For many reasons, the US financial crisis is bringing back old discussions about

monetarism versus fiscalism as well as about monetary policy instruments. It is only necessary

to mention: the zero interest rate bound; and the major increases in Government spending.

The fact that interest rates will be reaching zero very soon is decoupling monetary aggregate

targets from interest rate targets. In other words, when interest rates reach zero, the Fed can

increase the monetary base (basically purchasing Federal Government bonds) without limits,

because the basic interest rate cannot be negative in nominal terms. As a matter of fact, if there

is deflation, real interest rates can be highly positive.

The question of Government spending raises the old textbook discussions about

financing of the deficit: printing money versus bond financing. The difference here will not be

necessarily in terms of interest rates, but mainly in terms of the credit market, to the extent

that a bond financing of new Government spending tends to produce a crowding-out effect on

the credit markets, by leaving less space or no space at all for private borrowing through loans

or bonds. On the other hand, the question of “printing money” always brings back fears of

inflation or even hyperinflation. This may sound paradoxical, but the Great Depression

specialists such as Friedman and Schwartz always emphasized that those fears certainly

affected the decision of monetary policymakers at that time, even though there was deflation

(perhaps because of the European hyperinflations of the twenties).The fact is that monetary

aggregates in the US were flat for one year around US$ 850 billion, and jumped dramatically to

US$ 1.5 trillion between September and November 2008 (almost 80%). (Andrews, 2008)

On the other hand, M1 and M2 continued to be basically flat in the past 14 months, with

only a slight increase of less than 10% in both cases. (Irwin, 2009)Going back to textbooks of

money, credit and banking, what is happening is an amazing fall in the “money multiplier”,

which is basically influenced by two ratios: currency/deposits and reserve/deposits. The public

is bringing the currency/deposits ratio up intensely, by hiding cash under the mattress, and the

banks are also bringing the reserve/deposits ratio up very quickly, showing their preference for

cash, as opposed to loans and investments. (Koo, 2009)

Given the uncertainties about the behavior of the money multiplier, basically dependent

on confidence, as well as the uncertainties about the effectiveness of fiscal policy without

monetary expansion (due to the crowding-out effect), the only solution for Bernanke’s Fed is to

do much more of the same – print much more money –and forget about those fears of

inflation or hyperinflation. With zero interest rates and a major confidence crisis, both

monetary and fiscal policy must be used intensely.

Printing money and increasing the Government deficit. At this point in time, the

monetarist debates of the 60s and the 70s about the impact of an increase in nominal GDP

produced by a mix of aggressive and expansive fiscal and monetary policy – producing at the

end of the day only inflation and not necessarily real economic growth – become entirely

meaningless. (Koo, 2009)

In other words, we must be all monetarists now, but with a twist. Just like Friedman and

Schwartz did when they studied the Great Depression. In normal times, Friedman emphasized

that one cannot get away from a recession by printing money and by more government

spending. As a matter of fact, Bernanke is worried about deflation, that is, zero nominal interest

rates and positive real interest rates. This is why the monetary base need to grow much more

than 80% and economic analysts must become “monetarists” again, not “Keynesians”. (Koo,

2009)