Prominent economist and former vice chair of the Federal Reserve Board has written an interesting and accessible book on macroeconomic policy from 1961 to 2021. The title is deliberately similar to the tome written by Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867–1960. Blinder clearly wants to emphasize that fiscal policy matters.
Blinder’s perspective of this history is mostly persuasive, and he effectively argues against Milton Friedman’s simplistic and often quoted statement: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” One of the weaknesses of monetarism as a policy guide is its assumption that velocity is more or less constant in the famous identity, MV=PQ. Monetarism holds much less sway among economists than it did in the 70s and 80s.
While I recommend the book for those interested in the subject from historical, political, or economic perspective, I will focus here on Blinder’s comments about economic policy in the first few years of the Reagan Presidency. I did not find Blinder’s analysis here convincing.
When Reagan entered office, the Federal Reserve under Paul Volcker was pursuing a very tight monetary policy and the economy was suffering from a recession. In the summer of 1981, the Congress passed and Reagan signed The Economic Recovery Tax Act of 1981, which provided large tax cuts. Also, there was a large increase in defense spending, and the federal budget deficit increased dramatically.
In other words, monetary policy was contractionary and fiscal policy was expansionary. As we know, this policy mix eventually worked. Inflation came down and the economy recovered. However, in discussing this episode, Blinder attacks economist Robert Mundell.
Blinder states that “according to the mainstream view, contractionary monetary policy (à la Volcker) raises real interest rates, though perhaps only transitorily, and slows the growth of aggregate demand...[E]xpansionary fiscal policy (à la Reagan) raises real interest rates and speeds up the growth of aggregate demand. Put them both together at the same time, as Reagan and Volcker did, and you should expect real interest rates to rise sharply while the net effect on real output depends on how the tug-of-war just sketched works out.” (p. 143).
He contrasts this conventional view with what Mundell wrote in a 1971 paper: “Monetary acceleration is not the appropriate starting point from which to initiate the expansion [in 1971], because the risk of igniting inflationary expectations. Tax reduction is the appropriate method. It increases the demand for consumer goods, which reverberates on supply...Because of the idle capacity and unemployment, in many industries increased supply can generated without causing economy-wide increases in costs. Tax reduction is not, therefore, inflationary from the standpoint of the economy as a whole.” (p.144).
There does not seem to be a huge difference between the two views, but Blinder asserts without much discussion that there is. He views the “Reagan-Volcker policy mix” as “a bold experiment” and asks: “Which side of the policy mix debate came out looking better?” He answer that it is “the conventional side, by a country mile.” To prove that, he discusses an increase in real interest rates (defined as the Treasury ten-year rate minus CPI inflation over the past 12 months) and an increase in the dollar exchange rate. However, he has not provided any information about what Mundell may have said about the effect on real interest rates or exchange rates.
While one can criticize both the size and the details of Reagan’s enormous tax cuts, the size and details of the increase in defense spending, and the effect on the lives of many people suffering from unemployment at least partly due to monetary policy, it is nonetheless true that the economy recovered and inflation came down. Blinder does not like the argument that Mundell essentially made: the government had two policy goals (ending the recession and reducing inflation) which should be addressed with two different policy instruments (fiscal and monetary policy). Blinder may have good reasons to disagree with using fiscal and monetary policy differently when faced with stagflation, but he does not effectively argue why.
It is not clear whether Reagan or his economic advisers had developed their economic policy with any formal analysis of the combined effect of a contractionary monetary policy and an expansionary fiscal policy. They may have stumbled into it for polical or ideological reasons. Blinder is surely right that Republicans have since then seemed to think that tax cuts are always the answer to whatever the current economic problem is and are effectively more relaxed about budget deficits after the Reagan experience (no matter their rhetoric arguing for balanced budgets).
It is disapointing though that Blinder does not have a better analysis of the policy mix in the early Reagan years and whether he thinks that there could have been better policies at the time. A better thought out and explained argument against what Mundell was advocating would have been interesting.
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