The Keynesian Corner
Last Tuesday the
Fed announced a surprise rate cut of 75 basis points, the biggest cut in 24
years. Even so, the stock market plunged, with the S&P 500 shedding
1.1% during the session, bringing its total losses to over 10% for
2008.
The Fed has now
painted itself into a Keynesian corner. According to old-school
Keynesianism, the government faces a Phillips Curve
tradeoff. It can adopt a loose monetary policy, which spurs output but
leads to price inflation. Or, the government can adopt a tight monetary
policy, which keeps prices under control but leads to recession.
The sobering experience of
the 1970s demonstrated that this Keynesian orthodoxy was nonsense.
Ultimately, printing green pieces of paper doesn’t make a society richer, it
just causes prices to rise. Once citizens adjust to the constant
injections of new money, unemployment returns along with massive price
hikes. Thus the term “stagflation”—meaning double-digit rates of
unemployment and inflation—was coined.
Yet memories are short.
It has been decades since Paul Volcker took over the helm at the Federal
Reserve in 1979 and jacked up interest rates—yielding the painful recession in
1980—to wean the country off of his predecessors’ cheap-money policies.
Since that readjustment, Americans have become used to the new paradigm, where
unemployment can safely remain under 5 percent while inflation stays even
lower.
Despite this clear-cut
lesson, Keynesian thinking permeates the financial press. Those concerned
about recession clamor for aggressive rate cuts, saying that inflation can be
handled down the road. They ignore the fact that once the inflation genie
is out of the bottle, it’s very difficult to get it back in again.
We are closer to the dark
days of the 1970s than many people realize. During 2007, consumer price
inflation was 4.1 percent, the highest it’s been in 17 years. The dollar
is near record lows against the euro. Gold and oil prices have set
all-time record highs in the past few months.
If the national discussion on
monetary policy is bad, the debate over fiscal policy “stimulus” may be even
worse. The politicians and pundits never explain how borrowing money from
one group of Americans, in order to give tax rebates to a different group of
Americans, is supposed to raise total spending. Things would be different
if the politicians proposed spending cuts to offset the rebates to
taxpayers. But naturally no one proposes such a sensible policy; they
want to give us more money to spend, and to spend more money themselves, too.
The truly
depressing feature of all the stimulus talk is that even someone as
knowledgeable as Treasury
Secretary Paulson believes a rebate is only good if the recipients “spend”
it, rather than using it to pay down debts. Here we see the true
insidiousness of the Keynesian mindset: In a time of recession, when we
need to tighten our belts, the politicians encourage us to go buy new cars and
plasma screen TVs. The idea seems to be that if we all just ignore the
recession, it will get bored and go away.
Those readers who believe in
the virtues of hard work and thrift know that this Keynesian mindset
must be wrong, but they may have a hard time pinpointing the sleight of hand in
the trick. So let me give a hint: Whether you spend $500 on music
CDs or on bank CDs, that money is still “in the economy.” Everyone
understands how spending money on music boosts employment in that industry, so
we don’t need to explain that portion.
But people apparently don’t
recognize that when you lend $500 to the bank, you are still contributing to
employment and GDP growth. The bank doesn’t put this money in a tin can
under the bed, after all. No, it lends it out to a business, perhaps, so
it can buy a new factory, or it lends it out to a young couple, so they can buy
a home. Rather than output and employment expanding in the music and
retail industries, in this scenario jobs are created in the manufacturing or
construction industries.
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