[My own fault no doubt, but in getting this article from the PKT
archive--gopher, I got impossible to read text. I spent hours
making it readable and in doing this, read it a dozen times.
Then I went to the web and got it from the URL given at its top.
Be that as it may, it is essential reading for policy wonks; and
there are a few on PKT. And its a quiet Sunday. Take a break
from your taxes and enjoy. Surrender? Under this banner, we
have just begun to fight.] JJG
Copyright 1996 by New Prospect, Inc. Preferred Citation: James K.
Galbraith, "The Surrender of Economic Policy," The American Prospect
no. 25 (March-April 1996): 60-67 (
http://epn.org/prospect/25/25galb.html).
_________________________________________________________________
THE SURRENDER OF ECONOMIC POLICY
James K. Galbraith
There is a common ground on economic policy that now stretches, with
differences only of degree, from the radical right to Bill Clinton.
Across the spectrum, all declare that the main job of government is to
help markets work well. On the supply side, government can help, up to
a point, by providing education, training, infrastructure, and
scientific research--all public goods that markets undervalue. But
when it comes to macroeconomic policy, government should do nothing
except pursue budget balance, and leave the Federal Reserve alone.
To accept a balanced budget and the unchallenged monetary judgment of
the Federal Reserve is, by definition, to remove macroeconomics from
the political sphere. Thus, the remaining differences between Clinton
and the Congress are over details. Should we head for budget balance
in seven years, eight, or ten? Should we cut (or impose) this or that
environmental regulation? Do Head Start, the AmeriCorps, and
technology subsidies justify their cost? And so on, in long litanies
that no one believes will make a fundamental difference in American
lives. Even if there were substantial gains to be made by public
investments on the supply side, the conservative fiscal consensus
precludes them by denying the resources.
We have now seen two Democratic presidents--Carter and Clinton--deeply
damaged because they did not dispute this orthodoxy in good time and
therefore could not control the levers of macro policy.
Macroeconomics, not microeconomics, is the active center of power.
Practical conservatives understand this. It is no accident that
conservatives always seek to control the high ground of deficit and
interest rate policy, nor any surprise that liberals defeat themselves
from the beginning when they concede it.
Yet, the economics behind this consensus is both reactionary and
deeply implausible. It springs from a never-never-land of abstract
theory concocted over 25 years by the disciples of Milton Friedman and
purveyed through them to the whole profession. Liberals--and anyone
else concerned with economic prosperity--should now reject this way of
looking at the world.
_________________________________________________________________
THE RIGHT-WING CONSENSUS ON EMPLOYMENT AND INFLATION
The conservative macroeconomic creed is built on three basic elements.
They are, first, monetarism--the idea that the Federal Reserve's
monetary policy controls inflation, but has little effect on output
and employment except perhaps in the very short run. Second, there is
rational expectations, which is the idea, for which Robert Lucas
just won the Nobel Prize, that individual economic agents are so
clever, so well informed, and so well educated in economics that they
do not make systematic errors in their economic decisions, especially
the all-important choices of labor supply. And third, there is market
clearing: the idea that all transactions, including the hiring and
firing of workers, occur at prices that equate the elemental forces of
supply and demand.
Taken together, these assumptions conjure an efficient labor market
that yields appropriate levels of employment and wages. The employment
level generated by this abstraction is the core policy concept of
mainstream macroeconomics, known as the natural rate of unemployment.*
If unemployment is above the natural rate, the theory dictates that
prices and wages will fall. If unemployment is below the natural rate,
the theory dictates that inflation will rise. Sustainable,
noninflationary employment growth occurs only at the natural rate.
[See Robert Eisner, "Our NAIRU Limit: The Governing Myth of Economic
Policy," TAP, Spring 1995.]
Among most economists these ideas are amazingly noncontroversial. The
only dispute is over a narrow point of policy--whether there is any
value in attempts to steer the economy toward the natural rate if it
happens to be, for a time, either above or below it. To the strictest
natural-raters, doing nothing is always and everywhere the right
prescription, because the economy will always return to the natural
rate on its own. Policy cannot help, and the very instruments of macro
policy should be abandoned.
The self-described "New Keynesian," a breed found throughout the
Clinton administration, believes a vestigial role for macro policy can
be preserved. Unemployment may persist above the natural rate because
wages take more time than other prices to adjust to changes in supply
and demand, leading to failure of the labor market to "clear." That
being so, there may be no harm in policy measures--a little stimulus
now and then when there is a serious recession--to speed the return to
the natural rate so long as a "soft landing" is carefully engineered.
Alas, the location of the natural rate is not actually observed.
Worse, the damn thing will not sit still. It is not only invisible, it
moves! This is no problem for the never-do-anything crowd. But it
poses painful difficulties for would-be intervenors, those few voices
in the administration who call, from time to time, for summer jobs,
public works programs, and lower interest rates. How can one justify a
dash to the goalposts, if you don't know where they are? New
Keynesians obsessively estimate and re-estimate the location of the
natural rate, in order to guide their policy judgments. Sadly, they
have never yet been able to predict its location, which may be one
reason why there has never yet been a successful "soft landing."
_________________________________________________________________
WHERE IS THE NATURAL RATE?
To the (questionable) extent that the Federal Reserve has any coherent
macroeconomic theory, it tends to be implicitly New Keynesian on this
issue. That is, the Federal Reserve Board is an inveterate intervenor,
raising interest rates when unemployment is too low, and lowering
them, grudgingly, to end or sometimes to avoid recessions. And so the
Federal Reserve also spends a good deal of time and effort trying to
pin down the phantom and elusive natural rate.
In 1994, with the natural rate estimated by numerous astrologers at
about 6 percent, monetary policymakers faced an interesting problem.
Actual unemployment, now at 5.8 percent, had fallen below the
estimated natural rate. So how then to interpret the rest of the data,
which contrary to theory showed no evidence of accelerating inflation?
Did the apparent lack of inflationary acceleration mean that the
natural rate had perhaps fallen, and if so to what value? Or, had the
barrier been broken and, in Robert Solow's phrase, was inflation
"acceleration just around the corner"? Or again, was the whole theory
rotten and fit for the garbage?
The Federal Reserve proved unwilling to change its estimate of the
natural unemployment rate. So it tightened monetary policy, from Feb
ruary 1994 through early 1995, as the economy broached the 6 percent
unemployment barrier. But then the Federal Reserve shifted course and
started cutting interest rates in July 1995, even though unemployment
remained below 6 percent. Why? It will be interesting to learn, when
the full minutes are released, whether the Federal Reserve formally
changed its estimate of the natural rate in July of 1995, and if so,
on what ground and to what number. Or we may learn that the Federal
Reserve doesn't really have a natural rate theory anymore, but is only
holding on to the rhetoric of these ideas, for want of any alternative
that ideological conservatives might accept.
The components of today's low inflation rate are not at all consistent
with the natural rate theory. No part of present inflationary
pressure, such as it is, stems from wages. Wage compensation,
two-thirds of all costs, remains flat. The whole of today's modest
inflation stems from a boom in profits and investment income, and from
the effects of this boom on commodity prices and other incidentals of
the inflation process. There has also been some contribution from the
rising interest costs imposed since February 1994 by the Federal
Reserve's own policy.
This problem is illustrated in "What's Driving Inflation?" (above).
The old relationship between inflation and labor costs really has
busted up since Reagan fired the air traffic controllers and he and
Volcker overvalued the dollar. Prices may be rising at 2.7 percent
annually, but real wages are scarcely moving. Indeed we find that all
inflation accelerations after 1960, with the sole exception of that
following Richard Nixon's election campaign in 1972 (when price
controls were in force), were led by prices and not by wages.
_________________________________________________________________
THE NOMADIC AIRU
How is all of this to be reconciled with a theory of inflation
acceleration based exclusively on the natural rate of unemployment in
an aggregate labor market? It can't be done. If there is excess demand
for labor, surely a good (new) classical economist must insist that
real wages are rising. But they aren't--and haven't been in 20 years.
Something must be wrong with the natural rate model. (Good economists
at the Federal Reserve know this, and it bothers them, as it should.)
In fact, something is more than wrong with the model. The model is
junk, as we should have known long ago.
This is nicely shown by the two graphs above ("Follow the Bouncing
Natural Rate"). The first shows how the unemployment rates at which
inflation accelerated have changed over the last 40 years. In the
1950s they were low, in the 1970s, quite high. But recent data rather
resemble the 1950s again, which would indicate that there is room for
unemployment to come down without kicking off inflation. Depending on
how you factor in the high-inflation decade of the 1970s, an honest
estimate of the natural rate--even if you believe it--might be 6
percent or much lower.
But the second graph shows how fruitless the search for a natural rate
really is. The graph employs centered 12-month moving averages of
monthly data for both inflation and unemployment. It illustrates that
rising inflation is essentially unpredictable: The shocks that cause
it sometimes happen at high unemployment, sometimes not until
unemployment is quite low. There is no sign in recent data of rising
inflation as unemployment falls.
Indeed, the pattern of widening gyres reversed itself after the deep
recession of 1982. Through the rest of the 1980s, unemployment fell
without wage pressures and without sharp rises in inflation. The
recession of 1989 hit while inflation was low by historic standards.
And in the past four years, 1992 through 1995, there has been falling
unemployment with falling unit labor costs and no rise whatever in
inflation (see the horizontal ellipse). We do not know where the
nomadic accelerating inflation rate of unemployment (AIRU) is
today--because we don't know when the next shock might hit us. So why
not go for full employment?
_________________________________________________________________
LIBERALS LOST ON THE SUPPLY SIDE
At the very least, New Keynesian acceptance of the New Classical
theoretical structure reduces macroeconomic policy to the fringe role,
that of large-scale intervention only in deep and lasting recessions.
In all other circumstances, the macro authorities are warned off--as
was Clinton himself during his brief Keynesian phase in early 1993.
What then can liberals do? The actual approach of the Clinton
administration illustrates: Liberals can favor education, training,
adjustment assistance, and other programs that upgrade skills and help
workers move from one job to the next. They can support public
investments in infrastructure, on the ground that these assist in the
international competitiveness of the economy. They can support a
combination of research and development assistance to advanced
enterprises, alongside efforts to open foreign markets to American
products, that help shore up the position of American companies in the
world. If they are feeling brave, they can also support a higher
minimum wage.
All of these are supply-side measures (except the last, which is a
direct intervention in the labor market). Their purpose is to improve
the long-term competitive performance of the American economy, on the
thought that a more productive economy will generate higher average
living standards. The further thought, that these higher averages will
trickle down to low-paid production workers, is left as an assumption.
We can all agree that expenditures on education, training, research,
development, and infrastructure are generally good things. But a
macroeconomic commitment to full employment is the key to translating
these investments into higher growth and living standards.
Education and Training. As work by Richard Rothstein in this journal
and elsewhere has shown, the American system of public education is
much better than its critics allege. To be sure, there are poorly
educated Americans who are unqualified to fetch high wages in the job
market. Yet as Katherine Newman and Chauncy Lennon have shown [see
"The Job Ghetto," TAP, Summer 1995], there are far more qualified
applicants in central Harlem than there are minimum wage jobs. In this
macroeconomic climate, based on a false theory of the NAIRU, raising
education standards will not call better jobs into being. That remains
a demand-side problem. This does not mean we should give up on the
task of improving inner-city schools. It only means that unless we
also raise growth rates--indeed, even if we gave everyone Ph.D.s--so
long as the Federal Reserve held the growth rate to 2.5 percent, it
would not change the current trajectory of living standards. As a
student of mine from Buenos Aires once cracked, if education alone
were that powerful, Argentina would be much richer than it is.
Research and Development. A stronger case can be made for the idea
that government R and D helps American companies become more
technically advanced and more competitive in global markets. For four
decades, our highly interventionist technology policy was a by-product
of the Cold War. Now, a more explicit civilian technology policy may
be needed to make up for reduced Pentagon R and D. There is surely a
role in general terms for science and technology policy--ultimately
many technologies lead to a better life. But they do not and cannot
bring full employment, nor do they bring about a fairer and more just
social order. To make science and technology policies the centerpiece
of a progressive agenda, while giving up macroeconomics, is absurd.
Infrastructure. Public works expenditure is the historical cornerstone
of liberal interventionism. Public works are the fastest, most direct
way to put the unemployed to work. They have direct and multiplier
effects on total employment. They have the side benefit that the works
themselves remain useful for many decades after they are completed.
They also represent, in political memory, the triumph of liberalism in
the first New Deal.
But the liberal supply-siders make an entirely different claim for
public works spending. Renaming it "infrastructure," (as I too have
done on many occasions) they argue that it contributes in definite
ways to the productivity of the private business economy. The jobs
created directly, by doing the work, are immaterial to this argument.
What matters is how the finished work contributes indirectly to cost
reduction and increased output in the private sector.
The evidence that such effects exist is, alas, regrettably thin.
Almost all of it rests on aggregative statistical relationships,
essentially on the bare fact that average measured productivity growth
declined during the same years that saw cutbacks in gross public
investment. Almost none rests on detailed analysis of the contribution
of particular projects to business efficiency.
And this is not surprising. While America might well benefit from more
public investments on public-amenity grounds, export-oriented American
manufacturing enterprise is evidently not hamstrung by infrastructure
problems. Roads, rail, electricity, and water service are adequate to
their needs. Boeing is not short of runways from which to launch its
planes, nor is Silicon Valley suffering brownouts. Phones work well in
this country--we even have the Internet! Pollution costs do not
necessarily fall on private business producers, but on their
neighbors.
Infrastructure and associated environmental spending is undoubtedly of
enormous need and value. But to whom? To the American citizen, as an
element in the standard of living. Roads, water, sewer, power, and
communications systems are all durable public consumption goods. It is
consumers and workers, not the main business shippers, who hit the
potholes on the road to work. It is people who breathe the air, drink
the water, and boat on the rivers and lakes. All this has little to do
with international competitiveness--which is very sad, but true. This
explains why business interests are not demanding higher
infrastructure spending and why these items were the first to fail in
the face of Republican opposition in the Congress.
We are left with the unpleasant conclusion that the liberal mainstream
has fallen into a self-deluding trap. The right has taken over the
commanding heights of both fiscal and monetary policy, leaving
liberals with token sums to spend on supply-side interventions.
Education, training, and infrastructure are very important, but not
for the reasons usually given. Business won't support funding them at
levels that liberals desire, and it is wishful to argue to business
that they should. We must find, instead, a language in which to defend
them for the sake of the people themselves, and organize the people
around them for the vital direct benefits they bring (as indeed the
environmental, consumer protection, and health and safety movements
have traditionally done). Otherwise they will continue to lose the
budget battles.
And if we want full employment, we need something else--a full
employment macroeconomics.
_________________________________________________________________
MACRO POLICY IN A STRUCTURALIST WORLD
Conservatives employ the myth of the market to oppose political
solutions to distributive problems. But to leave things to the market
is no less a political choice than any other.
Suppose the concept of an aggregate labor market and the associated
metaphor of a natural rate of unemployment could be wiped away with a
stroke from the professional consciousness (as it deserves to be). The
policy notion that controlling the reduction of unemployment is the
principal means of fighting inflation would lose its power. It would
then become intellectually possible to revive the idea of giving a job
to everybody who wants one. The issue becomes not how many jobs but
rather who to employ and on what terms?
Investment and Consumption. Creating jobs is a matter of finding
things for people to do. Investment of all kinds creates jobs, and
stabilization of private investment demand is the traditional
macroeconomic issue. Low and stable interest rates are essential
here--more on that later. Public investment can step in where private
investment will not go, and should be designed and pursued for its
direct benefits, not its imaginary indirect ones. But consumption is
also an important and much maligned policy objective. People should
have the incomes they need to be well fed, housed, and clothed--and
also to enjoy life. Public services can help: day care, education,
public health, culture, and the arts all deserve far more support than
they are getting.
Technology. Technological renewal should be understood as part of a
strategy of maintaining investment demand. It makes sense
progressively to shut down the back end of the capital stock, for
environmental, safety, energy efficiency, and competitive reasons.
Properly designed regulation can help, and this will open up
investment opportunities for new technologies. At the same time, a
flatter wage structure and bigger safety net, including retraining but
also more generous early retirement for older displaced workers, would
reduce the cost of job loss and the resistance from affected workers.
Again, this is an adjunct of high-growth macro policy, not a
substitute for it.
Inflation. Inflation policy would not go away. But the pursuit of
relative price stability, rather than being the result of sluggish
growth and tight money, would become concerned with the management of
particular elements of cost, as the economy got closer to full
employment. This includes wage pressures, and also materials prices,
rent, and interest. Management of aggregate demand--an undoubted force
on nonwage prices--could operate through channels with less effect on
employment (a variable tax on excess profits, for example). Since
wages are a major element in costs, inflation policy would be
concerned with the institutional mechanisms of wage bargaining.
Distribution. This exercise returns us to the real, inevitably
political questions obscured by technical mumbo jumbo about natural
unemployment rates: our overall structure of incomes and
opportunities. What should be the distribution of incomes? How much
range, between the bottom and the top? Between capital and labor?
Between skilled and not? In my view, the present course of rising
inequality must be reversed, and liberals should frankly support the
political steps required for this purpose. Trade unions should be
strengthened and the aggressive new organizing campaigns of the
AFL-CIO strongly supported. Minimum wages should be raised. And
liberals should strongly defend the progressive income tax, as well as
support proposals for wealth taxation, as proposed by Edward Wolff in
this magazine. [See "How the Pie Is Sliced: America's Growing
Concentration of Wealth," Summer 1995.]
Once the basic distribution of income has been set right, further
gains in real wages can only happen, on average, at the rate of
productivity growth. But to keep the distribution from getting worse
again, these gains should be broadly distributed, substantially social
and only slightly industrial or individual. In other words, we need to
return to the principle of solidarity--that the whole society advances
together.
Higher minimum wages are especially important for this purpose. In
their new book, Myth and Measurement, David Card and Alan Krueger
argue that raising the minimum wage within a reasonable range would
not cost jobs. In fact, higher minimum wages may increase employment
by reducing job turnover. This is a doubly important work, once for
its direct policy relevance and again because it flatly contradicts,
and deeply undercuts, standard models of the aggregate labor market.
Interest Rates. Low and stable has to be the watchword. Interest rates
should lose their present macroeconomic function, which has been to
guarantee stagnation. They should serve instead to arbitrate the
distribution of income between debtors and creditors, financial
capital and entrepreneurship. As a first approximation, real rates of
return on short-term money should be zero. And there is no reason why
long-term rates of interest in real terms should exceed the long-term
real growth rate of the economy. Indeed they should lie below this
value, effecting a gradual redistribution of wealth away from the
creditor and toward the debtor class and a long-term stabilization of
household and company balance sheets. Speculation in asset markets
should be heavily taxed.
Deficits. Ironically, the budget deficit hardly comes up in this
discussion. During the postwar boom, we were a high-employment,
low-inflation, low-interest-rate society with a progressive tax
structure. Such societies do not have structural-deficit problems. A
peacetime military budget would also greatly help. At any rate, the
present fixation on balancing the budget is nonsense, as all serious
economists should loudly declare.
The above, all taken together, would be a macroeconomic policy to
fight for! The liberal microeconomic supply-siders can do some useful
things--or think they can--by getting a little money into education,
training, infrastructure. But the point is to raise living standards,
to increase security and leisure, and to provide jobs that are worth
having. And that requires us to reclaim macroeconomics as a major
policy tool.
_________________________________________________________________
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