Alan S. Blinder. Monetary and Fiscal History of the United States, 1961-2021. Princeton: Princeton University Press, 2022.
For those of us interested in economic policy, this is a useful history of the past six decades. It provides a handy reference for recalling the economic ideas and policies of particular administrations. Although it is rather technical in spots, such as the chapter on “rational expectations” theory, much of it is accessible to non-economists with an interest in public affairs.
Trying to summarize a book of this kind would be a challenging exercise. Fortunately, Blinder has identified a few general themes that unify the narrative. They are, as he titles them in the sections of his final chapter:
- Who sits in the first chair, fiscal policy or monetary policy?
- The rise and fall and rise and…of Keynesian economics
- Do budget deficits matter?
- The rise (without a fall) of central bank independence
This post will focus on the second theme, the ups and downs of Keynesian economics as an influence on federal government policy.
Keynesian economics in vogue
Blinder does not explain Keynesian economics as one would in a textbook, but jumps right in to discuss how different federal administrations have applied it (or failed to do so). I think he would have done non-economists a favor by providing at least a short overview at the beginning of the book. He does define Keynesian policy briefly as the “belief in using fiscal policy to influence aggregate demand.” The government can set spending and taxing levels not just with the aim of balancing the budget, but with an eye toward raising or lowering the demand for economic goods and services. Theoretically, these variations can stabilize the economy by either stimulating a recessionary economy or curbing an inflationary one. Blinder is a sympathetic observer of such policies, saying that his own “macroeconomic framework is decidedly Keynesian.”
Several decades before the era covered by this book, the Franklin Roosevelt administration revved up the economy with massive spending on the New Deal and World War II. But FDR was more of a pragmatist than a theorist. The economic theories put forth by John Maynard Keynes in the 1930s did not become an explicit basis for economic policy until the Kennedy and Johnson administrations of the 1960s. The previous president, Dwight Eisenhower, had maintained the strong belief in balanced budgets more typical of early twentieth-century Republicans.
The centerpiece of Kennedy-Johnson policy was the tax cut proposed by Kennedy after the 1960-61 recession, but not passed until 1964. Blinder describes it as “the first deliberate and avowedly Keynesian fiscal policy action ever undertaken by the U.S. government.” The tax cut’s apparent success in stimulating economic growth and reducing unemployment helped establish the reputation of Keynesian economists in the 1960s. (My college classes in economics around that time were explicitly Keynesian.)
But there was a cloud on the horizon. Blinder says that “in theory, fiscal policy is symmetric. You raise taxes or cut spending to rein in aggregate demand, just as you cut taxes or boost spending to spur aggregate demand.” Nice theory. But politically, raising taxes or cutting spending can be a tough sell. In practice, Keynesian policy has been asymmetric, more often expansionary than contractionary.
Lyndon Johnson did not want to raise taxes or cut his Great Society social programs in order to pay for the (increasingly unpopular) Vietnam War. Instead, he made the macroeconomic mistake of “piling a mountain of defense spending on top of an economy that was already at…full employment.” That generated inflation. In 1968, Johnson approved a temporary surcharge on income taxes, but it was too little too late. And that was about the last time that a Keynesian fiscal policy would be used to cool down the economy instead of to stimulate it. After that, the task of fighting inflation would fall mainly to the monetary policies of the Federal Reserve.
Keynesian economics under attack
Faced with a mild recession during his first term, President Nixon (1969-1974) coordinated with his Federal Reserve Chair Arthur Burns to provide both fiscal and monetary stimulus. The latter was in the form of low interest rates to encourage borrowing and spending. The growth rate soared again, just in time to help get Nixon reelected in 1972, but he had to resort to wage and price controls to counter the resulting inflation. When those controls were phased out during his abbreviated second term, inflation really took off.
To make matters worse, the oil shortages imposed by OPEC in the 1970s produced price spikes in oil and related products. The economy fell into a period of stagflation, when it suffered from both higher prices and higher unemployment at the same time. Keynesian economists had been accustomed to thinking in terms of an either-or, either a sluggish economy with high unemployment or a booming economy with rising prices. How to deal with unemployment and inflation at the same time was not immediately obvious.
Many economists began to interpret stagflation as a failure of Keynesian theory and practice. That opened the door to non-Keynesian perspectives. Milton Friedman’s monetarism provided a simple alternative. He viewed inflation as a purely monetary phenomenon resulting from the Federal Reserve’s failure to control the money supply, a failure that could occur even in times of high unemployment. The way to avoid inflation—including stagflation—was to allow the money supply to grow only slightly faster than the growth of GDP. Government fiscal policy had little to do with it.
Friedman’s monetarism was part of a general movement in economics back to pre-Keynesian thinking. Neoclassical economists had imagined the economy as a self-stabilizing system requiring little government management. Flexible pricing was the key to rapid stabilization in the face of economic fluctuations. If the supply of labor exceeded the demand, leaving many workers unemployed, the price of labor would fall until more employers found it economical to hire. The economy’s natural tendency was toward full employment, and workers who chose not to work at the prevailing wage were considered out of the labor force instead of unemployed.
Economists like Friedman followed a similar logic, although they saw the economy fluctuating around a “natural rate” of unemployment well above zero. (Some workers were hard to employ even if they wanted to work.) Whatever the natural rate of unemployment really was, the point for policy was that government spending or tax cutting couldn’t really reduce unemployment in the long run. Government could control inflation, but with monetary rather than fiscal policy. That left little for fiscal policy to do.
The economists Blinder calls “new classical” provided additional reasons why Keynesian policies were ineffective, often involving what they called “rational expectations.” A temporary tax cut might not stimulate as much new spending as policymakers intended, since a rational taxpayer might save the money in anticipation of higher taxes to come.
Blinder defends Keynesians against the charge that they had failed either to explain or control inflation. He argues that they soon incorporated supply shocks into their models, which then did a pretty good job of accounting for stagflation. Controlling inflation in the face of those shocks without increasing unemployment would have been hard for any policymaker. What actually happened was that a new Federal Reserve Chair, Paul Volcker, took over in 1979 and drastically raised interest rates. That discouraged borrowing and spending, dramatically cutting inflation, but threw the economy into a deep recession in 1981.
Blinder obviously feels that the critics were too quick to declare the death of Keynesian economics. In their eagerness to bury it, they exaggerated the market’s capacity for self-stabilization, the speed with which prices adjust to changes in supply or demand, and the degree to which people’s expectations confound policymakers’ intentions. As for Friedman’s monetarism, his main recommendation to set targets for the money supply itself—as opposed to just manipulating interest rates—was tried for a few years but soon abandoned as unworkable.
Reaganomics
Blinder sees a number of American presidents as “basically Keynesians”—Kennedy, Johnson, Nixon, Ford, Carter, Obama and Biden. He says that three Republican presidents—Reagan, George W. Bush, and Trump—“shunned the Keynesian label but acted Keynesian in practice” because of their large tax cuts. However, Blinder makes clear that the tax-cutting tradition begun by Ronald Reagan (1981-1988) had a very different economic rationale. I would call it “pseudo-Keynesian” at best.
Reaganomics was never just about stimulating aggregate demand by putting more money in the hands of taxpayers. It was about stimulating the “supply side” by giving people—especially wealthy people—more money to save and invest. In effect, this would give capitalists more capital, so they could grow the economy from the top down. Supply-side economists claimed that the tax cuts would pay for themselves because of the additional tax revenue generated by economic growth, a dubious claim in the eyes of most economists. Reaganomics was not supposed to be about deficit spending. It had the twin goals of reducing taxes and reducing spending, with the aim of moving toward balanced budgets and less government debt.
In most respects, Reaganomics failed to live up to its billing. The Reagan administration did not produce economic growth rates higher than the administrations that preceded or followed it. Nor did it cut spending enough to offset its tax cuts, and so it increased the federal deficit. Ironically, the unwanted deficit provided a Keynesian stimulus after the Fed’s high interest rates threw the economy into recession. The period from 1982 to 1990 was a period of steady, although unspectacular, growth. Keynesianism in practice, maybe, but certainly not in theory.
Republicans interpreted the mixed results as a victory. They began to preach the doctrine of perpetual tax cutting without regard to economic conditions. “[T]he desirability of tax cuts, whether the budget is near balance or showing a big deficit and regardless of whether the economy is soaring or sagging, has become the central tenet of Republican economics.” Republicans also preached the doctrine of balanced budgets, but mostly when the other major party was in office! Little of this made sense from the standpoint of mainstream macroeconomics.
[A] clear political pattern had emerged: Republicans railed against budget deficits when a Democrat was in the White House but accepted them willingly, even eagerly, when a Republican was in the White House, especially if the deficits stemmed from tax cuts for the wealthy. In retrospect, the Reagan episode was not a deviation from the norms of the party that once stood for fiscal discipline. Rather, it marked the start of a new normal, interrupted by Bush I and Clinton.
Why “interrupted by Bush I and Clinton”? Because those presidents were the first to face the pressure to reduce the deficits associated with Reaganomics. In 1990, George H. W. Bush reached a deal with Democrats to combine spending cuts with some tax increases. That got him in trouble politically because it violated his “read my lips, no new taxes” campaign promise. Under Bill Clinton (1993-2000), Congress passed another deficit-reduction package, this time with no Republican support at all. That was because Republicans were now holding out for a plan that included only spending cuts and no tax increases. They continued to do so after they took control of the House in 1995, giving in only after trying unsuccessfully to use government shutdowns to have their way. (Does this sound familiar?)
Other things being equal, deficit reduction would be expected to slow the economy. Instead, the country experienced an economic boom extending throughout the 1990s, with higher tax revenues that helped turn the deficit into a surplus. Blinder attributes this to special circumstances. In the bond market, interest rates remained high because of inflation fears. (Lenders demand higher rates when they fear that inflation will erode their returns.) When the deficit-reduction plan calmed those fears, “interest rates dropped like a stone, which helped jump-start the economy and throw the great American jobs machine into high gear.” Fed Chair Alan Greenspan helped this expansion too, by betting that rising productivity would allow more growth without inflation, so a tighter monetary policy was not called for. (Blinder himself became vice chair of the Fed in 1994, so he knows.) Unfortunately, these developments reinforced the belief that deficit reduction is generally good for the economy, a clearly anti-Keynesian notion.
The Clinton budget surplus did not last for long. It disappeared after a new round of tax cuts by George W. Bush (2000-2008).
George W. Bush’s fiscal policies turned out to be among the most profligate in U.S. history to that point. His precedent of not “paying for” tax cuts in 2001 and 2003 was quickly extended to not paying for the wars in Afghanistan and Iraq and even to his expansion of Medicare to include prescription drugs.
Like the Reagan tax cut, these policies provided a Keynesian stimulus without a theoretical justification, since the economy was too strong to need the stimulus at the time. The decline of Keynesian economics had left at least one political party without a coherent and economically grounded policy. But economics was on the verge of big changes.
Beneath the Surface 