Among other things, the Great Depression is remembered today for having a calamitous effect on the economies of developed world that saw declining incomes, rising unemployment, and a paralyzed government machinery unable to prevent the economy’s downward spiral. For example, total output in the US declined by one third and one fourth of its labor force was out of work at the lowest point of Depression.
What Keynes prescribed, which later came to be known as Keynesian economics, was that the use of fiscal and monetary policies—essentially, budget spending and money supply growth—would strengthen aggregate demand and, thus, would offset the fall-off in private demand, the original source of Depression.
Keynes argued that recessions and depressions are caused exclusively by the deficiency of aggregate demand, due mainly to the erosion of investors’ confidence in future growth of the economy—a darkening of economic outlook. Government’s role, then, was to offset the deficiency in private demand by increasing its own demand through expansionary fiscal policy, supplemented by central bank adopting a looser monetary policy to accelerate money supply growth.
Keynes’ policy prescription helped the World come out of Great Depression, followed by an unprecedented economic good times enjoyed by the West that lasted through the late 1960s. But the overuse of stimulative policies focused on strengthening of aggregate demand showed the seeds of trouble that became apparent in the 1970s.
What these economies experienced then was the twin evils of economics—rising inflation and rising unemployment, which meant lower economic growth and declining prosperity, a phenomenon that came to be know as stagflation. Received economic theory at that time, known as the Phillips curve hypothesis, prescribed the cure for high unemployment to accept high inflation, the so-called unemployment-inflation trade-off, but what these countries got, instead, was rising unemployment and rising inflation!
The main contribution of this year’s Economics Nobel Laureates—Sargent and Sims—has been to unravel this mystery: Why the classical macroeconomics failed to take note of this seemingly unexplainable phenomenon, an absence of trade-off between inflation and unemployment, meaning that high inflation and high unemployment can co-exist, which was actually experienced by most developed countries in the 1970’s and 1980s?
A corollary to this strange occurrence—positive relationship between unemployment and inflation—has been the erosion of confidence in Keynesian economics and its policy prescription of stimulating aggregate demand to keep the economy on a stable path of low inflation and full employment. Instead, effort to fight unemployment with stimulative fiscal and monetary policies has resulted in high and rising unemployment. In many instances, unemployment problem worsened as policies tended to become more expansionary.
Sergeant’s and Sims’ analysis helps to understand why the standard Keynesian policies cannot be effective: Because they lack credibility for achieving longer-term objectives.
Sargent’s and Sims’ answer to this mystery was conceived in the form of rational expectations hypothesis that theorized that market participants, consumers and investors, do no respond just to one set of policies announced by government—reduction in tax and interest rates and increase in government spending, for example, to fight a recession. This is the sort of “stimulus package” that has been tried in the United States in recent years in response to the financial crisis of 2008-2009 and the accompanying recession. However, there has been very little success.
The use of rational expectations theory would show that stimulus measures have failed because their focus was on the short-term, which was not consistent with expectations for long-term growth. The main problem with the stimulus was that policies that were being implemented lacked credibility: That government could sustain the announced policies over the long-term.
Sargent tested his theory about the policy credibility by studying four episodes of hyperinflation, when prices can rise thousands of times a year, in the aftermath of World War I. Soon after the War, many of the European countries started to have high inflation and in four countries—Germany, Poland, Austria, and Hungary—it accelerated into hyperinflation. They tried to stop it but failed repeatedly. Finally, the four countries noted above announced policies of no more budget deficits and instituted rigid controls over money supply. Inflation was stopped right its track, almost overnight, which Sargent attributed to “policy credibility.”
On the contrary, many of the countries which suffered from inflation in the double-digits during the 1970s and 1980s implemented “demand management policies”—acronym for spending cuts and lowering the money supply growth—but failed to tame it. It wasn’t that they didn’t do all those Keynesian things. Actually, they made elaborate policy announcements to backup their intentions. However, very few trusted that government was committed to whatever it was pledging and would follow-through.
Predictably, many of the so-called stabilization programs undertaken under the supervision of International Monetary Fund didn’t work. People just didn’t believe that government was committed to stability. On the contrary, Israel experienced an agonizingly high and persistent inflation in the 1980s which, they later realized, was hurting the economy and was the source of social unrest. They soon adopted harsh policy measures to stop inflation and ensured that public believed them in whatever they are doing. Inflation declined from high 20 percent range to low single digit within a year
In summary, Sergeant’s and Sims’ analysis helps to understand why the standard Keynesian policies cannot be effective: Because they lack credibility for achieving longer-term objectives. For example, increased government spending will increase deficit and debt later on, which raises the possibility of future higher taxes and thus hurts incentive. Similarly, a looser monetary policy is feared to stoke inflation, even if it helps the economy now.
The new Nobel Laureates’ contributions are on the cutting edges of the evolution of macroeconomic theory and is not well-understood even by professional economists. This makes it all the more possible that putting their theories in actual use will take time, as did Keynes’ theory that didn’t become widely accepted until the late 1950s or more than 20 years after it was expounded.
It then appears that Sergeant’s and Sims’ theory will take time—ten or twenty years—to take roots and get implemented. Until such time, the world economy and especially of the United States are likely to remain in doldrums—low growth, high unemployment, unstable expectations—all because of the failure of governments to be trusted, that it would follow consistent policies over the long-term.
The writer teaches economics at universities in the US
sshah1983@hotmail.com
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