SSRIC Teaching Resources Depository
James Gerber, San Diego State University

Macroeconomics Chapter 2: Schools of Thought

© The Author, 1998; Last Modified 14 August 1998
As disciplines go, macroeconomics is fairly young. The primary concepts for measuring the macroeconomy, the national income and product accounts, were not developed until the 1930s and 1940s. During America's greatest macroeconomic crisis of the 20th century (the Great Depression of the 1930s), presidential advisers and economists were more or less at a loss to explain what was happening and what, if anything, federal policy could do to end it. Roosevelt surrounded himself with some of the brightest people available, but no one had the tools or concepts to provide a consistent analysis of the problems.

Of course we like to think that "It could not happen again," and "We know too much to let it happen," but this is probably magical thinking. It could happen again, and when it does, we won't see it coming. But, we have learned some things in the last 70 years, and macroeconomics is not quite as helpless as it was when it was first born. It is highly probable that we could avoid, or end less painfully, a 1930s style depression. It's the 21st century style depression that should worry us, because that is the one we have no experience with and no sense of what it will look like.

Sometimes economists define microeconomics as the study of how the economy holds together, and macroeconomics as the study of how it falls apart. There is no doubt that it can fall apart in many ways, and when it does, there is still significant variation in opinion among professional economists as to what should be done and what can be done. The range of opinion varies across a spectrum which is, in some ways, more political than economic, from doing nothing to actively intervening with increased spending, tax cuts, and monetary expansion. One camp, the do nothing (or, at least very little) group, believes that the economy will usually fix itself and any attempt to speed up the process is as likely to make things worse as it is to make them better. This camp has a lot of faith in the inherent stability of a capitalist economy such as ours. They were the people advising George Bush during last economic recession in 1990 and 1991. In 1992, Bush lost to Clinton.

In part, Bush lost because candidate Clinton managed to convey the message to the American people that he could "feel our pain." So, we expected him to do more than wait for the economy to get better on its own. Economists and political scientists find this somewhat ironic given our general dislike of big government. However, when it comes to economic bad times, we clearly have very little tolerance for doing nothing, even though that may be the best policy in some cases. For example, in the last recession (1990-91), by the time the election rolled around in the fall of 1992, the economy was clearly on the mend, and by the time Clinton took office, it was set to begin a good recovery. All, more or less, on its own.

At the same time that economists were grappling with the development of the concepts they needed to categorize activities in a national economy, another group of thinkers in the 1930s was trying to understand how economic policy might help to end the deep depression. The leading figure in this effort is probably the most important economic thinker of the 20th century, John Maynard Keynes. (The name Keynes is pronounced so that it rhymes with rains. If you say "Keenes," everyone will doubt anything you say after that.)

Keynes' life is well worth reading about, and is a good way to absorb macroeconomics. There are several good biographies, including the relatively recent work by Skidelsky (1996). Keynes' theory of recession was shaped by the experience of the 1930s--bank failures, stock market crashes, protectionist trade policies, and several other factors created widespread uncertainty and a loss of income. Uncertainty and unemployment caused people to favor saving over consuming, and holding more money over buying goods. The decline in spending by households was felt throughout the economy; businesses responded with cutbacks in production. This, of course, only made things worse because it led to more layoffs, higher unemployment and another decline in income.

While Keynes' analysis was aimed at explaining the 1930s, it was widely accepted after World War II as a general explanation for economic fluctuations and recessions. One of the key elements of this explanation is that disturbances in the macroeconomy originate in a change in the aggregate demand for goods and services. That is, the sum total (aggregate) of household, business, foreign, and government purchases falls off. It is not necessary that each component falls, only that one or more falls enough to send a signal to businesses to produce less.

The Keynesian model is often described as a "demand side" model because demand is in the driver's seat in terms of the level of economic activity. Supply, or the output of businesses, responds passively to changes in demand. When demand is booming, businesses hire more workers, and increase production. When demand drops off, they fire or lay off people and cut back on output. Demand can rise or drop suddenly due to unexpected events that change the way in which households and businesses view the future. Supply, on the other hand, is a function of the capacity of an economy and is determined by the availability of labor, machines, natural resources, and technology, none of which changes overnight.

The key element in the Keynesian cure for recessions was to raise demand. If consumers were afraid to spend, and businesses saw no reason to expand (invest), then it was up to governments to raise the level of spending in the economy. Prior to Keynes, governments saw this as a worthless policy since they were convinced that each and every dollar they spent would reduce by a dollar the spending of households and businesses. One of Keynes' great contribution was to show why this was not necessarily true and to demonstrate that increases in government spending could act as a stimulus to the rest of the economy in times of recession.

One last important element of Keynesian economics was added after Keynes. This was the Phillips curve, named after the economist that first verified a stable relationship between inflation and unemployment. The Phillips curve showed that over long periods of time, increases in unemployment were associated with predictable decreases in the rate of inflation (Figure 3).

Figure 3

The Phillips curve gave policy makers a (mistaken) belief that they could choose from a list of pairs of inflation and unemployment rates. This went hand in glove with Keynesian ideas about demand management, in which it was assumed that government could stimulate the economy when there was a recession, and slow it down if it became overheated. As these ideas came to dominate economic thinking in the United States, President Kennedy assembled an economic team of leading Keynesian thinkers who proposed a package of tax cuts to stimulate private spending. The tax cuts were stalled in Congress but later passed after Kennedy's assassination.

Although President Nixon proclaimed that "We are all Keynesians now," not every economist was in agreement. In particular, Milton Friedman carried on a crusade against using government policy to "fine tune" the economy. Friedman was not alone in his criticisms, but he was one of the most outspoken and vocal opponents of Keynesian ideas.

Friedman based his objections to Keynesian ideas on three main points. First, he argued that the ability of economists to predict the overall effects of tax cuts or spending increases was not very good. Therefore, if governments could not say exactly how households and businesses would respond to a change in government spending, or a change in taxes, then it was impossible to predict the effects a policy might have on GDP and unemployment. In Friedman's view, this problem was compounded by the fact that there were long lags between the time we recognized a problem in the economy, and the time Congress and the Whitehouse could agree on a course of action. In effect, this means that by the time government did something, the need might be gone and government action might actually make things worse rather than better.

Second, Friedman objected to the bias in Keynesian policy that seemed to increase the role of government. Government expenditure programs to increase demand in the economy inevitably resulted in a larger government, and this went against Friedman's free market ideology. And third, Friedman argued that the Phillips curve was unstable, and that it would breakdown once we experienced a prolonged period of low unemployment.

Friedman's last point was soon put to the test. The Keynesian tax cuts of 1964 helped to keep the economy growing at a rapid rate, and unemployment stayed low. Meanwhile, as predicted by the Phillips curve, the inflation rate began to creep up during the late 1960s and early 1970s. Policymakers began to worry about rising inflation, particularly during the administration's of Presidents Nixon (1969-1974) and Ford (1974-1976).

Meanwhile, the US economy was hit by several events that caused inflation to rise independently of the rate of unemployment. Bad harvests in the early 1970s raised the price of food, while the first oil crisis in 1973 caused the price of oil and gas to skyrocket. By the mid-1970s, the US had entered a period of higher than usual inflation, in which price increases seemed to go on independently of unemployment rates. Friedman's prediction that the Phillips curve would breakdown was born out.

Friedman had argued that the Phillips curve appeared stable because people did not expect inflation. That changed after several years of very low unemployment, coupled with the oil price hikes and the food price hikes. Businesses and households began to expect inflation. Businesses tried to anticipate rising costs due to the inflation, so they responded by raising the prices of their output. And households responded to the way in which inflation eroded the purchasing power of their incomes with demands for higher wages. Higher wages meant higher business costs, which meant higher prices, which meant another round of demands for higher wages, and so on. If an unemployment rate of 4% under the old Phillips curve was associated with 2% inflation, it now translated into a 4% inflation rate. And next year or the year after, it might translate into a 6 or 8% inflation rate. Clearly, the Phillips curve no longer applied, at least in its original form.

The 1970s introduced the term stagflation into the thinking of economists. The term is a combination of two concepts: stagnation, meaning recession, and inflation. Stagflation is economic hell--high rates of unemployment due to recession, coupled with high inflation. According to the Phillip's curve, that could not happen, but clearly it did. The appearance of something that theory said was impossible resulted in the collapse of the Keynesian consensus. The idea that a wise and careful government could fine tune the level of production through its use of government spending and tax policy was challenged, debated, and ultimately rejected.

The appearance of stagflation threw academic macroeconomics into disarray. The Keynesian model seemed hopelessly flawed, but what could take its place? Should governments try to counteract the naturally occurring highs and lows of a capitalist economy? Or, should they keep their hands off, and let the economy take care of itself? If the collapse of the Phillips curve was partially a result of businesses and households changing their expectations about inflation, then how did government policy interact with the formation of new expectations?

Furthermore, the stagnation part of stagflation began to be a serious problem. the economy experienced a deep recession in 1974-75, and a weak recovery. By the late 1970s it began to be apparent that the long run rate of growth of the economy had slowed. This raised a number of additional questions. For example, how did government policies change the incentives for businesses to invest and expand? Were industry specific regulations hurting economic growth by preventing innovation? Did tax policy hinder entrepreneurs?

The breakdown of the Keynesian consensus provided an opening for a more conservative, and laissez faire style of macroeconomics. In some respects, this was a return to pre-Keynesian ideas. Many economists took on the name of neoclassical, after the classical economists of the 19th and early 20th centuries. (The prefix neo- means new, so neoclassical can be translated as new classical.) Classical economists saw no role for government in the management of the macroeconomy. Government intervention was viewed as ineffective, in part because of the natural self-equilibrating mechanisms in the economy. An economy in recession, for example, will put downward pressure on wages since unemployment will be high. Workers will have to take pay cuts in order to find jobs or to keep the ones they have. The reduction in business costs will, in effect, stimulate production and lead to a recovery. According to neoclassical economists, governments that try to speed up this process are as likely to make things worse as they are to make them better. As you might imagine, President Bush's economic advisers were giving him this kind of advice during the last recession (1990-91).

At the same time, Keynesians have regrouped, older and wiser now, under the banner of neo-Keynesian economics. They share many of the ideas of neoclassical economics, and in the spectrum of opinion where the two meet, many macroeconomists have one foot in each camp. The chief distinguishing characteristic, however, is the idea that a macroeconomy can be delayed in its natural tendency to come out of a recession. Consequently, some Neo-Keynesians see more room for government to help the economy along. The role for government depends on circumstances, however. Some recessions may end on their own fairly quickly, while others can be prolonged and unnecessarily painful without government policy to assist. If President Bush's advisers tended towards the neoclassical spectrum, President Clinton's are neo-Keynesian.

This debate probably seems odd in some respects. Why don't economists simply gather some data and test the hypothesis that economies in recession will return to normal in a reasonable period of time? It seems straightforward, and if we had laboratories in which we could control every factor, economists would do that. The problem, of course, is that economic systems are too complex, and too subject to uncontrollable and unforeseen events. Consequently, the data don't speak clearly. Both viewpoints find justification and, given the entrenched political ideologies (activist government versus laissez faire government), both sets of ideas have audiences inside and outside the economics profession.

One last school of thought must be mentioned because of the prominence they attained in political circles. This is the supply side ideology. Supply side economics is somewhat of a misnomer since there are no economists in any leading university that take the supply side label. Supply side economics was a purely political movement which played off the conservative reaction to Keynesian economics. That is, a group of journalists and politicians took the arguments of conservative, neoclassical economists and exaggerated them to the point where they became extremist and far outside the mainstream of academic economics. While these ideas still garner support in some political circles, they have no economic value and are ignored by mainstream economists. We will return to this issue in Chapter 4.

On Keynes, see

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