Keynesian Redux

Not so fast. Before we rush to follow Keynesian prescriptions for our current economic woes, everyone should stop, take a deep breath, and read Robert Samuelson's new book about Keynesian economics and the economists who gave Keynesian advice to both Democrat and Republican presidents. It's also about arrogance, hubris and chutzpah. It's about people whose advice caused great harm and who would have kept on causing harm had policymakers continued to listen.

Beginning with the administration of John F. Kennedy, a new breed of economist came to Washington, armed with the tools of demand-side management of the economy. They stayed on – through the administrations of Lyndon Johnson, Richard Nixon, and Jimmy Carter. And the longer they stayed, the worse things got.

By the time Paul Volcker became head of the Federal Reserve System and Ronald Reagan became President, things were bad. They were very bad. The inflation rate, for example, climbed from barely more than 1% in 1960 to almost 15% in early 1980. The prime rate in December, 1980 hit a record 21.5%. By 1981, 85% of the saving and loan associations were unprofitable. The word "stagnation" became part of the American vocabulary.

The cast of characters that wrought these problems is star-studded: Walter Heller, Arthur Okun and Alice Rivlin, to name a few. Three of them (Paul Samuelson, Robert Solow and James Tobin) went on to win Nobel Prizes. But as Samuelson is quick to point out, it was the ideas, not the individuals, who were at fault.

One such idea was the belief that the economy could be manipulated to eliminate the business cycle. To avert a slump, for example, the government could employ such "pump priming" measures as tax cuts and deficit spending. To avert overheating, the process could be reversed. Another idea was the Phillips Curve, a reliable trade-off between inflation and unemployment. Paul Samuelson and Robert Solow, for example, suggested that an unemployment rate of 3% could be purchased with a permanent inflation rate of 4.5%. In defense of such goals, James Tobin wrote as late as 1974 that there was "a vast amount of exaggeration of the cost of inflation."

Yet the theory was wrong. The models were wrong. And the implementation was wrong. Although Samuelson doesn't say so, I find it remarkable that as early as 1962 Milton Friedman wrote in Capitalism and Freedom that economists had no reliable theory to "fine-tune" the economy. And as Friedman and Edmund Phelps showed, there is no stable Phillips Curve.

Even though most economists at the time were convinced that the Keynesian model worked fairly well, former Federal Reserve economist Athanasios Orphanides has shown that the errors were huge. At a time when the Fed believed full employment was between 4% and 4.5%, later estimates put it closer to 6%. Whereas economists expected productivity growth between 2.5% and 3%, for much of the late 1970s, it barely exceeded 1% per year. Whereas the "output gap" in the mid-1970s was thought to be 12%, later estimates put it at a modest 2%.

Aside from the Phillips Curve, the Keynesian economists had no theory of inflation and certainly no coherent plan for dealing with it. Invariably they saw rising prices as a problem rather than as a symptom of a problem. President Johnson tried to control wage and price hikes by "jawboning." President Nixon imposed wage and price controls briefly. The economic advisors warmed to the idea of an "incomes policy," a euphemism for price controls. Of course, none of this worked.

Enter Reagan and Volcker. Samuelson gives them both credit for a huge economic turnaround and writes that the success was a turning point moment. In fact, Samuelson compares it to the Civil War, the Great Depression and World War II. In terms of the progression of ideas, the notion that the Federal Reserve cannot control inflation was permanently discredited. The notion that a little less unemployment can be exchanged for a little more inflation was also discredited.

For the past 25 years, monetary policy has focused on providing stable prices. Fiscal policy has alternated between goals of budget balancing and supply-side tax cuts. It has been mainly a period of prosperity (creating 46 million jobs), in which pump priming, fine-tuning, the Phillips Curve, incomes policy, jawboning and wage and price controls played no part.

Barack Obama is the President-elect and Paul Volcker is a key advisor. That's a sign at least that the lessons of Samuelson's book will not go unheeded.

A longer version of this review will appear in the January issue of Business Economics.

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