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Keynes or Friedman: Who Won The Battle in The Global Financial Crisis

Updated on September 16, 2013

Keynes or Friedman: Who Won The Battle in The Global Financial Crisis

By Francis Adams

The Global Financial crisis, now half-a-decade behind us has been less catastrophic compared with the Great Depression of the 1930s. But the pain of its economic, political and social impact – shrinking wages and uneven recession (affecting some parts of the world more severely than others) – has influenced economies, their neoliberal economists and policymakers to return to Keynesianism. Pioneered by Briton John Maynard Keynes, the most popular economist of the twentieth century, Keynesianism and its recommendations – fiscal stimulus and expansionary monetary policy – have seen a major resurgence since the outbreak of the current global economic crisis.

The Keynesian economic philosophy that served as the benchmark for policymakers in the advanced world from the end of the Great Depression up until the 1970s, lost support following criticism led by American economist Milton Friedman and others including Friedrich von Hayek and Robert Lucas Jr. Of them, Friedman’s influence was more profound as he opposed activist Keynesian government policies, instead, proposing an alternative macroeconomic policy called Monetarism. Unlike Keynes, Friedman hypothesized that the rate of unemployment existing in an economy was natural and that the government’s intervention to increase employment above this rate, by increasing aggregate demand, would only cause rate of inflation to escalate.

Apart from arguing that the Phillips Curve – the link showing that unemployment declined when the rate of inflation increased – was not stable, Friedman also predicted Stagflation, a situation where the rate of unemployment continues to be high amidst a high rate of inflation and slowing economic growth. These observations helped convince policymakers and economists to adopt Friedman’s economic philosophy of the virtues of a free market economic system with minimal state intervention at the expense of Keynes’ philosophy.

In fact, Keynes’ graduation as an economist had taught him that it was best to leave matters to be sorted out by the free market forces. Thus, initially he had little reason to be inflexible in advocating state intervention. However, the uncertainty and the magnitude of varied economic problems the world was facing in the 1930s prompted him to look for new and bold policies needed to bring stability to an economic system on the verge of collapse and eventually leading him to recognize the importance of state intervention.

During the Great Depression, the economic philosophy of Franklin D. Roosevelt, the 32nd President of The United States, matched that of Keynes’. Both were keen on safeguarding capitalism backed by government policies that would stabilize and secure the market system. According to Keynes, the primary objective of a government’s economic policy was the achievement of full employment along with equitable distribution of market power in order to provide economic growth, stability and improving the standard of living.

Friedman, who was in favor of and even tried to save the free-market ideology, had to admit to Keynes’ answer that government action was indeed required to prevent depressions, although insisting that such an intervention should be very limited or narrow. Friedman argued that there was no need for new government programs if the central bank acted appropriately, such as saving banks by injecting enough reserves into the banking system to avoid a decline in money supply.

Up until the Global Financial Crisis (2008), policymakers and economists worldwide and specifically in the advanced economies were on the same wavelength that fiscal stimulus would have little effect even during a recession and should be utilized occasionally.

The Global Financial Crisis brought about a radical change in thought as these policymakers and economists returned to the Keynesian philosophy by announcing major stimulus packages in their bid to avert another global depression. A year later, this belief again lost its sheen. With a depression successfully prevented, policy makers had a change of heart about providing further fiscal stimulus despite the reality that rate of unemployment in many countries continued to remain high.

In his book, The General Theory [of Employment, Interest and Money] , published in 1936, Keynes challenged the prevailing classical economics at that time by arguing that the level of employment was determined, not by the cost of labor but by the spending of money (aggregrate demand). “The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes,” he stated in the book.

In other words, Keynes was able to see the big picture of how aggregate demand is linked to and determines levels of employment and inflation. He also elucidated the impact of demand on the distribution of income, government budgets and national trade deficits. The foundation of economic policy, according to Keynes, should be based on creating full employment ad stabilizing the economy. This approach and the book led to the creation of the term macroeconomics as well as the “Keynesian Revolution”.

While working on his book, Keynes is reported to have written a letter to Irish playwright and co-founder of the London School of Economics George Bernard Shaw, whom he considered a friend, saying, “I believe myself to be writing a book on economic theory which will largely revolutionize, not I suppose at once but in the course of the next ten years – the way the world thinks about economic problems… I don’t merely hope what I say, in my own mind I’m quite sure.”

Keynes realized that at the macroeconomic level, uncertainty and imperfect market conditions or structures would create coordination problems between aggregate demand and aggregate supply, which in turn would affect full employment. In such a situation, Keynes believed, the state had to step in and provide what private markets could not.

The experience of the past decade in East Asia, the Eurozone and the United States have indeed shown us that Keynes has proved himself right and Friedman wrong in the need for a more activist government.

As a result, at the heart of the stimulus-austerity debate that has gripped the advanced economies during the past few years is the effectiveness of Keynesian stimulus.

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      iakovos 3 years ago

      The Causes of the Economic Crisis for non Economists

      http://www.scribd.com/doc/201709399/The-Causes-of-...

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      Howard Schneider 4 years ago from Parsippany, New Jersey

      I totally agree with your analysis, KnowingNews. The U.S. Fed Chairman Ben Benanke is an economist whose concentration was the Great Depression of the 1930s. This was lucky for us because he knew the causes and also what worked and did not. Keynesian economics lifted the economy and was then thwarted by Conservatives in 1937. They created a pullback that plunged the economy back into a deep depression. Bernanke knew this and has continued to keep our economy liquid even with the Republicans withdrawing spending and blocking spending. This is why America has come out of its deep recession quicker and stronger than Europe. Excellent Hub.