by Paul Krugman
So-called “classical” macroeconomics asserted that the economy had a long-run tendency to return to full employment, and focused only on that long run. Its two main tenets were the quantity theory of money—the assertion that the overall level of prices was proportional to the quantity of money in circulation—and the “loanable funds” theory of interest, which asserted that interest rates would rise or fall to equate total savings with total investment.
Keynes was willing to concede that in some sufficiently long run, these theories might indeed be valid; but, as he memorably pointed out, “In the long run we are all dead.” In the short run, he asserted, interest rates were determined not by the balance between savings and investment at full employment but by “liquidity preference”—the public’s desire to hold cash unless offered a sufficient incentive to invest in less safe and convenient assets. Savings and investment were still necessarily equal; but if desired savings at full employment turned out to exceed desired investment, what would fall would be not interest rates but the level of employment and output. In particular, if investment demand should fall for whatever reason—such as, say, a stock-market crash—the result would be an economy-wide slump.
It was a brilliant reimagining of the way the economy worked, one that received quick acceptance from the brightest young economists of the time. True, some realized very early that Keynes’s picture was oversimplified; in particular, that the level of employment and output would normally feed back to interest rates, and that this might make a lot of difference. Still, for a number of years after the publication of The General Theory, many economic theorists were fascinated by the implications of that picture, which seemed to take us into a looking-glass world in which virtue was punished and self-indulgence rewarded.
Consider, for example, the “paradox of thrift.” Suppose that for some reason the savings rate—the fraction of income not spent—goes up. According to the early Keynesian models, this will actually lead to a decline in total savings and investment. Why? Because higher desired savings will lead to an economic slump, which will reduce income and also reduce investment demand; since in the end savings and investment are always equal, the total volume of savings must actually fall!
Or consider the “widow’s cruse” theory of wages and employment (named after an old folk tale). You might think that raising wages would reduce the demand for labor; but some early Keynesians argued that redistributing income from profits to wages would raise consumption demand, because workers save less than capitalists (actually they don’t, but that’s another story), and therefore increase output and employment.
Such paradoxes are still fun to contemplate; they still appear in some freshman economics textbooks. Nonetheless, few economists take them seriously these days. There are a number of reasons, but the most important can be stated in two words: Alan Greenspan.
After all, the simple Keynesian story is one in which interest rates are independent of the level of employment and output. But in reality the Federal Reserve Board actively manages interest rates, pushing them down when it thinks employment is too low and raising them when it thinks the economy is overheating. You may quarrel with the Fed chairman’s judgment—you may think that he should keep the economy on a looser rein—but you can hardly dispute his power. Indeed, if you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: It will be what Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.
But putting Greenspan (or his successor) into the picture restores much of the classical vision of the macroeconomy. Instead of an invisible hand pushing the economy toward full employment in some unspecified long run, we have the visible hand of the Fed pushing us toward its estimate of the noninflationary unemployment rate over the course of two or three years. To accomplish this, the board must raise or lower interest rates to bring savings and investment at that target unemployment rate in line with each other. And so all the paradoxes of thrift, widow’s cruses, and so on become irrelevant. In particular, an increase in the savings rate will translate into higher investment after all, because the Fed will make sure that it does.
To me, at least, the idea that changes in demand will normally be offset by Fed policy—so that they will, on average, have no effect on employment—seems both simple and entirely reasonable. Yet it is clear that very few people outside the world of academic economics think about things that way. For example, the debate over the North American Free Trade Agreement was conducted almost entirely in terms of supposed job creation or destruction. The obvious (to me) point that the average unemployment rate over the next ten years will be what the Fed wants it to be, regardless of the U.S.-Mexico trade balance, never made it into the public consciousness. (In fact, when I made that argument at one panel discussion in 1993, a fellow panelist—a NAFTA advocate, as it happens—exploded in rage: “It’s remarks like that that make people hate economists!”)
What has made it into the public consciousness—including, alas, that of many policy intellectuals who imagine themselves well informed—is a sort of caricature Keynesianism, the hallmark of which is an uncritical acceptance of the idea that reduced consumer spending is always a bad thing. In the United States, where inflation and the budget deficit have receded for the time being, vulgar Keynesianism has recently staged an impressive comeback. The paradox of thrift and the widow’s cruse are both major themes in William Greider’s latest book, discussed in the first essay. (Although it is doubtful whether he is aware of the source of his ideas—as Keynes wrote, “Practical men, who believe themselves quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”) It is perhaps not surprising that the same ideas are echoed in places like the New Republic; but when you see the idea that higher savings will actually reduce growth treated seriously in BusinessWeek you realize that there is a real cultural phenomenon developing.
To justify the claim that savings are actually bad for growth (as opposed to the quite different, more reasonable position that they are not as crucial as some would claim), you must convincingly argue that the Fed is impotent—that it cannot, by lowering interest rates, ensure that an increase in desired savings gets translated into higher investment.
It is not enough to argue that interest rates are only one of several influences on investment. That is like saying that my pressure on the gas pedal is only one of many influences on the speed of my car. So what? I am able to adjust that pressure, and so the cop who pulls me over for speeding will not normally accept the fact that I was going downhill as an excuse. Similarly, Greenspan is able to change interest rates freely (the Fed can double the money supply in a day, if it wants to), and so the level of employment is normally determined by how high he thinks it can safely go—end of story.
No, to make sense of the claim that savings are bad you must argue either that interest rates have no effect on spending (try telling that to the National Association of Homebuilders) or that potential savings are so high compared with investment opportunities that the Fed cannot bring the two in line even at a near-zero interest rate. The latter was a reasonable position during the 1930s, when the rate on Treasury bills was less than one-tenth of 1 percent; it is an arguable claim right now for Japan, where interest rates are about 1 percent. (Actually, I think that the Bank of Japan could still pull that economy out of its funk, and that its passivity is a case of gross malfeasance. That, however, is a subject for another essay [“What Is Wrong with Japan?”].) But the bank that holds a mortgage on my house sends me a little notice each month assuring me that the interest rate in America is still quite positive, thank you. Anyway, this is a moot point, because the people who insist that savings are bad do not think that the Fed is impotent. On the contrary, they are generally the same people who insist that the disappointing performance of the U.S. economy over the past generation is all the Fed’s fault, and that we could grow our way out of our troubl
es if only Greenspan would let us.
The story seems to go like this: Increasing savings will slow the economy—presumably because the Fed cannot induce an increase in investment by cutting interest rates. Instead, the Fed should stimulate growth by cutting interest rates, which will work because lower interest rates will induce an increase in investment.
Am I missing something?
Unmitigated Gauls: Liberté, Egalité, Inanité
Fifteen years ago, just after François Mitterrand became president of France, I attended my first conference in Paris. I can’t remember a thing about the conference itself, although my impressions of the food and wine—this was my first adult visit to the city—remain vivid. The only thing I do remember is a conversation over dinner (canard aux olives) with an adviser to the new government, who explained its plan to stimulate the economy with public spending while raising wages and maintaining a strong franc.
To the Americans present this program sounded a bit, well, inconsistent. Wouldn’t it, we asked him, be a recipe for a balance-of-payments crisis (which duly materialized a few months later)? “That’s the trouble with you Anglo-Saxon economists—you’re too wrapped up in your theories. You need to adopt a historical point of view.” Some of us did, in fact, know a little history. Wasn’t the plan eerily reminiscent of the failed program of Léon Blum’s 1936 government? “Oh no, what we are doing is completely unprecedented.”
The French have no monopoly on intellectual pretensions, or on muddled thinking. They may not even be more likely than other people to combine the two. There is, however, something special about the way the French political class discusses economics. In no other advanced country is the elite so willing to let fine phrases overrule hard thinking, to reject the lessons of experience in favor of delusions of grandeur.
To an Anglo-Saxon economist, France’s current problems do not seem particularly mysterious. Jobs in France are like apartments in New York City: Those who provide them are subject to detailed regulation by a government that is very solicitous of their occupants. A French employer must pay his workers well and provide generous benefits, and it is almost as hard to fire those workers as it is to evict a New York tenant. New York’s pro-tenant policies have produced very good deals for some people, but they have also made it very hard for newcomers to find a place to live. France’s policies have produced nice work if you can get it. But many people, especially the young, can’t get it. And, given the generosity of unemployment benefits, many don’t even try.
True, some problems are easy to diagnose but hard to deal with. If George Pataki can’t end rent control, why should we expect Jacques Chirac to cure Eurosclerosis? But what is mysterious about France is that as far as one can tell, absolutely nobody of consequence accepts the obvious diagnosis. On the contrary, there seems to be an emerging consensus that what France needs is—guess what?—more regulation. Socialist leader (and now prime minister) Lionel Jospin’s idea of a pro-employment policy is to require employers to pay workers the same money for fewer hours. Even conservative leader Philippe Séguin, regarded as an iconoclast by French standards because he has questioned the sacred goal of European monetary union, thinks that one way to add jobs is to ban self-service pumps at gas stations.
Beyond more of the same, what does the French elite see as the answer to the nation’s problems? For more than a decade its members have sought salvation in the idea of Europe—that is, a unified European economy (under French leadership, of course), with common regulations and a common currency. In such a continental market, they imagine, France can once again prosper.
Now a unified European market is a pretty good idea. There is even a reasonable case for unifying Europe’s currencies—although there is also a good case for doing no such thing. (There is a whole industry of people—eurologists?—who make a living by debating that issue.) But to acknowledge the potential virtues of European economic integration risks missing the essential fatuousness of the whole project. France’s problem is unemployment (currently almost 13 percent). Nothing else is even remotely as important. And whatever a unified market and a common currency may or may not achieve, they will do almost nothing to create jobs. Think of it this way: Imagine that several cities, all suffering housing shortages because of rent control, agree to make it easier for landlords in one city to own buildings in another. This is not a bad idea. It might even slightly increase the supply of apartments. But it is not going to get at the heart of the problem. Yet all the grand schemes for European integration amount to no more than that.
Indeed, in practice, the dream of European unity has actually made things worse. If you are going to have a common currency, everything we know suggests you should follow what Berkeley’s Barry Eichengreen calls the Nike strategy. But instead of just doing it, European nations agreed to a seven-year transition period during which they would be required to meet a complex set of criteria—mainly to reduce their budget deficits while keeping their currencies strong.
There is nothing wrong with balancing your budget. In fact, European nations need to do some serious fiscal housecleaning. And as the happy experience of America under Bill Clinton has shown, it is quite possible to reduce the deficit and increase employment at the same time. All you need to do is cut interest rates, so that private spending takes up the slack. But you can’t cut interest rates if you are obliged to keep your currency strong. So the Maastricht Treaty (the blueprint for European currency union) ensured that the budget-cutting it required would be all pain and no gain. Nobody can make a precise estimate, but a guess is that without Maastricht, France’s unemployment rate might be two or three percentage points lower than it is.
While some French politicians have been willing to say nice things about budget deficits, however, nobody seems willing to challenge the dogma that European integration is the answer. Even Séguin the iconoclast declares that “the fight against unemployment is inseparable from the realization of the grand European design.” But let us not blame French politicians. Their inanities only reflect the broader tone of economic debate in a nation prepared to blame its problems on everything but the obvious causes. France, say its best-selling authors and most popular talking heads, is the victim of globalization—although adroit use of red tape has held imports from low-wage countries to a level far below that in the United States (or Britain, where the unemployment rate is now only half that of France). France, they say, is the victim of savage, unrestrained capitalism—although it has the largest government and the smallest private sector of any large advanced country. France, they say, is the victim of currency speculators, whose ravages President Chirac once likened to those of AIDS.
The refusal of the French elite to face up to what looks like reality to the rest of us may doom the very European dreams that have sustained the nation’s illusions. After this last election it is clear that the French will not be willing to submit to serious fiscal discipline. Will the Germans still be willing to give up their beloved deutsche mark in favor of a currency partly managed by France? It is equally clear that France will not give up its taste for regulation—indeed, it will surely try to impose that taste on its more market-oriented neighbors, especially Britain. That will give those neighbors—yes, even Tony Blair—plenty of reason to hesitate before forming a closer European Union.
But if it turns out that Chirac’s political debacle is the beginning of a much larger disaster—the collapse of the whole vision of European glory that has obsessed France for so long—we can be sure of one thing: The French will blame it all on someone else.
Part 2
Right-Wing Wrongs
Some of my friends tell me that I should spend more time attacking right-wingers. After all, while the economic nonsense of the right may be no worse than that of the left, it is a fact of life that any idea appealing to the prejudices and interests of the wealthy is guaranteed a powerful constituency. Supply-side economics is a crank doctrine pure and simple, yet it has been the official ideology of th
e Republican party for seventeen years.
The problem is finding things to say. Supply-siders never tire of proclaiming that taxes are the root of all evil, but reasonable people do get tired of explaining, over and over again, that they aren’t. My personal experience is that once you have stated the main case against supply-side economics a few times, diminishing returns set in; after that you must find other angles of approach.
One such angle, of course, is to ask why anybody believes this stuff in the first place; I begin here with an essay called “The Virus Strikes Again,” originally written just after Bob Dole’s presidential campaign decided to run on a supply-side platform.
Another apparent opportunity to say something useful about supply-side economics came in the summer of 1997, when even conservatives found themselves asking how the remarkable prosperity of the economy could be reconciled with the grim warnings of their ideologues only a few years earlier. In fact, the new op-ed page editor of the Wall Street Journal commissioned me to write a piece on the subject, which I duly did. What was he thinking? For that matter, what was I thinking? As surely as night follows day, the supply-sider editor, Robert Bartley, intervened to kill the piece, accusing me of “intellectual dishonesty.” Anyway, the piece is published for the first time here as “Supply Side’s Silly Season.”
Supply-siders are actually most interesting (and self-revealing) when they talk about subjects other than the miraculous effects of tax cuts. It is illuminating, for example, to see how they deal with uncomfortable realities. The third essay here, “An Unequal Exchange,” looks at the contortions that the House majority leader—a former economics professor—is willing to go through in an effort to deny the plain fact that America’s income distribution has become much more unequal in the last twenty years. “The Lost Fig Leaf” is about another piece of conservative mythology, the belief in a thoroughly false picture of what the government actually does with taxpayers’ money. The final essay is about the near-mystical devotion of some conservatives to the gold standard.
