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ECON 301
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February 11, 20xx
A Comparison of Keynes and Friedman’s Approach to Stimulus Taxation
Keynes and Friedman on economic stimulus and taxes
In 2001 President Bush pushed tax cuts through Congress in order to jump-start the
economy after the 2000 stock market bubble had burst. The critics and supporters of such
an initiative often rely on rationale based on demand-side economists such as John
Maynard Keynes or supply-side economists such as Milton Friedman. This paper will
highlight the assumptions of both Keynes and Friedman and explore how they influence
economic decisions.
Keynes
Keynesian economics is based on the theories of John Maynard Keynes, a British
economist who lived from 1883 to 1946. Known as the father of modern economics,
Keynes's theories were the first to encourage the government's involvement in solving the
problems of unemployment and were used as the bases of President Roosevelt's New Deal
programs, designed in response to the Great Depression.1 An economic debate in the US
involves identifying what caused the Great Depression of 1928 – 1932. Keynes proposed
that in a good economy money circulates freely between people who buy and sell. A
shoemaker sells his products to a tailor, while the tailor sells her products to the baker, and
the baker sells his products to the shoemaker, and so forth. Their earnings through
exchange increases everyone’s wealth. Everyone’s spending is part of everyone’s earnings.
But if there is a disruption in this cycle of spending and earning because of difficult times,
people began to hold back on spending their money. When this occurs, people cannot earn
a living, so everyone reduces spending. This creates problems for everyone.2
1
Keynes, John. (nd) The End of Laissez-faire. From the BMGT 610 student reader.
Binder, Alan. (nd) Keynesian Economics. Retrieved Jan 18, 2004 from The Library of Economics and
Liberty The Concise Encyclopedia Web site http://www.econlib.org/library/Enc/KeynesianEconomics.html
2
1
Keynes suggested that expanding the supply of money would return consumer confidence
and people would once again start up the circular flow of money. Keynes proposed that
recessions are caused by people hoarding money and depressions are caused by a liquidity
trap. A liquidity trap occurs when people save money and refuse to spend it even if the
government increases the money supply through the central bank. Events such as
earthquakes, drought, floods or stock market declines can prompt decreased consumer
confidence. Increased confidence arises from high employment, strong markets, and
optimistic projections. Keynes suggested that during downward situations the government
can revive the circular flow of money again by spending. Some believe that the main cause
of the Great Depression is that the government restricted the money flow too much for too
long. Most economists agree that World War II cured the Great Depression. Keynes
attributed this to the fact that large sums of money circulated through government spending
on the military for the war.3
Keynes explains that the Great Depression was followed by one of the greatest economic
booms because of large military spending. Keynesian economics gained strong support
Before World War II. Eight U.S. recessions worsened into depressions (as happened in
1807, 1837, 1873, 1882, 1893, 1920, 1933, and 1937). Since World War II, under
Keynesian policies, there have been nine recessions (1945-46, 1949, 1954, 1956, 1960-61,
1970, 1973-75, 1980-83, 1990-92), and not one has turned into a depression.4 The success
of Keynesian economics was such that even Richard Nixon once declared, "We are all
Keynesians now." In the chart below, the yellow bars represent the proportion by which the
duration of the expansions exceeds the duration of contractions.
Inflation, Deflation and the Relative Durations of
Expansions and Contractions (4)
3
Heilbroner, Robert L. The Worldly Philosophers. (1999). Touchstone New York, NY. p. 276
4
Banerji, Aniryan. (2001) Deflation Ahead? If So, It's a New Page in History. Retrieved January 19, 2004
from the Web site The Street.com http://www.thestreet.com/comment/spincycle/10000549.html
2
The U.S. government can expand and contract the money supply in different ways. The
Federal Reserve banks can buy debt from commercial banks, which allows commercial
banks to increase lending from those government securities. Banks can also make it easier
to obtain credit so that consumers will obtain more money to circulate. The Federal
Reserve can also cut the prime lending rate to commercial banks which makes credit more
appealing to consumers. In order to reduce the flow of money the government takes the
opposite of these actions. When there is too much money in the economy, inflation occurs.
Prices rise and it takes more money to consume products. In response, the government
raises lending rates, raises standards for obtaining credit, and buys less debt from
commercial banks.
Many Keynesian politicians voted for the tax cuts in 2001 and most mainstream economists
support the Keynesian approach to stimulus policy. They offer various interpretations of
why the Reagan years were strong and why the Clinton years outperformed Reagan’s. 5
When Reagan cut taxes Congress also closed tax loopholes resulting in a higher yield of tax
income on those who previously avoided taxes. That lasted a few years until new
loopholes could be exposed. This is an important point that many tax-cut advocates ignore.
5
Tax Cuts in Camelot? JFK lowered taxes, but supply-siders wrongly claim he's their patron saint.
By David Greenberg Posted Friday, Jan. 16, 2004, at 8:00 AM PT http://slate.msn.com/id/2093947/
3
Additionally, the Cold War was waging and computer technology was beginning to make
an impact on workplace productivity.
It is noteworthy that supply-side economists who oppose Keynesian policies predicted that
there would be a severe recession when the Clinton administration increased taxes on
upper-income families. Newt Gingrich predicted a recession while the Wall Street Journal
and Forbes urged readers to get out of the stock market.6 However, the economy roared,
technology investment multiplied because there was a wealth of investment money. Robert
Rubin argues that tax increases moved the budget to a surplus, cut interest rates, and
propelled corporate investment.
The tax-cutting of 2001 and the Iraq war has created a deficit that many economists believe
must get under control by means-testing entitlements, cutting farm subsidies and restoring
some tax revenue. With the pending baby boomer retirement and the looming costs of
Medicare and social security the U.S. will face possible problems paying back the deficit.
To fund US foreign policy, President Bush would need to cancel virtually all of his
proposed tax breaks. To guarantee the kind of competitive economy the US needs,
Washington would have to do what it has been loath to consider: develop a broad set of
government policies - other than tax cuts and deregulation - to increase the productivity of
the economy7
Friedman
Milton Friedman, recipient of the 1976 Nobel Prize for economics, has been a senior
research fellow at the Hoover Institution and taught at the University of Chicago from 1946
to 1976.8 In opposition to Keynes, Friedman claimed that the best way to manage the
economy was to keep the money supply steady by increasing it slightly each year rather
6
ibid.
7
Business Week). Business Week. New York: Nov 24, 2003. , Iss. 3859; pg. 160 The Debate Over
Deficits
8
The Hoover Institution, Stanford University. Milton Friedman (2002) Retrieved January 18, 2004 from
the Web site http://www-hoover.stanford.edu/bios/friedman.html
4
than trying to manage the economy by restricting or freeing up money by the Federal
Reserve. As a result, inflation, unemployment and recessions would correct themselves
through market trends. He believes that government should leave the market alone (the
invisible hand) and that privatization works better than government regulation or provision
of services. The term for this theory, monetarism, was tried in the US and Britain in the
late 70’s and early 80’s. Interest rates were dropped and money supply was made
available. What ensued was a sustained recession with high unemployment, high inflation,
and manufacturing output shrunk. As chairman of the Federal Reserve under Jimmy
Carter, Paul Volcker abandoned the monetary policies and instituted a process to restrict
the economy to stop inflation.9 When Reagan was in office it appeared that inflation was
controlled. The Reagan tax cuts and massive spending on government and military
programs resulted in stimulating the economy just as Keynes would expect. Monetarists
blamed the failed monetarism effort on the Central Bank for not allowing the market to
play itself out sufficiently. But most people credited Keynesian theory as the reason for the
good economic policies.
Friedman also developed a theory that the natural rate of unemployment hovers around six
percent. Neither monetary nor Keynesian policy can reduce it below that level. If the
Federal Reserve tightens money to reduce inflation, it creates unemployment. If the
Federal Reserve expands money to stimulate growth, employment lags behind business
expansion. So we are constantly left with unemployment either reducing or expanding in
response to economic conditions, and the level seems to be around six percent.
There are three central premises of Friedman’s supply-side economics.10 First, supply-side
focuses on suppliers rather than consumers. They recommend low taxes to keep investors
motivated to create a strong supply of goods and services. Friedman suggests that taxes
9
Greenspan, Alan. Remarks at the Meeting of the American Economic Association, San Diego, California
January 3, 2004 (2004) Cited from the web site http://www.stern.nyu.edu/globalmacro/
10
Bartlett, Bruce (September 26, 2003 The Laffer Curve works, as cited from
http://www.townhall.com/columnists/brucebartlett/bb20030926.shtml
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should be cut “any time, for any reason.”11 This contradicts Keynesians and traditional
monetarists who focus on creating a demand for goods and services by adjusting interest
rates and flow of money. They are labeled demand-side economists. They want a tax
system that creates demand for products and services by putting money in the hands of
consumers.
Second, supply-side monetary policy requires that the dollar remain stable and fixed to the
value of an ounce of gold to avoid dragging the economy.12 By using the gold standard the
Federal Reserve could keep the dollar stable and can then buy or sell bonds on the open
market. If gold prices rise, the economy is liquid because excess dollars are going to
purchase gold rather than into investments. At that point, the Fed can sell government
securities to take in the excess dollars. A lowering gold price indicates a shortage of
liquidity. Gold is sold to obtain dollars. The Fed should then purchase government
securities on the open market with new printed dollars which encourages investment.
Third, supply-side economic tax policy is built on the The Laffer Curve which projects
government income through taxes.13 Arthur Laffer indicates that there is a tax rate nexus
that produces the maximum amount of tax income while achieving the highest possible
levels of growth, production and employment. The curve shows that no taxes on capital
gains and low upper brackets stimulates investment, which in turn cycles money through
the economy to increase productivity and lower unemployment. High marginal tax rates
encourage tax sheltering, and create disincentives for people to earn more which in turn
reduces productivity and economic growth
Fig. 1: The Laffer Curve:
11
Interview with Ronald Robinson, September 16, 2003 http://www.rsrobinson.net/archives/000046.html
12
ibid.
13
ibid.
6
When the government taxes the highest incomes at 100% of income (d) it does not pay to
earn more money. At lowest incomes 0% (0) there is no income to the government, but
high motivation to earn. Since people are willing to pay taxes for infrastructure such as
roads, schools, etc. the people allow government to tax them. Laffer’s target is to find a
level of taxes that take in adequate income without creating a disincentive to grow. That
point is (b) on the above chart. Too high of a tax (c) produces shelters and low
productivity. Too low of a tax (a) does not provide adequate income for infrastructure. It’s
the government’s job to learn what tax the people will tolerate without creating
disincentives to invest.
Supply-side economists support their tax policy recommendations with logic and
historical trend analysis. The logic behind the supply-side economics is that there is a
distinction between tax rates and tax revenues. When tax rates are too high it decreases
the payoff that people derive from work and from other taxable productive activities.
When people are prohibited from reaping much of what they sow, they will sow more
sparingly. These reductions in productive effort shrink the effective supply of resources
and thereby reduce output.14
Supply-siders agree with Friedman that high marginal tax rates encourage sheltering in
hobbies and personal luxury items that can be deducted but do not invest in productive
enterprise. As a result of this tax evasion and reduction of work effort, higher taxes
actually shrink the revenues of government. For instance, in the 1920’s Andrew Mellon,
Secretary of Treasury, reduced the top marginal tax rate from 75 to 25 percent. Also, low
14
Gwartney, James. Supply-Side Economics. The Library of Economics and Liberty as cited from
http://www.econlib.org/library/Enc/SupplySideEconomics.html
7
income recipients had a virtual zero tax rate. The economy grew and the taxes collected
grew 63 percent from high income taxes. Revenues from low-income earners actually
decreased to near zero.
The Kennedy-Johnson tax cuts in the 1960’s reduced tax rates by approximately 25%.
These lowered taxes in real dollars of the bottom 95% from $31.0 billion in 1963 to $29.6
billion in 1965, a 4.5 percent reduction. In contrast, the real tax revenues collected from
the top 5 percent of taxpayers rose from $17.2 billion in 1963 to $18.5 billion in 1965, a
7.6 percent increase. As in the case of the tax cuts of the twenties, the rate reductions of
the sixties reduced the tax revenue collected from low-income taxpayers while increasing
the revenues collected from high-income taxpayers
Building on Friedman, William Niskanen and Stephen Moore of the Cato Institute provided
a defense of supply-side economics and tax cuts.15 They propose that the supply-side tax
cuts of the Reagan years catalyzed growth in personal incomes, productivity, improved
savings, interest rates, brought low inflation, and low unemployment. They propose that
the Reagan era economy was strong until George Bush Sr., and Bill Clinton increased
taxation and regulations that halted the boom years.
Keynes vs. Friedman Discussion
Friedman follows a strong tradition in the economic theories of Adam Smith and David
Hume. The market-driven economy assumes that since everyone is looking out for their
own self-interest (the invisible hand), eventually equilibrium will occur based on supply
and demand. Individuals will refuse to pay high prices for items readily accessible, forcing
sellers to negotiate downward to a reasonable limit. Human nature is selfish, and therefore
the interaction of two selfish individuals will ensure that negotiations will equalize the
transactions. The problem with this assumption is that due to the very nature of greed,
humans will find ways to tip the balance in their favor by cheating, using power, or even
15
Cato Policy Analysis No. 261 Supply Tax Cuts and the Truth About the Reagan Economic Record
by William A. Niskanen and Stephen Moore October 22, 1996 http://www.cato.org/pubs/pas/pa-261.html
8
violence. Daily newspapers are filled with accounts of people abusing their power or
cheating for personal gain at the expensive of the common good. When executives at
General Electric used their power and influence to dump millions of gallons of pollutants
into the Hudson River, they destroyed whole industries such as fishing and recreation, and
probably made many people sick. When they moved their plant, they left the taxpayers to
clean up the environment. When wealth and power are concentrated, equilibrium is
destroyed by the very “invisible hand” of selfishness that is supposed to ensure fairness
The supply-side issue of creating stability of the dollar by linking it to gold has several
criticisms. Since the US de-linked the dollar with gold in 1971 gold prices have varied
widely, and would create deflations when gold stayed below the Dow. Gold availability is
also determined by non-economic influences such as mining and dentistry.16
Another problem with supply-side economics is that many economists dispute the Laffer
Curve.
“After the Reagan tax cut, the U.S. economy sank into recession and
federal tax collections dropped nearly 10%. The deficit soared and
economic growth was tepid through much of Reagan's presidency,
despite sharp hikes in military spending. Some of the Republican
faithful continue to argue that tax cuts will unleash enough growth to
pay for themselves, but most are embarrassed to raise the now
discredited Laffer curve.” 17
An additional criticism is that tax cuts to the wealthy create an inflated stock market, and
real estate bubbles. However, if cuts were given to working families or state governments
then the money is immediately cycled through the economy through retail, automotive
sales, etc. This in turn provides money for businesses to invest.18
The Gold Bug Variations. The gold standard – and the men who love it. by Paul Krugman, Nov. 23, 1996
http://slate.msn.com/id/1912/
16
17
Frank, Ellen. (2003) Ask Dr. Dollar. Dollars and Sense. Somerville: Iss. 250; pg. 38
http://www.dollarsandsense.org/archives/2003/1103dollar.html
18
ibid.
9
Friedman and others have supported a variety of proposals to create a flat tax rate rather
than the progressive one we currently have. Supply-side economists suggest that overtaxing the wealthy reduces investment, while demand-side economists tend to put money
into the hands of consumers. An interesting fact is that the tax burden as a percentage of
income is nearly flat already. It would seem unjust to develop tax policies that continue to
burden the lowest income earners who can least afford it.
Late in the 80’s it was obvious that neither monetarism nor rational expectations were
adequate practices. After implementing their approaches the recession in the 70’s
seemed intractable. Only after implementing Keynesian principles of tightening money,
debt availability, and loans did the economy recover. The same appears to have
happened recently. Interest rates are very attractive, people are refinancing homes at an
unprecedented rate and purchasing large ticket items with the money they have drawn out
on equity. The stock market has responded and employment shows some signs of
10
improving. The Federal Reserve’s actions helped this to occur. We are at least
temporarily moving out from a recession. The Bush tax cuts put an average of $400 into
taxpayer’s hand. It is unreasonable to think that such a small amount would make much
difference in the economy. Surveys show that consumers spent just 25% of the 2001 tax
rebate. The other 75% was either saved or used to pay down debt.19 Deregulation and
poor oversight of energy and investment companies such as Enron and WorldCom has
recently cost Americans dearly, but the US has survived these high-lever corruption
debacles. Monetarists and supply-side theorists put too much faith in believing that
leaving the market alone, deregulation, and cutting any tax they can will produce
economic growth. The facts are not substantiating their theories. If that were the case
then prolonged recessions and depressions would have been self-correcting in the past.
The application of Keynes’ principles is once again proving effective.
Economic theory provides a decent guide to what's likely to happen, but when government
undertakes big policy changes, such as large or permanent tax cuts, there are always too
many variables to predict the economic outcome in any detail or with much confidence.20
Economics is usually unable to do the one thing most non-economists expect it to: predict
the future. Presidents take their chances anyway. The first President Bush raised taxes and
cut spending in 1990, hoping it would produce strong growth in 1992. It didn't. President
Clinton tried the same approach in 1993, and it worked spectacularly. Mainstream
economics supported them both, but conditions wholly independent of their deficit
reduction efforts - corporate debt levels, the price of computing power, and so on - led
businesses to respond to lower deficits in the mid-'90s in ways they didn't a few years
earlier.21
19
Taking the Voodoo Out of Tax Cuts by Brian S. Wesbury* June 2, 2003 The Library of Economics and
Liberty. http://www.econlib.org/library/Columns/y2003/Wesburytaxcuts.html
20
Shapiro, Robert. Tuesday, June 10, 2003 Will the Tax Cut Work? Here's how we'll know if it does. Cited
from Slate Magazine: http://slate.msn.com/id/2084135
21
Krugman, Paul (1996) the dismal science Supply-Side Virus Strikes Again
Why there is no cure for this virulent infection. Cited from Slate. org. http://slate.msn.com/id/1910/
11
Research across a broad group of countries has identified many determinants of economic
growth, leading to the conclusion that successful explanations of economic performance
have to go beyond narrow economic variables to encompass political and social forces.
Economic growth has been found to depend on variables such as education, health, fertility
rates, rule of law, and electoral rights. Also important factors are propensity to invest, size
of government, international openness, macroeconomic stability and even religious
beliefs.22
In the final analysis, Keynesian theory provides a more robust explanation of economic
phenomena. Friedman makes important contributions by warning us that too much
government can be inefficient, heavy tax burdens reduce motivation to produce, overregulation stifles creativity, and steep fluctuations in monetary value erode consumer
confidence. However, Keynesian practices of stimulating the economy through Federal
Reserve intervention and modest rather than drastic tax-cut policies has kept the economy
much more stable than any time in history.
22
Robert J Barro. Spirit of Capitalism Harvard International Review. Cambridge: Winter
2004. Vol. 25, Iss. 4; pg. 64
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