Economists have long relied upon certain consensus truths that are universally shared by others in the profession, or at least were until recently. Economists might have disagreed – and in fact often disagreed – on how these basic truths should be applied to particular situations, but the truths themselves were sacrosanct.
But the last few years have witnessed some extraordinary economic developments that have stood the basic tenets of economics on their ear. I have heard prominent economists – most notably former Fed Chairman Alan Greenspan and columnist Bob Samuelson – express the same complaint. It is as if religious leaders suddenly discovered that the Ten Commandments were a forgery.
The first and most obvious of truths to bite the dust is the assumption that flooding the marketplace with money will stoke inflation. For as long as I can remember, fear of inflation has been the one solid cornerstone of economics. In the late 1970s, inflation was in the double digits and the result was economic chaos. Fed Chairman Paul Volcker hiked interest rates, touching off a severe recession, but he escaped unharmed because it worked – we squeezed inflation out of the system, teeing up the longest and deepest expansion of our history.
But the last few years have undermined fear of inflation. The outgoing Bush Administration and incoming Obama Administration collaborated with Congress to pump massive amounts of money into the economy to prevent what appeared to be a looming depression. Economists disagree on how effective that was, but they agreed all that extra money chasing a finite supply of goods and services would spark inflation. It did not happen.
The next consensus truth of economics is that the Federal Reserve can stimulate economic expansion by lowering interest rates. The Fed has held interest rates at basically zero for years. According to all we know about economics that should have both stoked robust economic growth and evoked a round of serious inflation. Neither happened – not yet, anyway.
More recently, the Fed embarked upon its Quantitative Easing program that has pumped trillions more into the economy, a move that many predicted would lead to inflation. The QE is still in operation, though slightly reduced, but still we see no sign of significant inflation.
At the risk of promoting economic heresy beyond the pale, I have a sneaking suspicion that yet another basic truth of economics – that tax cuts stimulate economic growth – is another candidate for the dustbin. At the behest of conservatives in his party, President George W. Bush pushed tax cuts through Congress that transformed budget surpluses into deficits, but had little discernible impact on growth.
Conservative supply siders still contend cutting taxes is the one sure path to restoring economic growth. It is like a religion for them and without it they have nothing to say. But I don’t think the old theory works any more. An unprecedented combination of downward pressure on prices for goods and services coupled with anemic consumer demand mitigates against inflation – and also economic growth. What we need is a new economic theory to explain what is going on and presumably offer a way back to growth.