 One of the big clues about the kind of economics Friedman does and the kind that Hayek does is based on the level of aggregation and in fact, I came across a pretty strong claim by Axel Landhoof and slightly paraphrase, but right now I can't think that's what the slight paraphrase was. So your aggregation scheme is your theory. Well, that's a little bit of an overstatement, but not much, okay? But not much. That if you have y equals c plus i plus g and you don't get don't give the attention to what's inside of the investment aggregate, then you're going to miss a lot. Or even more severe if you have mv equals pq, which is what we'll talk about a lot in Friedman. m is the money supply, v is the so-called velocity of money. It's the rate of turnover of money on final output and p is the price level and q is the output of the economy and that's a pretty severe equation. You have to figure out what all is in q and what about p and so on. What about relative changes in prices and so on? So anyhow, your level of aggregation constrains you to the kind of theory that you have, okay? So here's Keynes, Friedman and Hayek on aggregation. Let's look at Keynes first. Since theorizing at a high level of aggregation, John Maynard Keynes believed that market economies perform perversely, especially in the market mechanisms that bring saving and investment into balance with one another. Seeing unemployment and resource idleness as the norm, Keynes called for counter cyclical physical and monetary policies and ultimately for a comprehensive socialization of investment. And that quote in phrase at the end, comprehensive socialization of investment, comes in the final chapter of the general theory. And most Keynesians, who look at the general theory, don't pay any attention to that last to that phrase or to that last chapter. They just say, oh, Keynes was just flying his kite for that chapter. Here's Friedman. Milton Friedman's monetarism was based on a still higher level of aggregation. The equation of exchange of equal PQ made use of an all-inclusive output variable, Q. That's both consumption output and intermediate output as well. Okay? Putting into eclipse the issue of the allocation of resources between current consumption and investment for the future. Seeing no problems emerging from the market itself, Friedman focused on the relationship between government-controlled money supply and the overall price level. Now the reason I put that one phrase in green is to show you, is to tell you, that on micro economic issues, Friedman is very, very good. Okay? It doesn't quite dovetail with Austrians, but almost. Okay? So there's a lot you can get out of Friedman reading is micro economic stuff. The micro economics, I think, is a whole different issue and we'll see how that goes. Here's Hayek. Capital based macroeconomics is distinguished by its propitious disaggregation. It does arrive. It gets the disaggregation to a point where you can make sense out of what's going on during a business cycle. Which brings into view both the problem and the intertemporal resource allocation and the potential for market solution. Hayek showed that coordination of saving and investment decisions could be achieved by market-governed movements in the interest rate and that does work in that investment sector. He also recognized that the aspect of the market economy is especially vulnerable to the manipulation of interest rates by the central bank. So he had it down pretty good in that blurb. Contrasting methods and we have two methods. One's contrasting the other even though we have three economists. We'll see who has what here. So Keynes, Friedman and Hayek on method will start with Keynes. Keynes was the type of theorist. This comes from Malin Meltzer who developed his theory after he had had developed a sense of relative magnitudes and of the size and frequency of changes in those magnitudes. He concentrated on those magnitudes that changes the most often assuming that others remain fixed for the relevant period. That's the way he went at it. And I've suggested that a particular tool that he uses for his theorizing and I call it a variation sieve. There's the sieve. It'll have to be changed a little bit to make it work like Keynes needs to. He simply pours all of the C and I and G and everything else through the sieve and see which one hangs up in the sieve and which one goes through. Anything that has a lot of variation back and forth and stay in the sieve. Anything where there's not all that much variation goes through the sieve and becomes no part of his theorizing. He only theorizes about what's going on that's that's captured in the sieve. And it turns out as you probably have already guessed that one thing that goes through the sieve is the interest rate. Especially in booms and busts as we see them. What we tend to see is a lot of the booms and especially the one that occurred in the 1920s were partly, but only partly, they were partly genuine booms. There was all sorts of things going on. Automobile manufacturing, lots of chemicals of one sort or another making things better. Refrigeration, electricity and so on. Lots of things going on during the 30s. That caused lots of people to borrow funds in order to further these kinds of activities. So that was a genuine part of the boom. But to the extent that they were borrowing and doing a lot of borrowing, that would drive interest rates up, wouldn't it? Interest rates would go up. Of course it would supply and demand. More people are trying to borrow more stuff in order to take advantage of the technological breakthroughs that happened during the 1920s. Now it turns out that interest rates didn't go up or they didn't go up very much. And the reason they didn't is because the Federal Reserve was pumping in money to keep interest rates down. Now for Keynes or for anyone working in the U.S. and looking at this situation, if they were using the variations, they'd let the interest rate go down the drain. Go through the sale. So it's sort of a bad strategy to just look what's changing the most. Now here's Friedman. What's his view? Well he says, I believe that Keynes' theory is the right kind of theory and its simplicity, its concentration on a few key variables and its potential fruitfulness. So he's doing the same thing as Keynes. And when he says potential fruitfulness, what he's thinking about is that, oh, all of this data that we can get is just what we need with our econometric equations. That's the fruitfulness. So it's an econometrics approach to business cycles. And yet that approach is not going to work too well because what turns out to be the key thing in the interest rate and the way it's juggled by the Federal Reserve is one of the big problems, or is the big problem. But it went through the sieve. The implications, as Friedman pointed out, is that big effects have big causes. Well, that's not always true. I mean, sometimes it's true. If you think of volcanoes destroying cities or something like that, you have a big volcano and destroyed city, they're both pretty large. But a lot of times you have something that you really can't quite savvy until you figure it out about what's going on with interest rates. Here's Friedman. We're all Keynesians now. This is Friedman. And he says, we're all Keynesian now. We all use the Keynesian language and apparatus. Well, no, that's not right. The Austrians don't use it. So he's just thinking about the Keynesians and the monetaries. Now, here's Hayek. The role of the economist Hayek points out, this is in pure theory of Capital 41, is precisely to identify the features of the market process that are apt to be hidden from the untrained eye. He says that in pure theory of Capital. And what he means is precisely about that interest rate that doesn't seem to change. So Friedman and Keynes don't pay much attention to it. And Hayek does because he knows that it should have changed. It should have gone up when lots of people were trying to borrow lots of funds to take advantage of technological aspects of... Okay, so for Hayek then the cause and effect relationship between the central bank policy during the boom and the beginning of the economic downturn has the first order claim on our attention despite the more salient co-movements in macroeconomic magnitudes that characterize the subsequent spiraling of the economy into deep depression. In other words, there's a serious link here between what happened initially when there started to be a downturn and the downturn happened because there were too many resources being used and there weren't that much savings going on as we heard in the last lecture. And that's what caused the economy to crash. And when it started crashing, it kept crashing. There was all sorts of ill-conceived measures to keep it from crashing that actually made it crash even worse. So those two things are very much tied together, the initial downturn and then the deepening into very deep recession. And here's what Hayek said. This is in his pretense of knowledge lecture when he won the Nobel Prize in 1974. He says, there may well exist a better scientific evidence. And he has that in scare quotes. That is empirically demonstrated regularities among key macroeconomic magnitudes but what makes them key is a lot of ups and downs. So interest rate wasn't key because it didn't change much, which will be accepted because it is more scientific against in scare quotes than for a valid explanation which is rejected because there's no significant quantitative evidence for it. That was Hayek. How methods shape substance, we'll see. Identifying the cause is what we're looking at. Keynes attributed the downturn to psychological factors affecting the investment community rather than to monetary or fiscal disturbances. He's gone off of economics on to psychology, we've got psychological factors. I suggest a more typical and often prominent explanation of the crisis is the sudden collapse of the marginal efficiency of capital. Is that an explanation? You might note the sudden collapse and wonder why it happened but that's what Keynes came up with. Keynes' main focus, however, is on the dynamics of the subsequent downward spiral and on policies aimed at reversing the spiral's direction. In other words, it's just out of sight for him to think about what's going on with interest or anything else during the boom. It's only when the bottom falls out that he wants to take a look and see why that might have happened and psychological is what he came up with. Okay, here's Friedman. Friedman is dismissive of the whole issue of cause and the initial economic downturn referring to, and I've noticed this in the literature, returning to it as a usual ordinary routine normal run-of-the-mill garden variety recession. In other words, the initial downturn. It's just key to understanding what's going on. That initial downturn is something that Friedman just blows off. We're not concerned about that. Those things happen a lot. What we're concerned about is why it dived into deep depression. For Friedman, the correlation between the subsequent movements in the money supply and the movements in total output leaves no doubt as to the central issue. Period. Here's Hayek. Hayek focuses on the policy-infected aspects of the boom that is artificially low interest rates. When I say artificially low, I don't really mean that it really dropped. It just didn't go up. It would have gone up just on the basis of technological considerations, but it wasn't allowed to go up, so it was artificially low. The post-bust relocation of labor and capital takes time, but the actual dimensions of the recession, its length and depth, are to be explained largely in terms of policy perversities that hamper the recovery. Hayek certainly had that ride. For Friedman, the full analysis of the business cycle consists almost wholly of an empirical accounting of the depression's depth and length. For Hayek, the Austrian business cycle theory is fundamentally a theory of the unsustainable boom and the subsequent allocations of misallocated resources. It's accounting for the actual depth and length of the depression that ensues, requires an economic and historical account of each particular episode. So you see these two economists, Friedman and Hayek, are looking at different aspects of the boom bust. There's a paper by Eichmann and Michener that Friedman had some thoughts about, okay, Eichmann, Barry and Chris Michener, 2003. The Great Depression has a credit boom gone wrong. That's a working paper, number 137. So here's what Friedman says about it. Ike and Green's paper is excellent, clear, well-written, thoughtful, there is little in it that I can disagree with. At the same time, I share the views expressed by his discussants, Michael Bordeaux and Charles Goodhart, they're both monetarists, that it does not contribute much to the key issue in question. Again, there's a key issue in scare quotes. The issue is whether the depth and seriousness of the depression is attributable to what took place during the 20s or what took place during the 30s. So he just wants to say that deep depression that's all just 1930s stuff has nothing to do with what was going on in the 20s. It has a lot to do with what was going on in the 20s. And here the only item, and I underline the only, the only item that has any bearing on that is the correlation of his measures of the credit boom with the depth of the subsequent depression. Here he gets a positive correlation of 0.43 for the hype that measures the stock market boom. That's pretty low. The bulk of his evidence is that what happened in the 30s explains the 30s, not what happened in the 20s. Okay? Well, once again, it's not a matter of how far it went down and how big a dive it was related to the earlier boom. In fact, he doesn't relate it to the earlier boom. And that's the problem. Okay, just to drive the point home, I subject you to this, the case of the cabbage-eating Mississippi monster. And we'll see how that goes. Suppose that in late October of 1929, a thousand-pound monster descended on Mississippi soil. It spent the next three and a half years eating all the cabbages and quite a few rabbits between Tupelo and Pascagula. By early March of 1933, the monster weighed 4,000 pounds. Two investigators are sent to Mississippi to get a handle on the situation. One's from Vienna and one's from Chicago. There they are. And I actually Googled Mississippi Monster and that's what I got. I guess it'll work. The B&E's investigator asks, where in the world did this hideous thing come from? It turns out on further investigation that the monster was the unintended consequence of some ill-conceived government-sponsored bionic project. It seemed like he nailed it there. The Chicago one shows up, shoves the Austrian aside and says, never mind how this thing got there. The key question is, how did it grow from 1,000 pounds to 4,000 pounds? How did an ordinary, usual routine run-of-the-mill garden variety monster quadruple weight in 22 months? The Chicago's answer, of course, is it was all those cabbages. He couldn't get good data on the rabbits. The strong correlation between cabbage consumption and weight gain of the Mississippi monster leaves no doubt as to the central issue. Now, that pretty much overlays what I've said before with the business cycle. That's the whole point. So to respect that data availability is what led the Chicago one to its conclusion and that the lack of hard data pertaining to the monster's origin caused him to be dismissive of questions about where the thing had come from, of course. These unrelated suspicions are what underlie the message of Hayek's Nobel address on the pretense of knowledge. Now, something about this. I spent time in Menlo Park when the Institute for Humane Studies was there. In fact, it was the same time that Hayek spent it at that same institution, which was very helpful to me. I was working on my dissertation at the time. It was nice to have Hayek next door, you know. But I had heard from a number of people that Friedman, who I knew drove a Cadillac, I'd heard that. That is his license plate, mv equal pq. And so the Institute for Humane Studies was walking distance to Samford. You could sort of cut through a little bit and be on campus in no time. And so I took my camera over there. This was about one of the last days that I was at the institute. I was walking around in parking lots to see if I could find his car. I knew I was looking for a Cadillac and I knew what license plate I had to have. Well, it was a hot day and I just plain old couldn't find it. But I did find this Cadillac. It's a late 1970s model and it has California tags. And so I took a picture and then did a job on that license plate. I wanted to show it to my students and I showed it to the students at Auburn and eventually I fasted up and said, well, it wasn't really his, but that's the story. And it is the story. But then later, see what we got here. Well, okay, we're going to go with this and I'll come back a little later about the car, I think I'll have time. So with a near constant velocity of money and output Q growing slowly, movements in the price level P largely reflect movements of the money supply M. Well, yeah, that's Friedman right there. So if you have just a little bit of uptake on Q, V has a bar over it means it's not changing. And the money supply though is, then that's going to give rise, of course, to an increase in prices almost as big as the increase in money supply. But for the increase in Q, it would have been exactly the amount. And of course, Friedman claimed that it was money that caused prices to go up. A lot of people on Capitol Hill were claiming that it was prices that caused money to go up. Prices are going up and so the Fed has to increase the money supply so they can pay the high prices. No, we'll give it to Friedman. He's got the right direction. With a lag of 18 to 30 months, you wonder why it wouldn't be that long. And the answer to be that long has to do with the structure of production and all the stuff going on. And Friedman with high ag, but Friedman just reports well, it's 18 to 30 months and sometimes he reports even a larger span. Inflation is always and everywhere a monetary phenomenon, he says. So Friedman's monetary rule, increase the money supply at a slow and steady rate to achieve long run price level constancy. And so if that Q goes up, then M should go up too. That's what he thinks should happen. And that would keep price level constant. Well, it would, but what happens within the Q aggregate as a result of the monetary injection. So that Q aggregate is just plain old Q. What's going on within the Q? And that's what Hayek has to say that it causes prices to get out of whack. And it comes from that diagram that you've seen in an earlier show. So it shows that even keeping the price level constant it still disturbs the equilibrium of the market. Friedman declares the 1920s as the golden year of the Federal Reserve. That was the interest rate during the 1920s because it didn't change much. That is, they fell through the Keynesian Friedmanian's variation sieve. But what if they should have changed but weren't allowed to? During the 1920s, breakthrough in technology increased the demand for loanable funds and put upward pressure on interest rates. But the Federal Reserve guided by the real bills doctrine met each increase in the demand for credit with an increase in the supply, thus keeping the interest rate from rising. And seeing little or no change in the interest rates, Friedman dismissed interest rates as a potential independent variable in his econometric equation. Well, he hadn't dismissed them because if they're not changing you're not going to get any results from them. Now, this is Hayek, seeing little or no change in the interest rates when they should have risen owing to the technological advances and the consequent increased demand for savings. Hayek was able to identify some critical market forces hidden from the untrained eye. Query, which view Friedman's or Hayek's is more firmly anchored in the empirical, historical of the 1920s. I think Hayek's is. Now, let me talk about this plucking model. Let me ask the show of hands. Has anyone ever heard about the plucking model that Friedman, no one has heard for? I'm not surprised at that. Milton Friedman, the plucking model of business fluctuations. It was an economic inquiry in 1993. However, it came from an article that he wrote back in 1964 when he was at the Bureau of Economic Research in Washington. And it turns out, just by happenstance, that before this plucking model here came out, I had found that stuff in the 1964 rendition, the plucking model. And I wanted to write a comment criticizing it. But, you never get that published. If I'm trying to write a comment somewhere around 1990 about something that Friedman wrote in 1964, not going to be published for sorry, okay? But it turns out that Friedman wrote a comment, I'm sorry, Friedman wrote an update on his plucking model in 1993. And the occasion was the economic inquiry that journal had a birthday party for Friedman, an 80th birthday. He was born in 12, 1912, and it was 1992 that had the party. And they wanted him to write something for economic inquiry. And he didn't know what to write. At that point, he was through with monetary theory. He had done lots of other things. And so he went back to this 1964 piece and revived it and put it in economic inquiry. And this time I was jumping up and clicking my heels because now I could write a comment and I did write the comment and send it to economic inquiry. I actually also sent it directly to Friedman and it did eventually get published. But let me show you what it was all about. And this is really peculiar where you see how it goes. Here's vertical axis, I say real output employment. Any of the big, big aggregates can serve on this graph. On the horizontal axis it's just time and it's showing that the economy grows. There's the economy. It's growing. It's tipped upward. Okay, fine. But it turns out that it doesn't grow in that smooth way that there are problems along the way. And the way that Friedman explained it, he said it says if we take a string, he said string, a string that's glued at the bottom of that plank or whatever that's called. Glue this string at the bottom. But then here and there the string gets plucked down. And there's a lot of plucking here. Like this. Now if that's a string, it's a strange string because it needs to be stretched. It's more like taffy, I think. But that's it. And Friedman identified if you look at these three episodes on the left is a bust and then when the economy gets back on track Friedman calls it a boom. Well, that's not a boom. And now it's on the string again. It's on the plank again and then you have a bust and another boom. And then a little bust and a little boom. He says that's what we're working with. That's what we've got to figure out. And then he notices that look, the bust in that middle is a whole lot bigger than the boom before. That's what it looks like. The boom in the middle is big compared with the bust that succeeds it. So he even said we really don't have a boom bust sequence. We have a bust boom sequence. But that's just missing. He just misidentified a recovery for a boom. But this explains why he is so adamant about saying that the downturn is a previous upturn. Because the previous upturn is not a boom really. It's a recovery. And also I can point out that he never shows the strain going above. And in a boom that's an artificial boom it shows the economy going above what its upward movement would suggest. It's getting overconfident, over investing, which eventually gives you the bust. So that's the story here. There's Friedman. I like that picture. Okay, so he says the empirical evidence supposedly shows that we simply do not have boom bust sequences to theorize about. This empirical study initially published in the annual report of the National Bureau of Economic Research is being utterly inconsistent with the von Mises theory. And it goes on so far as to claim that this one little bit of evidence is decisive refutation of von Mises. Really? I mean, when I went back to 64 I was thinking before I actually heard the the new version I was thinking, oh, you can't really have believed that. He probably even forgot he said that. But no, he brought it out and put it in the economic inquiry. Have the von Misesians in any way stopped saying exactly what they were saying for 50 years, not a word of it. They keep on repeating the same nonsense. That's Friedman. Oh, okay. I guess this goes back to my Cadillac here. Greg Manki's blog he was on television and he asked this question. It came out of the blue. How can you identify my car? Well, we want to look for something pretty special. Well, it's easy. It's not very imaginative. But there it is. And then there were some comments. You know, I hate to spoil things, but I must say I think Milton Friedman had a better plate. This is from an article I came across. He says, years ago, trying to find the Friedman's apartment in San Francisco I knew I was in the right location when I spotted a car with a license plate that read mv equal pt mv equal pt is Irving Fisher's version. And t stands for transactions. Friedman couldn't work with that because you can't get data on total transactions a whole lot bigger than income. So it can't be that. And then someone else writes Milton Friedman's license plate was mv equal pq, not mv equal pt. Well, there's several different ways you could say it. But this helped me. I was happy to see it was pq because I had to sort of guess just what the thing was. And let's see. Anonymous writes, this is pretty ridiculous. Somebody else writes I love economists. Now, it turns out I think I can get to the internet and there's France. Okay. And if you stroke and here it is, la vauture de Milton Friedman. Okay. I don't get to see that. I had it on my website too long. So I'm still wondering. Now, here's Friedman mv equal p y and y is income. But that version is actually wrong. It should be mv equal y because y here is is a real variable. But this is the best it could do. And so this is what he got from the Department of Motor Vehicles. And what he needed if you want to say mv with p y, you have to have a little y, a lowercase y. That's what Friedman and all the rest in a lowercase y. And so here I could say, I've heard recently that the only person that has had an argument with Friedman and won, could you guess who? It was Rose Friedman. But now we've got a second one. It's the girl that was working in the Motor Vehicle Department. I'm sorry, Dr. Friedman. We don't have a lowercase y. It has to be. So that's the story. Okay, thank you much.