"The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist."
The author was British economist John Maynard Keynes, and the key to the world's current financial predicament lies in the argument and interplay between Keynes and another defunct economist, the American monetarist Milton Friedman.
Keynes was a British Liberal and progressive of the first half of the 20th century who Europeans would now call a moderate social democrat, or in American terms, a centrist Democrat. He believed that governments could and should act as lenders of last resort and use deficit spending to create jobs and haul a country out of depression.
Friedman was initially a supporter of Franklin Roosevelt's New Deal and worked for it as a young economist. He was also a follower of Keynes, and it was he, rather than Richard Nixon, who originally said, "We are all Keynesians now."
A moderate conservative, Friedman was appalled by the way promiscuous use of Keynesian policies during non-depression periods had led to inflation and increased government intervention in the economy. Friedman became a critic (but remained an admirer) of Keynes and developed an alternative grand theory of economics that became known as monetarism. Its core contention was that "inflation is always and everywhere a monetary phenomenon" and that therefore the control of the money supply by the central banks was the key to getting into and out of depressions.
"The Fed was largely responsible for converting what might have been a garden-variety recession, although perhaps a fairly severe one, into a major catastrophe. Instead of using its powers to offset the depression, it presided over a decline in the quantity of money by one-third from 1929 to 1933," he wrote. "Far from the depression being a failure of the free-enterprise system, it was a tragic failure of government."
Broadly speaking, the global economy for the past 60 years has been run by apostles of these two men. Until the coming of Ronald Reagan and Margaret Thatcher in the 1980s, most finance ministries and central banks pursued Keynesian policies, sometimes to unsustainable extremes. Thereafter, they increasingly tended toward Friedman's thinking, but probably to equally unsustainable extremes.
One of the most intriguing aspects of the current financial crisis is that we are trying both remedies. So far, thanks to Ben Bernanke at the U.S. Federal Reserve and Mervyn King at the Bank of England, we have pursued Friedmanite policies, flooding the markets with liquidity and shoring up the banking system. Along the way, the Fed in the past year has increased its balance sheet from $700 billion to $2.3 trillion.
Bernanke, in a 2002 speech honoring Friedman on his 90th birthday, acknowledged the Fed's role in the Great Depression when he said to Friedman, "You were right, we did it. But thanks to you, we won't do it again."
But now comes Barack Obama with his vast $800 billion (or higher) stimulus package, which is straight out of the playbook of Keynes, as expressed in Keynes' famous open letter to the new President Franklin Roosevelt in 1933: "As the prime mover in the first stage of the technique of recovery I lay overwhelming emphasis on the increase of national purchasing power resulting from governmental expenditure which is financed by loans and not by taxing present incomes. Nothing else counts in comparison with this.
"It is beyond my province to choose particular objects of expenditure," Keynes went on. "But preference should be given to those which can be made to mature quickly on a large scale, as for example the rehabilitation of the physical condition of the railroads. The object is to start the ball rolling. The United States is ready to roll towards prosperity, if a good hard shove can be given in the next six months.
"I put in the second place the maintenance of cheap and abundant credit and in particular the reduction of the long-term rates of interest," Keynes added.
This "second place" priority of Keynes and the unblocking of the credit markets is now what Bernanke's Fed is trying to achieve.
So the thinking of the two great economic minds of the 20th century is now the lodestone of the key decision-makers who are seeking to haul us out of this recession before it becomes another Great Depression. The problem is that the theories of Keynes and Friedman are not really compatible.
Keynes believed that government and only government could, in the last resort, get us out of trouble, and that is also what Obama and most of the Democrats in Congress and most European policymakers believe.
Friedman, by contrast, was deeply suspicious of government and far from convinced of its wisdom and skill in crafting and implementing economic policy. He once said of himself, "I am a libertarian with a small 'l'" and claimed that his proudest accomplishment was helping to replace conscription with a professional military because the draft was "incompatible with a free society." In a perfect world, Friedman also noted, he would like to abolish the Fed.
This may go too far for many of today's Republicans in Congress, but on the whole they share Friedman's suspicion of big government. And since there are sufficient Republican senators to block Obama's legislative programs, it is an open question just how free Obama will be to apply Keynesian remedies. Republicans already have signaled their opposition to much of Obama's planned stimulus program.
For better or worse, the chances of avoiding another Great Depression look like hinging on these two defunct economists and on the coming battle between their political heirs.