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Economic Policy

When in office Mrs Thatcher repeatedly stated that in her view inflation was

the most important target for macroeconomic policy. How do you react to this


Well, that’s substituting a subordinate target for a real target. To the extent

that inflation is damaging to real standards of living now or in the future, then

inflation is something to worry about. But you could easily make greater

sacrifices of real output and real consumption in the name of inflation than

the benefits of reducing inflation are worth.

Structural budget deficits have been a feature of the US economy in the 1980s

and indeed at the moment there is a lot of talk of the problem of growing

budget deficits. Are budget deficits damaging? Do you think that the structural

budget deficit of the US economy is a real problem, and what should be

done about it?

Well, again you have to keep your eye on the ball and not confuse ends and

means. When you think about the objectives to which fiscal policy may be

relevant, it is the growth of our capacity to provide higher standards of living

to people in the future. For the USA we are talking about a deficit that is in

dollars, a debt that is in the currency that we print. It’s not a debt in sterling,

in yen, or anything else. It’s largely an internally held debt and when you

think about international wealth balance sheets it’s not important whether

foreigners hold our federal public debt, or hold other assets. There is a

burden, however, in that the public debt diverts some private wealth that

could be placed in privately owned productive capital to holding government

paper that was generated to finance private or collective consumption. In that

sense deficits which increase the debt have been using savings that could

have been used for productive investments in capital that would have raised

real wages that our grandchildren would earn. But that doesn’t mean we need

a deficit reduction this year, when the economy is in a slump. Today GDP is

not supply-constrained; the amount of investment in the economy is not

constrained by the supply of saving. In fact deficit reduction in a weak

economy would be counterproductive, reduce GDP, reduce investment. We

would be doing not as well for our children and their children as we would if

we did some spending on public investment or cut taxes in ways that stimulate

private investment. All this is terribly mixed up in the political discussion

about deficits. I have been one of the principal opponents of the kind of fiscal

policy that the Reagan and Bush Administrations ran for 12 years. And at the

same time, to rush into a blind policy of deficit reduction that begins too

soon, before we are out of the slump – I wouldn’t do that either. It all gets

back to trying to suit the medicine to the circumstances of the patient.

Are you still an advocate of incomes policies? Some Keynesians like Alan

Blinder have little enthusiasm for such policies, whereas you seem to think

that incomes policy has a role to play in addition to demand management.

Well I thought incomes policy did have a role in the 1970s, and especially in

the disinflation that was going to take place beginning in 1979. I think we

could have done that disinflation with less loss in output and employment if

we’d used some kind of incomes policy then. Right now, I’m not very excited

about incomes policy. One thing that has come out well in the 1980s, partly a

matter of good fortune, is that we haven’t had any more oil shocks. Wage

pressures are also very moderate. In 1979/80 there were very few economists

who would have said it was possible to get unemployment down to almost 5

per cent in 1988 and have virtually no inflationary consequences. I wouldn’t

have said that ten years earlier – yet it happened. We don’t have an inflation

problem right now. If it comes back, then incomes policy may be a possible

thing to do, but I wouldn’t muddy the waters and get excited about it right


Why has Keynesian economics experienced something of a restoration in the

last decade?

Well, it’s because you have had Keynesian problems for the last five years.

Keynesian economics got a bum rap in the 1970s. I see it all the time. People

say ‘Why do you want to go back to the failed policies of the 1970s and the

late 1960s?’ Keynesian policies were thought to be responsible for inflation

and stagflation – people never mention, or erase from the memory, the oil

shocks and the Vietnam War. Now we are back to a more normal environment

and the new classical ideas are not so appealing to a new generation of

economists, who have grown up subsequent to the high tides of the counterrevolutions.

If you were advising Clinton about the economic strategy to be pursued over

the next four years, what are the important things you think he should do?

Well, that’s a tricky thing for reasons we already discussed. The problem he

has right now is to pep up the economy and the recovery. The economy is

doing a little better than it was six months ago, but it is still not doing great.

At the same time there is all this pressure to do something about the federal

deficit. He is trying to do both. Since one really requires more deficit while

the other requires less deficit, it’s rather difficult. I’m afraid the stimulus he is

going to give is not very big, and it’s not going to last long enough. There is

going to be a deficit-increasing phase of his programme this year and maybe

next year [1994] his budget is going to be deficit-neutral. Thereafter tax

increases and cuts in entitlements and other outlays are going to be phased in,

so eventually for the fiscal year 1997 he will be able to say that he will have

done what he said. He is asking for both these things at once. It’s sort of like

saying we’re going to have to perform some surgery on this patient but right

now the patient is a little weak, so we’ll have to build the patient up first.

There are two difficulties. One is that the dual approach is a rather subtle

point to explain – why we do one thing now when we are going to do the

opposite later. In fact, he hasn’t even explained it yet.

Maybe he doesn’t understand it.

Oh he does, this is a smart guy. This is as smart a politician as I have ever met

– he understands it.

Additional Questions Answered by Correspondence January/February


In your 1995 paper ‘The Natural Rate as New Classical Economics’ you

suggested that Friedman’s [1968a] paper ‘The Role of Monetary Policy’ is

‘very likely the most influential paper ever published in an economics journal’.

In what important ways did that paper change macroeconomics and do

you regard the natural rate hypothesis as part of the ‘core’ of mainstream


Perhaps that was hyperbole, but the article was certainly very influential in

the profession and, in its implications for policy all over the world, far

beyond. If, as I argued in my 1995 paper, the article was a giant step towards

new classical macro and real business cycle theory, then the initial impact of

the Friedman paper was greatly multiplied. If those doctrines are now the

core of mainstream macroeconomics, then the natural rate idea is likewise.

While this may be true of academic macro theory, I think it is not true of

practical macro as used in government policy and business practice. There

the NAIRU is the preferred concept, and as I have argued in the 1995 paper

and elsewhere it is not the same as the natural rate. Both concepts have

suffered from the empirical surprises of the last few years, when previous

estimates of the NAIRU turned out to be wrong. Moreover, the idea that there

is a vertical Phillips curve in the long run has lost ground relative to my own

idea that a trade-off persists at low rates of inflation, a proposition recently

supported by Akerlof, Dickens and Perry [1996] in Brookings Papers.

The US economy currently [January 1998] has an unemployment rate of 4.7

per cent and an inflation rate of just over 2 per cent. Given that most

estimates of the natural rate of unemployment for the US economy are around

6 per cent, how would you account for this current situation?

Indicators of labour market tightness other than the unemployment rate suggest

that labour markets are considerably less tight than the unemployment

rate itself would suggest, given the experience since the mid-1970s. Vacancies

(proxied in the USA by help-wanted indexes) are more plentiful, quitting

jobs less frequent relative to losing jobs, and persons counted as out of labour

force more available for work. The Beveridge curve seems to have shifted

back to its location in the 1950s and 1960s. Other factors include the decline

in trade union membership and power vis-à-vis private business employers,

the increased acceptability of downsizing employment to improve the bottom

line and stock prices, even at the expense of long-time employees, import

competition, yes, but especially domestic competition, and of course the

absence of supply shocks, which has more to do with the stagflation of the

1970s than new classicals want to remember. It very well may be possible to

reduce unemployment to 4 per cent, the target of the Kennedy administration

in the 1960s, while keeping inflation below 3.5 per cent.

Although unemployment in the US and UK economies is relatively low at the

moment, the average rate of unemployment in the European Union economies

is relatively high. How can we explain the considerable unemployment

differentials that exist at the moment between the USA and countries such as

France and Germany? Do you think that EMU is likely to exacerbate the

unemployment problem in Europe?

I am incorrigible. I still believe that wilfully bad macro policy is responsible

for much of the excess unemployment in Europe. It can’t be that the natural

rate keeps rising along with the actual rate, from single to double digits. The

Europeans conclude that if they don’t see significant deflation at whatever

actual U-rate, then that rate must be equal to or less than the natural rate, so

that any expansionary monetary or fiscal policy will cause inflation to increase.

But it may be that the short-run Phillips curve is pretty flat, so that

this inference is not justified. Anyway they never try the experiment of

expansionary policy. I can believe that there are more structural obstacles to

reducing unemployment in continental Europe than in America and Britain. I

can believe that Thatcher’s bashing of labour unions helped, although I didn’t

see UK wages and prices tumbling when sterling was pegged to the DM. I

think some of the structural problems on the continent reflect hysteresis. The

governments and central banks never tried to recover from the 1979–82

recessions, unlike the USA, so the cyclical unemployment achieved by those

recessions became ‘structural’. Whatever the nature and cause, European

unemployment is a disgrace and should be within the power of European

governments to correct in some way, rather than complain about, as if it has

been imposed on them by the USA.

I don’t expect EMU to change the unemployment situation much either

way. If anything, it will get worse. EU members haven’t done much under the

EMS to improve their own macro outcomes. But to the extent they have done

anything individually, they won’t have any macro policy tools once they are

in EMU. Nor will the new central bank act differently from the Bundesbank,

and the Union has no fisc with which to conduct fiscal policy.

Do you feel that there has been any move towards greater consensus in

macroeconomics since we last talked to you in 1993?

Maybe there’s more consensus in macro theory, in the sense that Keynesian

theory is just ignored and graduate students don’t learn anything about it.

Maybe there’s more consensus in practical macroeconomics, because it can’t

help having large Keynesian elements and because mechanical monetarism is


Many prominent macroeconomists (for example Barro and Sala-i-Martin,

1995; Lucas, 1987) have argued that the part of macroeconomics that really

matters is growth. Do you agree with this view and have the endogenous

growth theories of the past decade improved our understanding of growth


Yes, without doubt increasing the productivity, health and life expectancy of

billions of people in poor and underdeveloped countries throughout the world

adds more utility than reducing the unemployment in Western Europe by

three or four points. I don’t think the macroeconomists studying growth have

answers on how to do that. Aggregate demand problems are a luxury available

to advanced industrial capitalist countries. The basic problem of poor

countries is poverty of supply. It’s possible that aggregate demand shortage –

the social disorganization of unnecessary poverty in the midst of potential

plenty in the Great Depression – is no longer a high-priority problem because

macroeconomics solved it, not because it never was a problem and the macro

theory and policy it evoked was wrong. The fact that there are few auto

accidents at intersections doesn’t suggest that traffic lights are unnecessary.

Barro and Lucas, it seems to me, trashed demand-oriented macroeconomics

and then left the field, saying it’s not interesting anyway. The endogenous

growth theories, which interestingly enough rely on externalities of one kind

or another to overcome diminishing returns, are intriguing but not as yet

convincing to me.