IF THIS IS RECOVERY, KISS THE KEYNESIANS GOOD-BYE
Whither the economy? A weak recovery, a strong recovery, or a double-dip recession? Forecasters differ in how they read the tea leaves. In thinking about how to place your bets, consider the following:
If there is a recovery, weak or strong, it will be the first in the post-World War II era that is not led by government policy. There is no monetary expansion to get the economy going, and Washington isn't providing any fiscal stimulus. To the contrary, the recovery will have to occur despite what Federal Reserve Board Chairman Alan Greenspan calls the continuing credit crunch and higher taxes at federal, state, and local levels.
It would be a blow to Keynesians if recovery happens in the face of what they regard as policies that reinforce the business cycle. That would mean there is not a single truth in the economic doctrine that guided postwar policy. If placing John Maynard Keynes and his followers--who have garnered most of the Nobel prizes in economicsQin the same category with Karl Marx is an implausible thought, then so is the forecast of recovery.
The leading principle of the Keynesian revolution is that market economies are not self-correcting. Without fiscal and monetary stimulus, unemployment feeds on itself as falling incomes limit demand, leading to a downward spiral. The economy would come to equilibrium at less than full employment and active anticyclical policies would be necessary to keep the economy from becoming stuck below its full potential.
A budget deficit and lower interest rates because of weak demand don't qualify as active antirecessionary policies. To be stimulative, the deficit must increase. also, it must be a discretionary increase by policymakers over and above the rise in red ink from built-in stabilizers (lower tax receipts and rising unemployment and welfare payments) that automatically operate in a recession. Textbooks continue to stress "that built-in stabilizers are a first line of defense but are not by themselves sufficient to maintain full stability" (Paul A. Samuelson, Economics, 12th ed.).
NO RESERVE. Looking at our current economy, the Keynesians who taught me would be worrying about parallels to the mistakes that contributed to the distress of the 1930s. They would point out that many investors and financial institutions made long-term commitments with the expectation that policies of high demand would continue, only to find themselves undercut by government policy.
Expecting tax cuts and $200 billion budget deficits as far as the eye can see to sustain inflation, investors flocked into real estate seeking an inflation hedge with a proven track record. Banks lent readily, relying on rising real estate values as collateral, and they failed to reserve against their massive Third World loans, counting on inflation to bail them out by raising oil and commodity prices.
No one expected inflation to collapse, much less remain low during a lengthy economic expansion. As miscalculations came home to roost, the government pulled the tax rug out from under real estate investments with the 1986 tax-reform bill. As prices fell and investors fled, the value of the collateral behind thrift and bank loans shrank, eating up the capital of the lending institutions.
As troubles mounted, the government destroyed the value of savings and loan charters with the ill-considered 1989 s&l legislation. My Keynesian teachers would have described that as an act of madness certain to contribute to the downward spiral and to spread the problem into other financial institutions. Now that commercial banks have found their capital positions under pressure, the government has responded by proposing, during a recession, banking legislation that encourages bankers to build their capital ratios by not lending.
LOSING FAITH? A Keynesian analysis of these events would find a prescription for "debt deflation." The New York Times' front-page headline of July 5, "Bankers expected to stay hesitant to lend for years," together with attendant cutbacks in state budgets, would not foretell a recovery to a Keynesian economist.
If the economy recovers from recession despite procyclical policies, it will discredit Keynesian economics. The maligned and caricatured classical economists, who believed in laissez-faire and Say's law (supply creates its own demand), will have triumphed over the postwar generation of interventionist economists, who stressed demand management to offset the "deflationary gap" that is still illustrated in economics textbooks.
Before letting hopes for recovery succumb to the authority of postwar economics, consider that economists themselves have lost faith. This recession did not produce the usual calls for countercyclical measures to restore full employment. Instead, economists cautioned against disturbing the recently enacted budget agreement designed to shrink the deficit and advised that the economy would be on the upswing before government could implement an antirecessionary policy. If this overthrow of Keynesian prescriptions proves to be a mistake, President Bush's 1992 reelection hopes will disappear into the deflationary gap.Paul Craig Roberts