Robert J. Samuelson (no relation to Paul Anthony Samuelson of MIT) is an economics columnist for the Washington Post and Newsweek. His new book is ostensibly about "inflation." But about the time the volume began arriving at bookstores, he penned a column with the title "Deflation is No Longer Unthinkable." It's not easy writing books on economics these days.
Still, all is not lost. With the resurgent interest in Keynesian solutions to our current economic woes, Samuelson's observations may be more relevant than he intended. Despite the title, this book is really 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.
The background is familiar enough to many readers of this journal. Yet it is a history one is unlikely to find in any introductory economics textbook. Beginning with the administration of John F. Kennedy, a new breed of economists 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. In fact, they were very bad. The inflation rate, for example, climbed from barely more than one percent in 1960 to almost 15 percent in early 1980. The prime rate in December 1980 hit a record 21.5 percent. By 1981, 85 percent 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 Robert Samuelson is quick to point out, it was the ideas, not the individuals, who were at fault:
It was the power of ideas that ordained failure, not the shortcomings of the individuals. All these Presidents and their advisors embraced the same basic concepts that, despite modest differences and disagreements, inevitably led them to make bad decisions in the name of a good cause.
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 three percent could be purchased with a permanent inflation rate of 4.5 percent. 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 Federal Reserve believed full employment was between four and 4.5 percent, later estimates put it closer to six percent. Whereas economists expected productivity growth between 2.5 and three percent, for much of the late 1970s, it barely exceeded one percent per year. Whereas the "output gap" in the mid-1970s was thought to be 12 percent, later estimates put it at a modest two percent.
Another problem was politics. Political leaders liked expansionary policies, and the economists apparently were accommodating. The errors of policy were not random. According to Samuelson, they were all in the same (expansionary) direction:
The Fed's mistakes reflected the powerful political and intellectual imperatives of the time, which reinforced each other. What was politically convenient was also rationalized intellectually.
The upshot is that economists provided the intellectual rationale for disastrous monetary policy. Whereas the money supply grew by 23 percent in the 1950s (mainly accommodating output growth), it grew by 44 percent in the 1960s and by 78 percent in the 1970s.
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. Samuelson writes:
Through its history, the Fed has made ... only two major blunders. The first was permitting the Great Depression; the second was fostering the Great Inflation ... Both stemmed from mistaken ideas.
Enter Reagan and Volcker. Samuelson gives them both credit for a huge economic turnaround and writes that, "If either had been absent, the story would have unfolded differently and ... less favorably." To appreciate their accomplishment, consider that six respected economic models at the time implied that unemployment would reach 20 percent if the rate of inflation were brought down to the level actually achieved.
Although actual unemployment peaked at about half that rate, wringing inflationary expectations out of the economy was far from painless. From mid-1981 until late 1982, industrial production dropped 12 percent. In autos, it fell 34 percent. In steel, 56 percent. Yet the exercise worked. The inflation rate fell from 13 to two percent, and a period of unprecedented prosperity followed. The success was a turning point moment. In fact, Samuelson compares it to the Civil War, the Great Depression, and World War II.
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.
Mr. Volker will be heading the Economic Recovery Advisory Board in the upcoming Obama Administration. That's a sign, at least, that the lessons of Samuelson's book might not go unheeded. Business economists will find this book valuable in assessing what might be ahead.
