John Maynard Keynes Versus Milton Friedman

The tale of the economy over the next couple of years is really a test of the theories of John Maynard Keynes, the father of deficit spending, or Milton Friedman, the Nobel Laureatee, who believed that inflation was a monetary phenomenon.

An interesting article on this subject on Bloomberg states:

"Bernanke’s gamble that the highest jobless rate in 25 years and the most idle factory capacity on record will hold down inflation is straight out of the late British economist Keynes. Should late Nobel-prize-winner Friedman’s dictum that 'inflation is always and everywhere a monetary phenomenon' prove right, the $1 trillion or more in liquidity Bernanke has pumped into the financial system by expanding the Fed’s balance sheet may leave him to cope with surging consumer prices."

So far, investors and economic data both back up the Bernanke-Keynes view. The market in Treasury Inflation-Protected Securities as of April 6 indicated long-term inflation expectations of 2.5 percent, below the 2.8 percent average inflation rate of the past 10 years. "

Of course, we haven't seen much of the stimulus spending yet. And the Fed has continued to pump money into the economy with a 0% Fed Funds rate as well as the increase in its balance sheet.

The real question is how long will the slack in the economy restrain prices and will the Fed be able to raise rates fast enough once inflation is seen? In the 1970s, the Fed kept rates too low for too long due to political pressure from Nixon. If inflation remains above 8% it's feasible we'll see this same type of pressure.

Still, the Fed's philosophy is that it knows how to deal with high inflation (raise rates) while deflation is a much tougher nut to crack. So, the first priority it to prevent deflation and then deal with any resulting inflation.

TIPS and I Bonds offer protection against future inflation.