The Obsolescence of Modern Economics - Fred Moseley

The U.S. economy is now going through its most serious crisis since the horrible days of the Great Depression. The “recession” of 1973-75 was the most severe decline in production and employment since the early 1930’s. Economists now refer to this most recent recession as “the Great Recession.” Furthermore, the ‘recovery’ from the Great Recession has been the slowest of the post-war period. As a result, unemployment remains significantly higher than the 4% rate that is usually considered “full employment.” The most optimistic economists forecast that the rate of unemployment will decline 1/2% a year until we finally reach the promised land of four percent in 1983 (just before you-know-what). Most economists are not so optimistic. The majority are counting the months to the next recession (will it begin in late 1978 or early 1979?) which will send the official unemployment rates back up to the 8-9% range and possibly even into double digits.

The situation in Europe is, if anything, worse than in the U.S. Europe already appears to be in the early stages of another recession. Unemployment in Europe increased last year, in contrast to declining rates in the U.S., and is expected to rise still further in 1978. The only question is by how much. A feature article in the New York Times Magazine (4/2/78), entitled “The Trouble with Europe,” reported recently that:

Europeans have a sense of being at the beginning of a downhill slide....There is a pervading sense of crisis....People are disillusioned and preoccupied. The notion of progress, once so stirring, now rings hollow.

One aspect of the current high levels of unemployment that is particularly disturbing to political leaders is that this unemployment is highly concentrated among young people. Roughly half of the people counted as unemployed in the major capitalist nations are under 25. This percentage is up from 30% in the 1950’s, and is expected to increase still further. The rate of unemployment for those under 25 is in the 15-20% range, over twice as high as the overall average.

The problem of unemployment among young people was the main topic of conversation at the economic summit meeting last May (1977) in London. This meeting of the leaders of the seven largest capitalist nations took place soon after the riots of unemployed young people in several major cities in Italy in March of last year. These events were a highly visible reminder of the “explosive” nature of the current situation. President Valery Giscard d’Estaing of France called upon his fellow leaders to “beat back the ideological challenge of pervasive and persistent Unemployment.”

The New York Times (5/9/77) described the concern of the leaders as follows:

The lack of jobs and the frustrations of recession have alerted these politicians to the menace a loss of prosperity would be to existing political systems. That is why they put such special emphasis on the unemployment of youth, which they feel threatens to create a whole new generation tending toward restless discontent and perhaps ultimately toward angry irresponsibility.

What is to be done to recover the optimism, the momentum, the lost sense of security of a period in which people were able to take their improving wellbeing for granted?

Another feature of the current economic crisis, and one which distinguishes this crisis from previous periods of prolonged high unemployment is that prices are rising at the same time. The rate of price increases in the U.S. has slowed somewhat from the double-digit days of 1973-74, but has remained "stuck" at around 6%. Moreover, most economists are forecasting that inflation has already “bottomed out” at this historically high level and is likely to accelerate in the coming year, Jimmy Carter's pleas for “voluntary restraint” notwithstanding. The price index reports for the first three months of 1978 indicate that another round of accelerating inflation is indeed on the way. Business Week (5/78) began a recent “Special Report” on inflation with the warning:

Anyone who is not at least mildly panicked about the inflation outlook for the U.S. does not recognize the seriousness of the situation.

* * * * *

This kind of serious economic crisis was not supposed to happen anymore. Throughout the more prosperous days of the 50’s and 60’s, economists claimed that they had made a great discovery which had solved the problem of economic crises. Economists proclaimed to all who would listen (including a generation of undergraduates who had no choice) that “the business cycle has been rendered obsolete.” Great depressions, they assured us, were a thing of the past. The discovery of modern economics meant that we need never--indeed shall never--incur the widespread suffering occasioned by periods of depression. Increasingly, economists talked not only about obliterating depressions, but also about “fine-tuning” economic activity to ensure a perpetual state of full employment.

The alleged discovery of modern economics was the use of government economic policies to eliminate whatever unemployment might occur. Whenever unemployment threatened, the economists suggested, the federal government should simply spend more money--or reduce taxes so that consumers would have more money to spend. At the same time, the Federal Reserve Board should print more money to pay for the budget deficits resulting from the expansionary fiscal policy. In effect, the discovery of modern economics was to print more money and spend it, in one way or another.

Economists argued that the skillful use of these fiscal and monetary policies would maintain a high and steady level of demand, which would eliminate the periods of depression that had in the past threatened the existence of capitalist economies. The ability of the government to regulate and control economic activity had ushered in a new era of permanent prosperity, the economists promised, which would make capitalism secure, once and for all.

Paul Samuelson, dean of economists in the U.S., likened the discovery of modern economics to the life-saving discoveries of modern medicine. Just as modern medicine had discovered the cure for smallpox and polio, Samuelson suggested, modern economics had discovered the cure for the economic disease of depression.

Unfortunately, there was one undesirable side-effect of this fiscal and monetary medicine which soon became apparent: if the medicine were applied in sufficient doses to bring the economy close to full employment, inflation would usually accelerate as unemployment declined. Charles Schultze, Carter’s chief economist, has expressed the problem as follows:

[i]The problem is that every time we push the rate of unemployment toward acceptably low levels, by whatever means, we set off a new inflation. (NYT, 7/18/76)

The explanation of this inflationary side-effect of modern economics, in brief, goes something like this: when the government tries to “push” the economy toward full employment by spending more money and thereby increasing the demand for the products of capitalist enterprises, the businessmen who run these enterprises respond, at least in part, by raising their prices rather than by expanding their output. This perfectly obvious and reasonable response by businessmen surprises and perplexes economists to this day. In the academic world of the economists, prices rise only when demand exceeds the capacity of the economy to produce; in other words, prices rise only in a situation of full employment and the full use of productive capacity. On the basis of this assumption, economists conclude that in a situation of high unemployment and substantial idle productive capacity, businessmen will respond to the government stimulus of demand by expanding output and employment, rather than by raising prices.

The businessmen, of course, refuse to play the game by these textbook rules. They experience the government stimulus of demand as an increase in their sales. This increase in sales provides the businessmen with an opportunity to increase their profits by simply raising their prices, without the additional expense and risk required to expand output. It would be bad business to pass up such an opportunity. Thus, businessmen typically respond to the increase in their sales by some combination of increased output and higher prices, depending on the particular circumstances.

In the 50's and 60's (which the Wall Street Journal described recently as “the good old days when problems had solutions”) nobody worried much about this inflationary side-effect of modern economics. The average rate of inflation during those years was less than 2%. In these favorable circumstances, economists and politicians were sometimes willing to “trade” a slightly higher rate of inflation for a reduction in unemployment. Economists called this policy option the “trade-off” between unemployment and inflation, and argued endlessly about the precise terms of the “trade-off” that were acceptable in a “democratic society.”

However, in the 1970’s, the rate at which busineenen are raising their prices has increased dramatically from the more tranquil days of the 50’s and 60’s. The rate of inflation in the U.S. since 1973 has averaged 8% a year. All nations have had double-digit rates of inflation for at least part of the 1970’s; some nations for most of the decade.

Very briefly, the main reason for this sharp increase in the rate of inflation is that the rate of profit has declined significantly since the mid-1960’s. The many different measures used to estimate the rate of profit all show a remarkably similar decline after 1965 (more on the reasons for this in future issues). Businessmen everywhere are well aware of and much concerned about this decline in the rate of profit. They are diligently searching for ways to increase the rate of profit back up to what they consider an “adequate return” on their invested capital. One obvious way to increase the rate of profit is to raise prices whenever the opportunity arises--and the government stimulus of demand provides just such an opportunity.

One leading investment banker summed up the current inflationary situation as follows:

The industrial order of the day is this: whenever you can, raise the price. Businessmen are now rushing to raise their prices because they think they can get away with it and because they see a chance to raise their profits. And with unemployment still high, they expect wages to lag a bit behind.

In these less than favorable circumstances, economists and politicians are reluctant to apply the medicine of modern economics to the disease of unemployment. The inflationary side-effect of this medicine makes it no longer acceptable at a time when inflation is already a serious problem in itself. This explains why most governments have not adopted strong expansionary policies in recent years, in spite of the highest rates of unemployment since the Great Depression. They are too worried that such policies would set off a new round of accelerating inflation which would take off from an already high level. They fear further that such an inflationary spiral, like the last one in 1973-74, would eventually topple the economy back into recession, thus making unemployment worse rather than better “in the long run” (which means next year or the year after). This fear has been expressed most strongly by Alan Greenspan, chief economic adviser to former President Ford, and has come to be known as the Greenspan Thesis.

Thus, history has dealt the economists a cruel and ironic blow. Economists thought that modern economics had rendered the business cycle obsolete. Instead, the new form of the business cycle, in which high unemployment coexists with high inflation, has rendered modern economics obsolete. (1)

* * * * *

The obsolescence of modern economics has been widely discussed in the business press in recent years. The following excerpts are a small sample from this discussion.

In March, 1976, Business Week ran a feature article under the heading: “Conventional Fiscal Policies Don't Work.” The article began as follows:

Despite encouraging news about the strength of the U.S. economic recovery; one critical problem stubbornly persists. Even with recovery, unemployment will stick at a very high level: at least 5% through 1980. In Europe, economists and politicians anticipate that unemployment will not drop back to the rates of the early 1970’s again in this decade. In the western world, something has changed radically in political economics. Economists and politicians now agree that the traditional modes of stimulating economies by government spending or increasing the money supply will not end high unemployment. There conventional policies will only create additional inflation in economies that have suffered too much inflation for years.

The fear is that high unemployment rates will trigger severe political upheavals….

More recently, Business Week complained about the “soporific atmosphere” of the latest meeting of the American Economic Association and criticized the economists for their failure to come up with any new remedies for the business cycle:

[i]The sessions of the ABA boringly demonstrated to anyone who could flog himself into listening that the economics profession faces intellectual bankruptcy. There were simply no important new ideas for proceeding with the nation's most pressing economic task: pushing inflation down and employment up at the same time. [i]

The New York Times is also upset about what it has called the “bankruptcy of modern economic theory.” In a recent editorial (9/24/77) entitled “Paralyzed Economists, Stagnant Economy,” the Times lamented:

A decade ago if unemployment were frozen at a high rate and the economy appeared headed for a slowdown, a Democratic President surely would have called for major economic stimulus - a tax cut, a spending increase, or both. But not now. Despite the unsatisfactory performance of the economy, policy is paralyzed here and elsewhere in the industrialized world because economists fear that faster growth would generate more inflation and, ultimately, sink us into another recession. We are left with uncommon inflation, high unemployment, and fearful economists.

Perhaps the clearest expression of the obsolescence of modern economics comes from the politicians. Chancellor Helmut Schmidt of West Germany has confided to friends (according to the New York Times) that “he feels an utter loss in the face of a situation for which economists no longer have solutions. Nobody, he complained, even thinks he knows what to do.”

Prime Minister James Callaghan of England had publicly acknowledged the failure of fiscal policies. In a speech to the British Labor Party conference in September 1976, Mr. Callaghan spoke frankly:

We used to think you could just spend your way out of a recession and increase employment by cutting taxes and raising government spending. I tell you, in all candor, that the option no longer exists. It only worked in the past by injecting bigger doses of inflation into the economy, followed by higher levels of unemployment as the next step....The cozy world, which we were told would last forever, where full employment could be guaranteed by a stroke of the Chancellor's pen, is gone.

The New York Times reprinted excerpts from this speech with the title: “Mr. Callaghan Talks Business.”

* * * * *

Recognition of the obsolescence of modern economics reveals the emptiness of the promises contained in the Humphrey-Hawkins Full Employment Bill, which passed the House last fall and which will soon be taken up by the Senate. This bill requires the President to prepare programs designed to reduce unemployment to 4% by 1983 and keep it there. But the bill itself legislates no specific programs, the task of devising new strategies that will reduce unemployment without making inflation worse is left to the President and to future legislation. Furthermore, the bill allows the President to recommend delays in the timetable for reaching full employment “as circumstances dictate.”

As this bill was being considered in the House last fall, the New York Times ran an editorial entitled “The Hollow Promise of Humphrey-Hawkins.” In this editorial, the Times remarked that this bill is a “mandate without a method” and that “the problem is not a lack of will to reduce unemployment: the problem is that the government simply does not know the way to reach the goal.”

A.H. Raskin, veteran commentator on “labor affairs” for the Times had this to say about the Humphrey-Hawkins Bill:

This bill arrives at a time when there is scant public belief in the government's ability to deal effectively with any major economic problem. This skepticism is strengthened by the meager accomplishments of past attempts to reduce uneaployulent.

More recently, the Times used even stronger language. This time, the title of the editorial was: “The Cruel Hoax of Humphrey-Hawkins”--perhaps inspired by ex-President Ford’s remark that the promise of a quick return to full employment was a “cruel illusion.” The editorial argued that this bill

[i]would legislate wishful thinking.... The bill would not create one new job; it would merely legislate a good intention…. The riddle no one can answer is how to use government economic policies to drive unemployment down in the promised land of 4 percent without triggering a worse inflation, and, perhaps, an accompanying recession.

The Humphrey-Hawkins Bill does not resolve that issue. It ducks it by proclaiming a promise that no one knows how to keep: let the goal be set and then someone will somehow figure out how to meet it. If not, the goal can always be changed.

The bill would play a cruel hoax on the hardcore unemployed, holding before them the promise--but not the reality--of a job.

* * * * *

Hollow promises were also the main events at the London summit meeting last May. The seven leaders acknowledged the unprecedented numbers of people unemployed in the advanced capitalist countries and pledged to create jobs for them. And yet no one there suggested any new policies as a means of accomplishing this task.

Prime Minister Callaghan sounded a familiar theme when he pointed out that “nobody quite knows any more why the economic ills of our countries no longer respond to the same old medication, nor how to prescribe correctly for simultaneous ailments that used to be opposites”

The New York Times, as you remember, asked in an article about this summit meeting:

What is to be done to recover the optimism, the momentum, the lost sense of security of a period in which people were able to take their improving wellbeing for granted?

The Times answered :

Nobody has been able to devise a simple overall formula. So the leaders have taken to grouping, experimenting with one measure at a time, hoping that a new system of stability will eventually evolve.... There are no guarantees that the effort will work….

The leaders are fighting a losing battle. In my opinion, we are in the initial stages of yet another worldwide capitalist depression, which no amount of government tinkering will be able to avoid. It is still too early to say much about the length and severity of this depression, but there is no reason to believe that it will be any less severe than the last one. It could be worse. (More on this in coming issues.)

Like all capitalist depressions, this depression will eventually be characterized by widespread bankruptcy of business firms and drastic reductions in the living standards of most of us. While economists and politicians “grope” for ways to avoid this outcome without disturbing the ownership and control Of the world’s productive resources by a small percentage of the population, the rest of us will probably have to devise more drastic solutions of our own.

F.M.
[Fred Moseley]

(1) For anyone interested in a more thorough analysis of all this, the best starting point is the writings of Paul Mattick, especially Marx and Keynes: The Limits of the Mixed Economy (available through Root & Branch). Long before the “limits of the mixed economy” became so painfully obvious, Mattick argued that those limits would sooner or later be reached, after which capitalism would fall once more into a period of depression. Well, here we are.