Keynes versus Friedman forever (II)

By Luis Arroyo, in Madrid | [Part I] Another burning debate has risen about the government spending multiplier, a topic Keynesians like very much. In their logic, when the interest rate reaches zero percent, monetary policy becomes sterile, because the issuing bank cannot lend money at negative rates. There is a liquidity trap because the real interest rate to stimulate investment is negative. The only stimulus that is available is the demand for spending, which would raise all non-used resources (unemployment, idle capital).

Let’s make a point: Keynes never said we had to stop printing money nor said that new spending be financed in the debt market (which would have a contractionary effect on private spending) but monetized. The increases of money M, by themselves, do not encourage private investment. The government takes the initiative, takes that money and spends it on building bridges and schools (as an example of well spent money, although we have seen in Spain that bridges and schools sometimes means sumptuous useless airports).

Keynes’s original model was therefore monetary/fiscal, and well funded, financially, it has a clear effect of increasing demand. But if financed with debt, then it would be replacing private spending with public spending. Stimulus multiplier is zero. Keynesians abandoned Keynes to his fate and soon advocated that monetary policy in a liquidity trap was useless, ergo public spending, financed in any way, even with a tax increase, had a multiplier effect.

Those on the other side argue that Ricardian equivalence makes any expenditure financed by debt into a sterile one, because people know that if taxes do not rise further now, they will not rise later to pay that debt and its interests.

Nick Rowe has a very good post about this, but the interesting thing is that it has led to a Krugman post: when-some-rigor-Helps-mildly-wonkish, which in turn has led me to his article of 1998, in which he spoke of the liquidity trap in Japan.

In Japan’s Trap, one of the first Krugman works I read, one can see how much he has changed. Back then, without quoting it, he said exactly the same as Friedman about Japan. Friedman’s article, Reviving Japan, summarized here, is a true gem, and was written before (1997) Krugman’s (1998). Both say something very similar: the Bank of Japan should raise (expectations of) inflation so real interest rate gets low enough to restore investors’ and consumers’ confidence. It did not do it.

A a result, the country suffers from a secular stagnation and what is worse, tax policy has increased government’s debt to a 200% of Japan’s GDP. In neither case we find a trace of fiscal policy. I quote Krugman’s words, and then Friedman’s.


“If this stylized analysis bears any resemblance to the real problem facing Japan, the policy implications are radical. Structural reforms that raise the long-run growth rate (or relax non-price credit constraints) might alleviate the problem; so might deficitfinanced government spending. But the simplest way out of the slump is to give the economy the inflationary expectations it needs. This means that the central bank must make a credible commitment to engage in what would in other contexts be regarded as irresponsible monetary policy – that is, convince the private sector that it will not reverse its current monetary expansion when prices begin to rise!”


“The surest road to a healthy economic recovery is to increase the rate of monetary growth, to shift from tight money to easier money, to a rate of monetary growth closer to that which prevailed in the golden 1980s but without again overdoing it. That would make much-needed financial and economic reforms far easier to achieve…. The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

“There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately…”

One sure thing, both articles are worth reading.

Luis Arroyo is a former Bank of Spain economist. He writes for

About the Author

The Corner
The Corner has a team of on-the-ground reporters in capital cities ranging from New York to Beijing. Their stories are edited by the teams at the Spanish magazine Consejeros (for members of companies’ boards of directors) and at the stock market news site Consenso Del Mercado (market consensus). They have worked in economics and communication for over 25 years.

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