Job Name:2045637 Date:14-11-03 PDF Page:2045637pbc.p1.pdf Color: Black PANTONE 188 C PANTONE 4545 C The Problem Stagflition The Problem Reflections on the Microfoundation of Macroeconomic Theory and Policy Gottfried Haberler American Enterprise Institute for Public Policy Research Washington, D.C. Gottfried Haberler is Galen L. Stone Professor of International Trade Emeritus at Harvard University and a resident scholar at the Ameri­ can Enterprise Institute. Distributed to the Trade by National Book Network, 15200 NBN Way, Blue Ridge Summit, PA 17214. To order call toll free 1-800-462-6420 or 1-717-794-3800. For all other inquiries please contact the AEI Press, 1150 Seventeenth Street, N.W., Washington, D.C. 20036 or call 1-800-862-5801. Library of Congress Cataloging-in-Publication Data Haberler, Gottfried, 1900­ The problem of stagflation. (AEI studies; 422) 1. Unemployment-Effect of inflation on. I. Title. II. Series. HD5710.H33 1985 331.13'72 85-9142 ISBN 0-8447-3578-7 (alk. paper) 1 3 5 7 9 10 8 6 4 2 AEI Studies 422 © 1985 by the American Enterprise Institute for Public Policy Research, Washington, o.c. All rights reserved. No part of this publication may be used or reproduced in any manner whatsoever without permission in writing from the American Enterprise Institute except in the case of brief quotations embodied in news articles, critical articles, or reviews. The views expressed in the publications of the American Enterprise Institute are those of the authors and do not necessarily reflect the views of the staff, advisory panels, officers, or trustees of AEI. "American Enterprise Institute" and ~ are registered service marks of the American Enterprise Institute for Public Policy Research. Printed in the United States of America The American Enterprise Institute for Public Policy Research, established in 1943, is a nonpartisan, nonprofit research and educational organization supported by foundations, corporations, and the public at large. Its purpose is to assist policy makers, scholars, business men and women, the press, and the public by providing objective analysis of national and international issues. Views expressed in the institute's publications are those of the authors and do not necessarily reflect the views ofthe staff, advisory panels, officers, or trustees of AEI. Council of Academic Advisers Paul W. McCracken, Chairman, Edmund Ezra Day University Professor ofBusiness Admin­ istration, University ofMichigan *Kenneth W. Dam, Harold J. and Marion R Green Professor ofLaw, University ofChicago Donald C. Hellmann, Professor ofPolitical Science and International Studies, University of Washington D. Gale Johnson, Eliakim Hastings Moore Distinguished Service Professor of Economics and Chairman, Depanment ofEconomics, University of Chicago Robert A. Nisbet, Adjunct Scholar, American Enterprise Institute Herbert Stein, A. Willis Robenson Professor ofEconomics Emeritus, University ofVirginia Murray L. Weidenbaum, Mallinckrodt Distinguished University Professor and Director, Center for the Study ofAmerican Business, Washington University James Q. Wilson, Henry Lee Shattuck Professor of Government, Harvard University *On leave for government service. Executive Committee Willard C. Butcher Richard B. Madden, Chairman ofthe Board John 1. Creedon William 1. Baroody, Jr., President Paul F. Oreffice James G. Affleck Richard D. Wood Tait Trussell, Edward Styles, Director of Vice President, Administration Publications Joseph 1. Brady, Vice President, Development Program Directors John H. Makin, Fiscal Policy Studies Russell Chapin, Legislative Analyses Jack A. Meyer, Health Policy Studies Denis P. Doyle, Education Policy Studies Michael Novak, Religion, Philosophy, and Public Policy Marvin Esch, Seminars and Programs Howard R. Penniman/Austin Ranney, Thomas F. Johnson, Economic Policy Studies Political and Social Processes Marvin H. Kosters, Robert·1. Pranger, International Government Regulation Studies Programs Periodicals Public Opinion, Seymour Martin Lipset and Ben 1. Wattenberg, Co-Eds., AEI Economist, Herbert Stein, Ed. Everett Carll Ladd, Sr. Ed., Karlyn H. Keene, Mng. Ed. AEI Foreign Policy and Defense Review, Evron M. Kirkpatrick, Robert 1. Regulation: AEI Journal on Government Pranger, and Harold H. Saunders, Eds. and Society, Anne Brunsdale, Mng. Ed. Contents FOREWORD William J. Baroody, Jr. ix SUMMARY 1 1 THE DILEMMA OF STAGFLATION 9 2 SOME PROPOSED SOLUTIONS OF THE DILEMMA 11 3 THE MONETARIST POSITION 13 4 AN EARLY CASE OF STAGFLATION: THE NEW DEAL, 1933-1937 15 5 VOLUNTARY VERSUS INVOLUNTARY UNEMPLOYMENT 18 THE CONCEPT OF INVOLUNTARY UNEMPLOYMENT 6 FURTHER CONSIDERED 20 7 RATIONAL EXPECTATIONS 22 8 THE EVOLUTION OF KEYNESIAN ECONOMICS 26 9 GROWING WAGE RIGIDITY 42 10 SOME FURTHER COMMENTS ON THE GREAT DEPRESSION 51 11 SUPPLY SHOCKS 54 12 THE WAGE PROBLEM FURTHER CONSIDERED 57 13 POLICY IMPLICATIONS 62 SPECIFIC MEASURES OF INCOMES POLICY II, 14 ALIAS SUPPLY-ORIENTED POLICY 67 15 INDUSTRIAL POLICY 71 Foreword In the 1970s a new term was coined in economics-stagflation. It was used to describe a relatively new phenomenon in the industrial econ­ omies, declining econo~ic activity accompanied by rising prices. Most previous recessions had been associated with declining prices. This phenomenon led to a number of competing explanations of its root causes and, more important, posed a dilemma for policy makers, who could no longer use standard macroeconomic policies to reduce unemployment without the risk of accelerating inflation. It became clear then that past economic policy prescriptions did not apply and that new methods for dealing with stagflation were re­ quired. In this study Professor Gottfried Haberler, one of our leading economic scholars, discusses and analyzes what the main paradigms of macroeconomic policy-monetarism, Keynesianism, and the school of rational expectations-have to say about the baffling prob­ lem of stagflation. In his wide-ranging study Professor Haberler discusses the strik­ ing contrast between the vigorous recovery of the U.S. economy and the sluggishness of European economies. This contrast is largely due to great structural advantages of the United States over Europe, such as a huge internal free trade area and, equally important, the fact that transportation, communications, and electric power are in the hands of efficient, competitive private enterprise. In Europe the Common Market has fallen far short of achieving its goal of creating a free trade area, and transportation, communications, and electric power are re­ served for national, public enterprises that, whatever their technolog­ ical prowess, are impervious to competition and incapable of efficient operation across national borders. Among Professor Haberler's important policy conclusions is that monetary and fiscal restraint should be assisted by micromeasures designed to bring the economy closer to the competitive ideal so as to minimize the pains of disinflation and adjustment. In Europe this type of policy is called supply-oriented policy, which is a much broader concept than supply-side economics as used in the United ix States. He argues that supply-oriented and demand-oriented policies should be regarded not as alternatives but as complements. Other topics addressed are the strong dollar and the huge U.S. trade and budget deficits. The last chapter critically examines the theory that the United States needs an "industrial policy," that it can no longer rely on private enterprises to initiate new methods of production and to develop new products to ensure sustained growth. The theory is rejected because its principal assumptions are not borne out by the facts. We at AEI are fortunate to benefit from the breadth of knowledge and the historical perspective of Professor Haberler. He has written a number of studies on the major economic issues of our times, and this study adds to the list of insightful economic analyses. This study was originally written for and will also be published by the Pacific Institute in a book edited by Thomas Willett entitled Political Business Cycles and the Political Economy of Stagflation. WILLIAM J. BAROODY, JR. President American Enterprise Institute x Summary This paper starts with the problems of stagflation, the vicious kind of inflation that developed in all industrial countries in the post-World War II period. While in the past spells of declining economic activity were accompanied with rare exceptions by falling prices-deflation­ ary depressions-we now have inflationary recessions. Stagflation poses a dilemma for macroeconomic policy: If it tries to curb inflation by tight monetary-fiscal policy, it increases unemployment. If it tries to reduce unemployment by easy money, it accelerates inflation. This paper analyzes critically what the leading paradigms of macroeco­ nomic policy, monetarism, rational expectations, and Keynesianism have to say about this baffling problem. Since Keynes was undoubtedly the most influential economist of the century, Keynesianism receives special attention. A sharp distinc­ tion is made, however, between Keynesian economics and the eco­ nomics of Keynes. The master himself changed his views fre­ quently-on some important occasions so quickly that many of his followers could not keep pace. The nature and causes of the Great Depression of the 1930s are discussed in some detail, because it was a world-shaking event and has been and still is widely misinterpreted. World trade slumped by about 50 percent in nominal terms (gold dollars) and 30 percent in