Question: What is a sure sign that someone’s economic knowledge is shoddy or hopelessly out of date? Answer: If they use the words “economy” and “fine tuning” in the same sentence.
If there is one thing on which economists under age 50 agree, it is the impossibility of “tuning” an economy. Pianos, yes; guitars and violins, yes; economies, no.
All this nonsense began when John Maynard Keynes published his General Theory of Employment, Interest and Money in 1936. Prior to this, most economists adhered to the classic principal of laissez-faire: Governments should not try to manage economic affairs. Keynes argued that economies sometimes suffered from insufficient demand, resulting in recession and rising unemployment. At other times, demand could be excessive, causing booms accompanied by inflation.
Governments could minimize harmful booms and busts by adjusting fiscal policy (taxing and spending, and monetary policy), the money supply and interest rates. If inflation is a problem, raise taxes, cut spending and constrict the money supply so as to raise interest rates. When recession looms, cut taxes, raise spending and loosen the money supply so as to drive down interest rates.
In fairness to Keynes, his proposals were quite general. Nowhere did he argue that governments could control unemployment and inflation with any precision. But in the post-World War II era, his followers did.
Keynsian “demand management” reached its apogee in JFK’s administration when the president’s principal economic advisor was University of Minnesota professor Walter Heller. Heller believed one could play the U.S. economy the way E. Power Biggs plays the Wurlitzer at Radio City Music Hall.
That was hubris, of course, but there was a lot of hubris among Keynsian economists in the 1960s. And, as in Greek plays, it led to downfall. Stepping alternately on the economic gas and brake pedals soon led to higher levels of both inflation and unemployment.
Keynes and his followers always had assumed that the problem would be one or the other.
By the Ford and Carter administrations, the U.S. and several Western European nations had both and did not know how to respond.
In the meantime, a group of economists, including Chicago’s Robert Lucas and Minnesota’s Neil Wallace and Thomas Sargent, articulated a new theory of “rational expectations” that cut Keynsian models off at the knees. Lucas won the Nobel Prize in 1995 for this work.
Not every economist younger than 45 is a full-blown rational-expectationist. But it is difficult to find anyone in this age group who has the sort of naïve belief in the efficacy of government management of the economy that pervaded the 60s and 70s.
Even those pragmatic individuals who are unswayed by theory could see the problems with Keynsian “fine tuning.” There are long lags between the time taxes, spending or the money supply is changed and when the effects of such changes show up in the economy. These lags vary unpredictably.
No economic model ever has predicted successfully when a boom was going to turn into a bust or vice versa. Presidents and congressional leaders find it much more fun to step on the gas than on the brake pedal. By some rare coincidence, they usually think some stimulus is necessary every election year.
This is not to say that all policymakers have returned to laissez-faire. When a recession looms, central bankers tend to loosen the money supply; they tend to constrict it when inflation rears its ugly head. But no serious economist believes anymore that government can “tune” an economy, much less “fine tune” it.
Unfortunately, two generations of undergraduates were force-fed the tuning myth in introductory economics classes. Thus references to “fine tuning” remain popular among journalists and among those tireless self-promoters from Wall Street who show up on the TV news.
Ironically, Keynes himself predicted this in the very last paragraph of his book: “In the field of economic and political philosophy, there are not many who are influenced by new theories after they are 25 or 30 years of age.”
I am not a rational expectations true believer nor am I an antigovernment ideologue, like some colleagues in the profession. But take it from me: Fine tuning does not work, and believing that one can micromanage an economy is a self-destructive delusion.
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.