Mainstream Voodoo Revisited

After reading Paul Volcker's April 10 Washington Post rant about the U.S. economy "skating on thin ice," followed by Alan Greenspan's efforts yesterday to resuscitate the handy hoax that interest rates depend on budget deficits rather than Fed, I thought it might be useful to recycle my characteristically respectful disagreement with such conventinoal claptrap back in 1984:


'Mainstream Economics': None Dare Call It Voodoo
By Alan Reynolds
The Wall Street Journal, 7 May 1984


The quality of public debate on economic issues is rapidly degenerating to the level of intellectual barbarism. Contradiction has become the mark of sophistication, evidence is dismissed as irrelevant, and "experts" are defined as anyone who advised the government during some economic catastrophe. Indolent journalists lean on an imaginary consensus, claiming that "most economists agree" about this or "Wall Street worries" about that.

Most economists are said to be concerned that a growing economy must raise interest rates, which will prevent the economy from growing. The solution, it seems, is for the Fed to raise interest rates to slow the economy, so that interest rates can fall and thus speed up economic growth.

Mainstream economists are reported to agree that a strong dollar causes trade deficits, and trade deficits make the dollar weak. The Fed therefore has to raise short-term interest rates to attract long-term foreign investment, or else the absence of foreign investment might raise interest rates. If foreigners keep investing in U.S. factories, on the other hand, most economists fear the U.S. will become a "net debtor" rather than a net lender (to Latin America and East Europe). The solution is to attract and repel foreign capital.

Most economists apparently believe that all countries should export more than they import, and can do that by periodically devaluing their currencies against each other. Exports are the benefit from trade, and imports are the cost. Inexpensive foreign goods make us poorer. The U.S. should try to raise import prices and cheapen exports, so that we can give up more wheat for less oil.

Most economists did not approve of the falling dollar of 1978-79, or the rising dollar of 1981-83. But most of all they do not like a stable dollar. The dollar must be free to float, but it always floats to the wrong level. Most economists agree that the dollar is overvalued 30%, and in danger of falling, but monetary authorities must ignore exchange rates and prices.

Most economists believe that future monetary policy should instead be based on either past real growth or past money stocks. The latter is because housewives and corporate treasurers decide how much to spend by consulting last year's balance in their checking accounts. If the Fed lowers interest rates, that always makes people expect more inflation, so interest rates rise. If the Fed raises interest rates, interest rates also rise. Most economists know that monetary policy is therefore optimal at all times, since easing or tightening raises interest rates.

Most economists understand that credit is good but debt is bad. Too much private borrowing will raise interest rates, and higher interest rates will result in too little borrowing. The object of tax reform is therefore to encourage lending by discouraging borrowing. There is a need to tax consumption in order to encourage saving for future consumption. The economy must produce more auto factories and consume fewer cars.

Most economists argue that budget deficits stimulate and crowd out private spending. Budget deficits also cause inflation and make the dollar too strong. Reducing deficits would therefore lower the dollar's value abroad and raise it at home.

Budget deficits are simultaneously described as the consequence of recession, the cure for recession and the cause of recession. Estimated future deficits are said to have effects in the present that actual deficits do not have now and did not have in the past. The 1989 deficit explains 1984 interest rates, but the 1984 deficit does not explain 1979 interest rates.

Budget deficits always "threaten to" do something. They threaten to raise inflation unless tax indexing is repealed, so that inflation can reduce the inflationary deficits. Using inflation to reduce the deficit would make people want to buy bonds, thus lowering interest rates. Deficits also threaten to stop a near-record increase in business fixed investment, unless taxes are hiked to reduce the after-tax return on capital.

Time magazine's "Monster Deficit" story noticed "a growing list of studies purporting to show that deficits do not raise interest rates." Indeed, the Congressional Budget Office's Economic Outlook lists two dozen studies with virtual agreement that deficits do not have a significant impact on interest rates, including several by economists at the Federal Reserve banks and Council of Economic Advisers. Yet Time goes on to explain that overwhelming evidence "has had very little impact on the thinking of mainstream economists." Reality, after all, is a matter of belief and consensus.

Economic policy has never before been so thoroughly dominated by ever-changing economic theories and forecasts. Economists who can't predict the next month now propose to fine-tune the 1989 budget or the 1986 inflation rate. There is a panicky political impulse to fix things that are not broken and ruin things that were almost fixed. Always, the rationale is that "most economists agree" that "something" must be done. If economists were actually guilty of believing half of the strange ideas that are attributed to them, it would be safer to base economic policy on astrology.