Keynes, Lerner and Friedman in an Uncertain Age paper presented to Canadian Economics Association meetings , Vancouver May 31, 2014

Keynes, Lerner and Friedman in an uncertain age






                                   by Harold Chorney

                                   Professor of Political Economy

                                   Graduate Program in Public administration                                  and Public Policy

                                   Dept. of Political Science

                                   Concordia University, Montréal












Paper presented to the annual meetings of the Canadian Economics Association, Vancouver, Simon Fraser University, May 31, 2014



Abstract: I have written elsewhere about the return of Keynes and the relevance of his work on aggregate demand and the slump of the 1930s to the current post crash prolonged slow recovery. I have also written about Friedman’s notion of the natural rate of unemployment and the importance of recognizing the lower limits to anti-inflation policy in terms of the natural rate of inflation. I have also written extensively on deficits and debt and the policy debate over deficit finance as a tool of economic policy. Finally I was one of the first economists to address the issue of what has come to be known as quantitative easing by exploring temporary debt monetization as a policy tool in the context of Canadian data over a 40 year time series from 1950 to 1989. Now that the Federal Reserve has begun to taper back its QE experiment and the U.K. appears to be following the Fed’s lead(but with a much more anti-Keynesian fiscal stance) more data will come available on how well the domestic economies and the global economy can accommodate these policy shifts over a relatively short time period. As one analyst has put it to me at a Conference on Social Economics in Montréal at which I presented my argument in a paper on the crash and Keynes and QE, the fact that we have had this experiment with QE and no inflation problem has emerged ,raises questions about what remains of Friedman’s monetarist case. In this paper I begin the process of integrating these different approaches as part of a strategy to develop a coherent theoretical framework that bridges the gap between Keynesian and neo –classical and classical analysis. I am aiming for a policy alternative which privileges low unemployment and moderately low inflation and takes as a given a high degree of uncertain behaviour in the financial markets which feeds back at certain points into asset markets and mass consumer behaviour. Bibliography available at the back of the paper. 








We live in an uncertain age. Perhaps in reality we always did. But despite enormous advances in science, technology particularly the technology of communications and mass behaviour, the core of economic behavior remains partly unpredictable, even perversely so. What we do know is that most of the time financial markets can be highly unstable with risk factors large enough to permit drastic errors in the valuation of assets, the supply of animal spirits – the very essence of animal spirits is of course the suggestion that they are beyond reason and are instead instinctual , animal like governed by passions, hunches, intuition and gambling.(See Keynes’s chapter on the state of long term expectations and the  behavior of stock markets in the GT.)


Sheila and A.Dow argue that John Maynard Keynes drew the term from his extensive knowledge of the classical and ancient world.(See S&A.Dow,”Animal spirits and Rationality” in T.Lawson&M.Peseran,Keynes’s Economics:Methodological Issues,1985 cited in Fitzgibbons, Keynes’s vision, 1988) Keynes revealed  some of that knowledge in his discussion of ancient coinage in the opening pages of the first volume of the Treatise on money published in 1930.


My daughter is a  student of neuroscience. She is convinced that by accumulation of enough scientific evidence we can anticipate most behaviour and tame most irrational acts. I am as befits my choice of title for this paper and my age, experience and knowledge of history much less certain of this.


Keynes was convinced that the relationship between risk, probability and uncertainty was central to his theory. He made it clear in his famous Quarterly Journal of Economics article,” The General theory of employment”( QJE Feb . 1937 CW, pp109-123) that followed the publication of The General Theory. The article was a response to four interpretative reviews published in the same journal in November 1936 . In this key article which is an absolutely necessary paper in furthering proper understanding of Keynes’s intentions in the General Theory, (GT) Keynes make it clear that in order to avoid an increase in the tendency to hoard cash and thereby force the rate of interest to rise which in turn reinforces a slump it is necessary to lower rates as far as possible. This is in fact the origins of the rationale for quantitative easing as I have argued in an earlier paper. “After the crash, rediscovering Keynes and the origins of quantitative easing.” (Posted on my web site Without an increase in the money supply the increased demand for cash in response to a slump , no matter how irrational this may seem in terms of the zero rate of return, in comparison to the fear of capital losses it is quite understandable. Hence, he came to believe in The General Theory and in his testimony before the Macmillan inquiry that it was necessary to fight the slump by  a policy of low interest rates supplemented with a program of deficit financed public infrastructure spending(See Peter Clarke’s account of how Keynes evolved to this position in a series of stages, The Keynesian Revolution in the Making, pp.297-304, See also Warren Young Interpreting Mr. Keynes:The IS-LM enigma, 1987.) Hyman Minsky takes both the GT and Keynes’s QJE article as the point of departure for his construction of the financial instability hypothesis that has loomed large during and immediately following the great Wall street crash and banking crisis that swept through the global economy. According to Minsky as with other Keynesians and post Keynesians the neo classical argument that Keynes was all about wage rigidity was clearly wrong. As Joan Robinson put it “Keynes’s argument was not one that was foisted upon him by the bastard Keynesians-that money wages are rigid for institutional reasons. It was that if wages could be cut, in a slump, it would make the situation worse..”  This is why the austerity policies of the European union and the IMF are so disastrous .


They are premised on the false assumption that cutting wages will restore employment because falling prices for labour will both increase exports  and restore employment. But the degree of wage cutting required to bring this result about is so large and socially damaging as to be impractical. In fact, according to Keynes and his circle the exact opposite will likely occur. Prices may fall faster than wages and real wages fall less than that level at the margin required to bring about full employment. Much of the evidence is in for this policy based on inferior theory. The rate of unemployment in countries like Spain 26.2%, Greece 27.5 % and Portugal 16.4 % is extremely high and in France and Italy it is very high 10.3 % and 12.1 % (Eurostat) In all of these countries political instability is also on the rise. There is a very real possibility that France will elect Marine Le Pen the right wing anti immigrant leader of the National Front to the Presidency in the next Presidential election, largely because of the high unemployment.(See How the National Front is systematically winning over the French March 26,2014)


But of course, if we believe that uncertainty that cannot be completely precisely quantified by probabilistic terms to be true  and Keynes clearly did despite Frank Ramsey’s position, then self reflexively we have to adjust our degree of confident belief in policy and its consequences, including Keynes’s policies. This was a point that Alan Coddington originally made in his critique of the Cambridge school’s promotion of uncertainty as the key factor in Keynes’s GT.(Alan Coddington Keynesian Economics :The Search for first Principles, 1983) Of course, Coddington was a fan of the Hick’s distortion of Keynes, the IS-LM analysis which came to dominate neo-classical thought during its Keynesian epoch . Indeed it was the Hicks Hansen model of the ISLM that is central to Gardner Ackley’s leading Neo-classical Keynesian macro text published in 1961.  Although Ackley does acknowledge in his discussion of liquidity preference that a tendency to hoard cash in bad times by private nonbank investors might disturb the smooth functioning of the securities markets and increase uncertainty in bad times. According to Ackley “What Keynes argued was that there exists an inherent tendency for hoarding and dishoarding to occur in a way that is systematically destabilizing.”(p173 Ackley)   Coddington argues that uncertainty ought not to prevent approximation  of near certainty sufficient for analysts to operate within. What is important he argues is not the fact of uncertainty but rather the way in which economic actors behave in the face of such uncertainty. So, for example , he argues that even if uncertainty does exist simply replicating the investment decisions of the last period where after the fact real information does exist is not very likely to result in wayward or unruly results. “Thus the fact of uncertainty does not of itself establish the conclusion concerning the wayward and unruly behavior of  particular macroeconomic variables.” Compare this statement with Keynes’s letter to Hubert Henderson on 28 May 1936 where he writes “I should I think be prepared to argue that in a world ruled by uncertainty with an uncertain future linked to an actual present, a final position of equilibrium , such as one deals with in static economics, does not properly exist.”(p.222, The General theory and After:A supplement, vol.xxix,CW)


Coddington may be right much of the time. But the explosive results of the bursting of the real estate markets and the cascading credit default swap algorithims that we witnessed in the crash suggests otherwise. As the fractal mathematician Benoit Mandelbrot has shown fat tail distributions of outcomes are more common than we once believed.(See Mandelbrot’s The Misbehaviour of Markets See also Nassim Taleb , The Black Swan; Scott Paterson ,The Quants:How a New Breed Of Math Whizzes Conquered Wall Street and Nearly Destroyed it;William Cohan, House of Cards;Michael Lewis, Panic, and The Big Short and Richard Bookstaber,A Demon of our own Design:Markets , Hedge Funds and the Perils of Financial Innovation)


As Keynes stressed we need to factor in the great importance of states of mind or beliefs for action. We cannot simply reduce policy to numbers, even probabilistic numbers. As Carabelli puts it Keynes “fought against the blind application of the calculus of probability and the reduction of probability and of other magnitudes like goodness,utility and price relations(in the context of index numbers) to numerical measurement.  (Carabelli pp99-100) So in fact we need not only a policy which understands the importance of animal spirits and the sustaining of aggregate demand but one which enhances our and the public’s robustness of belief in the efficacy of policy.

As William Greer puts it Keynes in responding to Ramsey made it clear that rationality could only be the result of “legitimate, reasonable information…probability is not an objective property of reality but rather one aspect of the way we perceive it to be. As Paul Davidson likes to argue “Keynes’s own perception of reality was that of a non ergodic ,transmutable world possessing a permanently uncertain future”. (Davidson and Keynes quoted in William Greer, Ethics and Uncertainty The Economics of John M.Keynes and Frank H.Knight p.36-37)

In the above sense of animal spirits sense there is some convergence of method in the approach adopted by Keynes and Lerner and later post Keynesians and Friedman and some of his followers who believed it was crucial for the success of their policy that public attitudes toward growth and inflation be shaped to resemble the behavior implicit in their models of stable monetary growth and moderation of inflationary expectations. Fitzgibbons explores many of these issues in his work on macroeconomics.(Athol Fitzgibbons, 2000)


One of the greatest strengths of John Maynard Keynes thus was his grounding in the work of probability and risk and uncertainty. His work in this area made him famous in the Anglo philosophical world and has been the subject of considerable interpretive research. His notion that there was a core of uncertainty to economic behavior served him well in making sense of the economic collapse that followed the crash of 1929 and equipped his followers like Hyman Minsky to anticipate the crash of 2007-08 although it was never truly understood by many of his peers and was in fact rejected in scientific terms by other leading theorists. (See the critical work of F.P.Ramsey, ‘Mr.Keynes on Probability”, 1921; A. Carabelli, On Keynes’s Method, 1988.) Of course, Keynes did not accept this rejection happily.


In fact, Carabelli argues quite persuasively that Keynes anticipates this response by developing his quite powerful and possibly feminine notion of induction, intuition and intuitive understanding as a counter to probabilistic hard analytical  knowledge . As Fitzgibbons pointed out in an earlier important work Keynes’s Vision, Keynes was strongly influenced by the events in the physical sciences and philosophy in the early part of the nineteenth century.(See Roy Harrod, The life of JMK, p.186) He was fascinated by both Einstein and Freud and hence he was trying to introduce some of these notions in his work in economics. Ever an optimist ,even he was deeply troubled by the long slide into the second world war and by what he considered to be the irrational fatheadedness of the powers that be which ran Britain in the 1930s. (See  Virginia Woolf’s comment “Maynard, even Maynard cannot find much that is hopeful now” in Quentin Bell, Virginia Woolf, A Biography, 1972, p.209 vol.2 and Keynes’s comment when the war broke out and a number of Jewish and other refugee economists were interned by Britain because they were refugees from the axis powers. “ Our behaviour towards refugees is the most disgraceful and humiliating thing which has happened for a long time. Also rather disconcerting to find that we have such obvious fatheads still in charge” quoted in Harrod p.497. See also Keynes’s memoir club paper My early beliefs for his commentary on his “pre Freudian habit” of “attributing an unreal irrationality to other people’s feelings and behavior (and doubtless to my own too) “ Keynes was seeking to show that in his late middle age he could appreciate the importance of passion as opposed to pure reason.(S.E.Rosenbaum, ed. The Bloomsbury Group, p.96 , 1995) Keynes also visited Einstein on several occasions . He clearly admired him and in an intriguing passage from the New Statesman in Skidelsky’s biography he is quoted defending Einstein and his theories against his anti semitic detractors in Nazi Germany. Skidelsky also points out the parallels between Keynes’s work and that of Einstein  (p.487)

                                                Keynes’s identification with Einstein is also too clear to miss. Keynes was writing a ‘ General Theory’ of employment in which he called classical economics a special case and classical economists Euclidean geometers in a non Euclidean world. “ (p.487-8) But according to Skidelsky Keynes had stopped at total revolution and made his peace with the bankers and businessmen as early as his Eton days.  He knew how to get on with them. “His mission was not to destroy them, but to persuade them into paths of righteousness.”  This ambiguity remains an issue to this day and the heart of a debate between the Kalecki inclined post Keynesians and the more moderate Keynesians, neoclassical and otherwise.

  Keynes’s Economic Consequences of the Peace had introduced him to Einstein and Keynes rightly considered him a sage.(See D. Moggridge,Maynard Keynes:An Economist’s biography p.659  “I paid a call on Einstein. The old sage was in bed with a vast olive corrugated countenance crowned with a white shock of Struwelpeter hair, and a big toe protruding from under the counterpane.  He was full of gusto and enthusiasm…” Keynes had also written about the importance of relativity with respect to time. He had done so as early as 1903. (‘Time’ A paper read at the Parrhesiasts Society, May 8, 1903, Marshall library manuscripts of J.M.Keynes cited in Carabelli, p.127+p.305) According to Carabelli the paper stresses the relativity of time and of “all time measurement. “ It is, Keynes writes “I believe impossible to arrive at any conception of time which shall be independent of the conception of change.” He argues in the paper the essential interconnection of ideas of time and change and the importance of knowledge to the measurement of time. So his fascination with Einstein, Freud and the rise of phenomenology all of which occurs at the end of the nineteenth century and the beginning of the twentieth century should come as no surprise and forms the intellectual backdrop to the development of his own ideas about economics. Einstein like Keynes argued that beauty and aesthetic judgement could be an arbiter of scientific truth. “He believed both in 1913 and hereafter that a theory had to be beautiful, formally graceful, if it was to capture a glimpse of nature in action. “ (Einstein in Berlin, p45, Thomas Levenson, 2003)


Keynes, of course , because of his being influenced by G.E.Moore operated with somewhat similar principles.  For Keynes for a theory to be sound it had to produce moral or beautiful outcomes. Unemployment and poverty were not beautiful nor  morally justified so the theories that justified them were inherently unsound.


It is intriguing that Pigou , Keynes’s straw man target in The General Theory, understood that Keynes was seeking to follow Einstein’s lead in arguing that classical and neo classical thought on market clearing and rationality was a special case and his general theory was the general case just as Einstein’s theory was intended to show that the classical mechanics of Newton was the special case. But Pigou was not pleased that, as he claimed unlike Einstein who had shown proper respect for the greatness of Newton, Keynes had disrespected his classical opponents. 


“Einstein actually did for Physics what Mr.Keynes believes himself to have done for Economics. He developed a far reaching generalization under which

Newton’s results can be subsumed as a special case. But he did not ,in announcing his discovery, insinuate, through carefully barbed sentences, that Newton and those who had hitherto followed his lead were a gang of incompetent bunglers.” (P.592 Moggridge. )


 These kinds of acerbic comments and counterblasts have bedeviled the profession of economics ever since its inception and they are not likely to be banished anytime soon. This is so for both ideological reasons since economics is closely bound up with politics but also because of human nature. But humanity faces very serious economic, ecological and demographic challenges. For reasons of peace and our very survival as a species being we cannot go on as we have in the past. Wars, instability and violence are always exacerbated by economic instability. The state of the global economy since the crash, the slowness and incomplete nature of the recovery obliges us as servants of reason, enlightenment and the public good to find a way to draw the most from competing theories to find more effective policies for increasing employment, diminishing poverty and restoring a sense of greater equity all the while respecting the environment as much as possible. It seems clear, at least to me, that the synthesis I am beginning to propose in this paper has some potential. I say so cautiously because I know that its very possible for bad policy based on flawed theory to reign supreme for a relatively long period of time.


Abba Lerner was originally part of the Hayek circle at the London School of Economics assembled by Lionel Robbins specifically to counter the subversive ideas of Keynes at Cambridge. But after his encounter with Joan Robinson and Richard Kahn at the London -Oxford -Cambridge student seminars he switched his position(as did Kaldor and Hicks) and became an outspoken advocate of Keynes’s economics and a strong advocate of stimulus through deficit finance, financed if need be by greater monetization of the public debt. Although he never called it by this name Lerner’s functional finance was in effect the equivalent of quantitative easing. Lerner was harshly critical of the fiscal conservative school as was Keynes. But Keynes understood the limitations of theory in the world of practical reason. As David Colander has shown in a now famous short article “Was Keynes a Keynesian or a Lernerian “Keynes was reluctant to publicly associate himself with a view that he privately knew to be impeccably correct , though politically difficult. This was Lerner’s assertion that in a slump if there were resistance by investors and the banks to buy government securities at the prevailing rate of interest driven low by the rise in the propensity to hoard cash the central bank could simply buy the securities to the necessary level and pay for them by issuing money or as is often commonly said by opponents of deficits by printing money.


Once while in Washington speaking at a function at the Federal Reserve attended by central bankers and other officials with Lerner and Evsey Domar of Harrod –Domar fame) in the audience Keynes made it clear to Lerner sotto voce that one had to curb theoretical excess with the discipline of practical policy. Lerner drawing upon his clear understanding of the role of deficit finance in Keynes’s work was suggesting that there would be no problem with excess saving after the war because the government could simply increase spending to soak up the excess and finance the increased spending by expanding the national debt. Indeed. in later years Lerner formalized these notions in his work on functional finance in the Economics of Control and the Economics of Employment. Keynes on this occasion was quite negative and insisted that Lerner was wrong. Domar who was beside Lerner as they spoke with Keynes whispered in his ear that Keynes should read his own work, The General Theory !


Later Keynes changed his view and wrote a very favorable review and letter to Lerner about his notion of functional finance. But at the time according to Domar he called Lerner’s suggestion “humbug” and said something about being unable to fool all the people all of the time. The great European turned American labour economist W.Woytinsky who had been an advocate of counter cyclical works in the late 1920s and early 1930s in Germany to fight unemployment reviewed Lerner’s work and Colander quotes a very revealing passage in which he identifies Keynes and Lerner in religious terms with Keynes being the chief prophet and Lerner his first disciple.


Lerner’s ideas about functional finance assumed that there was a direct one to one correspondence between theory and practical policy. Keynes despite his recognition of Lerner’s quality of exposition of his ideas didn’t quite see it that way. Practical politics and interests might well serve as a barrier or modifier of implementation. But Keynes wrote about Lerner’s work in praiseworthy terms .


In a letter he sent to James Meade about Lerner’s work he wrote:


 I recently read an interesting article (1943) by Lerner on deficit budgeting, in which he shows that, in fact, this does not mean an infinite increase in the national debt, since in the course of time the interest on the previous debt takes the place of the new debt which would otherwise be required. He , of course is thinking of a chronic deficiency of purchasing power rather than an intermittent one.) His argument is impeccable. But heaven help anyone who tries to put it across to the plain man at this stage of the evolution of our ideas. (April 25,1943,p 320 personal letter to James Meade , reprinted in CW JMK vol.27, 1980)


During 1936 he also had written to Lerner praising him for an article about Keynes’s GT which Lerner had written for the International Labour Review. Keynes calls the article “splendid” and then at Lerner’s request  makes several suggestions for improving it by mentioning the importance which Keynes gave to breaking away from  Say’s law and his emphasis upon the problem of effective aggregate demand; the fact consumption didn’t keep pace with growth of income and hence the importance of investment; finally he suggests that Lerner should distinguish between bank financed money creation through the purchase of treasuries from individuals and the case in which individuals experience greater income and therefore find themselves with more money. (letter from Keynes to Lerner, June 16, 1936)


In fact, Lerner’s conception of functional finance was clear and logical and very different from the advocates of sound finance who typical leaped to ahistorical conclusions drawing not on economic logic and data but on ideology and myth. But that does not mean that Lerner’s policy was without any political risk, particularly for those improperly schooled politicians who did not understand how to explain the argument to the general public and mobilize public opinion in support of the propositions . FDR when he argued in favour of the New Deal despite his earlier fiscal conservatism during which time he followed Morganthou’s balanced budget plans did to some extent later understand although he professed on meeting Keynes not to understand his mathematical prose !( See the discussion in Richard Parker.,John Kenneth Galbraith, His Life His Politics His Economics,   p.91 In a note to FDR Keynes offered him sage humorous advice about how to relate to business men that is worth reading.Essentially Keynes tells FDR not to be afraid of big businessmen .Treat them not as tigers or wolves rather as domestic animals even though they have not been brought up as you would wish. “If you work them into the surly, obstinate,terrified mood, of which domestic animals wrongly handled are so capable, the nation’s burdens will not get carried to market; and in the end public opinion will veer their way. Parker quoting Keynes to FDR first cited in Hession,’s biography of Keynes.)


Barack Obama clearly possesses the intellect necessary to understand these economic ideas yet he, at least in the beginning, like FDR deferred to his fiscal conservative leaning economic advisor Austin Goolsbee in the first term despite agreeing to and passing the key fiscal stimulus bill. But the fact that they for political reasons and also because of the presence of fiscal conservatives within Democratic party inner circles, enacted too small of a stimulus bill because of the politics involved or their own predilections and then complained when it didn’t work as well or as fast as they expected, once again demonstrates the perils of economic policy in practice.


  Lets look briefly at some of Lerner’s argument. Here I am drawing from Lerner’s paper Functional Finance and the Federal Debt published in 1943 reproduced by Brad Delong on his blog.(Abba Lerner Selected Economic writings)  Lerner opens his argument by linking to the task of winning the war and eliminating economic insecurity. In a way that has much relevance today he states “Many of our publicly minded men who have come to see that deficit spending actually works still oppose the permanent maintenance of prosperity because in their failure to see how it all works they are easily frightened by fairy tales

of terrible consequences” (Lerner p.38) Lerner stresses the new theory’s simplicity “ The central idea is that government fiscal policy, its spending and taxing , its borrowing  and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any traditional doctrine about what is sound or unsound…The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance.”



Lerner proceeds to develop his model by arguing  that inflation and unemployment  can be controlled by the government keeping spending neither more nor less than the amount required to buy all the goods and services possible to be produced at current prices.The neo-conservative onslaught on this approach was to develop the idea in public choice theory that politicians spend money to get themselves reelected, first and foremost, so it is naïve to expect them to do otherwise. In other words dysfunctional spending would occur if Lerner’s scheme could be enacted. It is ironic that such a powerful bulwark against functional finance arose out of the work on the political business cycle first explored by the co-discoverer of Keynesian economics Michael Kalecki.(See his essay on the politics of the trade cycle(1943) in which he advances the theory that boom economics is unsustainable because the establishment will not support the consequences of redistribution in favor of the poor and lower classes at the their expense.


The issue of distribution and the interests of the wealthy versus those of the poor and middle classes has become a hot topic. See Thomas Pikketty, Capital in the 21st Century) If spending is deficient it can either reduce taxes or spend more by borrowing or printing money all the while concentrating on keeping total spending at the optimal level that guarantees full employment and no inflation. Taxation is never undertaken because the government needs money since it can print all that it needs. Only when it is necessary to prevent inflation should taxes be levied.  At this point the reader should have a clear idea of why Lerner’s exposition would provoke enormous hostility from great swaths of the public and elite opinion even if his ideas were impeccable and logical.

Lerner goes on to argue that the government should borrow money from the public only if it desires the public to hold less cash and more government bonds and to lower interest rates. Lerner is very aware of the shocking nature of what he is proposing but he makes use of it to attempt to teach the public about the nature of public finance when faced with a fiat currency in a time of economic crisis.


“The almost instinctive revulsion that we have to the idea of printing money and the tendency we have to identify it with inflation can be overcome if we calm ourselves and take note that this printing does not affect the amount of money spent….In brief functional Finance rejects completely the traditional doctrines of sound finance and the principle of trying to balance the budget over a solar year or any other arbitrary period”  Instead the goal is stable full employment, very low inflation and a rate of interest which achieves the most desirable rate of investment and the printing, hoarding or destruction of money necessary to achieve the other goals.(p.41)


Lerner goes on to debunk the myths that are circulated about deficit spending by most conventional analysts. He points out that it was a mistake of Keynesians like Alvin Hansen who in their efforts to appease the critics of deficit finance argued that by keeping the ratio of debt to GDP within reasonable limits and that interest due on it would be easily available from the taxes imposed on a larger national income . “This ‘unnecessary appeasement’ opened the way to an extremely effective opposition to functional finance. Even men who have a clear understanding of the mechanism whereby government spending in times of depression can increase the national income by several times the amount laid out by government, and who understand perfectly well that the national debt, when it is not owed to other nations, is not a burden on the nation in the same way as an individual’s debt is a burden on the individual have come out strongly against ‘deficit spending’.(Lerner,p.43)


Lerner’s pain at this is understandable when we think about the growing hostility to deficit spending among governments and political parties across Europe and in the United States and Canada. This after it is clear that deficit spending combined with quantitative easing to keep interest rates from rising have rescued the global economy from the catastrophe of another great depression. Lerner explains that this reaction occurs because it is understood that the necessity of deficit spending may well continue for several years and cannot easily be a one off experience. This would lead to hikes in taxation which would it is argued discourage investment. As Lerner suggests this crowding out argument is not new. He then goes on to rebut the argument by showing that the deductibility of losses through taxation precisely compensates the investor for the tax burden. To deal with the assertion that a large national debt imposes a great burden in interest payments he points out that the interest on the debt is paid to the bond holders who are the taxpayers who have financed the debt in the first place. These days Lerner’s argument is phrased as “we owe it to ourselves.


“ Indeed the alternative to selling the bonds to taxpayers and paying them the interest thereby ensuring that there is no burden is for the central bank to print the money to finance the additional expenditure or for the central bank to buy the bonds from the Treasury. Clearly in the current world of nation states and national central banks or banks of federations it is possible to finance debt by selling bonds to foreigners and real burdens then do follow from this. But these can be reduced in Europe for example if the European central bank actually performed like a Lernerian central bank and helped overcome the mass unemployment and misery that is so unnecessary in Europe. Lerner argues that the growth of the debt is self limiting , ostensibly because once the debt is spent into the circular flow of the economy growth resumes , employment grows and tax revenues rise and the debt shrinks in proportion to the GDP and then eventually absolutely so long as the rate of interest on it is kept low.


So long as the real rate of interest on the debt is kept below the growth rate of the economy it will behave in this fashion. Inflation, the one legitimate worry that Lerner recognizes might emerge out of the printing of money will not occur because it is the duty of a Functional Finance regime to withdraw money supply to prevent inflation from happening. So in a funny sort of way Lerner respected certain monetarist inclinations insofar as he accepted the notion that excessive money supplied might cause inflation in certain circumstances.


The point is and one that I often make, Keynes was a monetary economist and money does matter but so too does fiscal stimulus, the scissors effect of the two strategies working together is what counts. Keynes in his Treatise on Money and in the chapter on prices in the GT had a well developed theory of how inflation might well develop through supply bottlenecks and disproportionalities and wage and profit push well before the point of full employment, thereby anticipating stagflation. Hence , he might have been skeptical of Lerner’s assurances in Functional Finance to the contrary although he didn’t write so in his praise of Lerner’s argument. Rather it is implicit in his statement quoted above “But heaven help anyone who tries to put Lerner’s argument across to the plain man at this stage of the evolution of our ideas. “ Lerner argues that” so long as Functional finance is on guard against inflation, for it is the fear of inflation which is the only rational basis for suspicion of the printing of money,” there is no problem in financing debt expenditure to fight a slump in the way that he proposes. He goes on to state that instead of crowding out occurring, crowding in is to be expected since “the guarantee of permanent full employment will make private investments much more attractive once investors have got over their suspicions of the new procedure.” This new investment will diminish the need for deficit spending. (p.48)



As the national debt increases tax yields will rise on higher incomes and inherited wealth (again Pickketty’s argument looms large although interestingly this is also the argument of some conservative critics of Pikketty who claim he is ignoring or underestimating the difference in after tax incomes of the rich in making his calculations.) and will help pay the interest on the debt. Finally if governments do not want to borrow from the rich it can increase taxes on them instead which will not reduce domestic spending by as much and the debt will be gradually reduced. (p.49)


 Lerner summarizes his argument: The national debt does not have to keep on increasing. Even if it does grow the interest on it does not have to be raised out of current taxes. Even if it is these taxes constitute only a fraction of the total benefit which flows from government spending in a slump and are not lost to the nation but transferred from taxpayers to bondholders,.” High income taxes need not discourage investment because appropriate deductions for losses can diminish the capital actually risked by the investor in the same proportion as his net income from the investment is reduced.” (p.50)


Lerner’s work in logical and analytical terms is impressive. But clearly Keynes was right to worry that its message would be difficult to convey to and convince the public of its wisdom. Yet , we can see now after five years or more of some degree of Lernerian functional finance unemployment has been reduced, growth has resumed and there is absolutely no sign of inflation. Indeed, the opposite worry is still present.


This then brings me to my final theorist, Milton Friedman. Friedman is undoubtedly among the great economists of the last century. His massive 860 page work with Anna Jacobson Schwartz, A Monetary History of the United States 1867-1960 published in 1963 is a major work of importance regardless of whether one agrees with all of its conclusions and policy implications with respect to the quantity theory of money. It is a work of great value for the historical research alone. Coupled with Friedman’s prolific publication of well written essays on policy and politics, his polemical pieces and his work on the permanent income hypothesis Friedman like Keynes and Lerner must be acknowledged as a major figure in the history of economic thought. Intriguingly the work on monetary history begins with a quote from Keynes’s teacher Alfred Marshall which is worth quoting because it still speaks to modern controversy.


“Experience in controversies such as these brings out the impossibility of learning anything from facts till they are interpreted by reason; and teaches that the most reckless and treacherous of all theorists is he who professes to let facts and figures speak for themselves, who keeps in the background the part he has played, perhaps unconsciously in selecting and grouping them, and in suggesting the argument post hoc ergo propter hoc.”(Friedman and Schwartz, A Monetary History p.xix )


This insight is of key importance when studying monetary policy and the supply of money and seeking to reach a conclusion about whether prices and employment follow money supplied or money supplied reacts as Kaldor and others argued to changes in prices and aggregate demand whose sources lie elsewhere. (See Nicholas Kaldor, The Scourge of Monetarism for the elaboration of this,) 1982&1986. (It is important to note judging from Friedman’s very worthwhile memoirs that he wrote with his wife Rose, Two lucky people that Friedman despite differences in ideology and policy preferences maintained a cordial and friendly relationship with Nicky Kaldor and Joan Robinson and other Cambridge Keynesian inclined economists. The chapter in the memoirs “Our first year abroad” makes this very clear. See the passage on p.245 where Friedman at a sherry party organized by Kaldor analyzes Keynes’s handwriting to confirm that he was an optimist . According to Friedman optimists have handwriting that slopes sharply upwards. Graphology being even less than an exact science than economics we should take this as a sign of Friedman’s sociability but not have complete confidence in the analysis. Friedman praises both Kaldor and Joan Robinson for being first rate technical economists but with whom he disagreed over values and policies.)


Interestingly Kaldor based his rebuttal of Friedman on the notion that the quantity theory of money stood or fell on whether or not the velocity of money was stable or at least largely invariant to changes in the quantity of money.


As Kaldor puts it “when I first heard of Friedman’s empirical findings I received the news with some incredulity , until it suddenly dawned on me that Friedman’s results must be read in reverse,;the causation must run from Y to M, and not from M to Y.”(p.22)Kaldor then introduces evidence about the degree of variation in a number of countries in velocity over time and concludes that Friedman and the monetarists are wrong in what they argue. Friedman’s partial response which is included in Kaldor’s book as an appendix points out that he and his American colleagues are quite aware of this argument and have taken pains to test out the direction of the causality. He acknowledges that some of what Kaldor is arguing is true but some of it is not. “The outcome is about as decisive as the answer to any question can ever be: Clearly there are influences running from income to the equaltity of money, as Prof. Kaldor asserts, but equally clearly, there are strong influences running from the quantity of money to income. The latter do not and should not exclude the former.(See also the discussion of Harry Johnson’s view of the monetarist case in Dimand, Harry G. Johnson as a Chronicler)


However, Kaldor does not accept this answer as an attempt by Friedman to compromise with his position. Indeed Friedman poses a question about post war data and British economic policy with Kaldor answering that Friedman has “invented data” to support his case and then he presents IMF data on a wide range of countries that shows great variation in the ratio of the money supply to the GDP indicating great variation in velocity.


The curious thing about Friedman’s argument is that he himself in his monetary history has a table on p.774 in the appendix which reports velocity from 1869 to 1960 for the U.S. Its value at its high point in the U.S. was 4.97 in 1880. Its low point was 1.16 in 1946.

But for the period 1931 to 1960 it varied between 1.16 in 1946 to 1.84 in 1942 Velocity of Money, 1860-1960 Table A-5 in Friedman and Schwartz, p.774)


Friedman and Schwartz’s description of these changes is worth quoting.


The velocity of money which affects the money holding propensities of the community, offers another example of the stability of basic monetary relations. As the real income of the people of the United States rose, and perhaps also as deposits were made more convenient by the spread of banking facilities, the community came to hold a decidedly larger amount of money relative to its income, which is to say that the velocity of money declined. In 1869 the stock of money amounted to less than three months’ income; in 1960 to more than seven months’ income. The numerical value of velocity therefore changed considerably. However the change occurred rather steadily…. In response to cyclical fluctuations, velocity has shown a systematic and stable movement about its trend rising during expansion and falling during contraction. Even the large movement accompanying the Great contraction partly fits this pattern; it was so large partly because the cyclical movement was so large. (p.682)


So Friedman clearly accepts that the cycle affects the value of velocity. This then means one has to adjust the degree of confidence you have in arguing that the movement is from money to income, as opposed to the other way round. To be fair to Friedman he does acknowledge this but presumes that the change will be slow enough to happen to permit changes in money supply to do their work.

But there is no guarantee of this, particularly in a time of crisis. For example the velocity of money in the U.S. was 1.95 in 1929 but it fell to 1.28 by 1932 a fall of 34 %. So just as with Lerner and Keynes we need to temper our enthusiasm when we come to actual policy implementation.


Friedman’s argument about the natural rate of unemployment also needs cautious handling. He borrowed this concept from Wicksell and his natural rate of interest. (See Friedman’s American Economics Association Presidential Address, “The role of monetary policy “, 1968 and my paper “Restoring Full Employment:The Natural Rate of Inflation versus the Natural Rate of unemployment “paper presented to the Conference on Social Policy as if People Matter, Adelphi university , Garden city NY, Nov. 12, 2004) He himself when he first broached the subject of the natural or Nairu rate of unemployment suggested that it was in the range of three per cent.He later said he didn’t know what the natural rate was “and neither does anyone else” (Milton Friedman quoted in Amanda Bennett, “Business and Academia clash over a Concept:’Natural Jobless Rate’ Wall street journal, Jan.24, 1995, p. A8 cited in Ronald Ehrenberg, Robert Smith & Richard Chaykowski, Modern Labour economics:Theory and Public policy,Toronto:Pearson education, 2004) If one completes his natural rate of unemployment concept with the natural rate of inflation notion that shows based on actual evidence where further tightening leads to accelerating unemployment then the two concepts together can be helpful in identifying the range within which policy can be productive.


These days 3 % unemployment would be a rate that Keynesians like myself would celebrate. He was also clearly wrong when he suggested that crunching the economy through central bank supported austerity would have little or no long term consequences. The reality is that each time the Bank of Canada has implemented that policy unemployed jumped substantially and stayed elevated for more than five years. That is much more damaging than the short term pain that was supposed to accompany the policy. It also violated Pareto optimality.

Finally followers of Friedman and other neo-con inclined and non Keynesian economists have warned very loudly about the dangers of inflation on account of quantitative easing or what in the 1980s I originally called the temporary greater monetization of the debt.


We have conducted this experiment in the United States now for more than five years and we see no rise in inflation. In fact for a while the rate actually fell. This would seem to permit us the luxury of cautiously embracing the policy along side its necessary partner of fiscal stimulus as an excellent, if imperfect policy response to a great slump. Keynes and Lerner both come into their own in such times. In the case of Friedman he retains some policy usefulness in times when inflation is threatening if price controls and incomes policies are too difficult to implement and if the initial rate of unemployment is close to 3 %. But the problem of defining the money stock and knowing which variable to target without the targeting itself affecting the behaviour of the variable and the endogeneity of money remain important obstacles. Simply raising interest rates and tightening regulations may well be more effective. At the same time his research and writings are still very useful and deepen our knowledge of critical institutions and history. And yes money matters.


Our age is shot through with uncertainty and the unexpected has become the expected. But with these three great economists there is plenty of material to work with to develop a coherent policy that is also politically feasible and capable of more than likely delivering the goods. Combining Keynes’s notions of aggregate demand and the critical role of investment in public infrastructure with Lerner’s emphasis upon banishing deficit hysteria with quantitative easing to hold interest rates at low level to faciltate investment and recovery seems like a winning combination which draws from all three theorists. Money supply management is part of the package because of the role of quantitative easing, but so too is fiscal stimulus. Together they may lead us to a more prosperous future .










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About haroldchorneyeconomist

I am Professor of political economy at Concordia university in Montréal, Québec, Canada. I received my B.A.Hons (econ.&poli sci) from the University of Manitoba. I also completed my M.A. degree in economics there. Went on to spend two years at the London School of Economics as a Ph.D. student in economics and then completed my Ph.D. in political economy at the University of Toronto. Was named a John W.Dafoe fellow, a CMHC fellow and a Canada Council fellow. I also was named a Woodrow Wilson fellow in 1968 after completing my first class honours undergraduate degree. Worked as an economist in the area of education, labour economics and as the senior economist with the Manitoba Housing and Renewal Corporation for the Government of Manitoba from 1972 to 1978. I also have worked as an economic consultant for MDT socio-economic consultants and have been consulted on urban planning, health policy, linguistic duality and public sector finance questions by the governments of Manitoba, Saskatchewan,the cities of Regina and Saskatoon, Ontario and the Federal government of Canada. I have also been consulted by senior leaders of the British Labour party, MPs from the Progressive Conservative party, the Liberal party and the New Democrats on economic policy questions. Members of the Government of France under the Presidency of Francois Mitterand discussed my work on public sector deficits. I have also run for elected office at the municipal level. I first began to write about quantitative easing as a useful policy option during the early 1980s.
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One Response to Keynes, Lerner and Friedman in an Uncertain Age paper presented to Canadian Economics Association meetings , Vancouver May 31, 2014

  1. circuit says:

    Excellent paper. I wasn’t surprised to see Friedman discussed along side of Lerner and Keynes. Friedman’s 1948 framework is essentially functional finance: deficit spending increases the money supply while budget surpluses decrease it. From the AEA in 1948:

    On a different issue, I’m always surprised that so few people know about Keynes’ fascination with Freud. Thanks for the discussion.

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