As we began to write our Principles of Economics text (Roy Ruffin and Paul Gregory, Principles of Economics) exactly thirty years ago, economics was in disarray, shaken by the stagflation that was not supposed to be. Ours was among the first to introduce the new ideas of the 1980s -- rational expectations, Barro-Ricardo equivalence, the natural rate of unemployment, moral hazard, and new Keynesian economics. At that time, Economics 101 was taught, with few exceptions, the unabashed Keynesianism of Samuelson and McConnell. Principles textbooks are intended to give a sense of the state of economics. Selected by committees, they must at least try to give a balanced viewpoint. Although labeled “conservative,” our text garnered strong sales for a decade. We must have done something right.
Will the deep recession, which likely ended in late 2009, require a rethinking of economics, as did stagflation? Compared to other economic downturns of the past forty years, the current recession definitely stands out. Its probable 20-month duration is greater than the previous peak of 16 months (and the 40-year average of 11 months); its peak unemployment of 10.2 percent was exceeded only by the 10.8 percent of 1981-82 (The 40-year average was 7.8 percent); and the 4.1 percent loss of output well exceeds that of previous recessions. Moreover, it follows a long period of economic growth, interrupted by extremely mild recessions, dubbed “the Great Moderation.” The current recession, despite its severity, pales in comparison to the Great Depression with its 25 percent unemployment rates and loss of a quarter of GDP. The threat of a repeat of this catastrophe was remote, although politicians could not resist invoking its image.
In 1980, policy makers despaired that “the rules of economics were no longer working.” The Phillips Curve had taught that we had a policy choice of inflation or unemployment and had no instructions for when both rose at the same time. Rational expectations provided the new paradigm: As inflation crept up due to the energy shocks of the 1970s and central banks created more money to combat the resulting unemployment, people began anticipating higher and higher inflation, which led to the incredibly high interest rates of the late 1970s and early 1980s. The new policy prescription was that inflationary expectations had to be beaten by a draconic and steady policy of monetary restraint, despite its negative effects on GDP and unemployment. A more positive message was that inflationary expectations could change quickly and in a positive direction if people became convinced that economic policy would be enlightened and consistent.
Complaints are again being voiced that “the laws of economics are not working.” Despite easy money, zero interest rates, and massive increases in government spending, unemployment rates remain high, and consumer and investment spending remain anemic. We may still face a double-dip recession. Are we, in 2010, facing a “new” phenomenon similar to stagflation of the late 1970s? Do we need entirely new ways of thinking? Can “contemporary” economics can explain these recent policy disappointments. Let us examine each of these failures to determine if they were expected or unexpected.
1. The failure of the fiscal stimulus to raise output and employment.
The Obama administration’s assurances that increased federal spending would have a potent effect through the multiplier have not proven to be true. This is not a surprising outcome at all. Contemporary economics long cast doubt on the multiplier – the notion that $1 of extra government spending would raise GDP by more than a dollar. The Keynesian multipliers of Samuelson and McConnell apply to an economy in which wages are stuck, and there is an almost infinite supply of workers prepared to work at going wages. Unemployment could therefore not be reduced by lower wages. In such a circumstance (that Keynes thought to apply to deep depression), increases in government spending have magnified effects on output and employment. (Much of “modern” Keynesianism is therefore about finding reasons for sticky wages in today’s economies). In contemporary texts, aggregate supply and demand replaced the Keynesian multiplier. The steeper the positive slope of the aggregate supply curve, the smaller the effect of a stimulus program. Moreover, the more the effects of stimulus are anticipated, the smaller its effect. We decided in 1980 (with surprisingly little resistance) to drop the multiplier from our text. It is therefore surprising that the Keynesian multiplier has played such an important role in the current policy debate. Is this again an example of Keynes’ warning that we are hostages to the outdated ideas of dead economists? The demise of the multiplier is not the only reason for questioning fiscal stimulus. The Keynesian model assumes that public debt does not affect consumer behavior. The Barro-Ricardo equivalence theorem teaches, to the contrary, that deficit spending can be offset as people cut private spending to prepare for tax increases that are sure to come. The current increases in private saving that have accompanied today’s soaring deficits are striking confirmation of this proposition. There is yet another effect: government spending “crowds out” private spending (More government spending for education or medical care mean less private spending for both). This “crowding out” may be particularly strong today as the government expands into more activities that were traditionally the responsibility of private individuals.
2. The failure of Obama’s 2009 tax rebate to stimulate private spending.
The textbooks of the 1980s introduced the Friedman-Modigliani permanent income hypothesis, which taught that temporary changes in current income (such as from a one-shot tax reduction) have no effect on consumer spending. Indeed, this proposition has been substantiated in the many failures of temporary tax cuts from the administrations of Johnson (1968) to George W. Bush (2001, 2008). Short term tax rebates remain politically appealing despite the evidence of their impotence because they show a government “doing something” about the economy. We have sufficient evidence to conclude that only tax changes that are perceived to be durable affect real outcomes. Hence, Friedman-Modigliani predicts that a one-year (or even two year) extension of the Bush tax cuts will have little or no impact on consumer spending. If anything, economists should have been surprised if the tax rebates of 2009 had had any effect whatsoever. Any positive impacts of the 2009 tax rebates would have been swamped by the persistent chatter about higher taxes – on energy, the expiration of the Bush tax cuts, “hidden” taxes associated with health care, value added taxes, and eliminating the cap on social security taxes.
3. The persistence of high unemployment.
The administration’s economic advisors were clearly unduly optimistic about unemployment. The textbooks of the 1980s substituted the natural rate of unemployment (of Friedman and Edmund Phelps) for the crude Keynesian concept. The natural rate hypothesis placed unemployment in the context of cost-benefit analysis. If the costs of remaining unemployed are high, the unemployment rate will fall. Hence, if unemployment compensation is generous and long lasting, the unemployment rate will remain higher than it would have otherwise. In fact, empirical studies found that unemployed persons remarkably found jobs just as their unemployment benefits were expiring. Other studies showed that the higher unemployment in the European welfare states was partially due to unemployment insurance becoming an entitlement. Admittedly, it is politically difficult to place time limits on unemployment insurance, but the administration’s extensions are on the verge of making unemployment insurance a permanent entitlement.
4. The lack of private investment and job creation.
Keynes wrote “in the long we are all dead.” His multiplier is dead, but his writings about uncertainty and investment remain as relevant as the day they were written. Keynes emphasized in his writings about “animal spirits” that business expectations can shift quickly. As businesses become pessimistic, they cut back. The future is always uncertain, and the greater the uncertainty, the fewer investments and the fewer workers hired. We live now in a world of great uncertainty. We do not know our future tax liabilities; businesses do not know what their employee health care costs will be. Boards of directors are less free to make compensation decisions; government bureaucrats now increasingly do either directly or through political pressure. Businesses cannot calculate their bottom lines and until they can, their best strategy is to sit tight. Lenders with first claims to assets have been told to go to the back of the line in some cases; others have been told to renegotiate mortgages. The result: little investment and little lending. In a word, businesses fear that the rules of the game are being changed by an administration that is unfriendly to them. These points are not to be found in Economics 101 textbooks. They are evident and have been with us since Adam Smith and before. Our main economic message to countries with poor institutions is to settle on reliable rules of the game; we have not followed our own advice. In my view, this is the main reason for the “failed” recovery.
The last three years will be dissected and analyzed by generations of economists. Their main question should be why the “Great Moderation” ended with such severe consequences? Was this a failure of private markets or public policy? We already know the immediate cause: the abrupt end of the housing price bubble and the associated collapse of mortgage and security markets worldwide. Some one half of private wealth in the United States was in home equity. The collapse of this wealth would inevitably bring the entire economy down with it. But were these events the result of market excesses or policy blunders? The argument for market excesses rests on the failure of asset markets to properly value risks. The argument for policy failure rests on the deliberate use of public institutions to underwrite high risk mortgages with the aim of making Americans home owners whether they could afford it or not. For a long time, we were warned that public lenders (Fannie and Freddie) were technically insolvent, but few law makers were willing to pay attention, on either side of the aisle. The textbooks of the 1980s introduced moral hazard. Applied to financial markets, moral hazard rears its head when lenders assume that a lender-of-last resort will bail them out. They therefore take risks they otherwise would not have. With moral hazard, it becomes extremely difficult for private markets to value risk because of moral hazard and the fact that the outcome depends on unpredictable government actions and reactions.
There is no need for a new Economics 101. What we have experienced over the past two years is nothing new. There is nothing unexpected that has happened. Events however should serve as “teachable moments. What is surprising is that Keynesian economists do not seem to have learned its lessons.
Paul Gregory is the co-author with Roy Ruffin of Principle of Economics, the first edition of which appeared in 1982 with Scott, Foresman.