Was Keynesianism Discredited in the 1970s?

Was Keynesianism Discredited in the 1970s?

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I often hear the notion thrown around that Keynesian ideas were discredited in the 1970s by the process of stagflation. Exemplifying this, the well-known Chicagoan economist Thomas Sowell claimed in a recent column that “Janet Yellen represents the Keynesian economics that once dominated economic theory and policy like a national religion — until it encountered two things: Milton Friedman and the stagflation of the 1970s.”

So what does Thomas Sowell claim that Milton Friedman and stagflation discredited? He claims they discredited the Phillips Curve: “At the height of the Keynesian influence, it was widely believed that government policy-makers could choose a judicious trade-off between the inflation rate and the rate of unemployment. This trade-off was called the Phillips Curve, in honor of an economist at the London School of Economics." He concludes: "The ultimate discrediting of this Phillips Curve theory was the rising inflation and unemployment, at the same time in the 1970s, in what came to be called “stagflation” — a combination of rising inflation and a stagnant economy with high unemployment.”


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Yet the Phillips curve was not considered a law of economics by William Phillips himself, the economist who discovered it. In his 1958 paper, The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957 he simply noted the empirical relationship between the two variables in the data. Historically, when one was high, the other was low.

In 1960, after this historical relationship between unemployment and inflation had been noted throughout the world, Robert Solow and Paul Samuelson made the mistake of portraying it a binary policy choice, a curve that could be manipulated by policy. Although Samuelson and Solow never advocated inflationism as they are sometimes accused, the trouble with this is that while there was clearly some kind of relationship between the two variables, the historically observed relationship could easily be disrupted, and broken. This should become apparent to anyone who really thinks about the underlying microeconomic complexity that goes into determining a macroeconomic aggregate like "unemployment" or "inflation".

As it happens, the breakdown of this relationship occurred very soon after Solow and Samuelson first postulated it, following the abolition of the Bretton-Woods regulatory system as geopolitical oil shocks pushed the price of energy upward, resulting in a spiral of cost-push inflation throughout the entire economy as spiralling energy costs meant workers — who were then strongly unionised, and so much more capable of demanding rising wages — demanded higher nominal wages. Price inflation and unemployment were — for the first time in a long time — both relatively high:

FRED Graph

With inflation so high, the so-called policy choice of trading off a higher rate of inflation for a lower rate of unemployment became a non-choice. Paul Volcker is given much credit for raising interest rates, calming the inflationary spiral by breaking expectations of future price rises, but the resolution of the ongoing geopolitical crises affecting energy prices (e.g. Iran-Iraq war) — alongside may have been the greater factor in bringing energy prices back down, and restoring the relationship between unemployment and inflation observed in the Phillips curve.

So did stagflation prove Keynes wrong? Well, the frankly silly notion that the Phillips curve was a stable, unbreakable relationship that could be manipulated for policy was the idea of Solow and Samuelson, not Keynes. Stagflation certainly falsified the idea that the observed historical relationship was unbreakable, but frankly this has nothing whatever to do with Keynes' ideas. Keynes noted in the General Theory that “too large a proportion of recent “mathematical” economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.” This passage could very easily refer to the work of Solow and Samuelson on the Phillips Curve, which lost sight of the complexities and interdependencies of the real world phenomena which are simplified into macroeconomic aggregates like "unemployment" and "inflation". If anything, stagflation proved Keynes right about those economists who would assume that observed empirical relationships will necessarily hold into the future. 

Keynesianism is quite simple. Sometimes an economy can fall into a depressionary state where prices of assets deflate, interest rates in the marketplace are reduced close to zero, and yet resources remain idle, and labour remains unemployed due to a flagging in the animal spirits of market participants. Eventually — in the long run — these issues will work themselves out. The animal spirits, as it were, will eventually perk up. But expectations can be self-fulfilling, and a depressionary state can be self-perpetuating, and hard to break away from. Modern empirical examples would include the 20 years Japan has spent in a depression, as well as the growthless 5 years most of the Western world has now experienced. By mechanically reducing the unemployment rate and employing idle resources through government spending, the animal spirits of the market place can be shifted out of depression, the misery of the unemployed can be abated, and the expectations of deeper and longer depression can be reversed. And large-scale visionary projects like Apollo create technologies that drive future growth can be undertaken with the idle resources, driving the economy back into a beneficent spiral.

It should be obvious that the circumstances in the 1970s were not a test for Keynes' theories. Interest rates never fell to zero. The Carter administration was not running large deficits or racking up public debt. Although an energy shock was involved in the genesis of both today's crisis, and those of the 1970s, in the 1970s there was no wide-scale deflation of asset prices, or long, slow deleveraging of a burst private debt bubble as there was after 1929 or 2008. 
Indeed, as Ann Pettifor has noted, the outcomes of the 1970s should be associated with the abandonment of the earlier Keynesianism — especially the Bretton-Woods era financial and banking regulation regimes — of the 1950s and 1960s. 

The solutions to stagflation  were ones that brought down the price of oil and quelled expectations of future price rises — expectations that had been stoked as early as 1967 in the UK with the devaluation of the pound, and especially following 1971 and the end of Bretton Woods. To argue that "the 1970s" and "stagflation" discredited Keynesianism is to not understand — or to not bother to have read — Keynes' ideas. This is particularly problematic in the context that the current crisis is a particularly Keynesian one — one of mass unemployment, very low interest rates, and a large output gap symptomatic of idle resources. This a crisis in which the state could simply decide to run a full employment policy until rising interest rates from rising private demand make it inflationary to do so, at which point the state can step back and let the private sector continue on a beneficent spiral of jobs and growth. Yet it seems that politicians and economists are too often fighting the last crisis and not the present one, and unfortunately this time that has been a result of a concentrated spread of misinformation about Keynesian economics.


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