A Primer on What’s ‘In’ and What’s ‘Out’ for Tinkering With Economy : As Each Theory Fails, Another Comes Along to Take Its Place

It can happen anytime. But usually it happens when you least want it to. Like at a dinner party of heavy hitters when the talk turns to economic policy, rendering you speechless.

You, who knowledgeably eats ortolan. You, the one with an opinion on everything from the desirability of subtitles for opera to which contra faction deserves support. You, of all people, pale during a discussion of whether Alan Greenspan is fit to head the Federal Reserve. Not only are you ignorant of what, exactly, the Fed does; you haven’t the faintest on whether Greenspan is an inflationist, a deflationist and--worse yet--which is better.

You are not alone. A lot of otherwise informed people think that the word monetarist is a conversational hot potato. And while it used to be acceptable to look blank at the mention of Keynesian fiscal policy, it’s now a major no-no. The stuff of economics has become hot stuff for those who wish to hold forth.

So, if you want to jump out ahead of the pack, here’s an economic Baedeker of what’s in and what’s out.

KEYNESIANISM.

Named after John Maynard Keynes, the Brit whose theories influenced the brightest of America’s postwar economists.

Keynes’ insight was that the market was not self-correcting, at least, not in the short run. Economic downturns could become permanent if people stopped buying things, thus making business cut production and lay off workers. Since these unemployed workers wouldn’t have money to spend, the economy might then stagnate at low levels of production and employment.

Keynes said the government should step in during the downturns and pep up demand for goods and services by spending, even if it means running a budget deficit. With the government buying stuff, businesses would hire more workers to produce more, and the economy would get rolling again.

(This idea led quickly to the notion that the government could even fine-tune the economy and avoid downturns altogether.)

The catch, however, was the price level. While Keynesian theory assumed that prices would remain constant, practice proved different.

During the late 1960s, the government spent itself silly to keep unemployment down, but prices rose. When the ‘70s came along, so did stagflation: Even though government spending took off like a rocket, both prices and unemployment went up. By the end of the decade, Keynesians were in retreat; they have yet to recover.

FINE-TUNING.

The conceit that the government can delicately intervene in the economy to promote growth and employment.

The idea of fine-tuning was put forward by Keynesian economists and politicians during the 1950s and ‘60s. The tuning itself was to be achieved through changes in the tax system and/or government spending. (Economy slumping a bit? Then inject a little spending oomph through lower taxes or more government expenditures.)

As it turned out, however, there were several problems. First, there is a lag between the time that something goes wrong and policy-makers recognize it, mostly because the collection of data on the economy takes time. Then there are further lags until the correct solution is hit upon and agreed to. After that, there are more delays until a solution kicks in. Finally, the economic data can be misleading, so that even if there were no lags, policy-makers might mistakenly tune a well-running machine.

At any rate, happy though the thought is, it doesn’t work. So, most economists now agree that fine-tuning fiscal policy is an act of hubris.

MONETARISM.

The view that too much money in the economy leads to increases in the general price level (inflation) and economic booms, too little leads to decreases in prices and busts, and up-and-down changes lead to an up-and-down economy.

Monetarists are utterly fixated on the Federal Reserve because the Fed, as the author of monetary policy, must be the most important player in determining the course of the economy. They argue that the Fed has no business trying to manage the economy because changes in the money supply will put the economy on a roller coaster. Instead, monetarists think that the Fed should just mechanically supply money at a constant rate.

During the Keynesian heyday in the ‘60s and ‘70s, monetarists argued that the excess money creation would lead to inflation. They were ignored. They were dismissed as naive. They were, however, right.

Thus, when the Keynesians retreated, the field of economic policy was left to the monetarists. Their reign was short-lived, however; by the early ‘80s, felled by incorrect assumptions and predictions, they were in retreat, too.

NEW CLASSICAL ECONOMICS.

The view that argues that the market produces the best solution to economic problems.

NCE is equipped with the latest mathematical techniques, a bunch of theoretical refinements and an undeniable sophistication compared to Keynesian and monetarist thought.

A key tenet is that people act in their own best interest--they “maximize.” Thus, people react to changes in the economy by protecting themselves; that is, since they anticipate shifts in government policies, it’s difficult for the government to surprise them into behaving against their own best interest. (That’s a lot different from the Keynesian notion that the government can manipulate people’s behavior through its policies and thus manage the economy.)

NCE argues that active government management is, at best, ineffective; at worst, it makes things worse. Further, NCE puts great emphasis on the power of monetary policy--particularly to cause mischief; inflation, for example. The bottom line? Government should not interfere with markets, so both fiscal and monetary policy should be rather passive and predictable.

With both the Keynesians and monetarists licking their wounds, NCE has emerged as the major alternative for policy-makers, though no policy-maker likes to be told that he or she shouldn’t actively muck around in the economy.

SUPPLY SIDE.

The view that economic policy should aim at stimulating supply rather than demand.

Demand-side economics means that government should concentrate on pumping up the demand for goods and services. That translates into higher and higher taxes so that government can have larger and larger revenue so that it can have more and more to spend. The results of this policy, however, are high rates of inflation, stubborn budget deficits and--eventually--low rates of economic growth.

Supply-side economics, which became the rage in the late ‘70s, takes an entirely opposite approach. Government should concentrate on increasing supply, or production, through its tax policies. The centerpiece is a cut in marginal tax rates. It’s a simple notion: If people can keep a larger portion of each extra dollar they earn, they will work more. The incentive effect holds true for saving and investing, too: Since the after-tax return on a dollar saved will go up when the tax rate goes down, people will save and invest more.

REAGANOMICS.

The political, and some would argue incomplete, version of supply-side economics.

The idea was that cutting marginal tax rates on individuals and business would encourage them to save and invest; this increased saving and investment would, in turn, generate higher incomes, more business and more jobs. Moreover, the super economic growth unleashed by the tax cuts would produce even more tax revenue--enough to reduce the deficit and, eventually, balance the budget.

That was the theory, anyway. The reality depends on who is doing the talking. The tax cuts did generate strong economic growth, but they also generated big budget deficits. Believers in Reaganomics blame those deficits on the monetary policy followed by the Fed, which precipitated a nasty, albeit short, recession. Non-believers blame the deficits on too much tax cutting, along with too much government spending.

Reaganomics at first blush appeared to be unique policy. True, it contradicted the policies followed by the three previous Administrations. Nonetheless, the idea of stimulating the economy through tax cuts was first outlined by Keynes. See KEYNESIANISM.