When John McCain was running for the Republican presidential nomination nearly 12 years ago, he declared that Alan Greenspan was so critical to the economy that, if the then-Federal Reserve chairman died, he’d put sunglasses on the body, prop him up and hope no one noticed.
It’s safe to say that GOP opinions of the Fed have slipped a bit since. Texas Gov. Rick Perry, a newly declared candidate for president, said it would be “treasonous” for Greenspan’s successor, Ben Bernanke, to “print more money between now and the election” in an effort to boost the economy. Other candidates have been equally damning if slightly less extreme in their statements. Rep. Michele Bachmann of Minnesota has accused the Fed of “debasing the currency,” while Rep. Ron Paul of Texas has written a bestseller called “End the Fed.” The party’s economic standard-bearer in the House, Paul Ryan of Wisconsin, repeatedly charges the Fed with “bailing out” what he considers President Obama’s reckless fiscal policy and wants the institution stripped of its mandate to promote employment.
If Republicans dislike monetary stimulus, they loathe its fiscal cousin even more, routinely labeling Obama’s stimulus as ineffective, or worse, counterproductive. They want balanced budgets, the sooner the better. Bachmann, for instance, has advocated an immediate 40 percent cut to federal spending by barring any increase in the debt ceiling. This, too, is at odds with the party’s earlier views. The administration of George W. Bush sold its 2001 and 2003 tax cuts as Keynesian-style economic stimulus. Lawrence Lindsey, a top Bush adviser, even likened opponents of the tax cuts to President Herbert Hoover, whose obsession with balancing the budget in 1932 worsened the Great Depression.
Certainly, some of this rhetoric is just political opportunism. The Fed and the stimulus package are handy proxies for Republicans’ real target, which is Obama in the 2012 election. But something more fundamental is going on: The economic ideology of the Republican Party has changed in recent years in an important and little-appreciated direction. Liberals and conservatives in the United States have long differed on how much the government should meddle in individual markets, whether for energy or health care. But they have largely agreed that the government should have at least some role in smoothing out the ups and downs of the business cycle — what economists call “macroeconomic stabilization,” that is, containing inflation in good times and boosting employment in bad.
But this is the consensus that many Republicans in effect now reject. In their view, the government has no more role meddling in the business cycle than in any other market. “Many of our problems can be traced to a misguided belief by politicians that the American economy is something that can be controlled or micromanaged or influenced positively by government intervention and borrowing,” House Speaker John Boehner (R-Ohio) said in a speech in May. He went on to explain that “for job creators, the ‘promise’ of a large new initiative coming out of Washington is more like a threat. It freezes them. … The rash of ‘stimulus’ legislation passed by Congress in recent years has been one of those obstacles.”
This is not to be confused with supply-side economics, the dubious Reagan-era doctrine that tax cuts would generate enough economic growth and revenue to reduce the deficit. Republicans still believe in lower taxes but generally don’t claim they pay for themselves. The new GOP views actually have a much longer pedigree: They are rooted in an intellectual contest that raged during the 1930s and 1940s, and had long been settled by the opposing side.
Before then, orthodox economics held that the economy was self-correcting. Just as the price of wheat or the wages of carpenters would always adjust to eliminate surpluses or shortages of either, so would wages throughout the economy adjust to eliminate temporary bouts of high unemployment.
The Great Depression shattered that orthodoxy, as high unemployment became entrenched in the United States and around the world. British economist John Maynard Keynes convincingly argued that when interest rates were zero — a condition he termed a “liquidity trap” — the economy’s self-correcting properties did not operate. The best solution, he argued, was a burst of public spending to restore demand and employment.
Among Keynes’s leading opponents were economists of the “Austrian school” such as future Nobel laureate Friedrich Hayek and Ludwig von Mises. Austrians considered recessions a natural feature of capitalist economies, and efforts to suppress them via monetary or fiscal policy were apt to distort investment, worsen booms and busts, or lead to inflation. No government planner could know enough about a complex, dynamic economy to competently manage it, and their interference would ultimately lead to a bigger state and socialism. “Today, the majority of the citizens look upon government as an agency dispensing benefits,” von Mises wrote in 1949, for which he blamed “Lord Keynes and his disciples.”
The Austrian view had little impact on mainstream economics but has always resonated with part of the public, and is now experiencing a renaissance with the tea party movement and among prominent Republicans. Bachmann says she takes Von Mises to the beach; Ryan is an admirer of Hayek (as was Ronald Reagan).
It’s Keynes’s views, however, that won out and came to dominate postwar economic policy. A generation of American economists such as Alvin Hansen and Paul Samuelson made their names by elaborating on his theories, and the Employment Act of 1946 enshrined the federal government’s responsibility to “promote maximum employment.”
Keynesian policy fell into disrepute in the 1970s, when its advocates tried to drive unemployment ever lower using fiscal and monetary policy. Instead, they brought on ever-rising inflation and a series of deep recessions. This did not, however, invalidate macroeconomic stabilization: The job simply became the preserve of the Fed. It handled it with aplomb, skillfully managing inflation and unemployment so that the 1980s, 1990s and early 2000s were a period of exceptional macroeconomic stability. No wonder McCain advocated the “Weekend at Bernie’s” strategy for keeping Greenspan around.
In retrospect, the stability of that era bred complacency, encouraging households to accumulate too much debt and financiers to take too many risks (something the Austrian economists warned against), leading to the economic turmoil that began in 2008. The subsequent crisis and recession were so deep that they exhausted the Fed’s conventional remedy of lowering short-term interest rates. Obama’s 2009 stimulus package and the Fed’s foray into “quantitative easing” — that is, buying government bonds to lower their yields and thus increase spending — were unprecedented but nonetheless orthodox responses to economic weakness when short-term interest rates are zero.
Many Republicans consider the tepid economic recovery an indictment of Keynesianism, and use the word as an epithet, as in “Keynesian utopia” (Sarah Palin) or “Keynesian bubble” (Ron Paul). They argue that aggressive fiscal and monetary stimulus have made things worse by generating uncertainty among firms and investors, and that austerity would put things right.
They almost surely have it wrong. Uncertainty about fiscal and monetary policy was also rampant in the early 1980s: Taxes were cut and raised repeatedly and the Fed tried, then abandoned, efforts to target growth in the money supply instead of interest rates. Yet after a sharp recession in 1981-82, the economy took off, primarily because the recession had been induced by high interest rates and, once rates fell, demand sprang back.
American businesses — with some justification — complain that regulatory uncertainty has increased under the Obama administration. But weak U.S. growth primarily reflects the difficulty of stimulating demand through lower interest rates at a time when the private sector and the financial system are trying to shed debt — exactly the sort of liquidity trap Keynes identified in the 1930s. Other countries have experienced similar stagnation in the wake of financial crises. As for austerity boosting growth, the International Monetary Fund has found that far more often it does the opposite: Cutting the deficit by 1 percent of gross domestic product raises unemployment by 0.3 percentage points. The effects tended to be worse when they were not offset with lower interest or exchange rates.
What would the Republican Party’s new economic ideology mean if the GOP nominee assumes the presidency in 2013? A Republican president would influence fiscal and monetary policy (remember, Bernanke’s term at the Fed ends in 2014 and the president will appoint his successor). The answer is not simple, because the candidates’ views are not monolithic. Bachmann and Paul are at one extreme; former Massachusetts governor Mitt Romney is at the other, personifying Republicans’ more traditional deference to economic orthodoxy and the Fed. In between are people such as Ryan, a rumored but undeclared candidate, who is fine with garden-variety monetary policy but opposes quantitative easing and disparages fiscal stimulus as “sugar-high” economics.
If we take their views at face value, we would not expect the new president, even if dealing with a renewed economic slump, to bless more fiscal or monetary stimulus. Indeed, more spending cuts and higher interest rates could be in store. That would be tolerable if a recovery were well entrenched by 2013 — but would constitute a major headwind if growth remained tepid. A shift toward fiscal and monetary austerity in the United States in 1937 helped prolong the depression. Fiscal tightening helped push Japan back into recession in 1997.
Of course, it’s one thing for a Republican candidate to inveigh against macroeconomic fine-tuning while stumping for tea party votes during the primaries. Once in office, presidents must think more carefully about the consequences of their decisions, both for the economy and reelection. At present, the public is far more worried about jobs than the deficit. Perry has criticized Obama for spending that would make “Keynes blush,” but as governor accepted Texas’s share of the money. Should he end up in the White House, policies that once looked treasonous might start to seem sensible.
Greg Ip is the U.S. economics editor of the Economist and the author of “The Little Book of Economics: How the Economy Works in the Real World.”
Three decades ago, George H.W. Bush decried supply-side economic theories as “voodoo.” Now,