What Milton Friedman Would Do for Greece
International Monetary Fund Managing Director Christine Lagarde wants the Greek government to offer a more specific plan for meeting its commitments to its creditors, but that might not be necessary. It should be enough to make sure Athens doesn't do anything to prevent its economy from running closer to capacity, in terms of unemployment and output levels. That's what Nobel prizewinning economist Milton Friedman's "plucking model" of economic cycles -- which is remarkably accurate in describing Europe's economy -- would suggest.
Friedman developed the model in 1964 and tested it again in 1993, finding that it accurately described economic cycles in a number of countries. According to Friedman, the magnitude of recessions is not correlated with that of preceding booms, but expansion rates are correlated with the depth of preceding declines -- the bigger the declines, the faster the subsequent expansion. Friedman wrote:
Consider an elastic string stretched taut between two points on the underside of a rigid horizontal board and glued tightly to the board. Let the string be plucked at a number of points chosen more or less at random with a force that varies at random, and then held down at the lowest point reached. The result will be to produce a succession of apparent cycles in the string whose amplitudes depend on the force used in plucking the string. The cycles are symmetrical about their troughs; each contraction is of the same amplitude as the succeeding expansion. But there is no necessary connection between the amplitude of an expansion and the amplitude of the succeeding contraction.
This is a surprisingly primitive analogy, but it does a good job of describing a country's economy. The board is, in Friedman's words, the limit on output set by "the available resources and methods of organizing them." The string is the actual output, subject to cyclical contractions. Subsequent recoveries tend to bring it back to the ceiling, which can rise or decline if resources and capacity increase because of demographic, technological and other factors (the underside of the board is uneven).
This is not the dominant theory of the economic cycle. Most mainstream economists rely on the natural rate theory, according to which output fluctuates around an equilibrium, consistent with a stable inflation rate. When output expands more quickly, there's higher inflation, and vice versa. In line with this theory, the higher output rises, the steeper its decline back to the "norm."
Gregory Claeys and Thomas Walsh of the Bruegel think tank in Brussels have pointed out in a recent blog post that the plucking model is more accurate in describing economic growth in post-crisis Europe than the natural rate one. The depth of the recession predicts the rate of the rebound, but the previous boom did not predict how deep the recession would be:
To Claeys and Walsh this means that the quick recoveries in some of the hardest-hit countries, such as Latvia and Estonia (LV and EE on the chart), may have had little to do with their post-crisis economic policies, rooted in tough austerity. "If these quick recoveries are the natural counterpart of the previous recessions," the researchers wrote, "it makes it difficult to infer anything on the success or failure of the policies implemented since the beginning of the crisis, and therefore to use these countries as role model in order to recommend similar policies to other European countries."
Claeys and Walsh do not stretch that conclusion to Greece -- in fact, it's not even on the chart because it hasn't had a recovery. They note that its crisis may have reduced Greece's economic capacity, so when its output heads toward the ceiling, it may stop at a lower level.
But if the European institutions monitoring Greece's economy use Friedman's model for guidance, rather than the natural rate one, they might conclude that the details of Greek policy don't really matter. All Greece needs to do is create conditions for its capacity utilization rate (the rate at which its potential output levels are being met) -- currently at 70.7 percent, quite low by the standards of developed countries -- to go up and its unemployment rate, at 25.8 percent, to go down. Keeping tabs on these two parameters, and advising the Greek government on how to get them moving in the right direction, could be enough to make sure Greece heads for recovery.
Assuming there is no natural growth rate could be healthy for European economies. Why should Germany, with a capacity utilization rate of 84.6 percent and an unemployment rate of 4.8 percent, grow much faster than the 1.1 percent expected by the Organization for Economic Cooperation and Development? It's relatively close to its output ceiling already. On the other hand, Latvia and Estonia, with capacity utilization of about 71 percent each and unemployment rates of 10.6 percent and 7 percent respectively, still have a way to go, and their relatively faster growth rates merely reflect that.
Looking at things that way doesn't invalidate the need for austerity policies. Countries still need to be fiscally responsible to shoulder their debt burdens and avoid further crises. Increased government spending is not the only way to boost its economy's ability to run closer to capacity: Creating incentives for private business to grow will do that, too. There are endless variations in how a country can let go of the plucked string so it bounces back to the ceiling. The important thing for a government is not to pull it back any further. Doing that may break the board.
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