- Rational expectations are a major factor in macroeconomics, particularly the Phillips curve for expected changes in money being vertical even in the short run, leading to the charge that the current Keynesian tradition fails to control or explain high inflation. “Failure to control,” I think, is true, although the cost of stabilizing inflation in the face of huge supply shocks would have been devastating. But “failure to explain” was clearly a false charge when you gave Keynesian economists months to extend their framework to include supply shocks.
- Alan S. Blinder, A Monetary and Financial History of the United States, 1961-2021, p. 106-107
Macroeconomics is the study of fluctuations in key economy-wide indicators such as unemployment, inflation, interest rates, and gross domestic product (GDP). Regarding macro study methods, my memoir says,
- Historians looking at the outbreak of World War I can list possible causes. They may give reasons for paying more attention to some factors than others, perhaps based on analysis of other historical events. However, no one would suggest that a system of equations is the best way to summarize the factors that lead to the outbreak of war. I think we should review and discuss historical events the way historians review and discuss wars and revolutions. We need to note the various changes that take place in each decade that affect the way the economy performs and the way it responds to shocks and policy interventions.
Blinder proceeds to give this sort of historical overview. This makes the book an excellent supplement, and perhaps a necessary counterweight, to standard macro texts that focus on equations, often illustrated in figures.
Blinder describes dramatic policy moves, such as the Nixon administration’s 1971 wage-price freeze, President Reagan’s tax cuts, and Federal Reserve Chairman Paul Volcker’s battle against inflation. He also explains what economists were thinking at the time, their ideas sometimes stimulated by facts, sometimes not. Finally, he explains the history of macroeconomics through his preferred macroeconomic framework.
Blinder’s interpretations are a deconstruction of Keynesian textbooks from the late 1970s. In this framework, there are three impulses that drive macroeconomic fluctuations. These are fiscal policy, monetary policy and supply shocks. Actually, might be a good title for the book A History of Fiscal, Fiscal, and Supply Shocks in the United States, 1961–2021.
He describes the facts and ideas of economists as well as the lessons learned by blind politicians. For example, it is important to try to avoid a recession during an election year.
- The recession of 1960-61 was particularly notable for its fiscal inaction because it was under Vice President Richard M. Nixon was greatly disturbed by the…. Nixon believed that the Depression cost him the 1960 election, and he may have been right. p.9
In later decades, Jimmy Carter and George HW Bush would suffer similarly. But as president, Nixon lifted all fiscal and monetary stops in 1972 to ensure no recession. He won re-election in a landslide.
Outsourcing the role of moderation to the Federal Reserve was another lesson. Fiscal stimulus seemed to be working to promote a strong economy in the 1960s, but when fiscal restraint was called for at the end of the decade, what was enacted was too little, too late.
- Finally, a die (of sorts) was thrown. In theory, fiscal policy is symmetric. You raise taxes or lower spending to curb aggregate demand, just as you lower taxes or raise spending to increase aggregate demand. In reality, however, future fiscal policy will be used (with rare exceptions) only to expand demand. When demand for contracts was the order of the day, policymakers turned to monetary policy instead, leaving politicians in charge. P. 22
This worked out well for President Reagan, who could take credit for lowering tax rates while letting the Fed do the dirty work of fighting inflation. From Blinder’s perspective, fiscal policy and monetary policy at that time were working at cross-purposes with the former expansionary and the latter contractionary. To the surprise of many Keynesians, monetary policy proved stronger because of currency appreciation.
- Between September 1980 and March 1985 the trade-weighted value of the US dollar against a basket of other major currencies rose 54 percent…. As a share of real GDP, the trade deficit rose from roughly zero in 1980–1982 to about 2.4 percent of GDP in 1984. 146–147
Within the three-impaled framework, fiscal and monetary policy would work better together. But that only seems to happen when an expansion is called for. When it comes to combating inflation, Congress and the President avoid any fight.
I have a disagreement with the blinders. I feel most strongly about the use of statistical-estimating equations, or macro-econometric models. I first encountered some of their flaws in the summer of 1975 when I was a research assistant at Blinder, and over the next several years I found them suffering from serious flaws. In my macro memory I wrote,
- … Macroeconomic data are not stationary, which invalidates many of the techniques used in macroeconometric models, particularly the use of lagged dependent variables.
- … A separate problem with the econometric method is raised in an iconoclastic book by Edward Limmer, called Search specifications. Limmer points out that statistical theory assumes that the investigator engages in a single encounter with the data. However, econometricians in practice try to fit various specifications to the data, until the investigator is happy with both the fit of the equation to the data and the consistency of the results with the investigator’s prior views. This process of searching for specifications makes the results unreliable and lacks objectivity.
Blinder continues to treat macroeconometrics as a scientific tool. I would caution readers that many economists distrust, with good reason, the kind of statistical analysis he often does.
My disagreement with the three-passion framework is relatively mild. In fact, I prefer it to other frameworks, including modern monetary theory or market monetarism. But I think there are many forces at work, and some of them are at least as important as fiscal policy, monetary policy, and supply shocks.
“The question of why interest rates fell, and whether the decline is sustainable, is quite important, and should concern policymakers.”
For example, there are secular tendencies. The rate of interest that Blinder describes in the first chapter of the book will shock any reader who came of age in this century. Such readers may be surprised to learn that interest rates have remained high in previous decades, even when inflation was low. The question of why interest rates fell, and whether the decline is sustainable, is quite important, and should concern policymakers.
Another issue of sustainability is the rise in government debt from about 25 percent of GDP in the 1970s to nearly 100 percent today, much of which is held by the Fed. Under these circumstances, can higher interest rates be used to combat inflation in a way that does not seriously disrupt financial markets?
Also, it seems to me that there have been structural changes that are likely to affect macroeconomic performance and policy. The manufacturing sector is far less significant than it was in 1961, and there is a growing disconnect between the meager jobs within the service sector and the fortunes of “laptop class” workers.
As Blinder points out, the financial sector was easy in the 1960s. There was no interstate banking, much less index funds, mortgage securities, currency swaps, derivatives, or cryptocurrencies. Even in the early 1980s when Paul Volcker was sending interest rates near 20 percent, it was illegal to pay interest on checking accounts. It is highly unlikely that the way monetary policy works now is the same as it was then.
The Internet has also changed the economy in many ways. I think it is foolish to rely on the three-impulse model without thinking hard about how these structural changes might affect the behavior of the economy.
Blinder has a strong term for “rational expectations macroeconomics” and I share his inclination. But I would go further and say that we don’t realize how much economic outcomes, especially inflation, reflect the habits and beliefs of consumers and investors, and we don’t understand the dynamics of how those habits and beliefs change. This reduces my confidence in any given macroeconomic framework.
For more on this, see
The financial crisis of 2008 was the point where Blinder and I parted ways. He interprets fiscal and monetary policy as if they were carried out using textbook stimulus, some fancy tricks. Blinder sees policy responses as successes, the only drawback being public ingratitude.
In my memoir, I see policymakers doing little more than finding new ways to inject stimulus. Although Blinder was comfortable characterizing the prevailing conditions in 2008 as textbook aggregate demand phenomena, it seemed to me that policymakers were creating a new theory of macroeconomics on the fly. Given that the theory of fiscal expansion favors broad-based measures to encourage consumer spending and business investment, why has so much fiscal stimulus taken the form of aid to certain corporations, especially banks? Given that monetary expansion is supposed to work by increasing bank lending, why did the Fed fill banks with excess reserves, which by definition do not become loans? Blinder does not raise such questions, much less answer them. In my memoir I agonized over them, trying and failing to work backwards from policy responses to hypothesize a theory behind them. I also struggle to develop and articulate alternatives to the three-impulse framework.
I believe that students of economics will derive considerable value from reading Blinders Finance and financial history. And I hope some of them like to read this as well as my macro memoir, to see where our perspectives overlap and where they differ.