Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul. He is the author of “The Benefit and the Burden: Tax Reform – Why We Need It and What It Will Take.”
Generals and admirals are always fighting the last war, it is said, designing weapons and devising strategies that are inherently out of date, rather than planning for the next war. Thus, before World War II, United States naval strategy was based on battleships, which proved largely useless when war came, rather than aircraft carriers and destroyers, which proved to be decisive.
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So, too, with economists. They tend to worry obsessively about the last big national economic problem, seeing its regeneration everywhere, rather than looking at the data and economic conditions objectively, thereby missing new problems that require a different strategy.
The Great Depression was for economists what World War II was for the military — a problem so big that it forced a complete reassessment of traditional thinking. When the depression and the war ended, the new ideas that they led to became the new orthodoxy.
The military learned the importance of air power and that formed the foundation of Cold War strategy, but left the United States vulnerable to guerrilla warfare in Vietnam, for which air power was ill suited.
Economists learned from the Great Depression that easy money and fiscal stimulus could stimulate growth. Pre-Depression classical economics had been based on a rigid balanced budget requirement for government and a gold standard that provided no discretion for the monetary authorities.
The new economic orthodoxy became associated with the theories of the British economist John Maynard Keynes and came to be called Keynesian economics. Supporters of classical economics were relegated to the sidelines of economic discussion, but they never went away. Throughout the 1950s and 1960s they continued to wage war against Keynesian economics, certain that the abiding truths of classical economics would triumph in the end.
The classical economists thought that inflation was the Achilles’ heel of Keynesian economics, and they hammered this point relentlessly. In truth, the Keynesians were vulnerable on that issue, believing that a little inflation was a small price to pay for bringing down the unemployment rate.
One problem for the Keynesians is that as time went by, their theories became increasingly divorced from the economics of John Maynard Keynes, becoming almost a caricature. Moreover, the economic circumstances were vastly different from those of the Great Depression and required different policies. But economists kept advocating more of what had worked in the 1930s and 1940s.
Keynesian economics was essentially reduced to something called the Phillips curve, which showed that there was always a trade-off between inflation and unemployment – more of one would reduce the other. The only question for policy makers was determining which problem, inflation or unemployment, was more important to voters.
Unfortunately, there was a political bias in the calculation; politicians tended to put reducing unemployment above reducing inflation and so inflation ratcheted upward. There was also confusion among economists about the cause of inflation. The Keynesians, whose view was shaped by the experience of the Great Depression, in which deflation or falling prices was the big problem, underestimated the role of the Federal Reserve and monetary policy in generating inflation.
This led to a counterattack by classical economists based mainly at the University of Chicago. By the 1980s, these economists had essentially overthrown the Keynesians by asserting that inflation had one and only one cause – excessive money growth by the Fed. Tight money had broken the back of inflation and the idea of tying the Fed’s hands, as the gold standard had done, gained popularity.
Fast forward to 2008. The nation fell into another recession. Initially, economists thought it was not dissimilar to those the economy had faced throughout the postwar era; they were slow to recognize its severity as a depression about one-third the size of the Great Depression.
Fortunately, the Fed was led by Ben Bernanke, whose expertise as an academic economist was the Great Depression. He knew that the Fed’s errors had contributed mightily to the depression’s origins, length and depth, and resolved not to make the same mistakes twice. Mr. Bernanke opened the monetary floodgates to keep the financial system and the economy from imploding. I believe that what the Fed did saved us from a rerun of the Great Depression or worse.
But the classical economists, whose ranks were much strengthened by the failure of Keynesian economics in the fight against inflation and the apparent triumph of classical policies in the 1980s and 1990s, immediately saw an inevitable replay of the 1970s. They were fighting the last war.
Virtually every classical economist declared that inflation would quickly return. Many urged people to buy gold to protect themselves, which led the gold price to rise, which was then taken as proof of impending inflation. They demanded that the Fed immediately rescind its emergency actions, withdraw the excess money that had been injected into the banking system and nip inflation in the bud.
Unfortunately, this was more than an academic debate, because many of the Federal Reserve’s regional bank presidents, five of whom sit on the policy-making Federal Open Market Committee, were inflation hawks who shared the view of the classical economists that high inflation was certain unless the Fed tightened monetary policy as soon as possible. They were supported by Republicans in Congress, who berated Mr. Bernanke in the harshest possible terms at every opportunity, as well as a large number of private economists and pundits with access to wide-circulation publications such as The Wall Street Journal and its editorial page.
While the Fed has generally maintained an easy money policy, inflation has remained dormant; some of the Fed’s inflation hawks have even become doves. But the constant drumbeat of attacks on the Fed for fostering inflation has constrained its actions, condemning the economy to slower growth and higher unemployment than necessary.
Next week I will have more to say about inflationphobia.
Article source: http://economix.blogs.nytimes.com/2013/07/09/inflationphobia-part-i/?partner=rss&emc=rss
