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?
Tags: hydaulic Keynesians, impotence of government, new classical macroeconomics, new Keynesian macroeconomics, nominal rigidities, rational expectations
January 23, 2010 at 6:37 pm |
A nice review of the history of macroeconomic though and macroeconomic history. However, nominal wages in the private sector are only growing slightly more slowly, and real wages continue to grow faster than trend. It is of course possible that the productive capacity of the economy has fallen 9 percent below its long run trend. Still, I think a better explanation is that nominal expenditure has fallen 9% below trend and prices have risen every quarter but one, and are only about 1 percent below trend.
I don’t doubt that the productive capacity of the economy has fallen and is below trend. For example, the CBO estimate has it 4% the trend of output. I think there has been a huge sectoral shift away from housing. But that still leaves a 5 percent output gap. And requires another 4% drop in prices. And, as I said, nominal wages have only slightly changed.
I don’t think we live in a new classical/real business cycle world. I don’t have much use for stimulus packages or having the Fed purchase toxic assets, but I think the notion that prices and wages are flexible enough so that the level of nominal expenditure is irrelevant is false.
Keeping nominal expenditure on a stable growth path, and raising it back to that growth path if it gets below it–remain the best way to provide a sound macroeconomic environment for the market process.
And how to manage that? Open market purchases of sound assets with greater than zero yields. And, of course, open market sales when the demand to hold money falls again.
It isn’t about fooling people. It is about change the quantity of money to match the amount people want to hold given a stable growth path of nominal expenditure. It is about avoiding the alternative method of adjusting real money holdings to desired holdings–changes in the level of prices and wages.
If the real business cycle people are right and people don’t want to invest, so they don’t want to save, so they don’t want to work, it is true that reduced production employment and production will result in a higher price level at a given level of nominal expenditure. I don’t see higher prices as an undesirable signal of people not wanting or not being able to produce things.
But I don’t think the real business cycle approach tells us much of anything about what is happening.
As Yeager explained, “Old Chicago” had it right. Monetary disequilibrium leads to changes in nominal expenditure and undesirable changes in output. If rational expectations models can’t show how this happens, then the problem is with the models.
January 23, 2010 at 7:14 pm |
This is an excellent comment. You make some very telling points. I should perhaps mention here that I am not a New Keynesian. I stepped into their shoes as best I could to show how far even from this position the hydraulic Keynesian solutions have drifted. My own judgment is that Milton Friedman and Old Chicago were exactly right and that the adaptive expectations model together with his monetary theory (1971 vintage) should have more play within the profession.
January 24, 2010 at 10:11 pm |
The key point to this analysis seems to be Johnson’s Great Society. This seems to be the period where some of the variables changed and caused distortion in the market place.
In Australia, during that period and up until the Howard Government made sweeping changes, we had a central wages fixing system, known as the Arbitration Commission. Its role evolved into being the one that set the minimum or basic wage. The market itself was not allowed to decide the cost of labour (but of course in occupations where there was a high demand for labour the wages were higher because of supply and demand). However, this Arbitration Commission and the setting of a minimum wage also created distortions.
Ian McFarlane, the former governor of the Reserve Bank in a paper for the Boyer series of lectures discusses three possible causes for the period of stagflation: (1) inflation (2) the form of Keynesian economic policy was unstable, and (3) what was initially good policy was eventually pushed too far. One of the many points made by McFarlane is the following: “Most economists at that time thought that the Keynesian system of demand management had provided the answer to the macro-economic problem. Furthermore, they felt that if the economy was not attaining the desired rate of economic growth and low level of unemployment, the remedy was simply to apply more Keynesian medicine. Any deficiency in private demand was to be met by an increase in public demand.”
I can attest that this was definitely evident at the time because the government of the day concentrated mostly on keeping unemployment at a very low rate. Every time that Unemployment (after seasonally adjusted figures were obtained) then measures had to be taken with an increase in government spending.
What is clear to me from what McFarlane stated is that the purpose behind the “stimulus” package (in Australia and the USA) was to allegedly increase demand for consumer goods with the purpose of increasing the demand for labour. So yes in effect we had a return to this imperfect understanding of Keynesian type theory, and this return is a failure.
Australia was one country that did not feel the big shudder from the Global crisis. I doubt it had anything to do with those measures taken for the simple reason that there are always lags to be considered. Providing money for “special projects” is not going to stimulate the economy in the long term. The measures taken were short term solutions to a long term problem. Plus, they failed to take into account the change in direction on employment and other policies due to the change of government.
Just like the period prior to the stagflation needs to be analyzed to see what went wrong, the same thing needs to happen with regard to the period prior to the collapse of the global economy. The collapse itself can be best explained as “a bubble bursting”, and an “over-heated economy”. Yet, some analysis leaves out the vital considerations of change in government policy that in fact led to a crisis in the housing sector – the housing bubble. These were legislative changes that insisted that mortgages were given to people who could not afford to repay what they have borrowed.
In other words, Govt made policy changes that in the long run caused an increase in the demand for housing, which in turn caused the housing bubble. That bubble, just like the oil bubble had to burst. There needed to be a shock.
The first oil shock preceded the stagflation, but it was not a direct cause of the stagflation. One real problem that we continue to face is OPEC continues to determine the price of oil plus OPEC limits the number of barrels of oil that can be produced. This kid of behaviour runs counter to the classical Keynesian theory. Thus economists need to take this kind of thing into account.