Central Bank Practices Are Heading in a Dangerous Direction – Twin Cities

The longtime University of Minnesota economics professor and 2004 Nobel laureate Edward Prescott is dead. So is the 1995 laureate, Robert Lucas, a University of Chicago professor who had a long research association with the Federal Reserve in Minneapolis. But if either were alive, the farce of monetary policy that has played out in recent weeks might have prompted both to echo Simon Bolivar’s last lament: “We have plowed the sea.”

Bolivar liberated South America from Spain, but died when the new nations fell into dictatorships. Similarly, brilliant economists sought to disprove economic theories that they believed were harming national economies, bringing misery to tens of millions of people. Yet after 25 years of work in which they largely won the intellectual battle, the U.S. Federal Reserve and other central banks returned to discredited practices with a vengeance.

These policies have involved central bank attempts to micromanage economies by juggling the money supply and, therefore, interest rates. The goal is to minimize volatility, whether booms or busts. One example is the widespread belief that the Fed can and should create an economic “soft landing” in 2024. As have calls for the Fed to flood markets with money if stock markets fall by 3 percent. Both argue that the body of economic thought known as “rational expectations” is as dead as a doornail. In general, this intellectual sea change is bad, but that’s only part of the reason we’re on a dangerous path.

To understand this, a quick review of economic thought is needed.

Four centuries ago, people believed that the prosperity of a nation depended on the government regulating all economic activity. We wear jeans “denim” because in France, the weaving of the durable blue material was prohibited, except in the city of Nîmes. Such regulations applied to all products and all trade.

The Scottish philosopher Adam Smith powerfully refuted this in his 1776 work The Wealth of Nations. If people freely cooperated in making and selling or buying and using what they wanted, such market activity, taken together, would allocate scarce resources more efficiently. More human needs and desires would be satisfied without government action. This was one of the most important insights in the history of human thought.

If anything, Smith was a keen, skeptical observer. He saw ways markets could fail. They weren’t perfect. But market economies were better than any alternative.

However, the proponents who formalized his ideas more systematically were not so reflective. In the mid-1850s, the prevailing doctrine was that any government “interference” in market activity made society worse off. This era was “classical” economics.

In the following decades, expressing economic ideas in terms of graphs and mathematical equations became common. British economist Alfred Marshall invented the supply-and-demand diagram that has haunted millions of students ever since. The “neoclassical” era began. As before, government was expected to play a minor role.

Some economists argued for social Darwinism. The poverty that horrified Charles Dickens or Victor Hugo was necessary and healthy for society. The death of the poor eliminated the least efficient and empowering society.

Not everyone went that far. But the belief that government should not interfere in the economy, either at the “micro” level of the household or firm, or at the “macro” level of the nation, was accepted doctrine for a century.

The Great Depression of the 1930s, in which production, employment, and trade collapsed, shook faith in this conventional wisdom. Communist dictators like Stalin and fascists like Hitler gained millions of followers. Free markets were at a crossroads, if not the edge of the abyss.

In 1936, however, British economist John Maynard Keynes challenged conventional thinking. While free markets were generally good, there were times when government action was crucial. This included fiscal action, governments changing taxes and spending. Monetary action, regulating the money supply and thus interest rates, fell to central banks. Harmful recessions were avoided. Prices could be held steady—without inflation.

Governments had to cut taxes and increase spending to stave off recessions. The central bank had to cut interest rates, increasing the money supply.

If inflation rises, governments must cut spending and raise taxes. The central bank had to restrict the money supply to raise interest rates. Problems solved!

It was World War II, not Keynesian policies, that ended the Great Depression. But after the war, Keynesian policies soon dominated economics education and politics. By 1960, all popular textbooks and governments in every industrialized country were Keynesian. University of Minnesota professor Walter Heller was President John Kennedy’s economics guru. His “dream team” of supporting economists included two future Nobel Prize winners. With the Cold War, the “space race,” solid-state electronics, jet airplanes, and the Vietnam War, the U.S. economy boomed. France enjoyed its “glorious 30” years of rapid growth, as did Germany and Japan. Even antiquated Britain was lurching in terms of culture and income. Economic nirvana had arrived.

But in the 1970s, that quickly fell apart. The Bretton Woods system of international payments collapsed. Thus, U.S. agriculture flourished, but imports to the U.S. became cheaper. Japanese goods, including cars, flooded the market. Industry became a “rust belt.” Oil prices soared, and inflation reached levels not seen in 25 years. Recessions with high unemployment became more frequent.

Keynes viewed inflation and recession as polar opposites. You had one or the other, but not both. But in the 1970s, “stagflation,” combining stagnation and inflation, became common.

In economics, the anti-Keynesian reaction gained strength. The new thinkers saw successive cycles of Keynesian pedal-to-the-barrel squeezing as not only futile but self-defeating. People, they argued, had learned the results of such squeezing. With each household rationally taking steps to best cope with the expected outcomes, the collective reactions of society as a whole directly counteracted the policy goals.

This “rational expectations” school grew out of the “monetarism” of Milton Friedman, a libertarian at the University of Chicago. It was Friedman who inspired conservatives like Margaret Thatcher to banish Keynesianism from politics, not the new theorists. But university professors and research economists at think tanks and central banks joined the movement. Keynesian-based doctoral dissertations became rare.

Yet the belief in the need for economic micromanagement continued to dominate financial journalism and the Democratic Party. Few Republicans actually understood rational expectations theory, but they opposed government economic activism on historical grounds.

Fed Chairman Paul Volcker, a pragmatic monetarist, drove inflation out of our economy. Alan Greenspan, his successor, was a libertarian who favored tight monetary policy and a policy of no interference.

That brings us to the 1990s. Coming into the decade, the US economy was in its best shape in 30 years. But by the end, we started throwing it all away in response to external shocks and the predictable results of our own stupidity. That deserves its own column.

St. Paul economist and author Edward Lotterman can be reached at [email protected].

Originally published: August 11, 2024 at 9:00 AM