Big Rate Cuts and Fiscal Stimulus Trump Conservative Ideology
It was 1971 when Richard Nixon, a conservative, uttered the famous phrase "We are all Keynesians Now. " But there was a backlash soon to follow, with Ronald Reagan and Margaret Thatcher changing the world as perhaps no two other people did in the 20th century. Ronald Reagan's "supply-side economics" was never taken seriously in the economics profession -- even at the height of his influence there was barely a handful of economists that would lend their names to it. But the economics profession did, in its research at least, throw out many of the insights that had made John Maynard Keynes the most influential economist of the century.
Among these insights was Keynes' explanation that self-regulating markets would not necessarily fix an economy that had fallen into recession, so as to restore growth and full employment. And that government intervention could help do the job that markets could not. This was painfully clear in the middle of the Great Depression, when Keynes put forth the economic theory that became the basis not only of intro economics textbooks (subsequently diluted) but also our modern system of national income accounting. But just as the dogma of the middle ages buried some of what the ancients knew about astronomy, these insights were lost in a right-wing ideological ascendance that infected policy circles and debilitated the social sciences over the last 30 years.
So it is striking to see the most Keynesian response ever to a recession that has not even officially begun (although it may have started - the National Bureau of Economic Research will decide that later). The Fed's three-quarter point cut today was its largest since 1990 and its first move between meetings since 2001 (just following the September 11 attacks). And the markets are anticipating another cut at the Fed's regular policy meeting next week - perhaps as much as half a point. The Fed will most likely be afraid to disappoint.
This is the negative aspect of the Fed's actions, which some economists have rightly criticized: its apparent reaction to the stock market. Most Americans do not have any significant investment in the stock market, even in retirement accounts; and when stocks are overvalued then it is good for them to come down. The stock market is not the economy, and the Fed -- which so foolishly ignored the world's biggest bubble when the stock market was engulfed in a speculative excess in the late 1990s -- should not be using monetary policy to defend current stock prices, no matter how many Republican voters and campaign contributors may see this as the nation's top priority.
But the good news, for the people of the United States and the world, is not only that the Fed now finally recognizes how serious a mess we are in, but that it is willing to ignore what is normally the main enemy of conservative central bankers (pardon the redundancy): the threat of any increase in the rate of inflation. The consumer price index is up 4.1 percent over the last year, far beyond Bernanke's target of two percent; and the drop in the dollar can be expected to add more by increasing import prices. But the Fed is ignoring this in order to focus on the threat of a downturn.
Perhaps even more importantly, the President and Congress are moving toward agreement on a fiscal stimulus. This is important because the Fed's interest rate cuts will not have anywhere near the stimulus effect on the economy that they had in pulling us out of the last (2001) recession. In that expansion, the cuts contributed to an enormous housing bubble, by lowering mortgage rates. It was this bubble, with rising home prices allowing people to collectively borrow trillions of dollars against their homes, and spend it, that drove the economic recovery of the last six years. But all that is now working in reverse, so lower interest rates won't have the same impact. (And all this is assuming that lower short-term interest rates will move long-term rates lower, which is no longer a safe assumption - but that is another story).
The details of the stimulus remain to be worked out, and of course it will be better if the stimulus is targeted toward those who need it most and will spend it. Some subsidies for energy conservation and public transportation could also potentially provide some long-term benefits (PDF). But it is testimony to the power of a volatile and alienated electorate that our politicians are moving so quickly, and that conservatives have rediscovered the Keynesianism of Richard Nixon. Of course the White House will still push for some tax breaks for business, but it seems likely that the bulk of the package -- including tax cuts for households -- will be a Keynesian one. In other words, it will be designed to put money in the hands of those who will spend it, so as to replace the lost spending resulting from the bursting of the housing bubble; not, as previous tax cuts such as capital gains and right-wing ideology prescribes: to give more money to rich people so that they will supposedly invest it and increase productivity in a full-employment economy.
It probably helps that the Republicans are quite scared that the combination of an unpopular war and a serious recession in a presidential election year has the potential to make them into a long-term minority party. The economy, it seems, is too important to be left to the ideologues. But in any case, despite the bad economic news that lies ahead before we get out of this mess, it is worth noting the return of some vitally important economic common sense.