Keynes, Friedman, and Higgs

Tim Congdon earns sustained applause for helping us to better grasp what John Maynard Keynes had in mind with his notion of a liquidity trap. Applause is warranted also for Congdon’s clear account of why Keynes’s model—in which there are only two assets, bonds and money—distorts our understanding of the economy and of monetary policy.

Congdon’s mission is to shove Keynesianism off of the policymaking stage so that it might be replaced by Milton Friedman’s monetarism. This move would improve policy. Likewise, saving monetarism as an intellectual project from the misunderstandings that permeate the pronouncements of economists such as Paul Krugman is laudable.

Keynesianism’s record of success is more a matter of dogmatic conviction than of historical experience: the 1970s’ stagflation really did happen, as did the persistence of high unemployment in current-day America despite fiscal stimulus spending on a gargantuan scale. (I know that Krugman insists that this stimulus was insufficiently gargantuan. As Tino Sanandaji notes, though, “In this vulgar form, Keynesianism is turned into a non-falsifiable theory”[1]–which is to say, this sort of Keynesianism is an exercise of faith rather than of reason.) But while monetarism, at least as a guide to public policy, has stronger scientific creds than does Keynesianism, it suffers some of the same deep flaws that mar the works of Keynes and his followers.

Keynes’s Liquidity Trap and Monetarism

In my second essay, I will discuss what I see are the flaws shared by Keynesianism and monetarism. For the remainder of this essay, will I reflect on the observational similarity between three theses, each of which attempts to explain the inadequacy of investment: Keynesianism; monetarists’ insufficient-supply-of-money thesis (which is defended in this forum by Congdon); and Robert Higgs’s thesis of regime uncertainty.

Here’s the key passage in Congdon’s interpretation of Keynes’s liquidity trap:

As an active speculator in financial markets, Keynes was well aware that errors in judgment could lead to the loss of capital… He knew that, because bond prices and yields moved inversely, somebody who bought bonds at a high price (that is, a low bond yield) might suffer a hefty capital loss if the next major price move were downwards.

Fears of a capital loss could therefore deter investors from buying bonds at even higher prices, even if official operations increased the quantity of money in their hands.

Keynes’s famous focus on the instability of investment spending combines with his assumption that the economy’s only nonmonetary assets are bonds to recommend this interpretation strongly. As Congdon points out, if prices of the only assets (bonds) other than money are already unusually high—and if the purchasing power of money is fixed (as Keynes here effectively assumed it to be)—then even the most animal-spirited investors are unlikely to buy more bonds simply because the central bank gives them more money.

Better that your portfolio’s value remains stable (as it will if weighted down, in these situations, with money) than that it tumble (as it will likely do when it is loaded down with overpriced bonds).

While simplifying assumptions are necessary building blocks of all useful theories, simplifying assumptions are not sufficient to generate useful theories. The simplifying assumptions must be chosen and used wisely. (I know: “wise” is a non-quantifiable matter of judgment, but there’s no avoiding it.) Congdon is spot-on to criticize Keynes for making the simplifying assumption that an economy’s only assets are money and bonds. That assumption is unwise. As Congdon observes, “the viability of Keynes’s liquidity trap idea disintegrates when portfolio choice is not merely between money and bonds, but between money and a wide range of assets including equities and real estate.”

So the failure of looser monetary policy to spur investments in assets other than money (or precious metals) simply cannot be explained by Keynes’s liquidity trap, because that notion doesn’t apply to the real-world economy as we know it. It follows that the theoretical possibility of Keynes’s liquidity trap, even when combined with a Federal funds rate of zero, is insufficient to support the case for more vigorous fiscal stimulus.

Congdon argues that today’s inadequacy of investment is caused by what in fact really is an inadequate supply of money. He insists that the Fed has failed to increase the money supply—specifically, M3—to levels high enough to fuel a significant increase in private investment. Money-supply growth, not fiscal stimulus, is still the key.

Maybe. Monetarism does have a coherent theory to explain this observance: if people’s demand to hold larger money balances rises but is not accommodated by a sufficient fall in the price level (to make any given nominal stock of money larger in real terms), households will increase their money balances by reducing consumer spending and, especially, firms will increase their money balances by reducing investment spending. Investment won’t rise unless and until the higher demand for money is satisfied by an increased supply of money.

Regime Uncertainty

Perhaps, however, investors are today standing on the sidelines not because of too little fiscal stimulus or because of too little money creation but because of a problem not curable by mechanistic policy manipulations—namely, regime uncertainty. This uncertainty is the economy-chilling condition described by economist Robert Higgs as “a pervasive uncertainty among investors about the security of their property rights in their capital and its prospective returns.”[2] (See also, for example, Higgs’s discussion here.)

To the extent that mainstream economists pay attention to Higgs’s thesis, they typically dismiss it as being unscientific. Paul Krugman ridicules its adherents for appealing to the “confidence fairy“—an odd criticism coming from someone who champions a theory that famously explains investment demand as being heavily influenced by “animal spirits.”

In fact, regime uncertainty is a more substantive—and, hence, a scientifically more legitimate—idea than is “animal spirits.” “Regime uncertainty” highlights expectations regarding the security of property rights, future tax burdens, and other expected consequences of today’s policies and political attitudes that are understood by all but the most intransigent opponents of free markets to affect, in predictable ways, the level of private investment. “Animal spirits,” in contrast, highlights inexplicable swings in investors’s confidence.

Consider, in this light, a lament, from a business executive named “Mr. Young,” given to New Dealer Raymond Moley immediately following a 1939 hearing of the U.S. Temporary National Economic Committee:

Therefore, the extent to which adventurous men and adventurous dollars are discouraged or paralyzed, you will have idle dollars awaiting investment and idle men awaiting employment. Indeed, you will have more, you will have stagnation of spirit, you will have so-called realism, which for the most part, as now used, is another name for destructive cynicism, in place of productive imagination and daring action. If the success of men and dollars in productive enterprise is to be scorned, rather than honored, if it is to be penalized by taxation, other than for revenue purposes, or be blackened by suspicion, there will be no adventure and no spirit of adventure, and, consequently, restricted opportunity for savings.[3]

In the same setting, General Motor’s CEO Alfred Sloan told Moley that

Before that necessity or opportunity [for U.S. businesses to put private savings to productive use] can be capitalized, we must have a different attitude of mind with respect to private enterprise as it is affected by political and economic policies. The chief influence is the lack of confidence in the long-pull position of industry and business, in general, from the standpoint of the security of the investment and the opportunity to earn and retain a reasonable reward commensurate with the risk and success of the enterprise.[4]

Even Keynes seems to have worried about regime uncertainty. In his December 1933 “Open Letter to President Roosevelt,” Keynes gently reprimanded FDR for creating programs such as the National Industrial Recovery Act: “even wise and necessary Reform may, in some respects, impede and complicate Recovery. For it will upset the confidence of the business world and weaken their existing motives to action, before you have had time to put other motives in their place.”

These are all complaints about Higgsian regime uncertainty.

It’s worth emphasizing that nothing about regime uncertainty—as understandably warned of here by Young, Sloan, and Keynes—will be mitigated by more government spending or by looser monetary policy.

My purpose here isn’t to “prove” that the inadequacy of investment during the Great Depression was—or today is—caused by regime uncertainty. Rather, my goal is the more modest one of pleading with scholars who set themselves the task of diagnosing the lingering stagnation of private investment spending to accord to regime uncertainty at least as much attention as they accord to Keynesian or monetarist diagnoses. Such attention to regime uncertainty seems to be warranted by both facts and theory.


[1] Tino Sanandaji, “Why Keynesianism Works Better in Theory Than in Practice,” The American, December 1, 2011.

[2] Robert Higgs,
>Depression, War, and Cold War (New York: Oxford University Press, 2006), p. 5.

[3] Quoted in Raymond Moley, “Business in the Woodshed,” Saturday Evening Post, 6 April 1940; reprinted in George Terborgh, The Bogey of Economic Maturity (Chicago: Machinery and Allied Products Institute, 1945), p. 28.

[4] ibid.

Also from this issue

Lead Essay

  • Tim Congdon argues that John Maynard Keynes’ latter-day followers have badly misinterpreted the theorist they profess to follow. Led by Paul Krugman, Keynesians have claimed that a near-zero Federal Funds rate is indicative of a liquidity trap. This diagnosis has several problems. First, it is not what Keynes meant by the term; second, even a rate of zero percent does not exhaust monetary policy; and third, a genuine Keynesian liquidity trap has not happened and cannot plausibly happen, in part but not solely because Keynes assumed constant prices throughout the economy, a condition that is unlikely in the face of a rising money supply. Congdon commends to readers Milton Friedman’s monetary prescription: a gradually and predictably rising supply of money, not the wild swings we have seen in recent years.

Response Essays

  • Dean Baker argues that Keynesians have not given up on monetary policy. Although the federal funds rate can’t go negative, the Federal Reserve can still set a higher inflation target, a solution both he and Paul Krugman endorse. Alongside monetary policy, Baker recommends fiscal policy: The recent economic stimulus legislation worked as intended, he argues, although the recession was more severe than the administration anticipated, and thus the stimulus proved to be too small. Policymakers have a duty to try to return the country to full employment, as the unemployed, who are suffering the most in the current crisis, are not to blame for their troubles.

  • Don Boudreaux agrees with Congdon that a monetarist policy approach would be preferable, but he draws our attention to a third relevant consideration: regime uncertainty, as described by the economist Robert Higgs. When businesses are uncertain about the major economic decisions of governments and central banks, they will defer new investments and retain cash rather than hiring new workers. Neither monetarism nor Keynesianism does anything to address the problem, which Keynes himself conceded was real.

  • Robert Hetzel reiterates that a zero lower bound for interest rates is a different phenomenon from a liquidity trap. The latter is an “irrelevant academic construct” as long as the central bank can create new money. Still, we learn little from this distinction unless we can determine the nature of the initial shock that caused pessimism among market participants; different types of shocks, monetary and real, call for different remedies. Central banks rarely use the analytical tools that would be necessary for them to evaluate their own roles in economically rigorous ways; instead, they tend to blame difficult times on the private sector, while taking credit for good ones.