Staking a great deal on how you think someone else will react is dangerous. An old map I found this week reminded me of how that applies to war as well as to economic policy.
It was a standard military topographic map titled “Bad Hersfeld.” That means nothing to most people, but thousands of Americans who served as U.S. Army officers since 1950 may recognize it as a map of the “Fulda Gap,” a set of valleys running through mountainous terrain near Fulda and Marburg at the south end of the old border between the former East and West Germanys.
It is familiar to Army officers because if the Soviet Union had invaded Western Europe during the Cold War, that was the logical place for them to thrust. Those of us who took officers’ courses beginning as lieutenants and on up through Command and General Staff College repeatedly played war games on very familiar maps including “Bad Hersfeld.”
After many such map exercises, one wondered if U.S. planning for fighting at the Fulda Gap might not be an intellectual repeat of the French Maginot Line. That was the enormous system of forts that France constructed in the 1930s along its borders facing Germany. The object was to defeat any German invasion.
Such fortifications could not be continuous, however. The French left one zone — opposite the Ardennes Forest in eastern Belgium — relatively open. They judged the Ardennes too dense for a modern army to pass. Better to concentrate defenses on more vulnerable zones. Of course, in 1940, the Ardennes was precisely where Germany aimed its Panzer forces.
There is an analogy in economic policy. Just as we were ready to stop an onslaught of Soviet armor at “the Gap” and the French prepared to halt the Wehrmacht at their borders, Keynesian economic policy-makers from the 1950s through the 1970s were poised to halt either inflation or unemployment.
They were sure they could vary taxes, government spending and the money supply to slow down or speed up the economy just enough to keep both economic threats at bay.
The success of their strategy depended on a crucial assumption — that households and businesses would respond naively to discretionary policy changes. Just as the French assumed that where they built forts would not fundamentally change German war plans, Keynesian theory assumed that people would always change consumption and investment in response to changing taxes and interest rates.
In practice, that turned out as false as the assumptions of French war planners. People soon learned what happens when governments tramp on economic gas and brake pedals. They learned the likely results of such policies and acted to protect themselves from consequences they could expect.
The upshot of such defensive reactions by millions of households and businesses was that Keynesian policies not only failed to work as billed, but also were counterproductive. Over the 1970s, baseline levels of inflation and unemployment grew over time in the United States and other industrialized nations.
A group of economists exploring actions of humans with “rational expectations” exposed gaping holes in Keynesian theory. These included Robert Lucas, who received the Nobel Prize in Economics in 1998, and Edward Prescott, who won it last October.
Rational expectations is not the dominant theory in economics. Moreover, mindsets in government and the media remain relentlessly Keynesian. Rational expectationists did destroy, naive assumptions that policy-makers could herd households and businesses into economic pens just as border collies maneuver flocks of sheep.
Even die-hard Keynesian theorists must alter their models to account for the fact that people get wise to the results of alternative policies to slow or speed the economy. Their self-defensive reactions to such expected results changes how well such policies work even if not completely negating them.
The French staked their freedom on crucial assumptions of how the Germans would act. They were wrong and paid a heavy price. NATO planned for a war based on assumptions of what communist armies would do. Thankfully, the Soviets never put us to the test at the Fulda Gap or elsewhere. One can only pray that there will never be another European war.
Economic cycles are shorter than political ones, however. Inflation, unemployment and economic stagnation rear their heads regularly. Some nations prosper while others stagnate. Economic policies clearly affect all of this in both the long and short term.
Despite the delusions of some, economists do not know the precisely right thing to do in the face of all economic challenges. We do know, however, that we must not rely unduly on assumptions that people will always do what we expect.
© 2005 Edward Lotterman
Chanarambie Consulting, Inc.