The New New Thing in Economics

The Great Depression brought John Maynard Keynes to the forefront of economic thought. The key "Keynesian" insight was that private investment spending is inherently unstable--due to fads and fashions among investors, or because of shifts in the "animal spirits" of businessmen, or because falling prices disrupt the financial system.

Keynesians thought that prudent monetary policy--central banks raising and lowering interest rates to diminish fluctuations in private investment spending--could go part of the way toward stabilizing the economy. But they also believed that government had to be willing to step in directly, through expansive fiscal policy, to keep the overall level of spending in an economy stable. Such a policy, they believed, would forever banish the specter of large-scale mass unemployment, as in the Great Depression. Moreover, near-full employment might effectively be guaranteed.

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The Keynesians foresaw that near-full employment raised the threat of inflation. After all, why should workers and unions moderate wage demands if governments will boost spending whenever high unemployment looms? One big curb on high wage demands--fear of being let go when unemployment rises--was gone. What would replace it?

For the first post-1945 generation, the predominant answer was that corporatist social democracy would replace it. Unions would bow to government requests to moderate their demands for wage increases, and governments would bow to union demands for public spending and social insurance.

Keynesian thinking guaranteed that nothing like the Great Depression would ever return. But its solution to the problem of creeping inflation was jury-rigged, and broke down completely in the 1970's. In the aftermath of the main industrial countries' burst of inflation in the 1970's, mainstream economic thought in the world's industrial core shifted into a "semi-Monetarist" channel.

Milton Friedman's victory was never as complete as the Keynesians' had been. But by the mid-1980's policymakers throughout the world were assenting to the following propositions:

Central banks must make their commitments to long-run price stability credible;

Central banks must accept that the average level of unemployment is determined not by cyclical factors, but by "structural" factors, which they have no business trying to address;

Announcing and trying to maintain a money-supply growth target is an easy way for a central bank to communicate its principal intentions, gain credibility, and give outsiders a way to check whether sound policies are really being followed.

Monetarism was the mirror image of Keynesianism. It seemingly guaranteed that nothing like the inflation of the 1970's would ever return. But it offered no solution to the problem of structural unemployment that arose in western Europe. The past decade and a half demonstrated that monetarism is as ill-equipped to deal with the challenges of falling prices in the context of highly-leveraged firms and banks as the Keynesian prescription was ill-equipped to deal with the challenges of inflation.

Back in the 1970's and at the start of the 1980's, many (I was one) blamed bad decisions for the breakdown of the social-democratic systems' ability to control inflation. Politicians did not understand that expanding social insurance was the inevitable price of wage restraint, while union leaders did not understand that if corporatist social democracy did not restrain inflation, political power would shift to the right and high unemployment would be used to restrain it.

Today, many blame today's alarming economic conditions in the world's industrial core--more than a decade of stagnation in Japan, deflation there and in Germany, recession in Germany--on other bad decisions. Japanese and European central bankers did not lower interest rates far enough fast enough, banking-sector regulators shied at the jump in speculative lending, and politicians were unwilling to expand fiscal policy sufficiently.

But politicians and central bank governors cannot always be expected to make good decisions: good policies must be designed to function even when rulers are short-sighted and badly advised. The inflation of the 1970's was a natural failure of Keynesian political economy. The deflation that threatens Japan, Europe, and perhaps the US with the prospect of a long period of large gaps between potential and actual output is a natural failure of the semi-Monetarist orthodoxy that governed macroeconomic policy in the world's industrial core since the early 1980's.

Round and round we go. But it's not quite a circle: no government would allow a repeat of the liquidity collapse seen in the 1930's, or the failure of banks and companies on a scale that puts the entire financial system at hazard. It is an upward spiral. The world's macroeconomic problems are real, but they will not lead to another Great Depression--in large part because policymakers remember that there once was a Great Depression.

We need another policy-making revolution like the Keynesian and semi-Monetarist ones, a revolution that will not (wholly) lose sight of its predecessor's achievements, but will eliminate its natural failures.

Where might that revolution come from? Perhaps the next revolution in economics will grow out of US Federal Reserve Governor Ben Bernanke's career-long concern with asset prices, the role of adverse selection in credit markets, and the need for central banks in difficult situations to do more than conduct short-term open-market operations. He believes that banks should try things like putting a floor beneath key long-term bond prices. Bernankeism, anyone?