Democrats and liberal Keynesian economists are in a state of shock. Not only have they been bumped out of power but, even worse, the theoretcial underpinning of their whole world has been rudely discarded by the "new right" economists who clearly dominate the Reagan administration.
Democrats reject as sheer fantasy an optimistic "scenario" created by OMB economists for President Reagan that calls for the present 12 percent infaltion rate to fall to 6.5 percent next year and to 4.5 percent in 1983. Some other officials think that is unrealistic.
But "scenarios" are in, and "forecasts" are out. A "forecast," say the Reaganites, is what Keynesians derive from past patterns of behavior. A "scenario," they say, is what can happen if you accept the Reagan program for revitalizing the economy and believe that future behavior, as a result, can be totally different.
The new boys in town who have cranked up the optimistic "scenario" for Budget Director David Stockman think that, regardless of the size of the federal deficit, inflation and interest rates will come down, once people become convinced that Reagan means business.
This is nothing more or less than the old theory of "rational expectations." It has been successfully fed into the Reagan White House by Stockman, who in turn has relied heavily on two young monetarists: John Rutledge, director of a California think tank, the Claremont Economics Institute; and Lawrence A. Kudlow, recently of Bear, Stearns and Co., a Wall Street brokerage firm. Kudlow has taken a staff job, and the Rutledge firm will work on contract to OMB.
In a candid interview, Rutledge called for a bold new approach -- a "U-turn" break with the past, abandoning Keynesian models that "didn't do a very good job of representing the real world." To do this, he says, "a very minimum requirement is a forecasting or scenario-building system which will allow you to make a U-turn." Rutledge's basic message: inflation "is a killer" that requires strict monetarist controls, as well as the supply-siders' emphasis on cutting taxes to stimulate production.
Rutledge pooh-poohs the idea that tax cuts will boost the federal deficit enough to exacerbate the inflationary problem. That's a muddle-headed Wall Street fixation, he feels. Budget deficits "cause damage" only because, traditionally, political pressure is placed on the Federal Reserve to monetize the debt -- that is, to print paper to support the debt, Rutledge said.
"What you're really talking about is that there are some pieces of paper [treasury obligations] out there, and you have to convince somebody to hold those pieces of paper," Rutledge argues. He says that if the public expects the inflation rate to go up, then it wants, instead, to hold tangible assets -- real property, gold, art objects and so on -- driving prices for such assets up (while prices for financial assets like stocks and bonds go down).
But if the expectations run the other way -- if people are convinced the inflation rate will come down -- then financing an $80 billion deficit in an economy where private assets may total $20 trillion is no problem. "You'd have tremendous demands for financial assets -- many times bigger than any deficit you'd ever think about. And higher prices in financial markets imply falling interest rates regardless of the deficit," Rutledge said.
Rutledge and the other "new right" spokesmen have been effective communicators and salesmen in the early days of the Reagan administration, although there is only a thin basis of analytical backup for their "scenarios." And what they are selling involves a much bigger departure from the past than merely a big tax cut, or a hefty across-the-board swing of the budget-cutting tax.
What it represents is a burial of what had become the conventional wisdom of the post-World War II economics "establishment." Gone would be the basic idea that business and consumer demand is what makes the economy go. Stockman, Rutledge & co. cast aside the notion that a main cause of inflation can be found in the push from oil prices, farm prices or wage costs. The reject the Phillips Curve relationship between inflation and unemployment. They disregard the theory that interest rates are either set by the Federal Reserve or influenced by different stages of the business cycle.
Instead, there is a passionate, almost zealous belief that inflation is a function of excessive government interference with the private economy, and that recessions are the direct result of erratic swings in government policy. The prescription, therefore, is a reduced size for government, and to keep what's left on a steady, predictable fiscal and monetary course.
"Our view of the world," Rutledge says, "is that it is expectation-driven. The only value the past has is in teaching people to think about the future. What you need to do is to provide them with signals that they view as reliable, and they will organize their lives around those signals."
There can be little doubt that the Democratic-Keynesian forecasting record since the glamour days of the '60s has been poor. Now, the Republican "new right," dominated by monetarists, has a shot at giving its theories a test run. We can only wait and see what happens.