When I was studying in graduate school in the 1960s there was a big debate among economists: Which version of macroeconomics best described the world, Keynesian or Monetarist? The Keynesians claimed that fluctuations in aggregate demand determined output, monetary policy was not very important, and fiscal policy is what is needed to pull the economy out of a slump.

Monetarists, on the other hand, believed that erratic monetary policy was the most important source of fluctuations and that, by stabilizing the money supply, the central bank could limit the severity of recessions and prevent a depression such as the U.S. experienced in the 1930s.

Economists, unlike scientists, cannot run a series of controlled experiments to pick a winner. We had to wait 70 years for another financial panic of the magnitude that hit our economy in the 1930s to shed light on the question.

Keynesians Start Well

Keynesians assert that business cycles are caused by changes in aggregate spending behavior. When businesses and consumers are optimistic, they increase their spending and the economy flourishes.

When they are pessimistic, spending falls and the economy slips into recession.

This latest crisis was indeed preceded by a period of optimism, particularly in the housing sector. When housing prices soared, many homeowners felt wealthier and increased their consumption.

Some believed that they were destined to be able to use their houses like ATM machines, cashing out their home equity as real estate prices rose.

But when the increased supply of housing overwhelmed demand, the euphoria broke and home prices fell. This led to the largest decline in consumption since the end of the Second World War. The cause of the recession was quite Keynesian in nature.

Monetarists, on the other hand, came up short on the cause. The supply of money and credit continued to advance before the financial crisis. In fact, in the year leading up to the start of the recession in December 2007, the money supply increased at a faster pace than in either of the two preceding years.

Although some claimed that the cause of the housing bubble was the Fed keeping interest rates too low too long, it is the money supply, not interest rates, that Monetarists watch.

Monetarism finishes Strong

But on the subject of the policies to get us out of the crisis, the Monetarists shine much brighter. Milton Friedman’s monumental work, "A Monetary History of the United States”, argued that whatever caused the Great Depression of the 1930s, the downturn was made much worse by the Fed’s failure to aid the credit markets.

In the early 1930s, as the economy worsened, millions of depositors tried to withdraw their funds from the banks (there was no deposit insurance at that time).

Although Congress created the Federal Reserve so that it could provide emergency reserves, the Fed did nothing, and billions of dollars of deposits were lost. The money supply fell sharply, and virtually all financial activity ground to a halt.

The fall in the money supply instigated a huge deflation that hit not only in the stock market and real estate but also commodities.

The consumer price index dropped 24 percent between December 1929 and December 1932. The collapse in the price level worsened the burden of debtors and added to the already sharply rising level of defaults.

Friedman claimed that if the Fed had prevented the collapse of the banking system and stabilized the money supply, deflation would have been avoided and the Great Depression would never have happened.

But Keynesians objected. Keynes claimed that the forces of deflation would have overwhelmed the central bank, leaving it powerless. Once interest rates hit zero, monetary policy no longer could stimulate the economy since negative interest rates are impossible.

Keynes called this situation "The Liquidity Trap” and claimed that, under these circumstances, only fiscal policy -- tax cuts and massive increases in government spending -- could prevent a recession.

A Test of the Theories

Although the Keynesians got it right on the cause of the crisis, it increasingly looks like Milton Friedman and the Monetarists got the solution right. Ben Bernanke, who studied Friedman’s "Monetary History”, made sure that the Federal Reserve did not repeat the fatal mistakes of the 1930s.

He not only reaffirmed the Fed’s support for bank deposits but expanded its coverage to money market mutual funds and all business accounts, no matter what the size. Virtually no depositor or money fund investor lost money in this crisis.

The Fed was indeed hampered by the Keynesian Liquidity Trap when the central bank set the Fed Funds near zero at the end of last year. But Bernanke initiated policies to mitigate this constraint.

First the Fed lent banks far more reserves than they required, an action called Quantitative Easing. This assured the banks would have sufficient funds to meet any withdrawals.

Secondly, the Fed established lending facilities to reduce the soaring interest rate on privately issued debt instruments.

During the Great Depression interest rates on private debt increased sharply because dramatically higher risk premiums were demanded by lenders. Indeed, last year, the libor rate, which is the rate at which banks lend to each other and upon which trillions of dollars of private loans are based, soared after the Lehman bankruptcy.

But when then Fed sharply increased lending to security dealers, banks, and non-bank financial institutions, these premiums shrank dramatically.

When the public saw that their deposits and money funds secured, the panic eased, the stock market rose, and consumer confidence improved. The latest data indicate that it is almost certain that the recession ended sometime this summer.

It is true that the Keynesians will claim that the Obama fiscal package of tax cuts and spending is also responsible for the economic recovery. I will concede these policies did stimulate spending somewhat.

The Obama package totaled $775 billion spread over two years, but the Fed has lent over $1 trillion in the first six months of the crisis, and stood ready to lend even more if necessary.

Fortunately, the Fed is now scaling back its lending as many financial institutions are paying back their loans and reducing their excess reserves.

The Winner?

Both the Keynesians and the monetarists are right. The Keynesian emphasis on unexpected fluctuations in spending did the best at explaining how we got into the crisis.

But the Monetarists’ claim that preserving the banking system is critical to prevent a recession from becoming a depression is also right.

I am in no way absolving policymakers, particularly the Fed, who failed to see the crisis coming and protect the financial system. But we should be thankful that economic theory provided us a framework that prevented the last recession from turning into something much worse.

The biggest winners are not the Keynesians nor the monetarists, but all of us counting on an economic recovery.

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