No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Seventeen: A Short History of Macroeconomics 437 MACROECONOMICS TODAY Keynesian macroeconomists revamped their toolkit after the experience of the 1970s, highlighting the supply side as a potential source of instability that demand management needed to consider. In their view, the oil shocks of the 1970s led to the stagflationary result, and consideration of supply shocks would improve demand management. Further, a new branch of Keynesians, called New Keynesians, tried to bridge the micro- macro economic divide by providing micro-foundations that could lead to macro results. These New Keynesians stressed what they called nominal rigidities that could prevent normal microeconomic adjustments from leading to equilibrium. Nominal rigidities simply mean that nominal (or money) values of economic variables, such as the price of labor, might be “sticky,” and in the face of some external shock might lead to large employment losses for extended periods. Nominal rigidities helped explain why wages and prices might not adjust quickly—an example might be longer term labor contracts that would not quickly adjust until the next contract negotiation. If the labor contract prevented a wage (price) adjustment, the only response would be in the quantity of labor. We could have an equilibrium at lower than full employment, and government fiscal or monetary policy could be used to stimulate the economy. Almost all schools of thought failed to predict the “Great Recession of 2007/08,” and the controversies over disproportionality and general glut remain. Keynesian economists blamed the financial crisis on excessive Wall Street exuberance leading to too much speculation and suggested government stimulus could correct. Most governments around the world provided both fiscal and monetary stimulus post the crisis, yet the recovery was much less robust than previous recoveries. Usually a severe economic contraction will lead to a much sharper recovery, and a shallow recession will lead to a modest recovery. The Keynesian response to the slowness of the recovery? We should have had even a higher level of stimulus. Other economists point to the housing bubble as a source of the problem, with government support of the housing industry and easy monetary policies leading to POLITICAL ECONOMY In modern U.S. politics, the Democratic Party has historically focused more on demand side considerations, whereas the Republican Party generally has a supply side focus. In practice, this often leads to public policies that stimulate parts of both the demand and supply side, and sometimes a policy can be seen as affecting both. For example, the Kennedy tax cuts in 1964 were argued by Keynesians as increasing the take home pay of workers and enabling them to consume more, while supply siders would argue that lower tax rates increased the reward to work and would lead to more work effort. Nevertheless, just as there is no atheist in a foxhole, politicians are usually Keynesians when the economy is slack—in politics there is immense pressure to “do something.” Demand side actions are relatively quick in comparison to supply side policies, hence politicians who frequently face voters generally favor demand side policies. Richard Nixon was quoted as saying, “we’re all Keynesians now,” and George W. Bush implemented Keynesian tax cuts and public spending in response to the financial crisis of 2007-08. Nominal rigidities: nominal (or money) values of economic variables, such as the price of labor, might be “sticky,” and in the face of some external shock might lead to large employment losses for extended periods