Stimulate this

Like Mickey Rourke in The Wrestler, the battered Keynesians have staged an astonishing comeback. After swaggering out of the Great Depression and the Second World War, the deficit-loving interventionists have been on the ropes since some time in the 1970s. That was when Milton Friedman and his tough-economic-love monetarist posse took control of economic policy in the U.S. and beyond. (His followers have pretty much been in charge ever since.) In fact, it has taken an explosion of unprecedented proportions-the veritable meltdown of the world economy-for Keynesian policies to regain the upper hand. You know these are hard times when even Arnold Schwarzenegger has lined up with the tax-and-spend stimulus girly men.

Unfortunately for them, pro-market academics are a tenacious breed. At the American Economic Association annual meeting in San Francisco in January, Stanford University professor John B. Taylor released a paper titled "The Lack of an Empirical Rationale for a Revival of Discretionary Fiscal Policy." His argument: A massive Keynesian-style stimulus, like the $1.75-trillion (all currency in U.S. dollars) budget deficit President Barack Obama now proposes for this year, is going to be a huge boondoggle. In fact, it won't merely be expensive and ineffective-it's going to make things worse.

Of course, this is exactly the sort of thing economists are always arguing over. In order to understand the finer points of the feud, you need to go back to the beginning: the Depression. In 1936, John Maynard Keynes published his classic tome, The General Theory of Employment, Interest and Money, which sold what seemed obvious to the unemployed masses at the time: the idea that a market economy isn't self-correcting, and it can remain mired in a deep slump for a prolonged period. According to Keynes, only massive borrowing and spending by the government, in addition to the central bank's opening up of the monetary spigot, will jolt us out of a recession. U.S. politicians (even FDR) and the Federal Reserve did neither during the Depression, but the war forced them to do both.

That's where Keynesians get cocky. They argue that governments can fine-tune their economies-step on the gas by running deficits during recessions, and on the brake by running surpluses during bouts of inflation-and, until the late 1960s, that prescription appeared to work beautifully.

In fact, it was easy to toss off guys like Milton Friedman as heartless tightwads. In 1957, his book, A Theory of the Con sumption Function, outlined what proved to be the very powerful "permanent income hypothesis." Consumers and investors, he argued, tend to base their spending and saving decisions not on what they made last week, but on their long-term income expectations. If they get a windfall, such as a temporary tax cut or a government cheque, they're likely to save it; they won't start borrowing and spending. In his paper, Taylor pointed to the $38 billion in tax rebates the Bush administration paid out in 2001, and the $152 billion it paid out last year, as proof. Net economic benefit by Taylor's calculations: zilch.

The Obama administration, as part of its gargantuan budgets for 2009 and beyond, is proposing a tax cut for 95% of American families. It proposes paying for much of that by allowing Bush's temporary tax relief for wealthy families to expire in 2011. As for stimulating the economy, one strategy will likely nullify the other.

That's not the only trouble with the stimulus approach, say Friedman's disciples. It also sows the seeds for future inflation. Government bonds form the basis of the money supply; the more governments borrow and spend, the more bonds they issue. Keep stimulating too much, and you could end up with stagflation- that is, a stubborn recession and inflation.

That's exactly what arrived in the 1970s. Some say Richard Nixon inherited a mess from Lyndon Johnson, who hadn't raised taxes to pay for the Vietnam War. Either way, Nixon didn't want to risk increasing unemployment by tightening fiscal policy. For the same reason, his Federal Reserve chairman, Arthur Burns, refused to hike interest rates. The president tried wage and price controls for a while. And Gerald Ford, when he took office in 1974, encouraged Americans to wear bright red WIN (Whip Inflation Now) buttons. None of it worked. U.S. inflation climbed from around 6% in 1970 to 13.5% in 1980.

Meanwhile, Friedman was winning converts among economists and, in 1976, he strapped on the Nobel Prize for economics. He and his Chicago School mob had a cure for the prevailing malaise. It was-and is-a painful one: Cut the money supply. That, in turn, forces up interest rates and squeezes down wages and prices. To the extent that impediments to the free market, like unions and regulations, prevent the necessary adjustment, they only make the pain worse. Ronald Reagan and Margaret Thatcher bought into this. Reagan's cigar-chomping Fed chairman, Paul Volcker, was the first to slash the money supply. It was hard to argue with the results: U.S. inflation plummeted to 3.2% by 1983, and unemployment, which had spiked to near 10% in 1982 and 1983, abated to about 7% by the middle of the decade. Many investors-though certainly not all-hailed Alan Greenspan, who took over as Fed chairman in 1987, as the "maestro" for his apparently deft handling of monetary policy.

Sniping aside, where the stimulus is directed is another problem altogether. In the U.S., hundreds of billions of dollars have been earmarked to prop up home prices, which soared during the housing bubble, and to rescue financial institutions that were infected by toxic mortgage-backed securities and other instruments that were tied to them.

In an op-ed article in the New York Post in February, Alan Reynolds, an economist and senior fellow at the right-wing Cato Institute in Washington, noted that just five states-California, Nevada, Arizona, Florida and Michigan-will receive the bulk of funding under Obama's proposed $275-billion mortgage bailout. Should the administration be subsidizing Americans who borrowed too much to buy houses they couldn't afford, most of them in just a few states? And will buying toxic securities and propping up house prices give consumers and investors confidence that market values are now realistic? Reynolds suggests it might be better to let the market solve problems the old-fashioned way: "If something becomes too expensive, cut the price. Or move."

He and the other free marketeers have a point. Keynesians may have won the day, but, like Rourke's Randy the Ram, America's own triumphant comeback will depend largely on how much pain it's willing to endure. -

Dead guys rule

Even today, most economists are either Keynesian at heart or Friedman to the core. Here, almost everything you need to know about both of them

John Maynard Keynes

1883-1946

Alma mater

University of Cambridge

Liked

Taxes, government

Disliked

Americans-reportedly

Required reading

The General Theory of Employment, Interest and Money (1936)

Less famous for

His sexual relationship with Scottish painter Duncan Grant

In three words

Balance is everything

Carrying the torch

Joseph Stiglitz

(Nobel Prize, 2001)

Paul Krugman

(NYT columnist; Nobel Prize, 2008)

Milton Friedman

1912-2006

Alma mater University of Chicago

Liked

Keynes-initially

Disliked

Taxes, government

Required reading

Capitalism and Freedom (1962)

Less famous for

Conceiving a system for quality control testing in manufacturing

In three words

Let markets rule

Carrying the torch

Robert Lucas Jr.

(Nobel Prize, 1995)

Thomas Sowell

(syndicated columnist)