Blinder faith - Federal Reserve Vice Chairman Alan Blinder

National Review, Sept 26, 1994 by Lawrence A. Kudlow

IVY LEAGUE debutants usually come out in traditional towns like New York, Boston, or Philadelphia, but ex-Princeton economics professor Alan Blinder, recently appointed vice chairman of the Federal Reserve, chose instead to make his maiden speech in Jackson Hole, Wyoming, at a meeting sponsored by the Federal Reserve Bank of Kansas City. But nobody asked him to dance. In front of many of the world's leading central bankers, business people, and economists, Blinder argued that interestrate policies should be aimed at reducing unemployment rather than simply targeting price stability. In so doing, Blinder contradicted the views of his boss, Alan Greenspan, and offended Bundesbank head Hans Tietmeyer, both of whom were present.

As a devout Keynesian, Blinder has always favored a demand-management approach to economic policy. In numerous magazine columns and books, he describes himself as an "inflation dove" with boundless confidence in the efficacy of government; he believes that the U.S. public sector is "emaciated" and the country "undertaxed." During his confirmation hearings for the number-two job at the Fed, Blinder told Congress: "The older I get, the less respect I have for the signals emitted by our vaunted speculative markets."

Reminiscent of the Carter era, Blinder's policy prescription would have the Fed pour money into the economy to keep interest rates low and stimulate demand by consumers and businesses. This demand stimulus, in turn, is expected to create jobs and lower the unemployment rate. Bolstered by government taxing and spending, money manipulation by the Fed is supposed to give the government a near-complete ability to drive the economy by stepping on the gas during recessions or putting on the brakes should the economy overheat into inflation.

Demand-siders like Alan Blinder have never understood the crucial role of supply. People work, save, and invest only if after-tax returns are sufficient, payable in dollars that have real value. Higher tax rates on high-risk investment, personal income, or business payrolls blunt incentives and cause individuals to withhold their supply of capital and labor from the market. Risk-taking, entrepreneurship, good management practices, and plain old hard work are all discouraged by frequent government intervention. Cheap money de-linked from gold or other real assets produced by the economy also causes people to withhold their supplies of capital and labor, since shrinking dollars further reduce the reward for work and risk-taking.

When both inflation and unemployment rose during the late Seventies, the Keynesian demand model imploded. Rather than stimulating demand, easy money drove inflation and interest rates sky high. Rather than holding down inflation, rising taxes weakened incentives and depressed the economy. Smart money and smart people boycotted the U.S. economy because it no longer paid to work and invest. Output and employment fell, while prices and interest rates rose.

Statistically, the demise of Keynesian demand-management policies is easy to chart. As the dollar was unhinged from gold, and as federal taxes and spending steadily moved up, aided respectively by inflation-driven bracket creep and by Great Society entitlements, the U.S. economy entered the stagflation period producing 7.2 per cent average annual inflation and 2.1 per cent real growth from 1968 to 1982. The average unemployment rate was 6.4 per cent. During the end of this period, from 1978 through 1982, industrial production declined 3.2 per cent, while the consumer price index rose 48 per cent. By late 1982, unemployment had risen to 11 per cent.

Contrast this with the early 1960s and most of the 1980s, when the dollar was more closely linked to gold and tax rates were brought down. From 1961 to 1967 real GDP growth averaged 4.9 per cent, yearly inflation 2.4 per cent, and unemployment 4.4 per cent. From 1982 through 1988, as President Reagan ushered in a return to hard money and free-market risk-taking incentives, including across-the-board deregulation and tax cuts, real GDP increased by 3.9 per cent a year, and inflation averaged 3.6 per cent; by the end of the period unemployment had fallen to 5.4 per cent. Under Kennedy and Reagan, the classical economic model of sound money and free enterprise produced strong growth with low inflation and unemployment. There was no Phillips Curve trade-off between inflation and unemployment. Under Johnson, Nixon, Ford, and Carter, the Keynesian model produced low growth with high inflation and unemployment. In all three periods, unemployment and inflation moved up and down together.

Have Blinder and his fellow Keynesians learned anything from the historical evidence? Says Arthur Laffer, one of the principal architects of President Reagan's successful growth policies: "There is no set of evidence that will ever shake their faith in the demandside Keynesian theory of the Phillips Curve."

IF THIS were merely an academic discussion, it would have little consequence. But Blinder is being touted by many as the next Federal Reserve chairman, and even now he is in a position as vice chairman to tilt the center of monetary gravity away from the relatively hard-money policies that have prevailed until recently.