During the stagflation of the 1970s, as U.S. interest rates and inflation were reaching unprecedented heights, a “rational expectations revolution” occurred in macroeconomics. As its name suggests, one of the most important insights to emerge from rational expectations theory is that expectations matter. Fiscal and monetary policies have effects that are shaped, not only by how they alter incentives for consumers to work and spend and businesses to invest and create jobs, but also on how they influence households’ and firms’ beliefs about the future.
In sharp contrast to the 1970s, when rational expectations theory took hold, the U.S. economy is now experiencing historically low interest rates and inflation. Under such benign conditions, it naturally appears that there are few risks to adopting more expansionary macroeconomic policies. Thus, progressive politicians have proposed ambitious new spending programs, including a “Green New Deal.” Citing an even more recent line of thinking in macroeconomics called Modern Monetary Theory (MMT), these politicians argue that those programs would not necessarily require large increases in taxes. Instead, the programs could be financed, at low cost, by issuing new government bonds. The Federal Reserve could help, too, by purchasing some of these bonds with newly printed money.
The danger is that these policy proposals, if implemented, will alter expectations in ways that send interest rates and inflation sharply higher—dramatically increasing their costs. Though economic circumstances are quite different from how they were 40 years ago, the lessons of the rational expectations revolution remain just as relevant today.
MMT has been the focus of heated debate, in academic circles and the media. Much of the controversy appears to stem from ambiguity about what the theory claims to say. For an especially clear and informative introduction, I recommend highly a CNBC interview with Stephanie Kelton, professor of economics at Stony Brook University, senior economic advisor to Bernie Sanders’ 2016 presidential campaign, and most importantly one of MMT’s creators.
In the interview, Prof. Kelton points out—correctly—that the U.S. government will never default on its debt. This is true for the simple reason that most U.S. government bonds are denominated in dollars—units of currency that the Federal Reserve creates. Of course, by printing money to pay off the U.S. Treasury’s debt, the Fed risks fueling inflation: a rise in prices that comes from “too much money chasing too few goods.” But, since U.S. inflation has run persistently below the Fed’s 2 percent target for virtually all of the past decade, few economists see rising prices as a major threat at present. In her interview, Prof. Kelton summarizes this view quite concisely by saying:
“The only potential risk with the national debt increasing over time is inflation. And to the extent that you don’t believe the U.S. has a long-term inflation problem, you shouldn’t believe that the US is facing a long-term debt problem.”
The biggest risk to following the prescriptions of MMT, therefore, is that the U.S. economy may experience a “regime change,” like those envisioned in rational expectations theories, that shifts expectations in a way that sends interest rates and inflation sharply and persistently higher. Today, U.S. government bond rates remain low, despite large budget deficits that will only increase in size as our aging population puts additional pressure on federal retirement and health care programs. Likewise, inflation continues to be subdued, despite the possibility that the Fed will be called upon to relieve some of this steadily building budgetary pressure through excessive money creation. Investors who buy Treasury bonds and businesses that set prices in long-term contracts must now expect that, through some combination of tax increases and spending cuts, the U.S. government will pay off its debts without resorting to inflationary finance. If the Green New Deal, or other new programs, places massive strains on the fiscal system, however, these expectations could change in a way that makes debt and inflation into much larger problems.
Could such a regime change actually happen? History tells us it might. From the mid-1960s through the 1970s, great strains were placed on the federal budget. In a 1979 lecture evocatively titled “The Anguish of Central Banking,” economist Arthur Burns, who served as Federal Reserve Chair for much of this period, describes how the events of the time pressured the Fed and ultimately led to a shift in expectations that embedded inflation into the American economy.
“From 1958 through 1964,” Burns observes, “the United States enjoyed a remarkable degree of price stability ... and then the inflation ... plaguing the American economy got under way.” Burns attributes this regime shift to “philosophic and political currents that have been transforming economic life in the United States.” Later he elaborates, explaining that “in the innocence of the day, the administration in office attempted to respond to the growing demands for social and economic reform while waging war in Viet Nam on a rising scale.” Although the details then differ compared to now, in broad terms the competing pressures placed on the federal budget in the lead-up to the high inflation years of the 1970s share much in common with those prevailing today.
As Burns observed in 1979, “Many results of this interaction of government and citizen activism proved wholesome. Their cumulative effect, however, was to impart a strong inflationary bias to the American economy. ... That is the way the inflation that has been raging since the mid-1960s first got started and later kept being nourished.”
Burns concluded, at the close of a decade marred by stagflation, “Nowadays, businessmen, farmers, bankers, trade union leaders, factory workers, and housewives generally proceed on the expectation that inflation will continue in the future, whether economic activity is booming or receding. Once such a psychology has become dominant ... any rise in the general price level tends to develop a momentum of its own.”
Thus, the relative price stability of the early 1960s was replaced by the chronic inflation of the 1970s.
Interestingly, Prof. Kelton also refers, indirectly, to the 1970s in her interview, offering a different interpretation of the times. She argues, instead, that “The U.S. economy hasn’t experienced ... demand pull inflation for almost a century. The types of inflation that have been important in the U.S. have almost always come on the cost side ... because of things like oil price shocks ... housing ... or health care.”
These observations are particularly useful because they point to an intellectually rigorous way in which debates over the wisdom of the Green New Deal and the usefulness of MMT might be resolved: by examining more carefully the political and economic history of the 1970s. Was the high inflation of that decade a consequence of excessive money growth, engineered by the Fed to relieve budgetary pressures—the source of the “anguish” in Burns’ speech? Or was it mostly bad luck, because of shocks to imported oil and other commodity prices that had little to do with domestic economic policy, as Prof. Kelton suggests instead? MMT invites us on a trip back to the 1970s, to ask what really happened.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
Editor’s Note: This piece was originally published by Economics21 at the Manhattan Institute.