The New Interventionist Economists

...Again, the economy is out of kilter, leaving a role for government intervention to push it back on its optimum course...

...Just as the stagflation of the 1970s dealt a blow to Keynesians, the events of the 1980s have been devastating to monetarist arguments that all the economy needs is a steady rate of growth in the money supply...

...As economists focus on trade in products manufactured by a handful of firms, or analyze the benefits to the country that is first with a new product in the international market, they find more and more instances where government export subsidies or protection against imports may make the country better off...

...If welfare spending does nothing to stabilize the economy, it should be eliminated...

...Where John Maynard Keynes had seen a world with imperfect markets and prices that did not rise or fall freely, the world of monetarism and rational expectations was that of Adam Smith...

...Translating such gains into real-world advantages is a far more complex matter, and the theorists are far from ready to start designing trade barriers beneficial to the United States...

...In all thesituations mentioned, unemployment persists because it is in the interest of employers to pay above the market-clearing wage...

...For a monopolistic firm the "menu costs"—i.e., the cost of printing a new price list—can be greater than the additional revenue to be earned...

...Barely had Richard Nixon pronounced himself a Keynesian, in 1971, when his Administration' s failure to control either unemployment or inflation threw Keynesian economics into disrepute...

...And those assumptions are crucial: The argument that government policy is impotent depends on having a world with flexible prices and perfect competition...

...the debate on many of the ideas one hears is still in its infancy...

...Although increasing the money supply may start inflation, Blanchard contends, adjustments in demand and sluggishness in price changes keep it going...

...To be sure, showing that free markets do not cure every ill is a far cry from prescribing policy for the government to follow...

...Their work, in fields as varied as labor economics and trade theory, rejects the prevailing view that, left to themselves, supply will equal demand and markets will "clear," automatically allocating resources efficiently...

...Joseph Stiglitz of Princeton and Andrew Weiss of Columbia have each developed mathematical models showing not merely that there can be unemployment in a well-functioning economy—but also that it's good to have in some degree...

...The only way I can make sense of it is the Phillips Curve explanation, which doesn't make me happy, because I still don't have a theoretical explanation," he laments...

...That's very different from going out and saying, 'You should do this or that.' What they have is a belief that it's a case-by-case thing...

...Among the most influential of these neoclassical economists were Robert Lucas of the University of Chicago and Thomas Sargent of the University of Minnesota, who criticized the Keynes-ians for assuming Washington's actions occurred in a vacuum...

...But the tideof mindless modeling has begun to ebb...

...Internally, they constantly adjust prices according to new information...

...Harvard's Man-ki w has proposed one reason why some prices don't budge in seeming defiance of economic logic...

...While government policy can't change the economy's output in Milton Friedman's rational world, its effects are entirely different when that one assumption of rationality is abandoned...

...For example, if individuals expect money supply growth to stimulate demand, they will simply raise their prices, so that after initial adjustments the economy will have a higher price level, but the same amount of unemployment as before...

...I think the efforts to use models that assume continual market-clearing were unfortunate to begin with and have become an increasingly hollow and scholastic exercise," Summerssays...

...I object to the Keynesian label because it carries too much excess baggage," says Benjamin M. Friedman...

...Since there is normally more demand to borrow than there is money to lend, banks can earn the biggest profit by raising interest rates above market-clearing levels...

...Some are hesitant to be called Keynesians...

...But we still haven't decided what theories we like and what theories we don't...

...Employers' lack of perfect information about performance is another reason for them to retain high wages, since reductions to market-clearing levels would induce the best employees to quit first, leaving an inefficient work force and requiring more effort at supervision than production...

...With minimal fanfare, a new generation of economists has been reconstituting the theoretical basis for an activist government...

...As a result, younger theorists are returning to their Keynesian roots...

...Consequently, there is nothing necessarily efficient about how stock and bond prices, exchange rates, and the prices of physical assets are set...

...In fact, the view may be so much worse that everyone is bet ter off if the government tells the crowd to sit down...

...In credit markets as in labor markets, therefore, persons seeking to maximize their own private welfare may collectively drag the economy down the drain...

...Indeed, Blanchard, a theoretician distrustful of casual empirical observation, recently analyzed unemployment and inflation trends in Europe hoping to prove no trade-off exists and reluctantly found otherwise...

...As graduate students increasingly churned out dissertations on why the economy does best when left alone, however, their underlying assumptions were obscured...

...Slow but steady money supply growth would end inflation while increasing unemployment only briefly, they maintained...

...That position, too, is crumbling...

...when mortgages are not available at lOper cent, it is because other borrowers—obviously the people able to do most for society—are willing to offer a higher return for the use of the funds...

...In the United States, disinflation has been accompanied by persistent high unemployment...

...His recent work has begun to provide the theoretical foundation for an industrial policy of the sort advocated by Robert Reich and Lester Thurow, which has heretofore lacked intellectual standing because of its weak underpinning...

...The implications of this line of reasoning were quickly picked up by political conservatives...

...The view from Economics 101, that all parties are always better off with t ree trade among nations, has largely been discarded by academia...

...Unemployment will not just go away—and from the standpoint of economic efficiency it is not desirable to have it completely disappear...

...Further, substantial turnovers lead to additional hiring and training costs that represent a net economic loss to society...

...That is not to say a unified body of thought has emerged...

...The best way to characterize these people is to say they' reopen to the idea that policy may work," declares Olivier Blanchard...

...FACING THE REAL WORLD The New Interventionist Economists bymarc levinson It's been a dismal decade for the dismal science: In the shadow of monetarism, economists have found little to do except manipulate ever more abstract models of the world, reaching conclusions so irrelevant that the layman can only shake his head in dismay...

...In Britain, high unemployment and slow growth have continued, despite monetarist policies...

...Those free-marketeers in the Milton Friedman tradition have dominated the scene for a decade and a half...

...Others are not so reticent...

...In place of the traditional supposition that the economy naturally tends to an "equilibrium" point where prices and interest rates will stabilize, many highly complex papers are now exploring the mathematical characteristics of an economy with multiple equilibria...

...Where economists of the postwar generation saw unemployment as the greatest of all ills, their young counterparts worry about savings, investment, productivity, and other issues that had been the near-exclusive domain of the monetarist camp...

...George Akerlof and Janet Yellin, a husband-and-wife team at the University of California Berkeley campus, have examined what occurs if individuals are only "near-rational"— if, say, they are slow to realize inflation is eroding their real wages and do not immediately adjust their wage demands...

...Solid, low-risk projects will have a harder time finding capital, because financial markets will not automatically allocate resources to the undertakings that would be most advantageous for the economy as a whole...

...The political appeal of the neoclassi-cists is in large measure due to their basically cheerful message that economic policy does not entail trade-offs...

...The economics of the 1980s is an arcane art, and the interventionists make full use of the complex mathematical analysis that is part and parcel of modern economic research...

...A place for government intervention has been found by trade theorists as w ell...

...N. Gregory Mankiw, a clean-cut young professor at Harvard University, explains: "The only similar vein in any of this work is being anti-market clearing...

...supply and demand have not resolved the problems of the labor market...

...Personally such near-rationality is about as good as total rationality...

...Milton Friedman and his followers argue strongly for permitting markets to allocate resources by determining stock and bond prices, interest rates, and currency exchange rates...

...The market clearing guys said there's no role for government intervention in the economy...

...That means countervailing monetary and fiscal policies will do what you expect them to do...

...Their models reject the notion that interest rates will adjust until the supply of money available for lending equals the demand from borrowers...

...Nonetheless, the case for invariably leaving the market alone has been demolished...

...As Robert Lucas puts it rhetorically, "Why don't unemployed people get jobs as cab drivers...

...Both monetarists and supply-siders have staunchly denied the existence of the Phillips Curve, postulated 30 years ago to show the connection between low unemployment and high inflation...

...The welfare loss due to a firm not changing its price can be far bigger than the costs to the firm," though, Mankiw observes...

...And, chastised by the lessons of the '60s and '70s, all of them look upon government intervention as a crude instrument, capable of broadly shaping macroeconom-ic developments but poorly suited for evening out the economy's minor fluctuations...

...If firms were to pay the lowest wage they could hire at, workers would shirk on the job, because they would have no fear of being without a paycheck: Another job at the market-clearing wage would always be available...

...Stiglitz and Princeton colleague Carl Shapiro, for instance, suggest unemployment may be a worker discipline device...

...mass psychology, he says, has more to do with market performance than does efficiency...

...The array of new work confirming numerous propositions John Maynard Keynes put forth 50 years ago, yet pointing to prescriptions startlingly different from those of past American devotees of the English economist, impliesanew Keynesian synthesis...

...With huge budget deficits firmly in mind, these theoreticians downplay government spending and tax policy as solutions to economic problems...

...The assumptions fed into the model shaped what came out...

...If deficits can't put the unemployed back to work, the budget should be balanced...

...Standing up is individually optimal, but if everybody stands up, the view overall is no better than if everybody sits down...

...Externally, markets automatically make the best allocation of resources for the economy as a whole...

...the cost of a stock already embodies everything that might affect its value, so no one can systematically make a profit buying and selling...

...You have to recognize the real world is a lot more complicated than the people who believe in open markets would admit...

...In his latest work, Blanchard—who retains French citizenship and confines his policy recommendations to Europe— develops a theoretical model of the old wage-price spiral, a Keynesian artifact rejected by those convinced excessive money creation alone causes inflation...

...Many interventionist economists actually support—shades of Milton Friedman—monetary rules for the Fed, albeit of a far less rigid nature than Friedman would allow...

...Nonetheless, it has important implications if you believe government can make things better for citizens without Marc Levinson, a previous contributor to The New Leader, is currently a senior editor at Dun's Business Month...

...It was based on assumptions of perfect competition between producers and trading nations...

...That's the next step before we go to Washington and tell people what to do...

...In many cases, the answers are not yet clear...

...Markets left to themselves, it is claimed, are "efficient" in two different ways...

...Most of the interventionist economists understand that what governments are likely to do may well negate the economic pluses suggested by theory...

...They share their generation's grave doubts about the ability of government to deliver what it promises: Although comfortable recommending government intervention in theory, they are hesitant to stipulate specific government actions in practice...

...Several economists have even developed models of "credit rationing" suggesting that the supply-and-demand model just does not work for capital markets...

...I guess they don't want to...

...Few of the practitioners are ready to speak in terms of application...

...Benjamin M. Friedman of Harvard, among the most influential of the younger mac-roeconomists, has forcefully urged tying monetary policy to real world preoccupations like the unemployment or the inflation rate, rather than to abstractions like the monetarists' "money demand...

...If an economy has several equilibrium points, one may involve higher output than another, and there is no assurance of market forces picking the top one...

...By definition, that means some workers will remain without jobs...

...Lawrence H. Summers, age 31, also of Harvard, has already earned a reputation as one of the profession's most creative thinkers and has emerged as a vociferous critic of the free-market perspective...

...Friedman had been calling for fixing the long-term rate of money supply growth, and a new generation of adherents using flawlessly crafted mathematical models proved his assertion that government monetary or fiscal policy could not improve the nation's economic condition in the long run...

...This conclusion, self-evident as it may seem, is a far cry from the Reagan view that the free market assures the best result...

...It's coming back," reports Richard Freeman, director of labor studies forthe National Bureau of Economic Research...

...Even in mathematical economics— the most apolitical of fields—researchers are advancing reasons for government intervention...

...As individuals who might borrow at lower rates withdraw from the market, those who remain have projects with higher risks that will, if successful, generate enough return to pay the steep interest charges...

...unemployment would drop as soon as the public became convinced the Federal Reserve was seriously pursuing an anti-inflationary policy...

...A long with sticky wages, sticky prices offer a key to the Keynesian world: If prices do not fall once supply exceeds demand, markets for goods and services will not clear and the free-market economy will produce less them it could...

...Policy should be determined according to some kind of system or rule that's flexible," advises Stanford University's John Taylor, "one that says you'll expand the money supply by some amount if unemployment rises, but with that amount known in advance...

...In that circumstance, government fiscal or monetary policy could help move things in the right direction...

...Faith in the invisible hand in financial markets is not free from attack either...

...Thus, to rational expectationists, long-term unemployment is voluntary...

...collectively there is a vast difference...

...If people anticipate its moves and act according to their "rational expectations," Lucas and Sargent argued, they will negate the effects of whatever the government does...

...Yale's Robert Shiller has gone so far as to incorporate psychological research into technical economics papers...

...The philosophy was turned into policy by the monetarists who followed Ronald Reagan into office in 1981...

...Martin Neil Baily of the Brookings Institution sees the financial markets suffering from a "signal-to-noise problem," in which basic economic information simply doesn't get through...

...With the evidence of the last five or six years, where we've put unemployment up very high and gotten all these wage concessions, you can't pooh-pooh the Phillips curve...

...Baily offers an analogy the Gipper would understand: "It's like a football game...

...I personally believe we need more capital formation and less consumption, and I'm not in favor of income redistribution as much as most Keynesians...

...Where wages and prices are flexible, of course, unemployment is a temporary problem: Eventually wages will fall to the point where employers want to hire everyone seeking work...

...Asserts Krugman, "Tosimplysay, Tmforfree trade and you're never going to budge me from it' will never wash in the real world...

...Ithink they largely diverted the profession toward a dead end...

...Those people don't lose a great deal by their behavior, but they do cause significant changes in the economy," Akerlof says...

...One of Keynesianism's theoretical weaknesses has been its failure to demonstrate why wages and prices should not adjust quickly in a well-functioning economy...

...They have better things to do with their time.' New interventionist analyses paint a very different picture...

...Our work has shown you can develop equally plausible theories for government intervention...

...Much of their output is not accessible to anyone unable or unwilling to wade through pages of equations in the discipline's journals, and it is more likely to examine the behavior of hypothetical individuals with quasi-concave twice-differentiable utility functions than to analyze statistics from the Department of Commerce...

...Providing more and faster information to financial markets may be all that can be done to make them more efficient...

...Yet this is also under challenge...

...Instead, it points to ways that government intervention can make the economy perform more effectively...

...This revisionist view of an imperfect world leads to ideas unexpected from believers in the effectiveness of government actions...

...In the postwar period Keynesian economics was geared up to stimulate consumption...

...The free-market case rests critically on the assumption that individuals are continually attempting to achieve the absolute maximum in economic welfare for themselves—what economists label "rational behavior...

...Rather than stimulating the economy, the White House was advised to eliminate regulations that keep wages and prices from adjusting to the deflationary environment...

...If he has his way, economics will return to focusing on the real world, where workers are jobless, resources are unemployed, and people have other concerns besides maximizing their economic welfare...

...A growing group of skeptics question this double-pronged confidence...

...and foreign economies...

...We're not back to the activist days...

...Monetary policy, an area Keynesians of the 1960s paid little heed to, is widely accepted as a potent macroeco-nomic tool by Keynesians of the 1980s...

...There's clearly a movement back," notes Olivier Blanchard, a Frenchman who teaches at Massachusetts Institute of Technology...

...Another look at the facts suggests the facts are what we thought they were...

...creating inefficiency, because it offers the first theoretically cogent response to the economists who purported to show that the best economic role for government is no role at all...

...Paul Krugman, an international economist at MIT, contends that the high dollar is a "speculative bubble," reflecting continuing misperceptions of basic factors in the U.S...