The Limits of Monetary Policy
Lindsey, Lawrence B., The Public Interest
TWENTY-ONE YEARS AGO this fall I sat in my first economics class and listened to the conventional wisdom of the time, as set forth by the eigth edition of Paul Samuelson's classic introductory text Economics. Today tha book retains a valued place on the shelf of my office, in part a reminder of what is enduring in economic thought, but also a testament to the ability of the economic mainstream, if not individual economists, to change long-cherished beliefs.
In retrospect, my introduction to economics came at the high point of an entire paradigm of economic thought, one which promised an increasingly activist role for government policy. John F. Kennedy's "New Economics, " of which Samuelson and his text were a part, had proved a tremendous success. Richard Nixon had just established a bipartisan recognition of this, declaring that "We are all Keynesians now," and was using Samuelson's lessons to engineer an economy highly favorable to his reelection.
For the economics profession, the 1960s and early 1970s was an era of can-do problem solving, with virtually unlimited prospects. Economics, the "Queen of the Social Sciences," drawing from history and the social sciences as well as mathematics and statistics, was about to add an immensely powerful tool to its arsenal: the computer. Samuelson urged his students to become like medical doctors, "to cultivate an objective and detached ability to see things as they are." Ultimately, wrote Samuelson, "understanding should aid in control and improvement." No more enticing set of words could have been chosen. Like so many of my compatriots, I was an idealist seeking to change the world. I was hooked by the end of chapter one.
Sadly, the experiences of the last two decades suggest taht Samuelson's words had more to do with the hubris of the G.I. generation than with the real world his yound readers would face as decisonmakers. Today, "seeing things as they are" means recognizing the limits of the economic policy tools at our disposal, not relishing their potential for control and improvement.
Today, monetary policy is being asked to carry an increasing responsibility for assuring our nation's economic performance. In many ways, the themes of the New Economics of the 1960s and early 1970s are popular again today--activism is in vogue. My mission in these pages is to flash a yellow light of caution about a return to monetary policy of the kind envisioned twenty years ago, while highlighting those aspects of successful economic policy for which a properly conducted monetary policy is indispensable. I will begin with three lessons of the past twenty years, which have dramatically changed the mainstream view of inflation and monetary policy.
Lessons of the last two decades
Lesson 1: Excess money, not excess demand, causes sustained inflation. Twenty years ago, the economic mainstream focused on demand as the key determinant of the economy. Demand could take a number of forms: consumption demand by households, investment demand by firms, and government spending. Inflation occurred in this stylized world if the sum of these types of demand--consumption, investment, and government--exceeded the capacity of the economy to produce. Money played only an indirect role in boosting demand. Indeed, my edition of the Samuelson text introduces the concept of inflation before introducing the concept of money!
What proved his view wrong was the emergence in the 1970s of "stagflation"--inflation during periods of high unemployment and economic stagnation. Excess demand could not have caused the inflation, since it was occurring during a period of weak demand. During such periods, prices were supposed to fall, not rise. Because they didn't, the role of money began to take on renewed importance in economic analysis.
A retrospective look at the 1970s and 1980s that it is changes in monetary policy which lead to price level changes. …