The Economic Theories of Keynes versus Friedman

I was asked in an on line discussion to summarize the different economics approaches of John Maynard Keynes (1883-1946) and Milton Friedman (1912-2006) and I thought the conflict between the two who are so rarely read or understood was an interesting subject for this blog briefly and simplistically: 

Keynes was a strong supporter of capitalist markets and an astute investor in them. And his approach can be seen as an attempt to avoid communist or fascist central planning, non-market authoritarianism. He did, however, think that Classical economics made a fundamental error. Say’s Law suggests supply creates its own demand and he thought this nonsense, not only for reasons of wage and price stickiness, but because aggregate demand could get stuck well below capacity for prolonged periods. In the 1920s he invented a form of monetarism thinking that money supply manipulation and low interest rates were market solutions to the problem.

But by the 1930s he developed an approach around the role of government and fiscal deficits in times of major depression and fiscal surpluses in times of inflation and demand exceeding supply. One of his central insights was that the markets for savings and investment would often not be balanced by the interest rate, because we save for reasons other than interest income, in particular we save for precautionary reasons especially in hard times. So it was likely in depression that savings would greatly exceed investment spending especially as the latter would plummet given low demand for goods and services: why invest on capacity that was under utilized already?

Given this he thought it necessary that the short fall in aggregate demand could be made up by the government running a fiscal deficit: spending exceeding taxes, though this could be achieved by reducing taxes or increasing spending or some combo. (Haavelmo explained how this might work and Kalecki warned about some risks of this in a democracy). This might involved printing money or it might involve borrowing the excess savings and spending them on infrastructure. Keynes hoped that the latter would be productive and have a long term return for the economy in terms of roads, bridges whatever.

Friedman started as a Keynesian and never really disagreed fundamentally with the Keynesian approach but developed his own. He too thought capitalism flawed. He and Anna Schwartz studied the 1930s and thought the problem was the inadequate money supply because the Fed did not print enough money to maintain effective demand. He built on the work of Irving Fisher and Keynes in the 1920s to create modern monetarism as a way to manage capitalism and as an alternative to Keynes’ fiscal deficits. Essentially he thought that price inflation correlated with the money supply because the velocity of circulation and transaction rates were stable. Unfortunately it is almost impossible to measure the money supply and there is no reason to suppose in a depression or boom that velocity of circulation and transaction rates are stable. But his approach of printing money is the core of current QE policy and was central to Alan Greenspan’s free market fundamentalism and the famous Greenspan put.

Keynes approach was not really tried much in the New Deal and deficits were very limited relative to the size of the economy/size of the deficit in aggregate demand. But his approach was a brilliant success in WW2 and when extended via Bretton Woods to the international scene the foundation of post war prosperity, creating the landscape in which capitalism could thrive in a managed way. Unfortunately President Nixon who thought he was a Keynesian (as Eisenhower, Kennedy and Johnson were) but didn’t understand it. He took the US off gold, destroyed Bretton Woods and spent his way to election victory in 1972 and set the scene for stagflation of the 1970s. Keynes approach showed its limitations because he didn’t expect Nixonian insanity.

Friedman’s finest hour was when Paul Volcker appointed by President Carter shut down the money supply expansion and raised interest rates and strangled stagflation. Thereafter, via raising defense spending and cutting taxes producing large deficits. President Reagan became yet another Keynesian to put the economy back on track, though he was sane enough to raise taxes when the deficit got out of hand unlike President Bush 2. President Bush 2 was more like Nixon: a bastard Keynesian who ran deficits in response to 9/11 but then kept them in good times and in all ended in 2008 tears….

Friedman’s approach has never been much good in depressions because merely having money supply available does nothing to make businesses want to invest. As Keynes said it is like pushing string. And in fact the US has since 2008 been running fiscal deficits as per Keynes though in my view they should have been initially larger. QE has helped but has led to asset price inflation in stocks and housing that will come back to bite us.

And if you want to see what happens when you don’t use QE and you try to balance budgets in the face of a depression, look at Europe that is an economic catastrophe, partly because of the Euro but mainly because it has not done QE or the right fiscal stimulus. The UK is like the US but has recovered slower because it tried austerity too but fortunately wasn’t very serious about it.

Hope this helps, though I personally doubt many those who argue from a “markets/capitalism is never wrong” faith based viewpoint can actually take this in, even without agreeing as they tend to disregard any theory or data that contradicts it.  I have not met a conservative, who understood Keynes or Friedman except David Stockman who understands Friedman and hates his theory but has never read or understood Keynes at all. But then I may have met a skewed sample.

Milton Friedman and John Maynard Keynes:

About creativeconflictwisdom

I spent 32 years in a Fortune Five company working on conflict: organizational, labor relations and senior management. I have consulted in a dozen different business sectors and the US Military. I work with a local environmental non profit. I have written a book on the neuroscience of conflict, and its implications for conflict handling called Creative Conflict Wisdom (forthcoming).
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