John Maynard Keynes helped revolutionize macroeconomics with his seminal General Theory, supplemented by John Hicks. Since its publications most countries in the western world had adopted his theories, the European social democrats more so than others.
One of the principal hypotheses in that book was that during pronounced recessionary periods uncertainty rules. Investors and firms are loath to put their money into increasing capacity because of depressed aggregate demand, occasioned by high levels of unemployment and declining wages. Against the classical economists, Keynes reckoned that the economy could reach an equilibrium with these negative features. Recovery required government intervention in two forms: monetary expansion and fiscal stimulus.
Those who followed Keynes after the war sought to tame what appeared to be naturally occurring business cycles. When times are good, raise taxes and curtail federal spending. During austere periods, the opposite should hold.
Then along came William Phillips, a New Zealand economist. He observed an historical relationship between inflation and unemployment rates. This observation came to be known as the Phillips Curve: the lower the unemployment rate the higher the inflation level.
However, both Keynes and Phillips were upended by events in the 70s and 80s. There was the 1973 oil crisis, which led to soaring petroleum prices. Since much of the industrial economy depended on oil, GDP fell. At the same time things got more expensive—inflation rose. Diminished production led to higher unemployment. Both the high unemployment and high inflation undermined the Phillips Curve.
Prosecuting the Vietnam War also drove up prices. When Richard Nixon assumed office, he subsequently imposed wage and price controls then unilaterally prohibited the direct conversion of dollars to gold, a key feature of the Bretton-Woods Agreement, which had governed international monetary systems and currencies. Wikipedia:
By the early 1970s, as the Vietnam War accelerated inflation, the United States as a whole began running a trade deficit. The crucial turning point was 1970, which saw U.S. gold coverage deteriorate from 55% to 22%. This, in the view of neoclassical economists, represented the point where holders of the dollar had lost faith in the ability of the U.S. to cut budget and trade deficits.
In 1971 more and more dollars were being printed in Washington, then being pumped overseas, to pay for government expenditure on the military and social programs. In the first six months of 1971, assets for $22 billion fled the U.S. In response, on August 15, 1971, Nixon unilaterally imposed 90-day wage and price controls, a 10% import surcharge, and most importantly “closed the gold window”, making the dollar inconvertible to gold directly, except on the open market. Unusually, this decision was made without consulting members of the international monetary system or even his own State Department, and was soon dubbed the Nixon Shock.
Those studying economics during this volatile period began to question the wisdom of Keynes. In particular, the University of Chicago economics department, led by Milton Friedman, started developing their own macroeconomic theories, including an emphasis on monetary policies and “rational expectations.” Eventually one Chicago economist, Robert Lucas, pronounced Keynesian economics dead, or words to that effect.
It may be helpful to view a chart I prepared of this interval.
We see that oil prices rose sharply in 1973 and continued through 1975, before stabilizing, yet only to resume their upward trajectory in 1978, peaking in 1980. GDP, after rising steadily from 1970 to 1973, fell into negative territory between 74 and 75. The money supply (M1) also fell during that recession, which likely exacerbated the economic contraction. Inflation also soared during this period, coinciding with the 73 oil crisis. The 70s and 80s, we see, were rather unstable. Lots of peaks and valleys occurring frequently.
I’ve set off the years of Paul Volcker’s chairing the Federal Reserve. Just before he left, he reduced the money supply. It dropped even more dramatically in the two years after his departure, during George H.W. Bush’s presidency. Then from 80 to 92, the last year I’ve reflected in the chart, money supply soared along with an uptick in inflation. But by now oil prices had subsided, although GDP tapered off slightly in 1991.
All in all a crazy period, much different from the relative calm of the 50s and Clinton’s second term, which I did not show above. Indeed, and as I’ve mentioned before, Nixon’s assumption of office ushered in the Great Divergence, beginning a long, and as yet unceasing, process of greater wealth disparity, declining marginal tax rates, increasing federal debt, and the growth of the financial sector.
But I would suggest that it’s premature to bury Keynes. His theories applied especially to recessionary conditions, in particular those marked by depressed aggregate demand, a zero interest rate on US Treasuries, and low inflation, if not deflation. Some, including Ben Bernanke and Paul Krugman refer to these special conditions as a liquidity trap. (They were describing Japan at the time, but for Krugman at least the U.S. is in one now.)
I would suggest further that the anti-Keynesians had reached their conclusions in reaction to special conditions, namely that period we call “stagflation”—the combination of economic stagnation (reduced GDP) and higher inflation. This period, it seems, was caused by exogenous events (oil crisis, escalating war costs, and the Nixon Shock).
Today’s crisis has endogenous factors, namely the collapse of the housing bubble and major financial institutions (e.g., Lehman Brothers). What created the bubble can by explained as a prolonged Minsky moment. Animal spirits got carried away in herd-like fashion.
Now the world seems to be on a financial precipice, with another recession more likely, both here and in Europe. Unemployment rates remain stubbornly high. People aren’t buying things. And despite record low mortgage rates, home sales continue to decline along with housing prices.
What to do?
Republicans argue that taxes should be lowered further still, even in the face of rising deficits and reduced industrial capacity. Meanwhile, corporations are hoarding rather than investing cash. With lower taxes, they’d hoard even more.
The newly energized Keynesians, however, desperately urge governments to spend a lot more money to put people to work. I mean a lot more. Unless the economy starts growing robustly, too few jobs will be created. And it doesn’t look as if the private sector is the answer. In this situation, only the government can help—or so argued Keynes.
Alas, and assuming Keynes is correct in both his diagnosis and prescription, there’s little, if any, political will to fix the problem. We’re stuck, it seems, in yet another lost decade—if not longer.