Keynes v. Friedman

A question was recently posed to me "what do you think about Keynesian Economics?". My response: "it's definitely a viable theory, especially given today's economic climate". The questioner, let's call him Jan Patel, was surprised and argued that Supply Side economics was the superior theory. Now being the type of economics student that studied more David Ricardo (read:comparative advantage theory)than either John Maynard Keynes or Milton Friedman (Supply Side Economist), and even so not even much of him, I had to think about the long run effects of both policies for a little bit.

Here's what I came up with: In Keynesian theory, stimulation of the economy is achieved by a combination of two methods: 1. lower interest rates (to increase spending by decreasing savings/increase borrowing, because, hey, what the hell. Money's cheap); and 2. Increase Government spending.

Conversely, Supply Side Economics stimulates the economy by lowering tax rates, primarily for business and investors, which in turn leads to an increase of available capital.

So you can see the conflict. On the surface both theories seem to make sense. Now here's where it gets tricky - every economic theory is based on, wait for it, assumptions. The first year economics student, if he or she learns nothing else, learns a little bit of latin: ceteris paribus - "all other things being equal", which is the mother of all assumptions in economics.

So short and sweet here's my take: Keynes assumes that, all other things being equal, lower interest rates mean a.)that banks are less willing to lend money. When interest rates are too low banks and investors look for safe investments which have traditionally been government bonds. The Government can then use the proceeds from the bonds to invest in infrastructure which will pump inject capital into the market. Or b.) With lower interest rates more people are willing to borrow and invest in the private sector - which will also pump money into the market.

Supply Side Economics assumes that, all other things being equal, lowering taxes will lead to increased capital, which leads to increased market supply, which leads to higher demand (it's one of the few laws of economics - higher supply = lower prices which drives up demand until equilibrium is reached). The lower taxes lead to increased investment, which leads to cheaper goods and thus higher incomes.

Now here's the kicker: all other things are not equal! Both models when examined separately assume that the consumer is rational - that given the opportunity the consumer acts in his or her best interest. In recent months we have seen the folly of taking this assumption for granted. The consumer is anything but rational! Interest rates are at an all time low and money is indeed available for qualified borrowers. However, the paranoia propagated by the 24 hour media, by the pundits that are ill equipped to comment authoritatively on complex economic issues, but are ever so entertaining, has turned the average consumer/investor into quivering masses of hoarders. With low confidence, people are unwilling to borrow money and they are unwilling to spend the money that is pumped into the economy by the government. In addition, consumers are more likely to save, and thus, not purchase the supply of goods and capital that is produced via Supply Side policy - resulting in an inefficient allocation of resources; a cardinal sin for the economist.

So is it all doom and gloom? The short answer is "no". What is needed is a combination of both policies combined with an effective means of positively influencing the discourse of the media.

So Jeff, I mean, Jan Patel - there's my take on it.