 You can see my title, Vienna versus Chicago, on monetary issues. My original title, that sort of was parallel to an earlier talk I gave, was Hayek and Friedman, Head to Head. And it occurs to me that you've all seen another lecture earlier in the week called Friedman and Mises on Method by Roderick Long. I didn't hear that lecture myself, but I heard it had sort of a philosophical bend to it. Is that right? So here you'll get something a little different. I might edge off in the direction of philosophy, but not too far. Okay, I'm a macroeconomist, so it's mostly economics. Okay, Hayek and Friedman, Head to Head. But it turns out that Keynes is in the mix too. You just have to live with it that if you're going to talk about macroeconomics, Keynes is in the picture, all right? But Keynes will help us understand the basic differences between Friedman and Hayek, as you'll see. What I want to do for starters is look at Keynes, Friedman and Hayek, in a very summary perspective that I hope will help and sort of focus on what's to come. And it goes like this, there he is, Keynes. And so Keynes is often accused of having a high level of aggregation, Hayek accuses him of that, and that's certainly true. So theorizing at a high level of aggregation, Keynes argued that market economies perform perversely, especially the market mechanisms that are supposed to bring saving and investment into balance with one another. He threw out the loanable funds market, he didn't think it worked the way that his classical colleagues thought it did. So seeing unemployment and resource idleness as the norm, he called for counter-cyclical and monetary policies and ultimately for a comprehensive socialization of investment. That quoted phrase down there is lifted from the Swan Song chapter, the chapter 24 of Keynes's general theory. Interpreters of Keynes over the years have spilled a lot of ink trying to figure out just what did Keynes mean by a comprehensive socialization of investment, okay? I think I know and I don't have to write an article about it. I think he meant what he said. Okay, but now the important thing here is to get the contrast, there's Friedman and what we have to note is he has a still higher level of aggregation. So Friedman's monetarism was based on a still higher level of aggregation, the equation of exchange, MV equal PQ, you'll see that crop up in the exposition this morning made an all-inclusive, made use of an all-inclusive output variable Q. Q is economic output, economic output of consumer goods, economic output of producer goods. They're just lumped together and called Q. So that little construction, sort of upping the level of aggregation, just put into eclipse the issues of the allocation of resources between consumption and investment for the future. So that issues off the table with Friedman. Now he thought it was well and good to put it off the table because he didn't think there was anything wrong with the market that performed that allocation. In other words, loanable funds theory works fine. Thank you very much. But we're macroeconomists. We don't deal with allocation of resources within the Q aggregate. We deal with the whole Q aggregate. OK? So seeing no problems emerging from the market itself, Friedman shifted the focus. Really, he focused on the relationship between government-controlled money supply and the overall price level. And boy, he took that issue a long way. And that's what the Austrians give Friedman plenty of credit for, for reviving the notion of that relationship between money and the price level. There's the symbols in the equation of exchange. You can see what they are and we'll come back to that later. And so now if we go to HIAC, capital based macroeconomics, you should have said or could have said Austrian macroeconomics, is distinguished by its propitious disaggregation. I'll make my Auburn sophomores look up the word propitious. Means it's well suited, sort of the right level. Which brings in to view both the problem of intertemporal resource allocation and the potential for a market solution. The potential for a market solution. And that's why in my earlier lecture, I had part of it on sustainable growth and part on unsustainable growth. You get the potential for a market solution. But you don't necessarily get that solution if government's involved and is rigging interest rates. So FA HIAC showed that a coordination of safety and investment decisions could be achieved by market government and governed movements in the interest rate. You also recognize that this aspect of the market economy is especially vulnerable to the manipulation of interest rates by the central bank, all right? So he's got the lowest level of aggregation of the three and still call it macroeconomics. But he's brought into view this critical relationship and shows how it can be perverted by policy. Okay, now I want to look at contrasting methods. We'll see if I sound like Roderick Long. I don't think so. I think I can make it through a discussion of methods without bringing a whole lot of philosophy. And here's where I start with John Maynard Keynes. And I'm drawing here from a book by Alan Meltzer where he's summing up how Keynes went about his business. How did Keynes do macroeconomics? Anyway, so here's what Meltzer says. He says, Keynes was the type of theorist who developed his theory after he developed a sense of relative magnitudes and of the size and frequency of change in each of these magnitudes. So he just looks out the window or looks at the economy as a whole and see what's moving around a lot. And then those are his variables. And if something isn't moving around a lot, well, it gets dropped out of the picture. And something said about it in chapter four, which is his throat clearing remarks about what he's not looking at, okay? It's the things that aren't moving around a lot, all right? So he concentrated on those magnitudes that change most, often assuming the others remain fixed for the relevant period. That's why he had that fixed structure of production, for instance. He didn't see that moving around a lot, okay? But he did see the economy caving into depression. So total output was changing a lot. Investment was changing a lot. That's from Alan Meltzer's book on Keynes' monetary theory, a different interpretation in 1988. Very good book on Keynes, by the way. Now, what did Milton Friedman say? Well, he really didn't have his own judgment. He just accepted Keynes. So he says, I believe that Keynes' theory is right, is the right kind of theory, and its simplicity, its concentration on a few key magnitudes, and its potential fruitfulness, all right? That's from Friedman, an interview with him in 86. A more well-quoted statement of Friedman's is that we're all Keynesians now. He said that in a Time Magazine interview, and eventually complained that he was being quoted out of context. And he was, to the extent that people took him to mean that we want discretionary tax policy and discretionary spending policy in order to stabilize the economy. No, no, no, he didn't mean that. In fact, if you read the interview carefully, you see he didn't mean that, and you see what he did mean. And here's what he says. We all use the Keynesian language in apparatus, all right? Well, what is a Keynesian language in apparatus? It's C plus I plus G, it's the Keynesian cross, it's ISLM analysis. In fact, when he set out back in about 1970, he set out the differences between monetarism and Keynesianism, he set it out in terms of the ISLM analysis. So he argued within the context of Keynesian economics, differing with Keynes only in terms of stability properties of investment demand or money demand, and in terms of the elasticities of the different curve. So we all use the Keynesian language in apparatus. Now that's a little bit too overreaching. We all, who's we all? Well, Keynesians and monetarists, that's we all. Doesn't include the Austrians. They have a different apparatus, okay? And so here we get a distinction between the Austrians on the one hand and Keynesian Friedman on the other. It's quoted in Time magazine. Now, here's what Hayek says to pair off to sort of in contrast with that. He says the role of the economist, Hayek points out in Pure Theory of Capital, is precisely to identify the feature of the market process that are hidden from the untrained eye. That last phrase is the one that's a direct quote, hidden from the untrained eye, right? Any schmuck can look at an economy and tell it has gone into the toilet, okay? You can see GDP falling by a third between 29 and 33, okay? A local news reporter can report that, right? But the job of the economists is to look for features of the economy before that happened and see how the stage was set for that kind of a collapse in the economy, right? Does it go on here? So for Hayek, the cause and effect relationship between central bank policy during the boom and the subsequent economic downturn have a first-order claim on our attention despite the more salient co-movements in macroeconomic magnitudes that characterize a post-crisis spiraling of the economy into deep depression. Excuse me for stumbling over that quote, but. So he can say it's cause and effect that causes to pick out this or that to focus on and it's not the co-movements. One of the things you hear among modern economists is lots of discussion about co-movements. Unless you can show there are co-movements here or co-movements there, you really just haven't shown much of anything. This is what Hayek said when he accepted his Nobel Prize in 74 and he's criticizing, especially the monetarists, but econometricians generally, macro econometricians, there may well exist better scientific evidence that is empirically demonstrated regularities among key macroeconomic magnitudes for a false theory which will be accepted because it is more scientific. You put that in quotes because economists mean scientific. By scientific you've got data and you can put an equation, you can test it and so on. More scientific than for a valid explanation which is rejected because there's no significant quantitative evidence for it, at least not in the eyes of the econometricians. So this is another way of just reinforcing this difference between Friedman and Hayek. Okay, now this is something I want to get across in a way that you won't forget. We'll see if it works. But typically with any two theorists that are at issue with one another about the whole field, they tend to be asking different questions. They have different focuses. They're not even raising the same questions and of course then not giving the same kinds of answers. And that's what we find with Friedman and Hayek. And let's see how that works. Again, I'll bring Keynes into the picture. Keynes doesn't really have an economic explanation of why the crash occurs. He blames it on psychology, all right? So he attributes the downturn to psychological factors affecting the investment community, okay? These are not psychological factors that compound a bad situation. These are psychological factors that end the good situation, that the investors become introspective and they see the economy as a house of cards and they get cold feet and they pull back and sure enough the economy crashes, okay? So his main focus is really not on that. How long can you focus on that? His main focus is the dynamics of the subsequent spiraling downwards. That's where the Keynesian multiplier comes in and on policies aimed at reversing the spiral's direction. That's where the stimulus packages come in. So that's sort of, you know, sophomore level basic Keynesian fiscal spending and tax policy and so on. Let's look at Friedman. And this is something that people seem not to be aware of until you just show them the evidence here. Friedman is dismissive of the whole issue of the cause of the downturn. Referring to it as and I've become sensitive to these adjectives. It's ordinary run of the mill routine garden variety recession. I don't think a macroeconomist should be talking in those terms. The macroeconomist should be explaining why you had a recession at all rather than simply call it garden variety routine ordinary and so on, okay? So to use those kinds of terms is to be dismissive of the issue. We don't need to explain. It was just an ordinary recession, all right? The real question though is why the downturn was so dramatic. So his focus is on policy blunders. It turns out collapse of the money supply that occurred on the heels of the downturn. It didn't. And on the correlation between the decrease in the money supply and the fall in real GDP. So they were back to Keynes. He looked at the things that changed the most. You had the money supply falling dramatically. You had GDP falling dramatically. Those are co-movements. And you can get the numbers and you can show that one's related to the other. And then you're scientific and now you've explained depressions, okay? But what you haven't explained is how did the boom turn into a bust in the first place? Which is what Hayek was interested in, of course. I'm anticipating that. Friedrich Hayek focuses on the policy-infected aspects of the boom. He's the one that's looking at the 20s, not the 30s. And their implications of the boom's sustainability. Recovery from the subsequent bust takes time, but the particular dimensions of the depression, its length and depth are to be explained largely in terms of the policy perversities in each of the particular cyclical episodes, okay? It depends on what the government does to try to fix the problem. If it didn't do anything, like in the case of the 1921 downturn, you get recovery in 18 months or so. If they do a whole lot, like with Roosevelt or with Obama, you don't get recovery, okay? You get the economies tank. But you have to deal with Roosevelt and Obama to find out why the depression is as bad as it is, okay? But here, the main thing I want to show you is that Friedman and Hayek are focusing on different questions. I'll come back to that after I show you a little bit about Friedman's monetarism. And forgive me if you've already been through this in the classroom, but we can set it up in a way that might help. Mv will be accused. M's the money supply V is its rate of circulation through the economy, typically taken to be about eight right now, eight or nine, if you're looking at the number of times each dollar on average gets paid out as income. So the amount of money there is times the rate it gets paid out as income, that's total income, which gets spent one way or another on output, either investment goods or consumer goods at some price level call it P, okay? So Mv will be accused. That's really an accounting identity. It's always true as Friedman clearly recognized. This is with nearly constant velocity of money. Actually velocity while Friedman was writing had a slight upward trend, which he was aware of, but for simplicity, we'll have a constant velocity and output growing slowly. The price level moves with the money supply. So if we could ignore the rate of growth of the real economy, or if it's so small, we'll take it into account but it still doesn't affect much. That price level moves with the money supply. There are the two cove movements, okay? You can, there's the velocity is constant. There's quantity going up a little bit. Money supply goes up a lot. If so, then prices will go up about that much taking away the increase on the quantity variable, okay? And that's pretty much it, except for a timing consideration. It's always been the Achilles, that's not the right, the soft underbelly of monetarism because this relationship that increasing the money supply causes an increase in the price level works with a long lag. Friedman always says a long and variable lag sometimes longer than other times but long as much as 18 to 30 months. One of Friedman's last articles was pondering anew why would the lag be that long? He doesn't have an explanation that satisfies even himself, okay? So that's the monetary story there. Inflation is always an everywhere monetary phenomenon. That's probably the most famous quote from Friedman in a 1968 publication. And it's not that no one knew that before Friedman said it. Mises certainly did. If you read Mises writing, he understood full well that inflation was caused by an increase in the money supply. The equation of exchange is probably one of the oldest equations in all of economics but what Friedman gets credit for is reviving it in the 1950s and beating Keynes over the head with it, okay? And for that, we're grateful. So Friedman's monetary rule is increase the money supply at slow and steady rate to achieve long run price stability. So okay, if you've got some growth in the economy then increase the money supply about that rate and you have price stability as well. He took price stability just as the sign of macroeconomic health and he says there's a long tradition of that judgment but he doesn't actually defend it. In fact, when he gets theoretical about it, when he writes the optimum quantity of money he has expansion of the money supply that actually gives you a slight deflation. But for practical purposes, keep the price level constant. That's his monetary rule. He'll say increase the money supply maybe 2%, 3%, maybe a little more if the velocity of money changes in ways that would require that. And some monetarists think that that's not quite precise enough. Gee, we shouldn't be able to pin down how much to increase the money supply and the suggestion I like comes from Richard Timmerlake at University of Georgia because he wants that precision. So he says the money supply should be increased at 3.65% each year except for leap years, it'd be 3.66, okay? So if you want precision, there it is, okay? But here now, this is my Austrian question about what happens within the Q aggregate as a result of the monetary injection. So you got your increased the money supply with an eye to keeping price levels stable but the money supply comes through the loan market and it affects interest rates. You remember that story, there it is. If you increase the supply of money, drives a wedge between saving and investment and even though it's only keeping the price level constant, it's not increasing it, you don't get price level inflation, it causes problems. And in fact, that's the story of the 1920s. You got very little in the way of price level inflation but you've got loose money in the sense of pumping money through credit markets distorting interest rates and triggering a boom that couldn't be sustained. Friedman though, declares the 1920s as the golden years of the Federal Reserve. In his monetary history, the chapter on the 1920s is the high tide of the Federal Reserve, okay? The high tide. And in other places, he says golden years of the Federal Reserve. He ignores interest rates during the 1920s because they didn't change much, okay? They didn't change much. And so that is, they didn't pass the Keynes criteria. So Friedman is an econometrician. He's an empiricist. He bows before the data. That's the way that Chicago economists like to explain their humility, you know, their humble people. We bow before the data. And the data show that the interest rate didn't change during the 1920s so it didn't make it into their equations. You've taken econometrics, you know how it works, some of you have. If you think that there's an independent variable that's important and then notice that it doesn't change, it's not gonna explain anything in your econometrics to the dependent variable. In that right, dependent variable function, independent variable, then you put in the data and that particular independent variable didn't change. Well, there's not gonna explain any change in the dependent variable. So what do you do? You throw it out. You don't need it. And Keynes said, whoop! And Keynes said, I'm glad I didn't like it. Keynes said, you oughta throw it out. It doesn't change. We look at what changes first. So, and then I asked the burning question, taking my cue from Hayek, but what if they should have changed? What if interest rates should have changed? But weren't allowed to. More about that on the next slide. Also, is it true that it takes a big cause to explain a big effect? This is why Robert Lucas dismissed the Austrian theory. He says, you really don't get big enough changes in the interest rate to account for a horrendous depression as if the change is supposed to explain the depth and the length of the Great Depression. How big a change do you need to get? It could be a small change causes a big effect. Sometimes a big change causes a big effect. And what comes to mind here is Mount Vizubius and Pompeii. Big effect from a big change, okay? But how about, for instance, a careless smoker and a forest fire? That's a little change in a big effect. Can you imagine somebody arguing that this smoker couldn't have caused that forest fire? Look how small that cigarette was. It's just too small to have caused all that, all right? Okay. Now, why, just why was the interest rate, was it that the interest rate didn't change much during the 20s? Well, it's fairly easy. Here's where Hayek is looking for forces that are hidden from the untrained eye. That if we do sort of a full-bodied history, full-bodied economic history of the 1920s, we see lots of innovations. We see lots of technical advancements. And therefore, we see entrepreneurs increasing their demand for loanable funds to take advantage of those opportunities. Mises would call this the entrepreneurial component of the gross interest rate, right? Be a heavy demand for loanable funds. And they were borrowing. They're borrowing a lot of funds and undertaking these investments. But the interest rate didn't rise. And Hayek would look at that and say, well, why not? And of course, the reason is it wasn't allowed to rise because the Federal Reserve was increasing the supply of credit to match the increase in demand. In fact, doing it according to the statutes that created the Federal Reserve systems called the real bills doctrine. And so they thought it was their job to provide the funds for them to borrow. The statute doesn't say at what interest rate, okay? But what they did, Willie Nellie was accommodate the demands for loanable funds at the given interest rate, at the rate that existed before you had the innovations and the technological advances and so on, okay? Of course, if you're market oriented, you say, well, that's gonna cause an increase in demand for loanable funds. That's gonna cause the interest rate to rise because of that entrepreneurial component. And that's the way it should be. That's the way it should be, okay? But they didn't change much. Okay, it didn't break through some technology, increased the demand for loanable funds and put upward pressure on interest rates. Yes, but the Federal Reserve, guided by the real bill doctrine, met each increase in demand for credit with the increase in supply, thus keeping the interest rate from rising. Now, there was an occasion back in the early 90s, well, early to mid 90s, where I had correspondence with Friedman because he'd written an article called The Plucking Model. I'll talk more about that a little bit later in this lecture. And I wrote a comment. This is in the Western Journal of Economic Inquiry. I wrote a comment on the article. And before my comment went to press, there was some exchange between Friedman and me to see if we had a meeting of the minds that each of us understand the other one. And one of the first letters that Friedman sent me, this was back when letters were sent and not just email. First letter, he had an attachment that was a plot of movements in the interest rate over the whole period of the 20s. And he considered this just, he'd won the argument because look, you're trying to explain this in terms of the interest rate. The interest rate didn't change during the 20s so much for that explanation. And the Austrians are just sort of out of play on that one as far as he's concerned, all right? And yet, if you adopt the Hayekian research agenda, look for forces hidden from the untrained eye, you see that they should have risen and didn't. And I ask a little question here, I think, or do I? Okay, so seeing no change in interest rates, Friedman dismissed interest rates as a potential independent variable and his econometric question. And this is the Austrian view. Seeing no change in interest rate when they should have risen because of technological advances, Hayek was able to identify some critical market forces hidden from the untrained eye. The boom of the 20s was a little more boomy than it should have been, all right? And my query here, which view of Friedman's or Hayek is a more firmly anchored in empirical, that is, historical circumstances of the 1920s? The Chicago economy is always touting their empiricism, how they're anchored to reality as if the Austrian school is sort of free-floating out there, above reality. Not so, it's just that the Austrians want to do a little more full-bodied history to pick out these kinds of arguments. Okay, Friedman's view of monetary contraction. And here, when I first introduced Friedman, it was all about inflation. Macro economists are a product of their times. That was inflation as the problem when Friedman began writing about quantity theory of money. But in retrospect, if you apply it back to the Great Depression, then of course monetary contraction is an issue here. So a sharp monetary contraction puts downward pressure on P and Q. If prices are sticky downwards, or for some reason they don't fall, then Q will fall dramatically, well sure enough. And evidence shows, okay, so here's a bow before the data. Evidence shows that between October 1929 and March of 1933, decreasing M was the essential primary dominant cause of the decrease in Q. But I've heard Friedman present this kind of stuff at the professional meetings when he gets to this sort of bottom line. He talks, like a teacher, talks to students that have been kept in after school, okay? Okay, you people should see that. And he goes on that way. So that's the empirics. But look at what he's doing. He's confining the issue to the depth of the plunge without any attention whatsoever of what started the plunge in the first place. What about that ordinary recession or garden variety or whatever you call it? So M goes down and that's gonna affect Q because P is sticky. Actually, he even overplays the story. If you look at the full history, as you've probably heard from Bob Higgs and others, that prices were falling during that period, but the government was doing everything it could to prop them up. It was Roosevelt's programs that tried to keep prices from falling, which of course made the depression much deeper. Then it otherwise would have been. Okay, and male with another monetarist, Lanny Ebbenstein, you know who he is. He's written a couple of different biographies of Friedman. He's the only person I know who wrote two biographies of the same person. But I wrote him as I was trying to get the point across because when I mentioned this garden variety stuff, he emailed me back and he said, well, it was a garden variety recession. You need to explain why there was a recession. That's the point. The economists need to explain what caused that. So here I'm sending this, the case of the cabbage eating Mississippi monster. Might not seem completely relevant to the depression, but I'll get the point across. Austrian-Chicago methodology in action. Okay, suppose that late in late October, 1929, a thousand pound monster descends on Mississippi soil. It spent the next three and a half years eating all the cabbages and quite a few rabbits between Jackson and Pascagoula, okay? By early March of 1933, the monster weighed 4,000 pounds, okay? So two investigators are sent to Mississippi to handle the situation, one from Vienna and one from Chicago, you see. B&E's investigator asks, where in the world did this hideous thing come from? You know, what caused it? And here, I say, I seem to have stacked the cards against the Austrian, hard even to imagine an insightful answer to this question, unless of course the monster turns out to be an unintended consequence of some ill-conceived government-sponsored by Owning's project, which you could beat. In fact, y'all watch sci-fi, you remember, there was two makings of the blob, early one and late one. One's a Keynesian blob and one's a monetarist blob. You watch both movies. The first blob which just came from the heavens, you know, it was the way the reality is. And the second blob in that second movie was certainly it was misguided, ill-fated conclusion of a project carried on by the government, okay? They call it a monetarist blob, all right? So where did this thing come from? That's the question. At least I got the question right, right? Now, the Chicago show, Chicago show shows the Austrian aside. This is, you know, that's it. You know, enough for you off the stage. Never mind how this thing got here. The real question is, how did it grow from 1,000 pounds to 4,000 pounds? How did an ordinary run of the mill garden variety monster quadruple in weight in 40 months? All right, Chicago's answer, which could be delivered in the tone of the teacher talking to the students after keeping it in from class. It was all those cabbages. He couldn't get good data on the rabbits. What are you gonna do? The correlation between cabbage consumption and weight gain leaves no doubt about the issue. Okay, first the question is, what's the issue? What's the issue? Okay, get the point. I don't need to read that there. Now, I'm gonna spend a few minutes. I'm getting behind here, so it might go pretty quickly on this one. Monitor's conclusions depend on a constant or near constant velocity of money. That's the whole research program of the Chicago school during his high day. The graduate students all measured money supply and price levels in country after country in time period after time period to show that there was very close correlation and that the demand for money was pretty stable. And the point of that course is it means that the instability then came from the supply side of the market for money and that's the Federal Reserve. But to show that you have to have a constant velocity, well, you did up to a point, okay? There's rising price level up above and money supply down below. Those things, those cold movements were pretty close up until the early to mid 80s. And then they went haywire, okay? If you just look at that series, realize they're not gonna correlate very well, which means the velocity of money was changing. In fact, here's Brad DeLong. Velocity's supposed to be about constant. It has a slight upward trend. This gets exaggerated just with the scale. But he shows the purple is the projected velocity of money given behavior before about 1982 or so. And the rest of it shows what's actually happened to velocity, it went wild. Velocity of money balance, money became unstable after the 1980s, okay? Freedman's policy lost its velocity anchor that reserve abandoned monetary policy money stock policy and adopted interest rate targeting. This is what I call the irony of monetarism. Monetary rule that allows the economy to perform in its laissez-faire best presupposes a critical piece of intervention namely regulation Q, which is what got phased out. Before velocity went unstable. That makes a money supply operationally definable. Once money had lost its crisp definition, we even had Alan Greenspan testifying before the joint economic committee is sort of shrugging his shoulders and saying, we don't know what money is anymore, okay? It was a line picked up by Jay Leno, you know? He said, I really don't know what kind of a guy we want running our central bank, but surely it's somebody who knows what money is. It's gotta be. And of course, what happened, I think I've got this in here somewhere, but the regulation Q put a very sharp distinction between deposit money on which you could not draw checks. I'm sorry, deposit money on which you could not draw interest and savings account on which you couldn't write checks. Regulation Q made a black and white distinction and that piece of regulation is what gave the money supply M1 a pretty crisp definition. But once that distinction was removed and you have a blurring of checking account money and saving, then velocity goes haywire no matter what particular money supply you use. Implementation monetary policy requires stable and known commercial operating ratios, commercial bank operating ratios. And here's excess reserves. Have you seen that chart? Excess reserves for years on end. Well on that graph we're pretty close to zero. They were really 50, 60 billion or something like that in reserves or less. And then starting with the financial crisis, reserves, well it's an understatement to say they spiked. You can see where QE2 started. You know there's QE1, QE2, they kept pumping in more reserves. Demand deposits went up some but not nearly as much as what reserves did. In fact we see the M1 money multiplier taking a big nose dive and then going unstable. So when you see that kind of thing going on then you don't have a constant velocity, you don't have constant operating ratios and there's no way you could implement a monetary rule even if you want to. Now here's one part that I think I want to spend a little time on. I've got some time left. Why was Milton Friedman so unreceptive to Austrian theory? And it all turns on the capital theory that underlay the Chicago theorizing about business cycles. Hayek of course had the Austrian theory, that's the stages of production, the time element built in to the notion of production. What did Chicago rely on? They relied on a capital theory associated with Frank Knight. And it's one that took the time element out of the concept of capital. So there was no time element there. Let's see if we can explain this. There's Hayek and Knight, they butted heads in the 30s and if we wanted to do history of thought we could go back about 40 years and find that Clark and Bomba Veric butted heads on the same issue. In fact, they had the same argument. And Majliel reprinted Clark Bomba Veric articles as do the Knight Hayek articles. And let's see how it works. The Clark Knight concept of capital is what I call the black box capital theory. Y'all know what black box, what's the black box? Where have you heard that term? The airlines, yeah, the airline. And is the box black? I think it's orange, I'll give, it's orange. There's one, okay. And you know what it says, do not open. Black box has a different definition. It really comes from the field of electronics. Complex piece of equipment, typically a unit in an electronic system with a context that are mysterious to the user, okay. Which just means that in the airlines it just means that a subcontractor made that piece of equipment and they just stick it into the airplane. It's really a plug and play unit, that's all. So the airline manufacturer doesn't have to worry about what's in that black box. That's the subcontractor's job. That's what black box means. But Frank Knight and before him Clark had a black box capital theory, okay. And that's the output at the bottom and the input up at the top. And that's the capital stock. And stock it means it exists. There it is, boom, that's capital, all right. Do not open. So you don't know what goes on in there. And it turns out that what's in there either has to be totally nonspecific, it's just a glob, or has no structure to it. Or if it does have a structure, the structure is always right. And it has to be one of the two, but there's no way of knowing which it is, all right. Let's see how it works. This is a steady state economy. Now capital does wear out, Knight was aware of that. That's why we have that input up there. But the input really is just also output of the capital stock. Some of it has to be plowed back in to keep this capital stock from shrinking. And the rest of the output is consumption. And that gets consumed, okay. That's all there is to it. And let's see if we can make it work. There it is, there it is, it goes like that. So it's going at a rate that keeps that capital stock from changing. Now when you read Knight's exposition, he takes that maintenance of capital as part of the stock. In other words, by capital you mean the stock plus whatever it takes to maintain it as it is. So the way he would say it, the capital stock includes maintenance as a technical detail, all right. And because of that, the capital stock is permanent. That was a big debate between Knight and Knight. Knight said capital was permanent. Hayek called it the mythology of capital, referring to Knight, okay. And both Clark, maybe especially Clark, or Clark and Knight had little qualifiers that would sort of immunize them for many criticism. And for instance, they say capital stock is permanent in a sense, okay. And a few pages later, again, they reaffirm capitalism is permanent, as it were, okay. Or capitalism is permanent, so to speak, okay. And every time you see this, you know, okay, what he means is really not permanent, you know, you have to decide to maintain. And accordingly, the permanent capital stock yields a perpetual income, okay. Well, that follows, doesn't it. And are there any qualifications there? Well, sure there are. It's in a sense, as it were, so to speak, only to the extent that capital is permanent, okay. Now, he goes a step further. And he says, this might be confusing if you call it capital stock and consumption, you might be thinking of consumer goods, like a refrigerator, or something like that. And what he really wants to do is boil it down to a distinction based on dimensions. And so he says, really it's sources that emit services, okay. So sources is a stock and services is a flow. So there are no consumption goods. Any real consumption good would be one of the sources that yield a service. So a refrigerator is a source and service of cooling is the consumable output, okay. So he takes it that far. So he's completely left or abandoned the idea of means and ends and defined that relationship strictly in terms of dimensionality. Source is a stock and the consumption is a flow, right. So he says, there's really only one factor of production is capital in the broad sense of sources. So land, labor and capital is a classical trilogy become all capital in the broad sense. And I put an asterisk on labor because it sounds like a flow. It sounds like people working. So you might have to say the labor force or the work force. So you have capital, you have the work force, you have land that's the stock and they contribute a flow. And as long as you see that stock flow relationship well heck with distinguishing between land labor and capital is all just capital is sources and services. And I emphasize this because I'll show you I think I've got time that when Friedman thinks about the business cycle and tries to understand the Hayekian view he thinks in terms of guess what sources and services. Further, you can have an expanding economy that's almost be lies. So now you've got more input like so, right. This almost belies the notions of technological detail but Frank Knight would realize you could even have a contracting economy. How would that work? You'd probably get in trouble there. It's got sound effects too but we didn't get them up. But anyhow, what about production time? And that's what's important with the Hayekian view. What about production time? It goes like this, Knight and Clark before him says think of a forest and we've got a bunch of trees. These are rows of trees. You can't see the trees behind this first row but a lot of rows of trees here. And they mature, got a steady state is reached and production time is irrelevant. Trees have a linear maturity structure and actually a long linear. In each period, a sapling is set out and a mature tree is harvested. And so there's period one, set out the sapling, harvest the mature tree. Then in period two, those grow back and you've got what you had another year before. So each year you set out a sapling. Each year you harvest a tree and here's what Clark and Knight say and it is setting out the tree that enables the harvesting, it enables it. In quotes, that means as it were, so to speak, so on. And setting out the tree now produces the harvestable tree now. And so they conclude that production and consumption are simultaneous, right? So forget about period of production. You harvest and set out at the same time. Here's a quote from Stigler in his dissertation, 1941, which was written under, guess who, Frank Knight. Stigler defends Clark and dismisses Bulbaverk on the basis of the simultaneous production and consumption. Look at this, he says, we can say that any one row of trees takes 50 years to mature. He's got a different parameter there. But since there is a constant output of timber forever, there's simply no point in saying it, all right? So he's hardcore Knightian. Friedman picked up this same thing, which is kind of an incongruity. I mean, Friedman was a very good price theorist, very good micro economist. Why would he pick up something like this in capital theory? And I think the answer is that he didn't like Hayek's theory for whatever reason, and I can show you some of the reasons. And he took it on Knight's authority that we could safely ignore Hayek. And so it's not that he liked Knight's theory, he just liked Knight giving him permission to ignore Hayek. So maintenance is a technical detail versus maintenance is a matter of choice. Capital is permanent, no capital is ever changing. Capital is the only factor. Capital is unique and heterogeneous. I could elaborate on that, but I want to go on to more different points. Production time is irrelevant and production time is the key variable. The whole purpose of the Hayekian Triangle is to bring production time in as an endogenous variable. It's all about sources and services. It's all about temporal capital structure. That's the contrast. And it's about steady state equilibrium according to Clark Knight view. That's the only way that production consumption can be simultaneous. No, it's all about a dynamic market process according to Hayek. So we've got a huge contrast there. Does the interest rate play any role at all within the output aggregate for freedmen? And here is where I've got a couple of quotes that I've presented before and I've just left audiences cold. They don't understand it. But I think you will understand it now that you know about sources and services. All right? So the first part you could follow without that, freedmen is talking about what happens when there's an increase in the money supply. But he's talking about it starting from the point where the money is already in the hands of the people. All right? Oh gee, what about it coming in through loan markets? Doesn't that lower the interest rate? Well, he overlooks that. In fact, his model is the helicopter model where the money is dropped from the helicopter and gathered up by a bunch of people. And then he's interested in, will this affect the interest rate? So here's what he says. Holders of cash will bid up the prices of assets. If the extra demand is initially directed at a particular class of assets, say government securities or commercial paper or the like, the result will be to pull the prices of such assets out of line with other assets and thus widen the area into which extra cash spills. The increased demand will spread sooner or later, affecting equities, houses, durable producer goods, durable consumer goods and so on, though not necessarily in that order, he's fending off high act. This effect can be described as operating on interest rates. If a more cosmopolitan, I wrote, yeah, Austrian, interpretation of interest rates is adopted, then the one which refers to a small range of marketable securities. So this is the kind of effect he sees, but then he's dismissive of it for this reason. And I put the Clarkian model up there, and I'm tempted to have the audience all read this in unison, but I won't, I won't, okay? So listen to what he said. This is Friedman. He says the key feature of this process during which interest rates are low is that it tends to raise the price of sources of both producer and consumer services relative to the price of the services themselves. It therefore encourages the production of such sources and at the same time, at the same time, it's all simultaneous, the direct acquisition of the services rather than of the source, okay? But these reactions in their turn tend to raise the prices of services relative to the price of sources. That is to undo the initial effect of the interest rate. The final result may be a rise in the expenditure in all directions without any change in interest rates at all. Interest rates and asset prices may simply be the conduct through which the effect of monetary change is transmitted to the expenditure without being altered at all. See, because there's no time element there. So that all happens in a flash and it didn't have any real effect, okay? So I find that revealing, and I find it even revealing that he would try to exposit that in terms of sources and services, okay? He's not talking about Hayek. One point I'll make before I show you the next screen is that I was in a conference, I think it was in the mid-86, I think, in which during a break, Leland Yeager and I and Milton Friedman were discussing Dennis Robertson, who wrote some pretty turgid prose and the discussion was how hard it was to understand what Robertson was trying to get across. And Friedman was talking about that and then in mid-sentence, he interrupted himself and he turned to me and pointing a finger at me and he'll say, I'll tell you another book that you can't understand. He said, Hayek's Prices in Production. He says, I challenge you to read that book and tell me what's in it, okay? So I took him for his word and the reason that he can't understand it is because he steeped in the Frank Knight, John B. Clark tradition in capital theory. Now, another interesting point, how does Friedman account for this lag between rising M and rising P? If you don't have any time in the picture, something's gotta be going on to account for that. And now, now all of a sudden, he starts sounding like Hayek, okay? So here's what he says, how do you account for this lag? He says, well, it may be that the monetary expansion induces someone within two or three months to contemplate building a factory within four or five to draw up plans within six or seven to get construction started. The actual construction may take another six months and much of the effect on the income stream may come still later insofar as initial goods used in construction are withdrawn from inventories and only subsequently lead to increased expenditures in supply. That's very Austrian, okay? So in other words, he brings in the Austrian theory to explain the lag. And then once he's got the lag explained, there goes the Austrian theory and he's back to Frank Knight and the monitors. So if you look at our macro model, we've got that 18 month lag that during which you have the boom and then the descent back to the PPF and then you have the Keynesian spiraling downwards. But of course, it's only the Austrians that kind of detail what's going on during the whole path in terms of a means ends framework and not in terms of Clark Knight or in terms of Keynes. Okay, I think I'll end it there. Thank you.