Friedman’s Spending Matrix

The very famous Nobel Laurite economist Milton Friedman explains a key aspect of social behavior in his 1980 book Free to Choose (Friedman’s wife, Rose, is a coauthor).  Friedman’s book should be mandatory reading in all our high schools and is a very highly recommend read for anyone with an interest in politics and economics.  Friedman’s writing style make this book an easy read. In Chapter 4 on page 116 of Free to Choose, Friedman presents a matrix which sums up the economic decision-making process, and this is critical to the understanding of the behavior of people with regards to how they spend and who they spend on.  The following is my interpretation of Milton’s economic matrix:

Friedman’s Spending Matrix

This simple matrix is really quite easy to understand.  The two columns labeled “A” and “B” and the two rows labeled “1” and “2” result in four possible situations:  A1, A2, B1, and B2.  These four possibilities are described in the next few paragraphs.

A1 In this situation, someone earns money, assigns a value to that effort, and then spends the money on something for him/herself.   The personally “assigned value” is used to make decisions about how the money earned will be spent.  The amount earned will determine one’s priorities and motivation for distribution of it e.g. the spending.  Maslow’s “hierarchy of needs” directly applies to these decisions — If one earns only a small amount, the money will be spent on the necessities of life; if one earns more, one can indulge in some “frivolous” spending. The bottom line is, however, that the person who earned the money will spend it to maximize his/her personal satisfaction (consciously or unconsciously in the best way he/she knows.  Only the person who actually performed the work to earn the money can place a “true” value on it that is proportional to the effort that went into earning it.  Further the “value” will be different for every person. This situation is the only one that optimizes the individual’s spending. The optimization of the individual’s transactions when summarized in the market place maximizes the economic transactions of the society. The maximization of monetary transaction in an economy must be steered into this category if the economy is expected to be viable.

B1 In this situation, someone uses the money that they have earned to buy something for someone else.  A good example of this kind of spending is the simple birthday present.  What you buy for the other person, however, may not be what he/she would have bought had they spent that amount of money on himself/herself.  In many, if not most all, situations, an individual simply cannot spend money for another individual to the highest satisfaction of that recipient.   Even husbands and wives or parents and children do not achieve total success in this arena (imagine how much worse people of less familiarity must fare!).  This situation does not optimize the individual’s spending. However, the spender does allocate their money used in accordance with the value they placed on it. We all known how many times a person return gifts to a store after getting them, so time and money was spent by the giver to get the gift and time and money was spend by the receiver retuning it. So by definition this process can not be as efficient as that of A1. The best method for giving gifts would be to give cash or a gift card.

A2   In this situation, someone else uses the money he/she has earned to buy something for you.   This, of course, is simply the reverse of B1.  We have probably all experienced receiving a gift that we did not use or like, no matter how much we may have appreciated the effort made by the giver. The old expression “it’s the thought that counts” probably comes from this very situation.  This situation, like B1, tends to be economically inefficient, and does not optimize the individual’s spending.  (By all this Friedman does not mean to imply, however, that one should stop giving gifts there are other factors besides economics to consider!) Since B1 and A2 are just the flip side of each other they could be combined.

B2   In this situation, someone else uses the money you have earned to buy something for someone else.  This is the problem situation, because there is absolutely no motivation to optimize spending.   This scenario is epitomized by government actions and spending no matter what the form of the government:  The government taxes you (you have no choice but to pay), and subsequently uses that money to buy something, or provide a service for, somebody else.  This process can never be accomplished efficiently, since neither the spender (the government bureaucrat) nor the recipient care about the “value” of the money spent.  It should be understood that it is the very process itself, and not the individual government employees, that causes the problem. There is no way to make government (of any kind) an efficient method of providing goods and services since the “value” link is completely broken. This is why Social Welfare, Communism and Redistribution of Wealth do not and cannot work in practice, no matter how hard one tries to make any of these policies work. But there is more as a layer of bureaucrats are required to handle the taxes and the distribution of the money; this process provides no economic benefit and so as these programs go the economy become less and less efficient. .

One of the objects of Friedman’s work was to show why the welfare start could not work for long in any society.   Both Marx and Keynes tried to justify large transfers to those at the bottom from those at the top.  Forgetting the wanting to do good issue by now after trying to do this so many times and always having it work out badly one would think that we would realize that Friedman was right.  His B2 situation shows the fundamental issue with the process that makes it impossible to work.  And Adam Smith in his book the Wealth of Nations comes to the same conclusions from a different perspective. Government by its very nature and purpose is not suited for legislating social believer and for sure never every actually running anything.

By contrast, private industry must provide services or goods on which individuals are willing to place personal value and spend money on.  Private industry must entice the buyer with “Value” to make the sale (positive feedback).  Firms or organizations that don’t provide real “Value” do not last long, for when their sales slow down they must immediately find and correct the problems (negative feedback) or they will either lose market share or go out of business.  This is true for both large and small companies there are no exceptions.

For example, Sears which was the premier consumer retailer for decades stopped providing “Value” to its customers and was dethroned by Wal-Mart who found a more efficient way to supply goods to the consumer.   The too big to fail belief of this current administration is not valid.  Bailing out companies of any kind or size only make the situation worse for it mitigates the consequences of making bad decisions.

The Friedman matrix thus proves that it is virtually impossible for any government no matter how formed to efficiently manage an economy.  Moreover, this logic is borne out by history, which has witnessed the absolute failure of all attempts at central planning or collectivism.   The collapse of the U.S.S.R. (Russia) in the late 80’s and early 90’s was a result of the inability of the Russian “Central Planners” to make good economic decisions and their economy collapsed as a black market developed that was by some accounts becoming the real economy of Russia. We should keep this in mind as the progressive politicians are right now duplicating the very system that brought the Russians down.  What these Politian’s’ don’t understand is that there is no way to make Central Planning work unless you have an absolute static economy with no innovation and growth, a hydraulic society as existed thousands of years ago especially in China and India. These were systems with strong Central Planning and static or unchanging social systems i.e. things were the same today as they were 10 years ago or 100 years ago or a 1000 years ago.

Only market-based systems can efficiently allocate resources.

Although it may be argued that social goals must sometimes take precedence over economic efficiency, Friedman disagrees with this statement explaining in his book that there are other ways to achieve social goals. Friedman did suggest that if the government had to do something that the best system would be a negative income tax that only gradually disappeared as income rose so there would be no disincentive to work and earn more, which is the core problem with most all social welfare programs as exist today.