Yes, the Fed can do more, and probably should have done more a long time ago

The infamous quote from Milton Friedman was: "We're all Keynesians now."

Some, including Friedman, claimed that quote was taken out of context.  I can't find the precise quote right now, but he prefaced that statement with something along the lines of "in a sense.."  and appended that comment with something along the lines "and in another sense none of us are Keynesians now."

What Friedman  meant at that point in time, and I believe he thought up until the day he died, was that the vast majority of economists were Keynesians in the positive sense.  That is, the Keynesian model of macroeconomic business cycles was essentially correct.  But Friedman disagreed with Keynes' normative solution to the problem of severe recessions and depressions: that fiscal stimulus should be used to rescue the economy from recessions and depressions when interest rates hit the zero lower bound.   Instead, Friedman argued that appropriate management of the money supply (i.e, Fed policy) would correct the problem of severe recessions and thereby render fiscal stimulus unnecessary.

And I think most economists agreed with Friedman on both points.

Until now. (Err.., almost two years ago.)

The current severe recession pokes hard at this old debate because the Fed did all the things Friedman said the Fed should do, but despite these efforts, the economy is still in a liquidity trap--stuck at the zero lower bound of short-term interest rates with high, persistent unemployment and anemic growth.

I had hoped that this situation might give rise to renewed and thoughtful intellectual debate about (a) what more could and should the Fed do in a situation like this one; and (b) what kinds of fiscal stimulus would make the most sense if it had to be done.

Sadly, we haven't had much of this kind of debate.  Instead, I think the slap in the face that current events have given to economic thinking since Friedman's infamous quote seems to have caused a knee-jerk descent into denialism. One hand of that denialism has been to reject Keynesianism altogether, even the positive part that was more-or-less settled(**).  The other hand of that denialism has been to assume there is nothing or very little the Fed can do if stuck at the zero lower bound.  This wouldn't be so bad if the implications of this denialism were left in the ivory towers of academia.  Sadly, it hasn't; it's infected both fiscal and monetary policy in ways that  almost surely have and will continue to make our economic situation a lot worse than it needs to be.

Now it's true that blame on the denailism front goes to both sides of political spectrum.  But it's also true that one side deserves a heck-of-a-lot more blame than the other.  I think I'll leave it at that.

A critical issue here is, I think, that many who reject Keynesianism (in the positive sense) either (a) don't understand the essence of the model and/or (b) think of Keynesianism in purely normative terms (i.e., fiscal stimulus) and not in positive terms.  Keynesianism is strange and in many ways counterintuitive, especially to students subject to standard undergraduate and graduate training.  Yes, most 1st-year undergraduate textbooks have the standard Keynesian model.  But I gather most students in most classes don't understand what they're reading, if they're reading.  This stuff is too weird and most people are too impatient to figure it out.  And most graduate students are neck deep in the mathematics of real business cycle theory and Neo-Keynesianism that they don't see the forest through the trees.


One issue that confuses a lot of people about Keynesianism (and Friedmanism) is one that stumped me really badly but I was too shy and perhaps lazy to ask a professor to explain it to me.  I was always puzzled by the idea that the Fed lowered interest rates to increase the money supply, but that an increase in the money supply increased inflation (and thus interest rates).  Now, all this is true and completely consistent with both Keynesian theory and with the facts.  But it deeply confuses a lot of people, including one very accomplished economist who is President of one of the Federal Reserve banks.

Along these lines, I really like these two wonkish posts by Krugman [1, 2].  I think this kind of analysis is pretty much textbook and very few could substatively disagree.  But I've never seen this particular issue laid out so clearly.

This kind of stuff is important because a lot of the people who reject Keynesianism just don't get the *positive* aspects of Keynesianism.  Rather, it seems, they have a belief system that objects deeply to the normative Keynesian perscription (fiscal stimulus).  It makes it hard to have an effective debate, or find serious solutions to real and challenging problems, when one half is thinking of Keynesianism in the fully positive sense and the other half is thinking of Keynesiansim in the fully normative sense, and there are few even acknowledging that fact that everyone is talking past each other.

My one complaint about Krugman here is that he should have been using his exceptional communication skills at pushing more action by the Fed a long time ago.   After all, he's way more likely to influence the views of economists than those of congress and the President.

It seems the only person out there channeling Milton Friedman is Scott Sumner, and that's really too bad.

(**) Since Lucas's critique of Keynes there has been active research considering the fundamental sources of price stickiness, but none of these change the essential Keynesian story.  There's also the Austrians (a relatively small fringe group), who channel Hayek, but are model phobic and tell stories that, save for their logical inconsistencies, seem fundamentally Keynesian in nature.  Krugman [1, 2, 3] calls Austrians "self-hating Keynesians."  I think he's right.


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