I have explained in recent columns how hydraulic Keynesians promoted the case for fiscal intervention, through increased public expenditure and rising budget deficits, as a response to under-full-employment equilibrium under conditions of price stability. Once inflation raised its ugly head during the 1950s, as a consequence of excessive expansion of the money supply designed to accommodate rising budget deficits, these same Keynesians honed in on another exploitable opportunity: governments should exploit nominal wage rigidities to purchase a lower rate of unemployment at the price of (in their minds a tolerable) increase in the rate of price inflation. In essence, government should take advantage of a gullible work-force that would fail to recognize inflation-induced reductions in the real wage that would encourage firms to increase output.
Governments – always eager to take advantage of a free political lunch – fired up both the monetary and the fiscal furnaces to drive their economies beyond the natural rate of unemployment. For a time the strategy seemed to work. In the United States, however, the policy ran into serious headwinds when President Johnson simultaneously pursued war in Vietnam with a Great Society program. Inflation appeared to take on a momentum of its own and, by the end of the 1960s, it was out of control. Milton Friedman and Edmund Phelps explained the nature of the problem in terms of adaptive expectations models. Expectations, henceforth, would move center stage as an era of stagflation dampened the efficient functioning of macroeconomies world-wide. The days of the hydraulic Keynesians were over – at least that is what almost every major economist believed; until September 2008.
Adaptive expectations just would not cut the mustard, as economists now rushed to investigate the micro-foundations of macroeconomic theory. Drawing on an idea advanced earlier by John Muth, Robert Lucas and Thomas Sargent re-wrote macroeconomics in rational expectations new cloth: individuals in society optimally use all available information, including information about current government policies, to forecast the future. Because monetary and fiscal policies influence inflation, expected inflation depends on such policies.
With such knowledge in the hands of the people, governments seemingly cannot exploit a Phillips Curve. In the New Classical macroeconomics, governments are impotent to influence the level of macroeconomic activity through sysematic policy interventions. Only by surprise can they make an impact. Ironically, this pits the government against the people in an ongoing strategic battle that was never supposed to reflect the nature of democracy! The New Classical macroeconomics had launched a new Star Wars in the unending battle between mercantilism and free markets.
Initially, the Keynesians ceded the battle-field to the New Classicals, acknowledging, as economists must always be tempted to do, that rational expectations was the only game in town. But not for long. By the late 1970s, the Empire struck back, as Keynesians rose like Phoenix from the ashes in a New Keynesian form. A new brand of Keynesian, now immersed in rational expectations, searched high and low for any nominal rigidity that might arguably survive in the Brave New World. Larry Summers and Christina Romer were right there, with other leaders such as Gregory Mankiw, David Romer and John Taylor. And my, how contemptuous these New Keynesians were of the old-fashioned hydraulic Keynesians who struggled valiantly to compete with them in separate sessions at the annual conventions of the American Economic Association!
Well, the New Keynesians were quite successful. The Empire restored its rightful position, and the New Classical Jedi failed to take revenge. By the mid-1990s, governments once again pursued active monetary and fiscal policies as tools of macroeconomic stabilization policy. But they did so on a reduced scale. For even the most ardent New Keynesians recognized the fragile nature of their new nominal rigidities: staggered wage contracts that exposed workers to a modicum of real wage reduction, efficiency wages whereby firms attempted to hold on to superior labor by paying it above market rates, and menu price rigidities that exposed firms to a modicum of inflation-induced sales expansion, as government surprised the system with accelerated inflation. But policy leverage through this mechanism must be limited, and transient, since workers and the firms would eventually catch on to the government’s game, with labor shortening the duration of labor contracts, and with firms revisiting their efficiency wages and menu prices more frequently, in response to government manipulation of the macroeconomy.
The proof of the pudding, of course, is in the eating. The year 2009 has left the Obama administration and the Democrats in Congress with severe indigestion and acute intestinal discomfort. The temporary tax cuts have been pocketed, not spent, by debt-burdened households. Federal stimulus monies have been absorbed by the states in reductions in their own projected outlays, and by firms who have replaced privately-funded with federally- funded labor. Stated goals of unemployment reduction have proved worthless. Reckless Federal Reserve outlays in purchasing toxic mortgage securities have served only to promote the issuing of ever more volumes of such instruments by agencies of the government. Increases in the money supply have been hoarded by the banks, while good entrepreneurial initiatives are starved of funding.
Now dear reader, think just how useless demand stimulation by government is in a post-2008 environment where inflation is all but non-existent, where market pressures are such that wages and prices are only too evidently downwardly flexible as workers scramble to hold on to their jobs and as firms scramble to hang on to their markets in a severely recessed economy. If not before the recession, certainly now, we live, at least temporarily, in a New Classical environment.
Do you believe that once leading New Keynesians such as Larry Summers and Christina Romer experienced a limited attack of Alzheimer’s, forgetting their own scholarship, and retreating into a hydraulic Keynesian fantasy, when advising President Obama and Chairman Ben Bernanke to engage in reckless, wasteful and essentially impotent monetary and fiscal outlays? Or do you believe that they were acting not as economic, but as political, advisors to a President and a Congress desperate to exploit a financial crisis as a means of expanding the power of the state?