Five Easy Theses
Even though economies are always in flux, economic theories aren’t built to turn on a dime. As a result, it doesn’t take long for even the most hallowed hypothesis to stand exposed as just another version of the emperor’s new clothes. Here, for the record, a few items we’ve recently found balled up on the floor of the emperor’s closet.
THE LAFFER CURVE: A relic of the Reagan years, this was Economist Arthur B. Laffer’s much-applauded hypothesis, rumored to have been first sketched on the back of a cocktail napkin, stating that at some point tax rates can get so high—and the incentive to work so discouraging—that raising them further will reduce, rather than increase, revenues. The converse of this theory, popularly known as supply-side or trickle-down economics, maintains that a government, by cutting taxes, actually gets to collect more money; this version has been widely credited with creating the largest deficit in American history—before the current one, of course.
KONDRATIEFF LONG WAVE CYCLE: Obscure theory dating from the Twenties and periodically enjoying a certain gloomy vogue. Nikolai Kondratieff, head of the Soviet Economic Research Center, postulated that throughout history capitalism has moved in long waves, or trend cycles, which last for between fifty and sixty years and consist of two or three decades of prosperity followed by a more or less equivalent period of stagnation. Kondratieff described three such historical cycles, and when economists dusted off his graphs and brought them up to date in the 1960s and 1970s, they found his theories to be depressingly accurate. According to their predictions, we were all in for another twenty years with no pocket money. The Russians, by the way, weren’t thrilled with Kondratieff’s hypothesis, either, since it implied that the capitalist system, far from facing impending collapse, would forever keep bouncing back like a bad case of herpes. Sometime around 1930, Kondratieff was shipped off to Siberia and never heard from again.
ECONOMETRICS: Yesterday’s high-level hustle. Econometrics used to mean studies that created models of the economy based on a combination of observation, statistics, and mathematical principles. In the Sixties, however, the term referred to a lucrative mini-industry whose models were formulated by computer and hired out to government and big business to help them predict future trends. Government, in fact, soon became the biggest investor in econometrics models, spending millions to equip various agencies to come up with their own, usually conflicting, forecasts—this, despite the fact that the resulting predictions tended, throughout the Seventies, to have about the same record for accuracy as astrology. Today, econometrics models are still expensive and still often wrong, but they’re accepted procedure and nobody bothers making a fuss about them anymore.
MONETARISM: One of two warring schools of thought that feed advice to politicians on how to control inflation. Monetarists favor a laissez-faire approach to everything but the money supply itself; they have misgivings about social security, minimum wages, and foreign aid, along with virtually every other form of government intervention. They stress slow and stable growth in the money supply as the best way for a government to ensure lasting economic growth without inflation, and they insist that, as long as the amount of money in circulation is carefully controlled, wages and prices will gradually adjust and everything will work out in the long run. Monetarism owes much of its appeal to one of its chief proponents, Nobel Prize–winning economist Milton Friedman, whose theories are generally acknowledged to have formed the backbone of Prime Minister Margaret Thatcher’s economic policy in Britain (as well as Ronald Reagan’s here). Liberal critics say Friedman owes his own appeal to the fact that he looks like everyone’s favorite Jewish uncle.
NEO-KEYNESIANISM: Monetarism’s opposite number, a loose grouping of economists who are less inclined to wait for the long run. The neo-Keynesians argue that there are too many institutional arrangements—things like unions and collective-bargaining agreements—for wages and prices to adjust automatically. They maintain that the best way for a government to promote growth without inflation is by using its spending power to influence demand. Who wins in the monetarist/neo-Keynesian debate seems less important than the fact that each side has found someone to argue with.
Action Economics
So much for theory. Although no self-respecting economist ever dispenses with it entirely, there are areas of economics in which interpreting—or inventing—economic gospel takes a backseat to delivering on economic promises. That is, to keeping things—money, interest and exchange rates, deficits— moving in what’s currently being perceived to be the right direction. Here, contributor Karen Pennar explains what some of those promises (and some of those directions) are. Come to terms with them and you’ll be ready to queue up for her tour of the markets, stock and otherwise, where action turns into hair-raising adventure. THE FEDERAL RESERVE BOARD
Known in financial circles as the Fed (and not to be confused with the feds), this government body, our central bank, wields enormous control over the nation’s purse strings. In fact, it’s said that the Fed’s chairman is the second most powerful man in Washington. He and his six colleagues, or governors of the Federal Reserve Board, direct the country’s monetary policy. Simply put, they can alter the amount of money (see “Money Supply”) and the cost of money (see “Interest Rates”), and thereby make or break the economy. When the Fed tightens, interest rates rise and the economy slows down. When the Fed eases, interest rates fall and the economy picks up. Or so it used to be. The balancing act is so difficult, and the Fed so mistrusted, that its actions often have a perverse effect. So much for simplicity.
Many swear that the Fed is the root of all economic evil. In his landmark work, A Monetary History of the United States, 1867–1960 (coauthored by Anna J. Schwartz), Milton Friedman placed blame for the Great Depression squarely on the Fed (for tightening too much). He hasn’t stopped berating it since, and he has plenty of company. Beating up on the Fed is a popular sport—unfair, perhaps, but understandable. A little history: The Fed, created in 1913 by an act of Congress, grew steadily in strength during the Depression years. By the 1950s, it had evolved into an independent force, free of the pressures of Congress and the president. Checks and balances for the economy, you might say.
This explains why many presidents have had a love-hate relationship with the Fed, praising it when interest rates are falling, then cursing it when they climb. Members of Congress, similarly, are often frustrated by the Fed’s independence, and periodically threaten to limit its autonomy.
But the Fed tends to be blissfully immune to criticism. Board members pursue their own lofty economic objectives and routinely cast blame on Congress and the president for mismanaging the economy. MONEY SUPPLY
This is what the Fed is supposed to control but has a hard time doing. For decades, the Fed, and the people who make a living analyzing what money is doing, monitored the money supply because of the effect it was believed to have on the national economy. The Fed measures the money supply in three ways, reflecting three different levels of liquidity—or spendability— different types of money have. By the Fed’s definition, the narrowest measure, M1, is restricted to the most liquid kind of money—the money you’ve actually got in your wallet (including traveler’s checks) and your checking account. M2 includes M1 plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds. M3 includes M2 plus large-denomination ($100,000 or more) time deposits, balances in institutional money funds, repurchase liabilities, and Eurodollars held by U.S. residents at foreign branches of U.S. banks, plus all banks in the United Kingdom and Canada. Last time we looked, the M1 was around $1.2 trillion; the M2, $6 trillion; and the M3, $8.8 trillion. The Fed, by daily manipulation, can alter these numbers. If the Fed releases less money into the economy, interest rates rise, corporate America borrows and produces less, workers are laid off, and everyone’s spending is cut back. When the Fed pumps more money into the economy, the reverse happens. And if it moves too far in one direction or another, the Fed can create a depression (the result of too much tightening) or hyperinflation (the result of too much easing).