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Stabilization Policy

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 "scientific."

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.

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