One damn theory after another (2)

After the shocks of the seventies, Milton Friedman thought he had the answers. He didn’t.

With the election of Margaret Thatcher in 1979 and Ronald Reagan in 1980, a new era was promised. Trust us, they said. We’ll fix it.

But they needed a new economic theory. Milton Friedman, a professor of economics at the University of Chicago, had one ready to go. He called it “monetarism”.

As the name implies, it is a return to the Quantity Theory of Money that was so derided by Keynes. Friedman’s idea was that economies could be run by relying on monetary, rather than fiscal, policy: manipulating interest rates and (particularly) the amount of money in circulation.

Friedman took the old theory and dressed it up in new clothing, suitable for the flashy 1980s. The academic economist Robert Skidelsky (best known as Keynes’s biographer) explained in his later book, Money and Government, how the monetarists provided explanations that, even now, still drive central bank orthodoxies.

“Friedman introduced the idea of a ‘natural’ or ‘equilibrium’ rate of unemployment," Skidelsky wrote, “which he defined as that rate which is consistent with stable prices (economists started talking about the ‘non-accelerating inflation rate of unemployment’, or NAIRU). If the equilibrium rate of unemployment is socially unacceptable, the remedy is not to inflate the money supply, but to undertake structural reforms to reduce ‘market imperfections.

“Friedman would provide theoretical rationale for the ‘supply-side’ policies of Thatcher and Reagan in the 1980s and the ‘structural adjustment’ policies later advocated by the IMF as a condition of loans to needy countries.”

Neoliberalism was born.

The rich get richer. The poor don’t.

Reagan, in his first inaugural on the steps of the Capitol, promised a new and better world. The government had borrowed too much and spent too much. It was time to go back to basics.

“In this present crisis, government is not the solution to our problem; government is the problem. From time to time we've been tempted to believe that society has become too complex to be managed by self-rule, that government by an elite group is superior to government for, by, and of the people …

“It is time to check and reverse the growth of government, which shows signs of having grown beyond the consent of the governed.”

It didn’t happen that way. Reagan thought he could cut spending along with taxes. Tax cuts were easy and popular; spending cuts were difficult and unpopular. The result was typical of Republican administrations: promise to cut the deficit but deliver the exact opposite. In contrast, Bill Clinton – derided by conservatives as a tax-and-spend president – balanced the budget and slowed the inexorable rise of the deficit.

Borrowing to avoid raising taxes comes at a long-term cost. By 1980, interest costs already took 10% of the US federal government’s budget. Under Reagan, that rose to 16% within five years. In Britain, repayments fell only when Thatcher reached the end of her term. Britain and the US were not alone: borrowing was also the preferred option in Europe.

Arthur and his famous curve

In 1974 an economist called Arthur Laffer (like Milton Friedman, from the University of Chicago) had a dinner with the chief-of staff in the Ford White House, Donald Rumsfeld, and his deputy, Dick Cheney. The conversation naturally turned to the high rate of taxes being paid by rich people like them. Laffer took a napkin and drew a diagram of a parabolic curve.

In a tidied-up form, it would eventually drive policy under the Reagan administration:

The amount of revenue being raised, explained Laffer, depended on tax rate, particularly at the top marginal level. There were two points at which there would be no revenue: when the tax rate was zero and when it was at 100%. There was a sweet spot somewhere in the middle, at which revenue would peak.

Laffer and the Republicans thought the rate at the time was on the right-hand side of the curve, and that bringing it down would increase revenue and make top-earning taxpayers better off at the same time. So that was what they did.

But a lot of work has since been done by a lot of economists to work out where that sweet spot really is. The curve has since been redrawn and looks like this:

Reagan Republicans thought the sweet spot for the highest rates of tax was around 30%. More probably, it’s around 70%. Hardly any government anywhere is raising enough tax from rich people.

That wasn’t the only reason why free-market conservatives were attracted to monetarism. It also provided a theoretical case for cutting taxes and government spending. Monetarists said that big-spending governments would be tempted to fund their expenditure by creating money, thus increasing inflation. Monetarism also offered an apparently simple way of controlling the economy with minimal government intervention.

Cutting taxes and increasing borrowing in the 1980s was a fundamental rejection of Keynesian economics. “The boom, not the slump, is the right time for austerity at the Treasury,” Keynes wrote in 1937.

Austerity arrived, but not as Keynes intended.

Paul Volcker’s accidental recession

Jimmy Carter, assailed by a market revolt in 1979 for his initial choice to head the Federal Reserve, instead appointed a card-carrying monetarist as chairman: Paul Volcker. Inflation was rampant, reaching 18% in Britain and 13.5% in the US by 1980.

Volcker was a convert to the newly fashionable theory that “rational expectations” were the key to controlling the economy.

Under his leadership, the Fed restricted the money supply and intervened in the bond market, trying to force banks to increase their interest rates.  He hoped would reduce expectations of inflation and that, therefore, inflation could be tamed without causing increased unemployment or depressed growth – and a recession could certainly be avoided.

So began the worst recession since the 1930s. The theory was wrong.

“Inflationary expectations, as measured by bond rates, remained above monetarist forecasts for much longer than Volcker had expected,” wrote Robert Skidelsky.

Skidelski ... sceptic (and Keynesian)

“In 1982, monetarism American-style was abandoned but Volcker was hailed as the man who had broken the back of American inflation … Ironically, the worst effects of the Volcker recession were offset by the huge budget deficits Ronald Reagan ran to finance his arms build-up against the Soviet Union.”

Killing inflation with punishingly high interest rates took longer than Paul Volcker thought it would. Before the job was done, there was a series of economic shocks: the invasion of Kuwait by Iraq in 1990 and the first Gulf War, sending oil prices skywards; the collapse of a third of America’s savings and loan mortgage lenders; and a slump in construction industries in several countries.

The result was yet another recession. This time, inflation was killed, but – again – at enormous cost. Most economic indicators had returned to normal by 1992 with one exception: unemployment. It became known as the jobless recovery.

Prevailing economic orthodoxy said it couldn’t happen like that. But it did.

NEXT: When banks stopped being banks and took over the world.