The Surrender of Economic Policy

James K. Galbraith

[Reprinted from The American Prospect (March/April 1996, pp. 60-67]

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 macro economic 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.1 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.

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 macroe-conomic 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 February 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?" (Figure 1). 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 I960, 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 [not reproduced here] in Figure 2 ("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? ...

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.

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 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.

NOTES

1. Some economists prefer the term nonaccelerating inflation rate of unemployment or NAIRU. The idea is essentially the same. The natural rate/NAIRU was introduced to supplant the older Phillips Curve idea of a static trade-off between inflation and unemployment, and to suggest that inflation would not only rise, but inevitably accelerate, if unemployment falls too low.