MILTON FRIEDMAN'S SURPRISING SECRET

Author: By David Warsh, Globe Staff

Date: Sunday, May 17, 1992
Page: 37
Section: BUSINESS

The saga of how Friedman almost single-handedly overturned the Popular Front of the Keynesian Revolution during the 1960s and 1970s through clever arguments and imaginative research is not so widely known. William Breit and Roger Ransome took the creed of the Texas Rangers as the motto of their enthusiastic profile -- "Little man whip a big man every time if the little man's in the right and keeps a'comin' " -- and that was only 1972.

Since then Friedman has won the Nobel Prize and turned an influential 1980 television series, "Free to Choose," into a best-seller. His acolytes have led Chile -- and in turn the rest of Latin America -- in a decisive turn toward free markets; the same thing has happened in Eastern Europe. True, Friedman blunted his lance forecasting inflation in the 1980s, when he was deeply, frequently wrong. But as the animating intellectual spirit of "the Reagan Revolution," he remains a figure whose influence is of Keynesian proportions.

For all his polemical skill and energy, however, Friedman's fame ultimately rests on a single idea: The famous quantity theory of money. The quantity theory says the general level of prices is directly proportional to the quantity of money in circulation. We have talked this way about the "cost of living" and the "purchasing power of money" for centuries; Friedman is the most of recent of a long line of expositors.

The quantity theory is often written as an equation that describes the stock of money (M) and the frequency with which it changes hands (V, for its ''velocity") in terms of the average price (P) and the number of transactions (T): MV=PT. Some variant or other of this framework is used by bond traders to central bankers to the actuaries who calculate Social Security benefits, for talking about inflation. Friedman says the equation has "the same foundation-stone role in monetary theory that Einstein's E=MC2 does in physics."

There is, perhaps, a difference: Circumstantial evidence suggests the quantity theory is simply an extended analogy smuggled into economics from physics long ago, a dubious appropriation of Boyle's Law, cute, but ultimately not much more revealing than Parkinson's Law (work expands to fill the time allotted for its completion). Perhaps you remember Boyle's Law from high school physics, the first great proof that the atmosphere consisted of an ''ocean" of compressible air: the greater the pressure on a fixed quantity of gas, the smaller the space it occupies; the smaller the pressure, the greater the space.

What they will find is that the quantity theory of money rests on an ancient habit of mind, a curious assumption about the "plenitude"of the world that was inherited from Plato. Plenitude, too, can be found in early physics: A plenum, the opposite of a vacuum, is a space completely filled with matter. More largely, a plenum is something filled with every conceivable type of thing; a plenary session of a convention, for example, includes everyone at the meeting. In Platonic thought, it is the universe itself that is a plenum, an exhaustive gallery of possible types, complete once and for all.

For the purposes of monetary thought, the assumption of plenitude seems to entail the view that, while there may be great changes on the side of money, nothing much ever changes on the side of things. This conviction is implicit in English-language formulations of the quantity theory from its earliest days: It was David Hume, for instance, who wrote, "It seems a maxim, almost self-evident, that the prices of every thing depend upon the proportion between commodities and money, and that any considerable alteration on either has the same effect, either of heightening or lowering the price. Increase the commodities, they become cheaper; increase the money, they rise in their value price." Note how the phrase "the prices of every thing" subtly implies that there is a fixed inventory of things for sale.

Now this is clearly a very useful tool for static, short-term situations, where the significant changes are occurring mainly on the side of money. The sudden discovery of a new source of precious metal; a hyperinflation of the currency, when a government finances its expenditures through printing
presses: These are phenomena that can scarcely be understood without the quantity theory. Chronicles of episodes like these fill Friedman's new book, and they are fascinating.

But the quantity theory simply is not much good for thinking about the long-term evolution of the economy, where big changes that affect the cost of living are occurring on the side of things. These changes can be technological, as, say, when electricity replaced steam or when automobiles replaced horses. They can be institutional, as, say, when the machine-driven factory system replaced old styles of "putting out," or when new roles were assigned to governments in modern mixed economies. And, up close, these changes can be nearly invisible. But they may have a big impact on prices.

How? For a simple intuitive example of the relationship among money, prices and economic development, consider the familiar game of Monopoly. The game has a money supply, doled out by the banker. It has a general level of prices, meaning the average price you pay for landing on a square. And it features a great price explosion. In the course of a game, the "cost of landing" on Ventnor Avenue goes from $22 to $1,150.

But hardly anybody who plays would say rising prices stemmed from an ''inflation" of the money supply. Prices in Monopoly rise because monopoly blocs of properties are assembled and rents are increased accord to the rules. Houses and hotels are then built and their costs, too, are bundled into prices. To be sure, the quantity of money increases steadily throughout. But it is economic development -- changes in the complexity of the board, in the types of things that are created and offered for sale -- that causes the price level to rise. Only because money is deliberately kept too tight does the game end at all.

Friedman came close to acknowledging the existence of this sort of mechanism in the real world last autumn in an article on health care cost ''inflation." It was true that "care had become more sophisticated and expensive, and medical machines more complex," Friedman wrote. But this alone wasn't enough to explain the explosive acceleration of costs: It was the assumption by government of responsibility for hospital and medical care for the poor and elderly that really sent hospital bed prices soaring. "Anecdotal evidence suggests that increased administrative complexity played a major role in the explosion of total cost per patient day," Friedman wrote.

When you think about it, this is quite a statement from the man who gave us the mantra, "Inflation is everywhere and always a monetary phenomenon." The interplay is intricate between new goods and styles of delivering them on the one hand, and the existence of increasing money to pay for them on the other, but that's the point: It works both ways.

Health care "inflation" is by no stretch of the imagination simply a ''monetary phenomenon." It tells us nothing to say that the cost of a day in the hospital exploded because the money supply increased. As in the rest of the economy, a host of technological and institutional factors often contribute to rising prices. It is the assumption of plenitude, tacitly concealed in the quantity theory, that blinds the theorists to this fact. And that is Milton Friedman's surprising secret.

WARSH ;05/13 NKELLY;05/19,09:04 WARSH17