American Economic Association Stabilization Policies in the World Economy: Scope and Skepticism Author(s): Jeffrey Sachs Reviewed work(s): Source: The American Economic Review, Vol. 72, No. 2, Papers and Proceedings of the Ninety- Fourth Annual Meeting of the American Economic Association (May, 1982), pp. 56-61 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1802303 . Accessed: 20/04/2012 13:46 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected]. American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review. http://www.jstor.org Stabilization Policies in the World Economy: Scope and Skepticism By JEFFREY SACHS* Throughout the industrialized world, mac- ills, the sources of relative success across roeconomic performance since the mid- 1970's economies, or most important for the pur- has been very poor, and the prospects in the pose here, the right policy mix for sustained near term remain bleak. It is sobering to recovery. The interpretations offered here, reflect that all twenty-four OECD economies which must be regarded as tentative, lay suffered a slowdown in aggregate economic great stress on the various adverse supply growth after 1973 (comparing average growth shocks that affected all of the OECD econo- rates for 1965-73 with 1973-79); all but one mies during the past decade. These interpre- (Switzerland) experienced an intensification tations are based largely on a joint research of consumer price inflation. Overall, the an- project with Michael Bruno on the macro- nual GNP growth of the OECD slowed from economics of supply disturbances in open 4.9 percent during 1965-73 to 2.7 percent economies. during 1973-79, and it has slowed further since then. The slow growth has translated I. The CentralRole of SupplyDisturbances into rising unemployment, which stood at about 7 percent of the OECD workforce in The major competing schools of macro- 1981 as compared with a mere 2 to 3 percent economic thought have focused most of their in 1970. In the European Economic Com- blame for the current debacle on macroeco- munity, the 1981 unemployment rate ap- nomic policy. For the Keynesians, recent pears to have been a staggering 8 percent. policy has been too austere, overly directed Bright spots in this picture are few indeed, against fighting inflation. For the monetar- but their lessons may be instructive. After ists, the case has been almost the opposite: the steep recession in the OECD during that politicians have continued to drive up 1974-75, the United States alone of the major money growth to fight short-term unemploy- economies staged a rapid recovery; the un- ment, to the sacrifice of longer-term price employment rate fell significantly below its stability. And for the new classical macro- 1975 peak, while it continued to rise in economists, the policies have simply been too Europe. Unfortunately, U.S. performance on erratic, with policy " surprises" explaining most measures has deteriorated sharply (and the fluctuations in output growth. relatively) since 1979. Japan provides a case Unfortunately, these important proposi- of extremely successful performance since tions have been subjected to almost no sys- the mid-1970's, after a very sharp jolt during tematic, cross-country scrutiny. No strong 1973-75. Among the smaller economies, the comparative evidence has been set forth to neighboring economies of Sweden and Fin- show that high unemployment and slow land offer a vivid contrast of worsening and growth have been closely tied to more re- improving economic developments, respec- strictive policies, or to more uncertain and tively, since the mid-1970's. volatile policies, or that price stability has There is no consensus among macro- resulted from slow and stable money growth. economists regarding the diagnosis of these There is little doubt that tight policies can explain high unemployment at certain times *Harvard University and National Bureau of Eco- and places (the Thatcher experiment in the nomics. This work is part of a project with Michael U.K. is a case in point; see Willem Buiter and Bruno of Hebrew University on the macroeconomics of supply shocks. Errors in this analysis are, of course, my Marcus Miller), but it is doubtful that they own. Support from the National Science Foundation is provide a general explanation for the recent gratefully acknowledged. experience. The almost universal slowdown 56 VOL. 72 NO.2 MACROECONOMIC POLICY IN THE OPEN ECONOMY 57 in growth and rise in unemployment in the steel, shipbuilding, electronic components). OECD has characterized both activist and This import-competing growth of the NICs passive, as well as expansionary and contrac- has worsened the OECD terms of trade, and tionary policy regimes. To cite just two cases, perhaps more importantly, has shifted the neither the austere Barre policies in France locus of new world investment in key in- nor the expansionary Keynesian policies in dustries decisively away from the developed Sweden restored high employment or rapid economies. growth to their economies. On a theoretical level, the economics of I would suggest three lessons on macro- supply shocks are fairly well understood (see economic performance and policy from the my papers with Bruno 1981a, b, and my tangled comparative record. First, it is not 1982 article for general equilibrium analyses the policy choices but rather the policy op- in the case of output-market clearing, and tions that worsened in the 1970's, with supply Edmond Malinvaud and Robert Solow for shocks driving the stagflationary process. the non-market-clearing case). Consider, for Second, the appropriate policy response to example, a rise in real input prices. In a high unemployment or slow growth depends competitive, full-employment economy a on the source of the unemployment, with permanent input price shock reduces output "'supply-generated"unemployment less trac- on impact, and most likely sets in motion a table then the garden-variety Keynesian un- path of capital decumulation, along which employment. And third, since national eco- output and productivity grow more slowly nomic structures differ, particularly in labor than trend. For a given money supply, the market and financial institutions, the same nominal price and wage levels may either rise policy is likely to have very different effects or fall after the shock, though the shock across economies. probably requires the fall of other nominal Various "supply-side" shocks were of wages and prices. And very importantly, the dominating importance in the 1970's. All real wage consistent with full employment industrial countries faced a massive rise in (hereafter, the "full-employment real wage") the real price of raw materials inputs (both must fall in impact, and then must grow fuel and nonfuel) after 1970, following two more slowly than trend as the process of decades of falling real input prices. The oil capital accumulation proceeds. price increases (in 1973-74, 1979-80) were From the point of view of macroeconomic the most stunning, but by no means the only equilibrium, then, there are two problems. major hikes in real commodity prices. Over- After the supply shock, the nominal price all, the index of nonfuel primary input prices vector may be inappropriate given the exist- rose sharply relative to prices of final manu- ing money stock and exchange rate. If nomi- factured goods in the 1970's (see Irving nal prices and/or wages are sticky, a stan- Kravis and Robert Lipsey). Accompanying dard demand management problem arises these shocks was a persistent slowdown in (see Edmund Phelps in this context). The total factor productivity growth in almost all second and more novel policy issue involves of the OECD. The synchronization of the the need to reduce real wages to their new slowdown with the raw material price in- full-employment path. Most recessions up creases suggests a causal linkage running until 1973 signalled little about the need for from prices to output (as suggested by Martin long-term real wage adjustment, while the N. Baily and Bruno, for example) but this resolution of post-1973 recessions has de- linkage remains an open question. Many, pended on the deceleration of real wages such as David Grubb, Richard Jackman, from an earlier trend. And for reasons that Richard Layard, and William Nordhaus, take we shall see, such a deceleration is only likely the productivity slowdown to be an indepen- after a transitory phase of high unemploy- dent event. A third supply shock, from the ment, and is also likely to be hard to bring point of view of the OECD, has been the about with standard macroeconomic policy rapid expansion of the newly industrializing tools. countries (NIC) into traditional export sec- For a number of years after 1973 (at least tors of the OECD economies (for example, two years in most countries: four to five in 58 A FA PA PERS A ND PROCEEDINGS MA Y 1982 others) OECD real wage growth remained A related argument holds that unions, or strong relative to productivity growth, and both employers and unions, failed to under- profitability was sharply squeezed (see my stand the link of higher oil prices and wage 1979 article, and Bruno's paper for details). moderation, and the ordeal of unemploy- The rate of return on manufacturing capital ment was necessary to "clarify" that link.