Let Friedman-Keynes deliver: Economic Times, 8th September 2007

Keynes did not believe that laissez faire economics could deliver adequately, while Friedman did. Keynes had a good role chalked out for the government while Friedman found it meddlesome and ineffective. Keynes preferred fiscal over monetary policy especially when there was a liquidity trap while Friedman relied on monetary policy. Friedman spoke of a long run rate of unemployment in which monetary policy could do nothing, while Keynes believed that in the long run we are all dead. Which of these two economists should one follow? Most central bankers today seem to believe that you can control the economy through cogent interest rates management. The focus is on inflation control and it is believed that interest rates can be used to either expand or contract credit growth and hence money supply. And barring oil prices, inflation at the global level is viewed as a monetary phenomenon a la Friedman. This conclusion has been independently arrived at by them based on their own domestic circumstances. Does this mean the end of Keynesian economics? This is interesting because the economics of Keynes has been the driving factor for several decades now where governments have used budgetary deficits to drive their economies. But, today deficits are not encouraged and even the Indian government is committed to fiscal responsibility. It fits in well with the modern tenets of globalisation wherein countries are covertly committed to free markets and less government interference in economic activity. Growth is spurred by lowering interest rates, which even Friedman would have admitted was effective in the short run though never in the long run. Now, Keynes had his theories right at times of economic distress when pump priming worked. It now appears that when economies are on a downswing, there will be a preference for the Keynesian prescription as it is the only way out from a low equilibrium trap. A clear case is Japan where a recession, on more than one occasion has made monetary policy impotent, due to the existence of a ‘liquidity trap’ where increase in money supply is ineffective as excess cash is only hoarded and not spent. The solution is to go back to Keynes and run deficits to induce demand-led growth measures, which worked reasonably well. In India too before we were on the 8% growth path, we did pursue discretionary monetary policies to induce growth through accommodative measures such as low interest rates and banking preemptions. The story becomes different when economies are on the upswing. At this stage, growth does not matter or rather becomes a concern because of prospective overheating. Governments are quick to advise their monetary authorities to apply the brakes because high inflation is possible, and could be politically destabilising. Interest rates are then increased until such time that a slowdown is engineered. The idea is to make credit expensive which lessens the impact of excess demand forces. So it is a case of monetarism taking over from demand-led strategies. Some curious conclusions can be drawn from these patterns observed both inter-temporally and inter-spatially. The first is that it is essential to identify the part of the business cycle that we are traversing for deciding on the economic doctrine as the remedies address specific conditions. The second suggests that developing countries should typically persevere with Keynesian economics where growth is low and deserves a big push. The developed countries could fall back on monetarism on the upward cycle but revert to Keynes in case of a downswing. But, when any country embarks on high growth through demand-led strategies, inflation would tend to be high and a 5-10% range should not be alarming. This is really a tradeoff which we should be prepared for because we were uncomfortable with a 6% inflation rate last year even as growth had crossed the 9% mark. The third ideological issue raised is whether or not deficits are good. Presently, fiscal deficits are not encouraged which makes implementing demand-driven policies that much more difficult. This is critical for developing countries as they would be at a disadvantage in the global financial markets when high fiscal deficits invariably lead to lower sovereign credit ratings. There is evidently need to move away from this mindset and make judicious use of fiscal deficits when warranted. The clues provided here are that it is not possible to be a monetarist or Keynesian all the time. The circumstances need to be examined before adopting an approach. Economic theory says that if there are two objectives, i.e., economic growth and price stability, then it is essential to use two instruments, in which case interest rates and fiscal policy are both pertinent. Fiscal policy is important in countries like India where distribution is critical as also for private sector incentives in the form of tax related concessions. Monetary policy combats inflation directly and can also drive growth. Therefore, we need both Keynes and Friedman today.