan would either be quickly discarded or prolong tax bill deliberations further, five days after its presentation, the Finance Committee rejected the plan by 12 votes to none (some members abstaining) and it was never heard of again. Friedman supported and in part elaborated the Treasury’s proposal, though refusing to treat part of the taxes raised as compulsory savings, unlike White’s prevailing position (see Friedman and Friedman, 1998, pp. 117–18). As in Keynes’s plan, the background to Friedman’s proposal was the disruptive effects of inflation which he deemed were in conflict with the utilization of the product for war purposes, fair income distribution and post-war stability. But Friedman thought that neither rationing nor compulsory savings could be effective in this regard. In the former case it would not be possible, according to Friedman, to get individuals to consume scarce goods in specified amounts and proportions (cf. also Wallis, 1942). In the latter case, the problem would be that compulsory lending might be satisfied with previous savings without decreasing the consumption of those who live on capital (Friedman, 1943A, p. 60). Furthermore, Friedman pointed out that it would be ‘impossible in principle’ to enforce compulsory savings ‘since income and expenditures are never definitely known until after the end of a period’ (Friedman, 1943A, p. 52). As in Fisher’s analysis of taxable capacity, when supporting his alternative proposal of a spending tax, Friedman first of all divided the individual income into two shares, a subsistence share and a surplus share. Thus he wrote (Friedman, 1943A, p. 58): As a resource, much of what (an individual) consumes is an intermediate product, a cost of production, like the food to livestock. As a consumer, what he consumes is a final product, designated to satisfy the wants of the prime mover of the production process. In ordinary times, the consumer aspect of the individual is dominant. He is an end, not a means …. In wartime, values change …. The individual becomes a means, not an end. Tax therefore has to be progressive to avoid workers receiving ‘less than they need for health and efficiency’ (Friedman, 1943A, p. 58). However, the marginal tax rate could in this case be so great that it impaired efficiency and: in order to achieve a more efficient distribution of the available consumer goods and at the same time maintain the incentive value of income as much as possible, fiscal methods involving the withdrawal of income must be supplemented by savings-inducement methods, that is, by methods that impinge directly on spending, rather than on income. (Friedman, 1943A, p. 61) The aim of this kind of taxation was in fact for Friedman to reduce ‘types of spending that are least necessary for the maintenance of output in general and war output in particular’. In the case of spending on commodities that use resources specially adapted to war production, special excises could to some extent be the appropriate remedy. For the rest, ‘the maintenance of output calls for restraining all spending in excess of a basic minimum’ (Friedman, 1943A, p. 61) and the result can be achieved by ‘a progressive spending tax that exempts a basic minimum and imposes a higher rate of tax the larger the excess of spending over the basic minimum’. But what is to be stressed is that Friedman’s arguments in favour of the spending tax and against compulsory savings remained not only with the belief that it was more effective, but with the need to minimize any intervention that imposes a limit on individual choices and market mechanisms. In both wartime and in peace, taxation should in fact, according to Friedman, modify the control over current output granted by income without however seriously impairing the ‘function of income in organizing the use of resources’. Moreover, in wartime, the amount of income above the basic minimum can still be permitted ‘to serve as a claim to future output’, while ‘even the separation of income from control over current output need not be complete’ (Friedman, 1943A, p. 56). Friedman thus viewed the spending tax as the best measure for stimulating savings and preserving them on a voluntary basis, as well as for ‘minimizing the role of government intervention into the details of the economic system’ in the transition from war to peace (Friedman, 1943A, p. 62, my emphasis).26 Therefore, unlike Keynes’s compulsory saving plan, Friedman did not try to avoid the claim on resources after the war being concentrated in the hands of the capitalist class alone. On the contrary, while curbing purchasing power, Friedman wanted to preserve savings as an individual effort to ameliorate one’s future condition when income exceeds a certain minimum level. The emphasis is thus placed on an individual choice between present and future consumption, which seems to clash with Keynes’s view of different social classes that are structurally characterized by different propensities to consume and thereby affected by the war in such a way that the wage-earning class ‘in spite of the extra-work done’ will run the risk, in the absence of any intervention, of owning ‘nothing, having lost the right to consume now and having gained no rights to consume hereafter’ (Keynes, [1941] 1971–89, vol. 22, p. 145). 6. Some final remarks To sum up, in the years 1941–43, Friedman appears to have to some extent already differentiated himself from the ‘Keynesian prevailing temper of the times’ which was testified by the works of Hansen, Harris and Lerner, as well as Roosevelt’s economic policies and the practice of economists such as Eccles, Galbraith, Henderson, Nathan and Salant. This differentiation emerged more clearly after the war, particularly when Friedman returned to Chicago in 1946.27 However, back in 1944, when reviewing Altman’s book, Friedman spoke in quite worried tones of a ‘Keynesian saving-investment theory’ which ‘has had such vogue in recent years’ (Friedman, 1944, p. 101). More importantly, in 1946 in his remark that ‘OPA alone cannot prevent inflation’ Friedman observed that ‘(a) major effect of OPA price control has been to disguise rather than prevent increases in price’ and: We can and must take measures now to control the basic causes of inflation by limiting the supply of cash and bank deposits. (Friedman, 1946, p. A2209)28 Friedman consequently advocated minimizing public expenditure and raising taxation as well as increasing the bank’s reserve requirements and the rate of interest. He put forward the same policy proposals as Mints (1946) and Haberler (1946), who had begun to focus on the importance of monetary versus fiscal policies and on the crucial role of wage rigidity in explaining labour unemployment.29 While Friedman’s monetarist ‘counter-revolution’ took on a definitive shape only some years later (see Friedman, 1956), just after the war his scanty Keynesian background and changed economic conditions thus led him to develop those aspects which were present in Mints and Simons30 against obstacles to market mechanisms and active fiscal and monetary policies. Friedman therefore outlined early on that: (e)conomists now tend to concentrate on cyclical movements, to act and talk as if any improvement, however slight, in control of the cycle justified any sacrifice, however large, in the long-run efficiency, or prospect of growth, of the economic system and he wanted to guarantee ‘both sets of objectives simultaneously’ (Friedman, 1948, p. 245) by reforming the monetary system in order to eliminate the private creation of money and discretionary controls over the quantity of money by the central bank authority. Moreover, he advocated automatic stabilizing mechanisms during the cycle by means of a progressive tax system and a fiscal policy determining the volume of government expenditures entirely on the basis of the community’s desire, need and willingness to pay for public services (cf. Levrero, 1999).31 At the beginning, the ‘conversion’ vis-à-vis a Keynesian approach mainly took the form of an insistence on rigidities in prices as a cause of unemployment (see also Patinkin, 1948) and on the time lag in the response by active policies to cyclical movements as a reason for abandoning those policies (see e.g. Friedman, 1947, pp. 413–14). As immediately stressed by Neff (1949), it assumed the idea of an automatic and rapid tendency of the market economies towards conditions of full employment, since otherwise, even in a flexible price world, at least a discretionary counter-cyclical policy would appear necessary. 32 It was, on the other hand, the firm belief in the absence of any automatic tendency towards full employment that led Keynes, against any laissez-faire ideas, to advocate using active policies to maintain a state of quasi-expansion and adopting measures that increase the propensity to consume and socialize a share of investment. In short, if influence of the ‘Keynesian temper of the time’ can be found in Friedman’s works in the years 1941–43,33 it is in the 1944–48 period that Friedman began to advance arguments in favour of policy rules against discretionary policies, and to refer explicitly to the quantity theory of money in determining the price level. However, it is only in the years 1948–58, after the start and first results of his work with A. Schwartz on the monetary history of the USA (cf. Friedman and Schwartz, 1963), that Friedman definitively clarified his analytical framework and laid the foundations of his ‘anti-Keynesian revolution’ (cf. also Harris and Tavlas, 2016). On the one hand, the belief that the observed correlation between changes in money supply and changes in prices would suggest a causal relation ranging from the former to the latter, as well as the belief that the 1929 crisis stemmed from Fed’s errors in shaping the monetary policy, led Friedman to his restatement of the quantity theory of money (cf. Friedman, 1952, 1956) and the proposal of a passive monetary rule in the form of an announcement of a constant increase in the money supply (cf. Friedman, 1958). On the other, Friedman advocated a greater efficacy of the monetary against the fiscal policy on the basis of his studies on the consumption function (cf. Friedman, 1957) and the belief in a high stable relation between income and the demand for money—the former lowering the Keynesian multiplier, and the latter increasing the value of the monetary multiplier. It is not the aim of this work to discuss these aspects of Friedman’s thought (see in this respect, Ando and Modigliani, 1965; Kaldor, 1982; Levrero, 1999; Temin, 1976; Tobin, 1970). It shows, however, that ‘(t)he man and the moment are always intimately linked’ (Palley, 2016, p. 648). The cultural climate after the Second World War which was characterised by a reaction against New Deal Keynesianism and the campaign in favour of the free market influenced the evolution of Friedman’s thought while at the same time finding in his works one of the main representative of neoliberal ideas. It took time, however, before Friedman’s thinking became a point of reference for macroeconomic theory and economic policy proposals. To use a category advanced by Sraffa when reconstructing the history of economic thought (cf. Trezzini, 2017), other ‘disturbing elements’ related to opposite social interests had to intervene from the mid-1970s to determine this result. Footnotes 1 See M. Friedman and R. Friedman (1998) [hereafter Friedman and Friedman, 1998]. As Friedman and Friedman (1998, p. 113) told us, in those years Friedman wrote numerous memoranda, reports and letters that have been ‘buried somewhere in the files of the Treasury Department’. My research at the US National Archives did not unearth them, though it gave me access to materials that I have used in this work. I have also used materials conserved in the Friedman Archives in the Hoover Institution, as well as publications of the US Congress and articles published at the time in the Wall Street Journal, New York Times and Washington Post (hereafter, WSJ, NYT and WP, respectively). 2 In the years prior to his ‘Washington phase’, Friedman’s activity concentrated mainly on various aspects of demand curves, econometric fields and the American income and consumption structure rather than on the relation between money, prices and income. 3 Friedman (1969, p. 97 and 1987, p. 256) maintains that the main proposition (or ‘error’) of Keynes is the idea that stable unemployment equilibria do not arise from wage rigidity, which is instead considered a ‘rational answer’ to those equilibria (see also Laidler, 1999, p. 265). In the meantime, however, Friedman interpreted Keynes’s work as a half-revolution which took place within the framework of the quantity theory of money by only emphasizing that during the cyclical phase of depression, the liquidity preference might become infinite and/or investments might be inelastic to the rate of interest. According to Friedman (1987, p. 257), Keynes viewed this situation as a limiting case whereas his disciples (including Hansen and Lerner) viewed it as normal. 4 They were organised by the Office of Price Administration (OPA), which was created in spring 1941 and had the authority to fix maximum prices. OPA action had some success in controlling prices, which rose less than in other countries (see H. Rockoff, 1985 and Early and Stein, 1942). However, the OPA’s activity was characterized by great contrasts, as in the cases of the Chrysler Corporation and Aircraft builders’ opposition to price ceilings (see for example WSJ, 27 June 1941 and 8 July 1942). Moreover, as in the case of agricultural produce, there were many exceptions to price freezing which reduced the chances of its success, e.g. by fermenting requests for wage increases (see Fellner, 1942, p. 123). 5 The discrepancies in these estimates persisted afterwards but were opposite in sign. According to Friedman and Friedman (1998, p. 111), this happened because, while in the process of lobbying Congress for the price control act the OPA had argued that price controls were the only way to stop inflation, after February 1942, its interest changed and ‘(t)he Treasury … became an ally, not a competitor’, in controlling prices. However, even before 1942, Henderson and other OPA officials stressed the need for taxation to prevent inflation while Friedman (1943C, p. 136) himself stressed that ‘the question of exactly what constitutes an inflationary gap is extremely difficult to answer’. It is also worth noting that Keynes believed that Salant and other OPA economists had overestimated supply and underestimated demand. Thus he wrote to J. M. Clark on 26 July 1941: ‘I have tried to persuade Gilbert and Humphrey and Salant that they should be more cautious’ (Keynes, 1971–89, vol. 23, p. 192). 6 Note that the foreword of the book written by Friedman with Mack and Shoup (1943) states that ‘(t)he outlines of the approach that is taken in Part I were developed first by Milton Friedman’. 7 On this point, see also notes 17 and 18 below. 8 In this respect, Friedman did not seem to follow Pigou (1941, p. 440), according to whom inflation can only stem from an increase in the stock of money or a (previous) increase in the desired proportion of money income to the stock of money. Thus Pigou stated that, in wartime, it is only because money is continuously created that wage inflation does not kill itself by leading to labour unemployment, but produces a ‘vicious price spiral’. 9 Note that according to Friedman, if there is no change in the ratio of saving to spending, inflation will only close the gap temporarily. For instance, if there is no business saving, no taxes, no stocks of consumer goods and the government needs half a production value of $100, whereas consumers always want to spend 70% of their received income, then the ‘primary consumer expenditure gap’ will be $20 in the first period, $24 in the second period and so on, whereas money income will rise from $100 to $120, to $144, and so on. Hence, the price response to the ‘inflationary gap’ will change according to the circumstances depending on whether and when profits rise, labour is quick to obtain higher wages or consumers are quick to interpret rising prices as a forerunner of further price rises, and so on (cf. Friedman, 1942D, p. 9). 10 See also Keynes ([1941] 1971–89, vol. 22). With regard to the long run, as is known, the idea that an increase in the rate of investment will lead to an increase in the amounts of savings per unit of capital through a fall in the real wage is an essential aspect of the post-Keynesian theory of distribution. However, also in the long run, the needed increase in savings can be obtained by a change in the degree of capital utilisation without any need for a change in distribution. Moreover, an increase in the amount of productive capacity will materialize (cf. Garegnani, 1992). This does not exclude the fact that in special cases, such as the one considered here, there may ultimately be no room for increases in production, thus achieving a redistribution of income to profits. 11 See, for instance, H. W. Spiegel (1942, pp. 112 and 123) and F. Machlup (1943). 12 See Robertson (1926) and Pigou (1929, pp. 146 and 153). 13 Indeed, it is not clear if in his 1941–43 writings, Friedman considered those real effects of price inflation as being only temporary in character. He viewed them, however, as necessary for stabilizing the level (or the rate of change) of prices, if resources are fully utilized. 14 Simons’s idea (1938, p. 23) that ‘saving may be a real affliction during a depression’ since it may ‘aggravate hoarding and thereby aggravate maladjustments between the flexible and sticky prices’ may have influenced Friedman in this regard. The effect of consumption on investment was, on the other hand, usually recognised at the time and at the Division of Tax Research. Thus Blough (1944, p. 6) wrote that ‘since a businessman is a practical and prudent person he must have the assurance of a consumer market to induce him to invest and expand; accordingly the road to high employment is a high level of consumer purchasing power, for consumption gives employment directly and also creates investment, thus giving employment indirectly …’. 15 Thus, in his statement on the Revenue Revision of 1941, I. Fisher 1941, p. 1976, my emphasis) noted that ‘there are those who doubt the possibility of controlling inflation by controlling the volumes of money because, they say, you would have to control the velocity of money too’. But ‘these people are badly misled. Velocity in its important sense is one of the most nearly invariable magnitudes known in statistics …. The really significant velocity is not “transaction velocity” including, as it does, speculative transactions where the same property, stocks or real estate is bought and sold over and over again, but “income velocity” which is centred on the spending of income and ultimate consumption, after the steady normal progress of commodities from farm and mine through successive manufacturing and marketing processes …’. However, note that in his explanation of the Great Depression, Fisher (1933) himself had maintained that over-indebtedness arising during the ascending phase of the cycle can lead to liquidation triggering distress selling, a fall in prices, a slowing down of the circular velocity of money and so on (see also Laidler, 1991, pp. 300–301). 16 On the origins of Friedman’s monetary analysis, see Patinkin (1969), Weintraub (1971) and Tavlas (1998, 2016). 17 It is worth noting that in his subsequent works Friedman, while never telling us what money is (cf. Tobin, 1965, p. 465), admitted that changes in its quantity can be determined by changes in the money income during the cycle (cf. Friedman, 1969, p. 269). However, he denied it could happen in the long run, as was argued for instance by Kaldor (1982) on the basis of the results of the Radcliffe Report. 18 As pointed out on page 4, Friedman does not specify at this time whether he considers as a normal state of affairs the existence of room for changes in the amounts of bank deposits in response to changes in the level of activity—something which would point us to an endogenous determination of the quantity of money. Nor is it clear why, even if the quantity of money remained the same, the rise in prices would lead to a fall in production, since, as we have seen, at the time Friedman seemed to link the amount of investments to changes in real income and did not emphasize any Pigou effect on consumption. 19 Friedman’s aim was probably to deny the possibility of averting inflation only by rationing, direct price controls or indirect taxes. 20 When considering unit constant costs in the case of unused productive capacity and thus a constant real wage when employment varies, this assumption is of course strengthened. 21 In other words, Keynes adopted a two-stage argument in approaching economic phenomena. Taking as given the state of the long-term expectations, techniques, available productive capacity, social structure and main forces determining distribution other than those acting through the changes in the level of output, Keynes first determined ‘in isolation’ the level of employment by assuming as given the marginal propensity to consume, the marginal efficiency of capital and the rate of interest. He then went on to consider the possible reciprocal influences of the envisaged variations in those independent variables as well as the effects of a change in income level on those variables, together with the influences of all the other changes in the social and economic situation possibly occurring in the meantime. According to Keynes, such a procedure is the only one possible in any serious investigation of the economic phenomena and is to be preferred to seeking refuge in useless and empty mathematical expressions (cf. e.g. Keynes, [1936] 1971–89, vol. 7, 297–98; see also Schumpeter, 1954, p. 473). 22 Even if not analysed here because not directly relevant to the theme of this paper, a part of Friedman’s activity in the years 1941–43 was also aimed at contributing to reforming tax collection, which shifted to a pay-as-you-go system. In this regard, the discussion of alternatives was very technical and centred on Ruml’s proposal (favoured by the New York financial community) of forgiving a full year’s tax as part of the transition to the new system. Friedman was one of the architects of the Treasury’s proposal which aimed to achieve a strongly greater collection of revenue and control of consumer purchasing power. Like other American Treasury advisers, he especially insisted on a matter of equity against Ruml’s tax forgiveness. While Ruml’s idea of equity was that of giving ‘equal treatment to all taxpayers under a change in method of assessing taxes’ (Ruml, 1942, p. 87), Friedman, Paul and others at the Treasury outlined that higher taxpayers ‘have capital, and they are in a position to meet the extraordinary demands on the new revenue act’ (Paul, 1942, p. 60), whereas ‘the cancellation of the 1941 liabilities would constitute a windfall gain to persons whose income were abnormally high in 1941’ thanks to ‘the war effort’ (Friedman, 1942B, p. 62; see also Paul, 1943). The final bill (the Current Tax Payment Act) was signed by Roosevelt on 9 June 1943 and included a substantial tax forgiveness but one that was lower than Ruml had sought. 23 See the Memorandum on ‘Taxation for Defense’, presented by Harris (1941) to the Ways and Means Committee. 24 See, for instance, WSJ, 2 September 1942 and WP, 6 September 1942. 25 Against the spending tax, see also Haensel (1943, p. 219). Although the tax was undoubtedly more complicated than the income tax, the difficulties associated with the proposal were not insuperable (cf. Poole, 1943; Harris, 1943), although the issues of determining the minimum subsistence to be exempted and how to treat housing spending still remained unsolved. 26 Friedman admitted that the change in the composition of production after the war might generate unemployment but maintained that, with no need for public intervention, it is the savings accumulated during the war that ‘can then provide the means for the repayment by bringing about the employment of resources that would otherwise be idle’ (Friedman, 1943A, p. 57). Note also that according to Friedman (1943A, p. 62), in peacetime a spending tax ‘does not seem satisfactory’. He thus disagreed with Fisher in this respect, who saw conversely any tax on savings as discouraging them and as merely a pre-tax on their yield. On the debate on the spending tax and taxable capacity, see Kaldor (1955). Of course, the spending tax stimulates savings and can be dangerous if the economy ever suffers over-saving in relation to investment opportunities. 27 As C. Friedman, Harcourt et al. (2016, p. 608) observe, Friedman went to Chicago with an ideological blueprint in defence of free market. As shown in Section 5, this was already apparent in his 1943 tax proposals and will be systemized in Friedman (1962). 28 The remark is included in an Extension of W. H. Judd at the House of Representatives, 16 April 1946. Lothian and Tavlas (2016) also mention a 1946 University Chicago Round Table radio discussion on ‘What Can be Done Against Inflation’ in which Friedman took a stance against price controls and the Federal Reserve’s policy of pegging interest rates on government securities. 29 In this respect, see also Modigliani (1944) and ‘A Symposium on Fiscal and Monetary Policy’ by Mints, Hansen, Ellis, Lerner and Kalecki in the Review of Economic Statistics, May 1946. See also in the same review Haberler’s (1946) assessment of Keynes’s General Theory. Hansen (1941, p. 324 and 1946) argued against such views of Mints and Haberler by observing that ‘(j)ust as cyclical price flexibility may intensify the cyclical problem because of the effect of such price changes upon business expectations, so sharp wage reductions are likely to be deflationary’. 30 See, for instance, Simons (1934, 1936). 31 In particular, Friedman resumed 1930s Chicago School proposals against the fractional reserve financial system and in favour of automatic public deficits financed by money when the level of employment falls. Their analytical framework was the quantity theory of money, and their aim was to stabilise the velocity of money circulation and avoid the fall in bank deposits and prices during the crisis. 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Did Monetary Forces Cause the Great Depression? , New York , W. W. Norton Tobin , J . 1965 . The monetary interpretation of history—a review article , American Economic Review , vol. 55 , no. 3 , 464 – 85 Tobin , J . 1970 . Money and income: post hoc ergo propter hoc ?, Quarterly Journal of Economics , vol. 84 , no. 2 , 301 – 17 Google Scholar CrossRef Search ADS Trezzini , A . 2017 . Piero Sraffa’s use of the history of economic thought in the Cambridge lectures , Italian Economic Journal , online October 2017 Wallis , W. A . 1942 . How to ration consumer’ goods and control their prices , American Economic Review , vol. 32 , no. 3 , 501 – 12 Weintraub , S . 1971 . Keynes and the Monetarists , Canadian Journal of Economics , vol. 4 , no. 1 , 37 – 49 Google Scholar CrossRef Search ADS © The Author(s) 2018. Published by Oxford University Press on behalf of the Cambridge Political Economy Society. All rights reserved. This article is published and distributed under the terms of the Oxford University Press, Standard Journals Publication Model (https://academic.oup.com/journals/pages/open_access/funder_policies/chorus/standard_publication_model) http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Cambridge Journal of Economics Oxford University Press

An initial ‘Keynesian illness’? Friedman on taxation and the inflationary gap

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Abstract

Abstract This paper examines Friedman’s writings in the years 1941–43 and compares them with those after the war with a view to assessing differences and similarities. Albeit a first assessment, Friedman’s claim that he was suffering from a ‘Keynesian illness’ in his ‘Washington phase’ appears to have been less ‘serious’ and deep than he himself feared, although he was to some extent influenced by the ‘prevailing Keynesian temper of the time’. 1. Introduction Friedman pointed out1 that his contributions in the years 1941–43 to the revision of the tax system prepared by the Division of Tax Research of the US Treasury Department had a distinct ‘Keynesian flavour’. As he wrote after rereading one of his statements made in 1942 before the US Congress, ‘I had completely forgotten how thoroughly Keynesian I then was. I was apparently cured, or some would say corrupted, shortly after the end of the war’ (cf. Friedman and Friedman, 1998, p. 113). Only scant literature and debate exists on Friedman’s initial alleged ‘Keynesian illness’, although it shows a first step in his views on price inflation before his restatement of the quantity theory of money. This work intends to be a first attempt to bridge this void by reconstructing Friedman’s activity in the period 1941–43,2 as well as the general cultural climate at the time. Section 2 is devoted to analysing Friedman’s works on the ‘inflationary gap’, whereas Sections 3 and 4 assess their alleged ‘Keynesian flavour’. I then go on in Section 5 to analyse Friedman’s writings on the spending tax, which are also central to evaluating his activity in his Washington phase. Finally, in Section 6, the content of Friedman’s writings in the years 1941–43 is compared with that after the war with a view to assessing differences and similarities. Albeit a first assessment, his initial ‘Keynesian illness’ appears to have been less ‘serious’ and deep than Friedman himself feared. Before I begin, a clarification regarding the meaning ascribed here to the terms ‘Keynesian theory’ or ‘Keynesian policies’ is required. In order to evaluate Friedman’s claim that his own work had an initial ‘Keynesian flavour’ and obtain a sharper comparison with his subsequent monetarist approach, we will consider as Keynesian ‘elements of the new message’ of Keynes that were neglected ‘by the IS-LM model’ (Laidler, 1999, p. 4) but not by the Cambridge economists nearest to Keynes, and Lerner and Hansen in the USA. In particular, in addition to the intrinsic monetary nature of the market economies, two features which Friedman himself eventually deemed as properly Keynesian3 will be considered. The first is the possibility of a persistent under-utilization of resources arising from a lack of effective demand, with the related point that an increase in the money-wage ratio will not necessarily lead to a rise in aggregate demand. Second, on a methodological plane, I will consider as Keynesian a non-simultaneous determination of equilibrium in the money market on the one hand, and in the commodity market on the other, namely a ‘linear’ causal chain running from the former to the latter market which, contrary to Hicks’s and Modigliani’s interpretation of The General Theory, Keynes himself seems to have followed as a first step in his analysis (see, e.g., Keynes, [1936] 1971–89, chapters 14, 18, 21; Keynes, 1937, p. 251; Pasinetti, 1974; see also below, p. 9). 2. The debate on the inflationary gap In the period 1941–43, the American economy was moving fast towards a condition of full employment of resources due to the huge increase in war expenditure (cf. Crum et al., 1942; Fellner, 1942; Rees, 1959). The short-term danger therefore became inflation rather than a shortfall in effective demand, also because shortages in basic commodities were rapidly increasing. As Eccles (1941A, p. 1284) already stressed in 1941, when the utilization of productive capacity was nevertheless still at 70%, ‘(t)oday our problem is to curb consumer demand and purchasing power so that they will not divert too much of our productive capacity to the manufacture of nonessentials …’. How to cut private demand and avoid price inflation therefore became at the heart of economic debates, with a broad consensus, however, that in conditions of full employment an excess of the nominal aggregate demand on aggregate supply could be ‘closed’ by means of taxation, direct price controls4 and the rationing of consumer goods (see, e.g., Eccles, 1941B; Koopmans, 1942, p. 53; Henderson, 1941; Morgenthau, 1941; Smithies, 1942). Friedman himself, in his statement made to the Ways and Means Committee of the House of Representatives in May 1942, while pointing out that ‘(t)he pressure to spend would be great enough … to break through any price control and rationing plan that could be devised without using a policing force so large as to constitute a serious drain on man power for industry and the armed forces’ (Friedman, 1942A, pp. 1–2), maintained that (t)axation is not, however, the only method being employed to combat inflation. Price control and rationing, control of consumers’ credit, reduction in governmental spending, and war bond campaigns are the most important other methods that are now being employed. But just as it does not seem feasible to prevent inflation by taxation alone, so these other methods cannot be relied upon in the absence of additional taxes. (Friedman, 1942A, p. 2) The issues on which there was no consensus were, on the other hand, those on the effects of price inflation, the relative efficacy of the above-mentioned various possible measures to prevent it, and in this respect, the amount of taxes needed to close the ‘inflationary gap’, namely the difference between the expected expenditures and the value of goods expected to be available. In particular, the estimates of the amount of taxes needed to prevent inflation differed markedly. For instance, those advanced in October 1941 by Friedman, Mack and Shoup in a preliminary mimeographed report entitled ‘Amount of Taxes needed in June 1942 to Avert Inflation’ were greater than those advanced by OPA economists who forecasted no serious inflation problem until the fiscal year 1944.5 Friedman’s writings on these matters are crucial in evaluating his view on price inflation and income determination during his ‘Washington phase’. Friedman here clearly distinguished between a cost-pull and demand-pull type of inflation. With respect to the former, he noted that you can move along an increasing aggregate supply curve or you can have a shift in that curve. Thus Friedman (1943B, pp. 4–5, my emphasis) wrote6 that ‘(a)lthough time rates of wages remain unaltered’ there may be ‘a rise in labor cost per unit, and possibly in other unit costs also’. Otherwise costs can rise ‘because the agents of production arbitrarily raise the price of their services by concerted action’. In both cases: taxation is no cure …. Whether the result were an increased money flow supported by an expansible credit system, or a decreased volume of production, or both, would depend in part on the tax policy that was adopted; but the rise in prices would be present in any case, in the absence of subsidies combined with rationing. Friedman contrasted this case of cost inflation with that of a price rise ‘touched off by something other than a rise in money costs’. The latter arises when: (c)onsumers, for whatever reason, increase their spending, or the supply of goods and services available declines, or there is a combination of both. As a result, dealers find that they can raise their selling prices without having goods pile up on their shelves. Indeed, according to Friedman (1943B, pp. 4–5, my emphasis), at the beginning of the war effort, an increase in aggregate demand would not necessarily lead to a rise in prices since there would probably be constant unit costs of production and ‘the absolute amount of consumer goods and services may increase as idle resources are utilized’. Nevertheless, ‘soon the scarcities become more general’ and there will be a stage in which ‘total output and total money income stabilize’. At this point, the rise in prices will become a necessity owing to ‘the decline in consumer goods as more production is devoted to war’. Such a rise will produce ‘windfall profits, at least in the first instance’, and in this respect ‘it differs from the price rise caused by increased difficulty of production’. Friedman refers to the former kind of inflation arising from ‘money income’ expanding ‘more than in proportion to income-earning activity’ as ‘atomistic inflation’ or ‘deficit-induced inflation’, citing A. C. Pigou (1941, pp. 439 and 442) as his main reference. 3. An initial Keynesian flavour? If the missing reference to Keynes in these works of Friedman, unlike those of Koopmans, Hansen, Harris and other American economists of the time when analysing the causes and impact of price increases, may appear striking, the analysis sketched out above contrasts to a great extent with Friedman’s subsequent view on the determinants of the price level and its changes over time. For instance, as in Hansen (1941, p. 171), Friedman pointed out that no general statement can be made about the effects on prices of an increasing public debt. Moreover, in his writings in the period 1941–43, there is no reference to what Hansen (1944, p. 39) called ‘a hangover from a crude quantity theory of money’, that is, that an increase in the income stream due to a rise in the quantity of money and/or in its circular velocity automatically resolves in a rise in the general price level with no effect on relative prices and the real income.7 Furthermore, unlike in his writings related to the restatement of the quantity theory of money (see e.g. Friedman, 1969, p. 172), Friedman did not now seem to consider the trade unions as affecting the general level of prices only in very short periods, while having no direct role (when not influencing money supply) in explaining its ample fluctuations or its long-run movements. Even if trade union action was to lead to ‘a decreased volume of production’ and therefore to labour unemployment, there is in fact still no reference in Friedman’s 1941–43 works to a forthcoming fall in money wages due to the pressure of competition in the labour market. Conversely, in the above quotations from Friedman (1943B), he even referred to the possibility of ‘an expansible credit system’, and thus, at least to some extent, to an endogenous money supply.8 In the next section, I will outline some elements that already distinguished Friedman’s position from a Keynesian one in the period 1941–43. However, a Keynesian flavour in his early writings on price inflation undoubtedly appears also when analysing what he called ‘atomistic’ or ‘deficit-induced’ inflation. On the one hand, Friedman, as mentioned above, not only maintained that such inflation cannot arise if there are ‘idle resources’, but he seemed also to suggest that labour unemployment (other than frictional) can be, in actual fact, a normal phenomenon (see again Friedman, 1943B, pp. 4–5). On the other hand, when considering a situation of full employment, as in wartime, he pointed out that if there is inconsistency at an initial price level between expenditure and the value of goods available for sale, it could be resolved by an increase in prices that raises ‘the ratio of saving to spending, or the ratio of tax revenue to spending, or both’ (Friedman, 1942D, p. 8; see also Friedman, 1942C, p. 316). He thus wrote: a price change does not involve merely a revaluation of goods and of incomes. Because of frictions and lags, price changes lead to a redistribution of incomes and to a change in spending-saving relationships. The initial increase in income from a rise in prices is likely to be concentrated in the hands of recipients of profits, a group that tends to receive fluctuating income and that is accordingly predisposed to save a disproportionately large part of any increase in income. Moreover, the receipt and spending of incomes are not simultaneous. All along the line, it takes time for recipients of higher incomes to readjust their spending patterns; it also takes time to make competitive readjustments of resource prices. (Friedman, 1943B, p. 11, my emphasis; see also idem, 1942D, pp. 7–8)9 Such a change in income distribution as a way of closing the ‘inflationary gap’ by raising the ratio of saving to spending is similar to what was put forward by Keynes in his works ‘Social Consequences of Changes in the Value of Money’ ([1923] 2010) and ‘How to Pay for the War’ ([1940A] 1971–89), in which Keynes,10 after considering the inability of voluntary savings to close the gap, advocated the need to obtain a ‘forced saving’ by means of a ‘deferred wage’ allocated in public bonds instead of by means of an inflationary process leading to an income redistribution that was unfavourable to the labourers (or at least to the less organized workers). On the other hand, at least temporarily, changes in distribution as a consequence of price inflation in conditions of full employment were usually admitted at the time on both empirical and theoretical grounds,11 and Friedman clearly shared such ideas. Like Hart (1942), Koopmans (1942) and Smithies (1942), Friedman thus saw the required fall in consumption in real terms as being achieved by wages lagging behind prices and leading to an increase in savings, as well as by the ‘illusion behaviour’ of income receivers who based their spending behaviour on the assumption that current prices and income remain stable. Moreover, Friedman also seemed to refer to the fact that ‘capital losses’ inflicted by inflation are taken into account when planning current expenditure. Two conclusions can therefore already be advanced at this stage. The first is that in the years 1941–43 the only ‘methods of avoiding inflation’ which Friedman mentioned ‘in addition to taxation’ were ‘price control and rationing’ (Friedman and Friedman, 1998, p. 112), whereas he did not even mention ‘money’ or ‘monetary policy’. Second, due perhaps to the influence of ‘How to Pay for the War’ or to that of Keynes’s Treatise on Money and the works on ‘forced savings’ of Hayek, Pigou and Robertson12 (all debated in Chicago in the 1930s), in his ‘Washington phase’ Friedman emphasized that price inflation would have real effects in the form of changes in relative prices and income distribution. Except for a case outlined below (see pp. 8–9), at no stage do we find any clear argument concerning money neutrality,13 nor any analysis of the determinants of the demand for money on which he will then found his restatement of the quantity theory of money (cf. Friedman, 1956). In this respect, the real effects arising from price inflation we detect in his 1941–43 writings should not be confused with those sometimes put forward by Friedman in terms of changes in the rate of inflation probably affecting capital accumulation by changing the desired real quantity of money and the allocation of wealth to the various activities. However, a difference from his subsequent works also appears when his calculations of the ‘inflationary gap’ and the amount of taxation needed to prevent inflation are analysed. When dealing with the inflationary gap, Friedman, like Keynes ([1941] 1971–89, vol. 22, pp. 291–92), stressed that at any given time there must be ‘momentary equilibrium’ between aggregate demand and supply since the income of the public must always ‘be equal to the sum of taxes plus consumption plus savings’. Furthermore, like Keynes, Friedman pointed out that the equilibrium to be maintained needed appropriate changes to be made in prices and in saving habits by placing obstacles in the way of consumption and so on. Thus he stressed that, while ‘(i)n retrospect, there can be no gap’, in prospect ‘there may well be a gap’ (Friedman, 1943C, p. 131). The ex ante inflationary gap could be closed with taxation rather than inflation and, according to Friedman, two methods were used to estimate the required amount of taxation. The first was that adopted by Angell (1941), who estimated the expansion in spending on the basis of the historical relation between changes in the stock of money and changes in income. The second method, adopted by Gilbert and Perlo (1942), referred to the historical relation between investment and the national income. In both cases, the estimates of the expansion of aggregate demand were then compared with the estimated possible increases in output in order to determine the probable degree of price change (Friedman, 1943C, pp. 114–15). In this respect, three elements characterized Friedman’s position, all attesting the influence of the ‘Keynesian temper of the times’. First, the estimate method he used is similar to the second one mentioned above. He compared the expected increase in the real output and in war expenditure in order to obtain the expected available civilian output. In order to obtain the consequent amount of decrease in the civilian aggregate demand needed to prevent inflation, he then subtracted the change in civilian demand that would occur if no new anti-inflationary measures were adopted from the (calculated) available civilian output. This latter change was estimated on the basis of the expected changes in the component parts of capital formation and in the propensity to consume assuming that disposable income and prices were the same as they were on the initial date. The second element worth noting is that in his estimates Friedman (like Hansen, Samuelson and others at the time) linked the expected changes in capital formation to the expected changes in consumer spending, whereas he did not mention any influence of the rate of interest on the amount of investments. Thus he wrote: capital formation probably has some tendency to decline if an increase in consumer spending slackens appreciably. Though this result is not to be counted on invariably, it seemed to deserve some consideration in the present analysis. (Friedman, 1943B, p. 42)14 Finally, and more importantly, Friedman refuted Angell’s method of estimating the expansion in spending on the basis of the relation between changes in the stock of money and changes in income when given the marginal circular velocity of money (i.e., the ratio between a change in national income from one year to the next and the associated change in the stock of money). On the one hand, Friedman rejected taking the government deficit as equivalent to an increase in the stock of money since it would mean assuming that the stock of money does not change for any other reason and stressed that ‘(a) change in the deficit as a result of taxes levied solely on high incomes’ may have a very different effect on spending ‘from an equal change in the deficit as a result of taxes levied on very low incomes’ (Friedman, 1943C, pp. 117–18). On the other hand, Friedman noted that Angell’s estimates were based on historical data which showed the actual changes in the stock of money, making no explicit allowance for the reactivation of formerly idle money as a way of financing the government deficit. This procedure ‘implicitly assumes a constant relation between the changes in the total-stock of money and the amount of reactivation of formerly idle money’ which, according to Friedman (1943C, pp. 117–18), was not supported by the data. In particular, the data did not support the conclusion that ‘the marginal circular velocity of money may be considered as fairly stable’. 4. Some elements of a traditional view on income and price determination Here Friedman was apparently rejecting a year-to-year explanation of income changes on the basis of a ‘rude’ quantity theory of money—an explanation which, though only in part, was supported by Fisher at the time,15 but not, for instance, by Simons, who had outlined that the circular velocity of money can change even abruptly during the cycle (Simons, 1936, pp. 5–6). However, Friedman (1943C, p. 119, my emphasis) also pointed out that the data used by Angell may be adequate for studying the average circular velocity of money or the relation between long-period changes in national income and the stock of money. Hence, on the whole, he already seems to share elements of the ‘Chicago tradition’ that afterwards were to characterize his monetary analysis where money will usually appear to be neutral in the long run, even if not in the short run (see e.g. Friedman, 1982, p. 60 and 1987, p. 250).16 Although there are no other traces in his ‘Washington period’ writings of the idea that the equilibrium of the money market can be reached by making changes in the price level given the real income and a stable desired quantity of money in real terms, the context of the above quotation reveals to us a causal chain which in the long run goes from changes in the nominal supply of money to changes in money income thanks to an (average) stable circular velocity of money.17 We thus begin to find a first element of a ‘traditional’ determination of income and prices which may help to explain Friedman’s ‘conversion’ from a Keynesian approach after the war. This is not, however, an isolated element and shows us that Friedman was still largely shaping his thinking in the period 1941–43. He thus maintained that a ‘monetary veil exists that obscures and at times conceals the physical realities of the economic system’ (Friedman, 1943A, p. 50, my emphasis), which clearly contrasted with Keynes’s emphasis on the intrinsic monetary nature of the economic relations in the market economies that led him to construct a ‘monetary theory of production’ (cf. Keynes, [1933] 1971–89, vol. 29, pp. 81–82). Moreover, when analysing the effects of cost-push inflation, as has already been seen (see pages 3–4), Friedman stated that it will lead to ‘a decreased volume of production’ unless ‘an increased money flow supported by an expansible credit system’ occurs. Quite mechanically, cost-push inflation could therefore easily be transformed into being temporary in character unless it is followed by an expansion in the quantity of money.18 Finally, when discussing the estimates by OPA economists of the inflationary gap, Friedman rightly observed that in a changing world their hypothesis ‘that ex ante saving next year is equal to ex post saving this year’ has ‘little basis in either theory or fact’. However, after simplifying the analysis by assuming an unchanged disposable income in calculating the inflationary gap, he further stated in response to Salant (1942) that the breakdown of the inflationary gap ‘among broad classes of output’ is impossible19 since ‘(t)he composition of the gap is determinate only at specified relative prices for different classes of goods’ and ‘it can be anything at all if relative prices are permitted to vary’ (Friedman, 1942C, p. 319, my emphasis). At least on theoretical grounds, if not in practice, Friedman thus stressed the existence of a strict relation between relative prices and outputs (namely, a strong, definite reaction of the latter to price changes), probably influenced by his previous works on the demand curves of commodities (see, e.g., Friedman, 1935), or by the works of Knight and Schultz, who had taught Friedman in the 1930s and kept the general equilibrium analysis alive in Chicago. In this way, he differs from a Keynesian approach since Keynes certainly never emphasized the effects of changes in relative prices on the composition of output. While in fact admitting in Chapter 20 of The General Theory that changes in the aggregate demand might lead to changes in relative prices and the composition of production, as a first necessary step in the analysis he considered output composition as given when determining real income.20 More precisely, in view of the uncertain effects of the changes in relative prices and the rate of interest on consumption and the propensity to save, Keynes made extensive reference to social and institutional factors (as well as to the different income levels earned by workers and the capitalist class) in determining the composition of output and the propensities to consume of the different groups of society (see, e.g., Keynes, [1936] 1971–89, vol. 7, Chapter 8). He also saw those factors as being relatively stable and given when determining the amount of employment on the basis of the income multiplier and autonomous demand.21 To sum up, Friedman’s analysis of the inflationary gap undoubtedly contained many Keynesian elements, but also traces of a traditional approach. Indeed, his observation (put forward when analysing ‘how the fraction of resources used to produce goods not available for current consumption adjusts to the fraction of income that individuals wish to save’) according to which ‘(n)o judgement is intended on the crucial issue separating the Keynesians and anti-Keynesians as to whether there is an automatic tendency for such an adjustment to be made at a level of full employment’ (Friedman, 1943A, note 2) also appears to move in that traditional direction if we simply consider the ‘prevailing Keynesian temper of the time’ (Friedman, 1953, p. 253). 5. The spending tax proposal Although in a different domain, a break with a Keynesian approach emerges even when we examine Friedman’s proposal of the spending tax as a measure of avoiding inflation.22 In ‘How to Pay for the War’, Keynes proposed a plan of compulsory savings to avoid inflation since the entire cost of the war could not be covered by taxation. According to him, ‘(b)y such a plan … the wage and salary earner can consume as much as before and in addition have money over in the bank for his future benefit and security, which would belong otherwise to the capitalist class’ (Keynes, [1940A] 1971–89, vol. 9, p. 375). More precisely, the plan would have avoided the ‘machinery of war finance’ operating ‘by the rise in price diverting real purchasing power away from the consumer to the profit-earning class, who in turn will transfer a large part of these profits to the Treasury’, which would have meant that at the end of the war it is the profit-earning class which owns, in the shape of holdings in the national war debt, a claim on future production; while the wage-earning class, in spite of the extra-work done, owns nothing, having lost the right to consume now and having gained no rights to consume hereafter. (Keynes, [1941] 1971–89, vol. 22, p. 145) The plan was debated in the USA, and an appeal for its adoption appeared in 194123 arguing that combining compulsory lending with taxation was the method of war finance ‘best suited to satisfy the requirements of equity’ (cf. Fellner, 1942, p. 11). The plan was on the other hand opposed by those who feared that compulsion would kill the ‘voluntary spirit’ and to some extent by the trade unions which were suspicious of the simultaneous request to stabilize wages. During the summer of 1942, however, the US Treasury developed a different proposal for a spending tax as a supplement to the income tax and presented it to the Senate Finance Committee in September 1942. Whereas Keynes had considered such a tax as theoretically sound but impossible in practice, perhaps heeding Pigou’s warning of the likelihood that the upper classes and savers would thus escape taxation to a great extent (cf. Kaldor, 1955, p. 12), the direct reference for the Treasury’s proposal was Fisher’s (1942) works on a progressive spending tax. Indeed, the Treasury’s proposal combined Keynes’s plan and the spending tax, using spending as the basis for extracting funds from the public and treating some of the funds raised as compulsory savings instead of taxes. The proposal was thus received as a plan for enforced savings24 and opposed by the Finance Committee and the financial community (see NYT, 1, 4, 5, 6, 7, and 8 September 1942).25 Also, due to the fact that it was presented so late in the tax hearings that the plan would either be quickly discarded or prolong tax bill deliberations further, five days after its presentation, the Finance Committee rejected the plan by 12 votes to none (some members abstaining) and it was never heard of again. Friedman supported and in part elaborated the Treasury’s proposal, though refusing to treat part of the taxes raised as compulsory savings, unlike White’s prevailing position (see Friedman and Friedman, 1998, pp. 117–18). As in Keynes’s plan, the background to Friedman’s proposal was the disruptive effects of inflation which he deemed were in conflict with the utilization of the product for war purposes, fair income distribution and post-war stability. But Friedman thought that neither rationing nor compulsory savings could be effective in this regard. In the former case it would not be possible, according to Friedman, to get individuals to consume scarce goods in specified amounts and proportions (cf. also Wallis, 1942). In the latter case, the problem would be that compulsory lending might be satisfied with previous savings without decreasing the consumption of those who live on capital (Friedman, 1943A, p. 60). Furthermore, Friedman pointed out that it would be ‘impossible in principle’ to enforce compulsory savings ‘since income and expenditures are never definitely known until after the end of a period’ (Friedman, 1943A, p. 52). As in Fisher’s analysis of taxable capacity, when supporting his alternative proposal of a spending tax, Friedman first of all divided the individual income into two shares, a subsistence share and a surplus share. Thus he wrote (Friedman, 1943A, p. 58): As a resource, much of what (an individual) consumes is an intermediate product, a cost of production, like the food to livestock. As a consumer, what he consumes is a final product, designated to satisfy the wants of the prime mover of the production process. In ordinary times, the consumer aspect of the individual is dominant. He is an end, not a means …. In wartime, values change …. The individual becomes a means, not an end. Tax therefore has to be progressive to avoid workers receiving ‘less than they need for health and efficiency’ (Friedman, 1943A, p. 58). However, the marginal tax rate could in this case be so great that it impaired efficiency and: in order to achieve a more efficient distribution of the available consumer goods and at the same time maintain the incentive value of income as much as possible, fiscal methods involving the withdrawal of income must be supplemented by savings-inducement methods, that is, by methods that impinge directly on spending, rather than on income. (Friedman, 1943A, p. 61) The aim of this kind of taxation was in fact for Friedman to reduce ‘types of spending that are least necessary for the maintenance of output in general and war output in particular’. In the case of spending on commodities that use resources specially adapted to war production, special excises could to some extent be the appropriate remedy. For the rest, ‘the maintenance of output calls for restraining all spending in excess of a basic minimum’ (Friedman, 1943A, p. 61) and the result can be achieved by ‘a progressive spending tax that exempts a basic minimum and imposes a higher rate of tax the larger the excess of spending over the basic minimum’. But what is to be stressed is that Friedman’s arguments in favour of the spending tax and against compulsory savings remained not only with the belief that it was more effective, but with the need to minimize any intervention that imposes a limit on individual choices and market mechanisms. In both wartime and in peace, taxation should in fact, according to Friedman, modify the control over current output granted by income without however seriously impairing the ‘function of income in organizing the use of resources’. Moreover, in wartime, the amount of income above the basic minimum can still be permitted ‘to serve as a claim to future output’, while ‘even the separation of income from control over current output need not be complete’ (Friedman, 1943A, p. 56). Friedman thus viewed the spending tax as the best measure for stimulating savings and preserving them on a voluntary basis, as well as for ‘minimizing the role of government intervention into the details of the economic system’ in the transition from war to peace (Friedman, 1943A, p. 62, my emphasis).26 Therefore, unlike Keynes’s compulsory saving plan, Friedman did not try to avoid the claim on resources after the war being concentrated in the hands of the capitalist class alone. On the contrary, while curbing purchasing power, Friedman wanted to preserve savings as an individual effort to ameliorate one’s future condition when income exceeds a certain minimum level. The emphasis is thus placed on an individual choice between present and future consumption, which seems to clash with Keynes’s view of different social classes that are structurally characterized by different propensities to consume and thereby affected by the war in such a way that the wage-earning class ‘in spite of the extra-work done’ will run the risk, in the absence of any intervention, of owning ‘nothing, having lost the right to consume now and having gained no rights to consume hereafter’ (Keynes, [1941] 1971–89, vol. 22, p. 145). 6. Some final remarks To sum up, in the years 1941–43, Friedman appears to have to some extent already differentiated himself from the ‘Keynesian prevailing temper of the times’ which was testified by the works of Hansen, Harris and Lerner, as well as Roosevelt’s economic policies and the practice of economists such as Eccles, Galbraith, Henderson, Nathan and Salant. This differentiation emerged more clearly after the war, particularly when Friedman returned to Chicago in 1946.27 However, back in 1944, when reviewing Altman’s book, Friedman spoke in quite worried tones of a ‘Keynesian saving-investment theory’ which ‘has had such vogue in recent years’ (Friedman, 1944, p. 101). More importantly, in 1946 in his remark that ‘OPA alone cannot prevent inflation’ Friedman observed that ‘(a) major effect of OPA price control has been to disguise rather than prevent increases in price’ and: We can and must take measures now to control the basic causes of inflation by limiting the supply of cash and bank deposits. (Friedman, 1946, p. A2209)28 Friedman consequently advocated minimizing public expenditure and raising taxation as well as increasing the bank’s reserve requirements and the rate of interest. He put forward the same policy proposals as Mints (1946) and Haberler (1946), who had begun to focus on the importance of monetary versus fiscal policies and on the crucial role of wage rigidity in explaining labour unemployment.29 While Friedman’s monetarist ‘counter-revolution’ took on a definitive shape only some years later (see Friedman, 1956), just after the war his scanty Keynesian background and changed economic conditions thus led him to develop those aspects which were present in Mints and Simons30 against obstacles to market mechanisms and active fiscal and monetary policies. Friedman therefore outlined early on that: (e)conomists now tend to concentrate on cyclical movements, to act and talk as if any improvement, however slight, in control of the cycle justified any sacrifice, however large, in the long-run efficiency, or prospect of growth, of the economic system and he wanted to guarantee ‘both sets of objectives simultaneously’ (Friedman, 1948, p. 245) by reforming the monetary system in order to eliminate the private creation of money and discretionary controls over the quantity of money by the central bank authority. Moreover, he advocated automatic stabilizing mechanisms during the cycle by means of a progressive tax system and a fiscal policy determining the volume of government expenditures entirely on the basis of the community’s desire, need and willingness to pay for public services (cf. Levrero, 1999).31 At the beginning, the ‘conversion’ vis-à-vis a Keynesian approach mainly took the form of an insistence on rigidities in prices as a cause of unemployment (see also Patinkin, 1948) and on the time lag in the response by active policies to cyclical movements as a reason for abandoning those policies (see e.g. Friedman, 1947, pp. 413–14). As immediately stressed by Neff (1949), it assumed the idea of an automatic and rapid tendency of the market economies towards conditions of full employment, since otherwise, even in a flexible price world, at least a discretionary counter-cyclical policy would appear necessary. 32 It was, on the other hand, the firm belief in the absence of any automatic tendency towards full employment that led Keynes, against any laissez-faire ideas, to advocate using active policies to maintain a state of quasi-expansion and adopting measures that increase the propensity to consume and socialize a share of investment. In short, if influence of the ‘Keynesian temper of the time’ can be found in Friedman’s works in the years 1941–43,33 it is in the 1944–48 period that Friedman began to advance arguments in favour of policy rules against discretionary policies, and to refer explicitly to the quantity theory of money in determining the price level. However, it is only in the years 1948–58, after the start and first results of his work with A. Schwartz on the monetary history of the USA (cf. Friedman and Schwartz, 1963), that Friedman definitively clarified his analytical framework and laid the foundations of his ‘anti-Keynesian revolution’ (cf. also Harris and Tavlas, 2016). On the one hand, the belief that the observed correlation between changes in money supply and changes in prices would suggest a causal relation ranging from the former to the latter, as well as the belief that the 1929 crisis stemmed from Fed’s errors in shaping the monetary policy, led Friedman to his restatement of the quantity theory of money (cf. Friedman, 1952, 1956) and the proposal of a passive monetary rule in the form of an announcement of a constant increase in the money supply (cf. Friedman, 1958). On the other, Friedman advocated a greater efficacy of the monetary against the fiscal policy on the basis of his studies on the consumption function (cf. Friedman, 1957) and the belief in a high stable relation between income and the demand for money—the former lowering the Keynesian multiplier, and the latter increasing the value of the monetary multiplier. It is not the aim of this work to discuss these aspects of Friedman’s thought (see in this respect, Ando and Modigliani, 1965; Kaldor, 1982; Levrero, 1999; Temin, 1976; Tobin, 1970). It shows, however, that ‘(t)he man and the moment are always intimately linked’ (Palley, 2016, p. 648). The cultural climate after the Second World War which was characterised by a reaction against New Deal Keynesianism and the campaign in favour of the free market influenced the evolution of Friedman’s thought while at the same time finding in his works one of the main representative of neoliberal ideas. It took time, however, before Friedman’s thinking became a point of reference for macroeconomic theory and economic policy proposals. To use a category advanced by Sraffa when reconstructing the history of economic thought (cf. Trezzini, 2017), other ‘disturbing elements’ related to opposite social interests had to intervene from the mid-1970s to determine this result. Footnotes 1 See M. Friedman and R. Friedman (1998) [hereafter Friedman and Friedman, 1998]. As Friedman and Friedman (1998, p. 113) told us, in those years Friedman wrote numerous memoranda, reports and letters that have been ‘buried somewhere in the files of the Treasury Department’. My research at the US National Archives did not unearth them, though it gave me access to materials that I have used in this work. I have also used materials conserved in the Friedman Archives in the Hoover Institution, as well as publications of the US Congress and articles published at the time in the Wall Street Journal, New York Times and Washington Post (hereafter, WSJ, NYT and WP, respectively). 2 In the years prior to his ‘Washington phase’, Friedman’s activity concentrated mainly on various aspects of demand curves, econometric fields and the American income and consumption structure rather than on the relation between money, prices and income. 3 Friedman (1969, p. 97 and 1987, p. 256) maintains that the main proposition (or ‘error’) of Keynes is the idea that stable unemployment equilibria do not arise from wage rigidity, which is instead considered a ‘rational answer’ to those equilibria (see also Laidler, 1999, p. 265). In the meantime, however, Friedman interpreted Keynes’s work as a half-revolution which took place within the framework of the quantity theory of money by only emphasizing that during the cyclical phase of depression, the liquidity preference might become infinite and/or investments might be inelastic to the rate of interest. According to Friedman (1987, p. 257), Keynes viewed this situation as a limiting case whereas his disciples (including Hansen and Lerner) viewed it as normal. 4 They were organised by the Office of Price Administration (OPA), which was created in spring 1941 and had the authority to fix maximum prices. OPA action had some success in controlling prices, which rose less than in other countries (see H. Rockoff, 1985 and Early and Stein, 1942). However, the OPA’s activity was characterized by great contrasts, as in the cases of the Chrysler Corporation and Aircraft builders’ opposition to price ceilings (see for example WSJ, 27 June 1941 and 8 July 1942). Moreover, as in the case of agricultural produce, there were many exceptions to price freezing which reduced the chances of its success, e.g. by fermenting requests for wage increases (see Fellner, 1942, p. 123). 5 The discrepancies in these estimates persisted afterwards but were opposite in sign. According to Friedman and Friedman (1998, p. 111), this happened because, while in the process of lobbying Congress for the price control act the OPA had argued that price controls were the only way to stop inflation, after February 1942, its interest changed and ‘(t)he Treasury … became an ally, not a competitor’, in controlling prices. However, even before 1942, Henderson and other OPA officials stressed the need for taxation to prevent inflation while Friedman (1943C, p. 136) himself stressed that ‘the question of exactly what constitutes an inflationary gap is extremely difficult to answer’. It is also worth noting that Keynes believed that Salant and other OPA economists had overestimated supply and underestimated demand. Thus he wrote to J. M. Clark on 26 July 1941: ‘I have tried to persuade Gilbert and Humphrey and Salant that they should be more cautious’ (Keynes, 1971–89, vol. 23, p. 192). 6 Note that the foreword of the book written by Friedman with Mack and Shoup (1943) states that ‘(t)he outlines of the approach that is taken in Part I were developed first by Milton Friedman’. 7 On this point, see also notes 17 and 18 below. 8 In this respect, Friedman did not seem to follow Pigou (1941, p. 440), according to whom inflation can only stem from an increase in the stock of money or a (previous) increase in the desired proportion of money income to the stock of money. Thus Pigou stated that, in wartime, it is only because money is continuously created that wage inflation does not kill itself by leading to labour unemployment, but produces a ‘vicious price spiral’. 9 Note that according to Friedman, if there is no change in the ratio of saving to spending, inflation will only close the gap temporarily. For instance, if there is no business saving, no taxes, no stocks of consumer goods and the government needs half a production value of $100, whereas consumers always want to spend 70% of their received income, then the ‘primary consumer expenditure gap’ will be $20 in the first period, $24 in the second period and so on, whereas money income will rise from $100 to $120, to $144, and so on. Hence, the price response to the ‘inflationary gap’ will change according to the circumstances depending on whether and when profits rise, labour is quick to obtain higher wages or consumers are quick to interpret rising prices as a forerunner of further price rises, and so on (cf. Friedman, 1942D, p. 9). 10 See also Keynes ([1941] 1971–89, vol. 22). With regard to the long run, as is known, the idea that an increase in the rate of investment will lead to an increase in the amounts of savings per unit of capital through a fall in the real wage is an essential aspect of the post-Keynesian theory of distribution. However, also in the long run, the needed increase in savings can be obtained by a change in the degree of capital utilisation without any need for a change in distribution. Moreover, an increase in the amount of productive capacity will materialize (cf. Garegnani, 1992). This does not exclude the fact that in special cases, such as the one considered here, there may ultimately be no room for increases in production, thus achieving a redistribution of income to profits. 11 See, for instance, H. W. Spiegel (1942, pp. 112 and 123) and F. Machlup (1943). 12 See Robertson (1926) and Pigou (1929, pp. 146 and 153). 13 Indeed, it is not clear if in his 1941–43 writings, Friedman considered those real effects of price inflation as being only temporary in character. He viewed them, however, as necessary for stabilizing the level (or the rate of change) of prices, if resources are fully utilized. 14 Simons’s idea (1938, p. 23) that ‘saving may be a real affliction during a depression’ since it may ‘aggravate hoarding and thereby aggravate maladjustments between the flexible and sticky prices’ may have influenced Friedman in this regard. The effect of consumption on investment was, on the other hand, usually recognised at the time and at the Division of Tax Research. Thus Blough (1944, p. 6) wrote that ‘since a businessman is a practical and prudent person he must have the assurance of a consumer market to induce him to invest and expand; accordingly the road to high employment is a high level of consumer purchasing power, for consumption gives employment directly and also creates investment, thus giving employment indirectly …’. 15 Thus, in his statement on the Revenue Revision of 1941, I. Fisher 1941, p. 1976, my emphasis) noted that ‘there are those who doubt the possibility of controlling inflation by controlling the volumes of money because, they say, you would have to control the velocity of money too’. But ‘these people are badly misled. Velocity in its important sense is one of the most nearly invariable magnitudes known in statistics …. The really significant velocity is not “transaction velocity” including, as it does, speculative transactions where the same property, stocks or real estate is bought and sold over and over again, but “income velocity” which is centred on the spending of income and ultimate consumption, after the steady normal progress of commodities from farm and mine through successive manufacturing and marketing processes …’. However, note that in his explanation of the Great Depression, Fisher (1933) himself had maintained that over-indebtedness arising during the ascending phase of the cycle can lead to liquidation triggering distress selling, a fall in prices, a slowing down of the circular velocity of money and so on (see also Laidler, 1991, pp. 300–301). 16 On the origins of Friedman’s monetary analysis, see Patinkin (1969), Weintraub (1971) and Tavlas (1998, 2016). 17 It is worth noting that in his subsequent works Friedman, while never telling us what money is (cf. Tobin, 1965, p. 465), admitted that changes in its quantity can be determined by changes in the money income during the cycle (cf. Friedman, 1969, p. 269). However, he denied it could happen in the long run, as was argued for instance by Kaldor (1982) on the basis of the results of the Radcliffe Report. 18 As pointed out on page 4, Friedman does not specify at this time whether he considers as a normal state of affairs the existence of room for changes in the amounts of bank deposits in response to changes in the level of activity—something which would point us to an endogenous determination of the quantity of money. Nor is it clear why, even if the quantity of money remained the same, the rise in prices would lead to a fall in production, since, as we have seen, at the time Friedman seemed to link the amount of investments to changes in real income and did not emphasize any Pigou effect on consumption. 19 Friedman’s aim was probably to deny the possibility of averting inflation only by rationing, direct price controls or indirect taxes. 20 When considering unit constant costs in the case of unused productive capacity and thus a constant real wage when employment varies, this assumption is of course strengthened. 21 In other words, Keynes adopted a two-stage argument in approaching economic phenomena. Taking as given the state of the long-term expectations, techniques, available productive capacity, social structure and main forces determining distribution other than those acting through the changes in the level of output, Keynes first determined ‘in isolation’ the level of employment by assuming as given the marginal propensity to consume, the marginal efficiency of capital and the rate of interest. He then went on to consider the possible reciprocal influences of the envisaged variations in those independent variables as well as the effects of a change in income level on those variables, together with the influences of all the other changes in the social and economic situation possibly occurring in the meantime. According to Keynes, such a procedure is the only one possible in any serious investigation of the economic phenomena and is to be preferred to seeking refuge in useless and empty mathematical expressions (cf. e.g. Keynes, [1936] 1971–89, vol. 7, 297–98; see also Schumpeter, 1954, p. 473). 22 Even if not analysed here because not directly relevant to the theme of this paper, a part of Friedman’s activity in the years 1941–43 was also aimed at contributing to reforming tax collection, which shifted to a pay-as-you-go system. In this regard, the discussion of alternatives was very technical and centred on Ruml’s proposal (favoured by the New York financial community) of forgiving a full year’s tax as part of the transition to the new system. Friedman was one of the architects of the Treasury’s proposal which aimed to achieve a strongly greater collection of revenue and control of consumer purchasing power. Like other American Treasury advisers, he especially insisted on a matter of equity against Ruml’s tax forgiveness. While Ruml’s idea of equity was that of giving ‘equal treatment to all taxpayers under a change in method of assessing taxes’ (Ruml, 1942, p. 87), Friedman, Paul and others at the Treasury outlined that higher taxpayers ‘have capital, and they are in a position to meet the extraordinary demands on the new revenue act’ (Paul, 1942, p. 60), whereas ‘the cancellation of the 1941 liabilities would constitute a windfall gain to persons whose income were abnormally high in 1941’ thanks to ‘the war effort’ (Friedman, 1942B, p. 62; see also Paul, 1943). The final bill (the Current Tax Payment Act) was signed by Roosevelt on 9 June 1943 and included a substantial tax forgiveness but one that was lower than Ruml had sought. 23 See the Memorandum on ‘Taxation for Defense’, presented by Harris (1941) to the Ways and Means Committee. 24 See, for instance, WSJ, 2 September 1942 and WP, 6 September 1942. 25 Against the spending tax, see also Haensel (1943, p. 219). Although the tax was undoubtedly more complicated than the income tax, the difficulties associated with the proposal were not insuperable (cf. Poole, 1943; Harris, 1943), although the issues of determining the minimum subsistence to be exempted and how to treat housing spending still remained unsolved. 26 Friedman admitted that the change in the composition of production after the war might generate unemployment but maintained that, with no need for public intervention, it is the savings accumulated during the war that ‘can then provide the means for the repayment by bringing about the employment of resources that would otherwise be idle’ (Friedman, 1943A, p. 57). Note also that according to Friedman (1943A, p. 62), in peacetime a spending tax ‘does not seem satisfactory’. He thus disagreed with Fisher in this respect, who saw conversely any tax on savings as discouraging them and as merely a pre-tax on their yield. On the debate on the spending tax and taxable capacity, see Kaldor (1955). Of course, the spending tax stimulates savings and can be dangerous if the economy ever suffers over-saving in relation to investment opportunities. 27 As C. Friedman, Harcourt et al. (2016, p. 608) observe, Friedman went to Chicago with an ideological blueprint in defence of free market. As shown in Section 5, this was already apparent in his 1943 tax proposals and will be systemized in Friedman (1962). 28 The remark is included in an Extension of W. H. Judd at the House of Representatives, 16 April 1946. Lothian and Tavlas (2016) also mention a 1946 University Chicago Round Table radio discussion on ‘What Can be Done Against Inflation’ in which Friedman took a stance against price controls and the Federal Reserve’s policy of pegging interest rates on government securities. 29 In this respect, see also Modigliani (1944) and ‘A Symposium on Fiscal and Monetary Policy’ by Mints, Hansen, Ellis, Lerner and Kalecki in the Review of Economic Statistics, May 1946. See also in the same review Haberler’s (1946) assessment of Keynes’s General Theory. Hansen (1941, p. 324 and 1946) argued against such views of Mints and Haberler by observing that ‘(j)ust as cyclical price flexibility may intensify the cyclical problem because of the effect of such price changes upon business expectations, so sharp wage reductions are likely to be deflationary’. 30 See, for instance, Simons (1934, 1936). 31 In particular, Friedman resumed 1930s Chicago School proposals against the fractional reserve financial system and in favour of automatic public deficits financed by money when the level of employment falls. Their analytical framework was the quantity theory of money, and their aim was to stabilise the velocity of money circulation and avoid the fall in bank deposits and prices during the crisis. 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This article is published and distributed under the terms of the Oxford University Press, Standard Journals Publication Model (https://academic.oup.com/journals/pages/open_access/funder_policies/chorus/standard_publication_model)

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Cambridge Journal of EconomicsOxford University Press

Published: Sep 1, 2018

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