Prior to the 1930s most economists did not consider the
government as a source of solutions to economic problems.
Rather they worried that poor decisions by the government or
central bank could be a source of problems, that they might
destabilize the economy.
The Depression of the 1930s caused economists to
reevaluate their prior beliefs about the government's role.
As a result of Keynes' General Theory, most
economists came to believe that the economy was inherently
unstable, and that this instability was the source of the
Great Depression. The impact of the income-expenditure model
on economists' thinking is hard to exaggerate. In textbooks
after World War II, macroeconomics expanded to roughly one
half of the text and was usually introduced before the
traditional tools of microeconomics.
The development of the computer in the 1950s and 1960s
increased the prestige of income-expenditure models. These
models were easily expanded into very large models with
hundreds or even thousands of equations. The models cost
millions of dollars to construct and involved the work of
talented economists using sophisticated mathematical and
statistical tools. Using their basic idea of trade-offs,
economists reasoned that one could buy more accuracy in a
model only by sacrificing something good, simplicity. Since
the models were complex, sometimes so complex that no one
person fully understood them, they were expected to be
accurate. Those developing the models promised to make
economic prediction and forecasting more accurate and
The high tide of stabilization policy occurred in the
1960s. At its height, many economists talked of
"fine-tuning" the economy. They believed that
progress in macroeconomics had rendered recessions obsolete
if politicians used the best economic advice available. This
view was reinforced by over eight years, from early 1961
until late 1969, without a recession (though there was a
near miss in 1966).
Though a few economists remained pessimistic about the
possibilities of fine tuning, it was not the logic of their
arguments that changed the way economists thought about
stabilization policy. It was the events of the 1970s which
did that. In the 1970s the U.S. economy found itself with
serious recessions, high unemployment, and much higher rates
of inflation than it had had during the previous two
decades. These results were not a consequence of economists
being ignored; they had been involved in policy decisions
throughout the period.
As a result of the disappointing performance of the U.S.
economy in the 1970s, economists have reexamined the
problems of stabilization policy. They have found that there
are serious obstacles to successful macroeconomic policy.
Economic consensus has moved away from the idea that fine
tuning is possible, and a significant minority has returned
to a pre-Keynesian position that the major focus of
government policy should be, "First, do no harm."
The issue of stabilization policy can be viewed in terms
of the concept of feedback.
Those who distrust an active role of the government believe
that the economy has strong dampening feedback impulses that
tend to correct deviations. Though the economy will have
problems of inflation and unemployment, these problems will
be contained, and with some time lag, eliminated. Those who
hold this view fear that active government policy may
interfere with normal feedback responses and destabilize
rather than stabilize.
Those who advocate an active role for the government, on
the other hand, believe that the dampening feedback impulses
are weak or absent. Without government action, any problem
of inflation or unemployment will persist.
It is easy to see how the Great Depression influenced the
beliefs of those who advocate an active role for the
government. The dampening feedback responses seem to be
working in the early 1930s because prices and wages fell as
unemployment rose. But this feedback did not contain the
fall; the decline lasted more than three years.
The only possible position for those who dislike an
active policy is to argue that the Great Depression was a
result of policy error. Milton Friedman and Anna Schwartz in
fact aggressively argued this position in their Monetary
History. They argue that the Federal Reserve established
a policy response that allowed bank reserves, and thus money
stock, to decline as business activity declined. The Fed
unintentionally set up a system of amplifying feedback in
the monetary sector that overrode the dampening feedback
responses in the rest of the economy. In this view the
instability obvious in the Great Depression (and also,
incidentally, in the Great Inflation in Germany) was the
result of a particular set of government policy responses,
not something inherent in the economic system.
Next we consider the problem of
lags facing policy makers.