A re­turn to Keynes?

The Washington Times Weekly - - Commentary - By Thomas Sow­ell

The nom­i­na­tion of Janet Yellen to be­come head of the Fed­eral Re­serve Sys­tem has set off a flurry of me­dia sto­ries. Since she will be the first woman to oc­cupy that po­si­tion, we can only hope that this will not mean that any crit­i­cism of what she does will be at­trib­uted to sex bias or to a “war on women.”

The Fed­eral Re­serve has be­come such a ma­jor player in the Amer­i­can econ­omy that it needs far more scru­tiny and crit­i­cism than it has re­ceived, re­gard­less of who heads it.

Ms. Yellen, a for­mer pro­fes­sor of eco­nom­ics at Berke­ley, has openly pro­claimed her views on eco­nomic pol­icy, and those views de­serve very care­ful scru­tiny. She asks: “Will cap­i­tal­ist economies op­er­ate at full em­ploy­ment in the ab­sence of rou­tine in­ter­ven­tion?” And she an­swers: “Cer­tainly not.”

Janet Yellen rep­re­sents the Key­ne­sian eco­nom­ics that once dom­i­nated eco­nomic the­ory and pol­icy like a na­tional re­li­gion — un­til it en­coun­tered two things: Mil­ton Fried­man and the stagfla­tion of the 1970s.

At the height of the Key­ne­sian in­flu­ence, it was widely be­lieved that gov­ern­ment pol­icy-mak­ers could choose a ju­di­cious trade-off be­tween the in­fla­tion rate and the rate of un­em­ploy­ment. This trade-off was called the Phillips Curve, in honor of an econ­o­mist at the Lon­don School of Eco­nom­ics.

Pro­fes­sor Mil­ton Fried­man of the Univer­sity of Chicago attacked the Phillips Curve, both the­o­ret­i­cally and empirically. When Pro­fes­sor Fried­man re­ceived the No­bel Prize in eco­nom­ics — the first of many to go to Chicago econ­o­mists, who were the pri­mary crit­ics of Key­ne­sian eco­nom­ics — it seemed as if the idea of a trade-off be­tween the in­fla­tion rate and the un­em­ploy­ment rate might be laid to rest.

The ul­ti­mate dis­cred­it­ing of this Phillips Curve the­ory was the ris­ing in­fla­tion and un­em­ploy­ment, at the same time in the 1970s, in what came to be called “stagfla­tion” — a com­bi­na­tion of ris­ing in­fla­tion and a stag­nant econ­omy with high un­em­ploy­ment.

Nev­er­the­less, the Key­ne­sian econ­o­mists have staged a po­lit­i­cal come­back dur­ing the Obama ad­min­is­tra­tion. Janet Yellen’s nom­i­na­tion to head the Fed­eral Re­serve is the crown­ing ex­am­ple of that come­back.

Ms. Yellen asks: “Do pol­icy-mak­ers have the knowl­edge and abil­ity to im­prove macroe­co­nomic out­comes rather than mak­ing mat­ters worse?” And she an­swers: “Yes.”

The for­mer eco­nom­ics pro­fes­sor is cer­tainly ask­ing the right ques­tions — and giv­ing the wrong an­swers.

Her first ques­tion, whether free mar­ket economies can achieve full em­ploy­ment with­out gov­ern­ment in­ter­ven­tion, is a purely fac­tual ques­tion that can be an­swered from his­tory. For the first 150 years of the United States, there was no pol­icy of fed­eral in­ter­ven­tion when the econ­omy turned down.

No de­pres­sion dur­ing all that time was as cat­a­strophic as the Great De­pres­sion of the 1930s, when both the Fed­eral Re­serve Sys­tem and Pres­i­dents Herbert Hoover and Franklin D. Roo­sevelt in­ter­vened in the econ­omy on a mas­sive and un­prece­dented scale.

De­spite the myth that it was the stock mar­ket crash of 1929 that caused the dou­ble-digit un­em­ploy­ment of the 1930s, un­em­ploy­ment never reached dou­ble dig­its in any of the 12 months that fol­lowed the 1929 stock mar­ket crash.

Un­em­ploy­ment peaked at 9 per­cent in De­cem­ber 1929 and was back down to 6.3 per­cent by June 1930, when the first ma­jor fed­eral in­ter­ven­tion took place un­der Herbert Hoover. The un­em­ploy­ment de­cline then re­versed, ris­ing to hit dou­ble dig­its six months later. As Hoover and then FDR con­tin­ued to in­ter­vene, dou­ble-digit un­em­ploy­ment per­sisted through­out the re­main­der of the 1930s.

Con­versely, when Pres­i­dent War­ren G. Hard­ing faced an an­nual un­em­ploy­ment rate of 11.7 per­cent in 1921, he did ab­so­lutely noth­ing, ex­cept for cut­ting gov­ern­ment spend­ing.

Key­ne­sian econ­o­mists would say that this was ex­actly the wrong thing to do. His­tory, how­ever, says that un­em­ploy­ment the fol­low­ing year went down to 6.7 per­cent — and, in the year af­ter that, 2.4 per­cent.

Un­der Calvin Coolidge, the ul­ti­mate in non-in­ter­ven­tion­ist gov­ern­ment, the an­nual un­em­ploy­ment rate got down to 1.8 per­cent. How does the track record of Key­ne­sian in­ter­ven­tion com­pare to that?

Thomas Sow­ell is a se­nior fel­low at the Hoover In­sti­tu­tion, Stan­ford Univer­sity. His web­site is www.tsow­ell.com.

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