Chapter 2: Schools of thought

1998; Last Modified 14 August 1998

As disciplines
go, macroeconomics is fairly young. The primary concepts for measuring the macroeconomy,
the national income and product accounts, were not developed until the 1930s
and 1940s. During America's greatest macroeconomic crisis of the 20th century
(the Great Depression of the 1930s), presidential advisers and economists were
more or less at a loss to explain what was happening and what, if anything,
federal policy could do to end it. Roosevelt surrounded himself with some of
the brightest people available, but no one had the tools or concepts to provide
a consistent analysis of the problems.

Of course we
like to think that "It could not happen again," and "We know too much to let
it happen," but this is probably magical thinking. It could happen again,
and when it does, we won't see it coming. But, we have learned some things
in the last 70 years, and macroeconomics is not quite as helpless as it was
when it was first born. It is highly probable that we could avoid, or end
less painfully, a 1930s style depression. It's the 21st century style depression
that should worry us, because that is the one we have no experience with and
no sense of what it will look like.

Sometimes economists
define microeconomics as the study of how the economy holds together, and
macroeconomics as the study of how it falls apart. There is no doubt that
it can fall apart in many ways, and when it does, there is still significant
variation in opinion among professional economists as to what should be done
and what can be done. The range of opinion varies across a spectrum which
is, in some ways, more political than economic, from doing nothing to actively
intervening with increased spending, tax cuts, and monetary expansion. One
camp, the do nothing (or, at least very little) group, believes that the economy
will usually fix itself and any attempt to speed up the process is as likely
to make things worse as it is to make them better. This camp has a lot of
faith in the inherent stability of a capitalist economy such as ours. They
were the people advising George Bush during last economic recession in 1990
and 1991. In 1992, Bush lost to Clinton.

In part, Bush
lost because candidate Clinton managed to convey the message to the American
people that he could "feel our pain." So, we expected him to do more than
wait for the economy to get better on its own. Economists and political scientists
find this somewhat ironic given our general dislike of big government. However,
when it comes to economic bad times, we clearly have very little tolerance
for doing nothing, even though that may be the best policy in some cases.
For example, in the last recession (1990-91), by the time the election rolled
around in the fall of 1992, the economy was clearly on the mend, and by the
time Clinton took office, it was set to begin a good recovery. All, more or
less, on its own.

    Keynes and the birth of modern macroeconomics

At the same time
that economists were grappling with the development of the concepts they needed
to categorize activities in a national economy, another group of thinkers in
the 1930s was trying to understand how economic policy might help to end the
deep depression. The leading figure in this effort is probably the most important
economic thinker of the 20th century, John Maynard Keynes. (The name Keynes
is pronounced so that it rhymes with rains. If you say "Keenes," everyone will
doubt anything you say after that.)

Keynes' life
is well worth reading about, and is a good way to absorb macroeconomics. There
are several good biographies, including the relatively recent work by Skidelsky
(1996). Keynes' theory of recession was shaped by the experience of the 1930s--bank
failures, stock market crashes, protectionist trade policies, and several
other factors created widespread uncertainty and a loss of income. Uncertainty
and unemployment caused people to favor saving over consuming, and holding
more money over buying goods. The decline in spending by households was felt
throughout the economy; businesses responded with cutbacks in production.
This, of course, only made things worse because it led to more layoffs, higher
unemployment and another decline in income.

While Keynes'
analysis was aimed at explaining the 1930s, it was widely accepted after World
War II as a general explanation for economic fluctuations and recessions.
One of the key elements of this explanation is that disturbances in the macroeconomy
originate in a change in the aggregate demand for goods and services. That
is, the sum total (aggregate) of household, business, foreign, and government
purchases falls off. It is not necessary that each component falls, only that
one or more falls enough to send a signal to businesses to produce less.

The Keynesian
model is often described as a "demand
side" model
because demand is in the driver's seat in terms of the
level of economic activity. Supply, or the output of businesses, responds
passively to changes in demand. When demand is booming, businesses hire more
workers, and increase production. When demand drops off, they fire or lay
off people and cut back on output. Demand can rise or drop suddenly due to
unexpected events that change the way in which households and businesses view
the future. Supply, on the other hand, is a function of the capacity of an
economy and is determined by the availability of labor, machines, natural
resources, and technology, none of which changes overnight.

The key element
in the Keynesian cure for recessions was to raise demand. If consumers were
afraid to spend, and businesses saw no reason to expand (invest), then it
was up to governments to raise the level of spending in the economy. Prior
to Keynes, governments saw this as a worthless policy since they were convinced
that each and every dollar they spent would reduce by a dollar the spending
of households and businesses. One of Keynes' great contribution was to show
why this was not necessarily true and to demonstrate that increases in government
spending could act as a stimulus to the rest of the economy in times of recession.

One last important
element of Keynesian economics was added after Keynes. This was the Phillips
, named after the economist that first verified a stable relationship
between inflation and unemployment. The Phillips curve showed that over long
periods of time, increases in unemployment were associated with predictable
decreases in the rate of inflation (Figure 3).

Figure 3

The Phillips
curve gave policy makers a (mistaken) belief that they could choose from a
list of pairs of inflation and unemployment rates. This went hand in glove
with Keynesian ideas about demand management, in which it was assumed that
government could stimulate the economy when there was a recession, and slow
it down if it became overheated. As these ideas came to dominate economic
thinking in the United States, President Kennedy assembled an economic team
of leading Keynesian thinkers who proposed a package of tax cuts to stimulate
private spending. The tax cuts were stalled in Congress but later passed after
Kennedy's assassination.

    The reaction to Keynesianism

Although President
Nixon proclaimed that "We are all Keynesians now," not every economist was in
agreement. In particular, Milton Friedman carried on a crusade against using
government policy to "fine tune" the economy. Friedman was not alone in his
criticisms, but he was one of the most outspoken and vocal opponents of Keynesian

Friedman based
his objections to Keynesian ideas on three main points. First, he argued that
the ability of economists to predict the overall effects of tax cuts or spending
increases was not very good. Therefore, if governments could not say exactly
how households and businesses would respond to a change in government spending,
or a change in taxes, then it was impossible to predict the effects a policy
might have on GDP and unemployment. In Friedman's view, this problem was compounded
by the fact that there were long lags between the time we recognized a problem
in the economy, and the time Congress and the Whitehouse could agree on a
course of action. In effect, this means that by the time government did something,
the need might be gone and government action might actually make things worse
rather than better.

Second, Friedman
objected to the bias in Keynesian policy that seemed to increase the role
of government. Government expenditure programs to increase demand in the economy
inevitably resulted in a larger government, and this went against Friedman's
free market ideology. And third, Friedman argued that the Phillips curve was
unstable, and that it would breakdown once we experienced a prolonged period
of low unemployment.

    Great Stagflation

Friedman's last
point was soon put to the test. The Keynesian tax cuts of 1964 helped to keep
the economy growing at a rapid rate, and unemployment stayed low. Meanwhile,
as predicted by the Phillips curve, the inflation rate began to creep up during
the late 1960s and early 1970s. Policymakers began to worry about rising inflation,
particularly during the administration's of Presidents Nixon (1969-1974) and
Ford (1974-1976).

Meanwhile, the
US economy was hit by several events that caused inflation to rise independently
of the rate of unemployment. Bad harvests in the early 1970s raised the price
of food, while the first oil crisis in 1973 caused the price of oil and gas
to skyrocket. By the mid-1970s, the US had entered a period of higher than
usual inflation, in which price increases seemed to go on independently of
unemployment rates. Friedman's prediction that the Phillips curve would breakdown
was born out.

Friedman had
argued that the Phillips curve appeared stable because people did not expect
inflation. That changed after several years of very low unemployment, coupled
with the oil price hikes and the food price hikes. Businesses and households
began to expect inflation. Businesses tried to anticipate rising costs due
to the inflation, so they responded by raising the prices of their output.
And households responded to the way in which inflation eroded the purchasing
power of their incomes with demands for higher wages. Higher wages meant higher
business costs, which meant higher prices, which meant another round of demands
for higher wages, and so on. If an unemployment rate of 4% under the old Phillips
curve was associated with 2% inflation, it now translated into a 4% inflation
rate. And next year or the year after, it might translate into a 6 or 8% inflation
rate. Clearly, the Phillips curve no longer applied, at least in its original

The 1970s introduced
the term stagflation into the
thinking of economists. The term is a combination of two concepts: stagnation,
meaning recession, and inflation. Stagflation is economic hell--high rates
of unemployment due to recession, coupled with high inflation. According to
the Phillip's curve, that could not happen, but clearly it did. The appearance
of something that theory said was impossible resulted in the collapse of the
Keynesian consensus. The idea that a wise and careful government could fine
tune the level of production through its use of government spending and tax
policy was challenged, debated, and ultimately rejected.

The appearance
of stagflation threw academic macroeconomics into disarray. The Keynesian
model seemed hopelessly flawed, but what could take its place? Should governments
try to counteract the naturally occurring highs and lows of a capitalist economy?
Or, should they keep their hands off, and let the economy take care of itself?
If the collapse of the Phillips curve was partially a result of businesses
and households changing their expectations about inflation, then how did government
policy interact with the formation of new expectations?

the stagnation part of stagflation began to be a serious problem. the economy
experienced a deep recession in 1974-75, and a weak recovery. By the late
1970s it began to be apparent that the long run rate of growth of the economy
had slowed. This raised a number of additional questions. For example, how
did government policies change the incentives for businesses to invest and
expand? Were industry specific regulations hurting economic growth by preventing
innovation? Did tax policy hinder entrepreneurs?

    On into the 1990s

The breakdown of
the Keynesian consensus provided an opening for a more conservative, and laissez
style of macroeconomics. In some respects, this was a return
to pre-Keynesian ideas. Many economists took on the name of neoclassical,
after the classical economists of the 19th and early 20th centuries. (The prefix
neo- means new, so neoclassical can be translated as new classical.) Classical
economists saw no role for government in the management of the macroeconomy.
Government intervention was viewed as ineffective, in part because of the natural
self-equilibrating mechanisms in the economy. An economy in recession, for example,
will put downward pressure on wages since unemployment will be high. Workers
will have to take pay cuts in order to find jobs or to keep the ones they have.
The reduction in business costs will, in effect, stimulate production and lead
to a recovery. According to neoclassical economists, governments that try to
speed up this process are as likely to make things worse as they are to make
them better. As you might imagine, President Bush's economic advisers were giving
him this kind of advice during the last recession (1990-91).

At the same time,
Keynesians have regrouped, older and wiser now, under the banner of neo-Keynesian
economics. They share many of the ideas of neoclassical economics, and in
the spectrum of opinion where the two meet, many macroeconomists have one
foot in each camp. The chief distinguishing characteristic, however, is the
idea that a macroeconomy can be delayed in its natural tendency to come out
of a recession. Consequently, some Neo-Keynesians see more room for government
to help the economy along. The role for government depends on circumstances,
however. Some recessions may end on their own fairly quickly, while others
can be prolonged and unnecessarily painful without government policy to assist.
If President Bush's advisers tended towards the neoclassical spectrum, President
Clinton's are neo-Keynesian.

This debate probably
seems odd in some respects. Why don't economists simply gather some data and
test the hypothesis that economies in recession will return to normal in a
reasonable period of time? It seems straightforward, and if we had laboratories
in which we could control every factor, economists would do that. The problem,
of course, is that economic systems are too complex, and too subject to uncontrollable
and unforeseen events. Consequently, the data don't speak clearly. Both viewpoints
find justification and, given the entrenched political ideologies (activist
government versus laissez faire government), both sets of ideas have
audiences inside and outside the economics profession.

One last school
of thought must be mentioned because of the prominence they attained in political
circles. This is the supply side
ideology. Supply side economics is somewhat of a misnomer since there are
no economists in any leading university that take the supply side label. Supply
side economics was a purely political movement which played off the conservative
reaction to Keynesian economics. That is, a group of journalists and politicians
took the arguments of conservative, neoclassical economists and exaggerated
them to the point where they became extremist and far outside the mainstream
of academic economics. While these ideas still garner support in some political
circles, they have no economic value and are ignored by mainstream economists.
We will return to this issue in Chapter 4.


    Krugman, Paul.
    Peddling Prosperity: Economic Sense and Nonsense in the Age of Diminished
    New York: WW Norton. 1994.

    Stein, Herbert.
    Presidential Economics. Washington, DC: American Enterprise Institute.

    Krugman is
    a liberal, Stein is a conservative. Both give an un-biased history of economic
    ideas and their interaction with macroeconomic policy.

On Keynes, see

    Skidelsky, Robert.
    Keynes. Oxford University Press: New York. 1996.

    This work is
    a short overview of the man and his ideas; Skidelsky has also published
    a very detailed three volume series on Keynes which is the latest in a number
    of "definitive" works.