Post-war macroeconomics: Part 2
The anti-Keynesian revolution gained serious momentum following the stagflation episode. Monetarists had established monetary policy as the dominant instrument for economic stabilisation. According to Friedman and other Monetarists’, for example, Allan Meltzer and Karl Brunner, the conduct of monetary policy should be guided by simple, fixed rules. Targeting (narrow) monetary aggregates was recommended by Monetarists who were critical of targeting market interest rates as suggested by the Radcliffe Report (1959).
Friedman’s views had been gaining traction among policymakers since, at least, the late 1960s (see, for example, Francis 1968).1 The US Federal Reserve, under the guidance of Paul Volcker, implemented Monetarist theory in 1979 by targeting the growth in the money supply. The apparent correlations between the money stock and inflation however disappeared due to financial innovation and deregulation. The experiment was subsequently abandoned in 1982.2
The theoretical foundations of Keynesian macroeconomics were also under attack by the New Classical economics of Lucas, Sargent and Wallace. Drawing on Muth’s (1961) rational expectations, Lucas (1976) argued that aggregate relationships would change with each policy initiative given adjustments to the decision problems of individual agents (i.e. the Lucas critique; see also Goodhart 1975).3 The Lucas critique had a profound effect on the direction of modern (mainstream) macroeconomics. In particular, the simulation of policy outcomes using large-scale macro-models was called into question; it encouraged the development of small formal macroeconomic models (e.g. the ‘econometrics without theory’ approach of Sims 1980); and, it strengthened the view that micro-foundations (e.g. tastes, technology) and forward-looking expectations were essential to dynamic economic modelling.
Meanwhile, policymakers became increasingly concerned with the rising budget deficits which followed the supply shocks. Academic debate largely echoed the political shift towards deficit and debt reduction or fiscal discipline. The efficacy and sustainability of government net spending came under intense scrutiny.
For Monetarists, restraint in government spending was considered important to avoid the need for central banks to finance the deficits and, in doing so, generate excessive money growth which would threaten price stability. Notwithstanding this, restraint in government spending had been necessary due to government commitments to the Bretton Woods exchange rate system (1944-1971).
While balanced budgets over the cycle were considered broadly appropriate, the government budget constraint, an accounting identity, was interpreted as set of ex ante financing choices for government net spending (see Patinkin 1956; Christ 1968). That is, government could raise taxes, borrow or issue high-powered money (‘print money’). Monetarism had already warned against the latter, and the other financing options for government generated a revival of crowding-out theory and Ricardian equivalence.
Crowding-out could take various forms, yet Blinder and Solow (1972:3) asserted that financial crowding-out was ‘disputed by almost no one’. Drawing on classical loanable funds theory, it was argued that government debt would compete with private debt in financial markets, put upward pressure on interest rates and therefore reduce interest-sensitive private expenditures.
Barro’s (1974, 1989) Ricardian equivalence maintained that under a certain set of (restrictive) assumptions an increase in government spending would be offset by an increase in current private savings as the private sector anticipated higher future taxes. Thus national savings, real interest rates, investment, and the current account balance would remain unchanged. This was a special case of Modigliani and Brumberg (1954) and Friedman’s (1957) earlier work on the life-cycle theory/permanent income hypothesis.
The long-term consequences of budget deficits or fiscal sustainability was analysed in terms of the debt dynamics, which had already been presented by Domar (1944). While there was (is) no operational definition of fiscal sustainability, numerous econometric investigations of the so called present value budget constraint were developed to assess the sustainability of fiscal balances (see Hamilton and Flavin 1986; Trehan and Walsh 1988, 1991; Hakkio and Rush 1991). Most investigations focused on the US with mixed evidence in favour of fiscal sustainability. The policy implications however were limited since the estimates relied on historical data.
Instead, policymakers required forward-looking measures which motivated the development of fiscal indicators, such as primary gap, tax gap and net worth indicators. These methods, largely due to the work of Buiter (1985, 1995), Blanchard (1990) and Buiter et al. (1993), underpin the European Commission’s S1 and S2 fiscal indictors currently used to assess fiscal sustainability.
The 1981 tax cuts of the Reagan administration characterised the shift in political and economic opinion regarding fiscal policy. Drawing on the so called Laffer curve and emerging supply-side economics, the tax cuts were an attempt to increase tax revenue. The budget deficit, however, increased which precipitated the Gramm-Rudman-Hollings Deficit Reduction Act (1985) to formally constrain government spending.
1 Monetarist views were particularly influential to the Carter and Reagan administrations in the US, and Thatcher’s conservative economic agenda in the UK.
2 While the Monetarist experiment failed, the theory offered the blueprints for modern day central banking. In particular, the argument that monetary policy can only target nominal quantities was the foundation to inflation-targeting, which first began in New Zealand in the late 1980s and is now widely practiced by central banks within advanced economies. In addition, the Monetarist argument that central banks should be independent and guided by transparent rules remains pervasive. The notion of central bank independence was reinforced by Kydland and Prescott’s work on time-inconsistency.
3 Keynes’ Z and D curve analysis was compatible with rational expectations regarding the short-run proceeds from the sale of output. However, Keynes questioned the applicability of rational expectations to long-run returns on financial and non-financial investments given fundamental uncertainty.