In classical (pre-Keynes) macroeconomic thinking, there was no accounting for the creation of bubbles, the fact that bubbles might burst, and that the burst might lead to painful, lengthy consequences. In the classical world, prices adjust and markets clear. End of story.
Of course markets sometimes take a long time to adjust, and Keynes got the economics profession to think about those dynamics, the downward spirals that can occur, and what might be done to reverse those spirals and, thereby, dampen the swings in the business cycle. This was the Keynesian revolution. In the 25 years following WWII there was a convergence in Keynesian and classical thought called the neoclassical synthesis, which thrived until the Great Stagflation of the 70s, during which the neoclassical levers of fiscal and monetary policy were challenged.
It was during the 70s that a new revolution was born, the rational expectations revolution. Whereas Keynes tried to account for consumer psychology (“animal spirits”), the rational expectations thinkers emphasized consumer foresight—namely that consumers and investors do not merely respond to changes in prices; instead, they look to the future. Keynesian models work on paper because they assume the government is this magical entity responding to shortages and surpluses in aggregate demand. When government spends in the Keynesian world, aggregate demand (and hence GDP) rises because consumers are simply non-thinking automatons that observe the new spending and feel happy about it (those dang animal spirits again!). But in the rational expectations world, consumers can see what the government is doing and ask, “What does this spending mean for the future?”
The rational expectations revolution killed the myopic consumer and myopic investor. There were now “New Keynesians,” but all their models had some kind of rational expectations framework built in. Even though the New Keynesians emphasized sticky prices and other factors that would keep markets from adjusting (thereby creating a role for traditional fiscal and monetary policies), no one believed anymore that people could be duped into not thinking about the consequences of government finance.
But the Great Recession brought forth a resurgence of old style Keynesians, led by their new arch bishop, Paul Krugman. They argue, once again, that the problem is inadequate demand and that the solution is for government to raise aggregate demand by spending. Deficits are of no concern because people don’t ask about the future. There is only today. For them the size of government and the future size of government are irrelevant. People aren’t spending enough so government has to fill in the gap. Krugman argues again and again that concerns about the deficit are silly because interest rates are low. He neglects to emphasize that they are low primarily because the Fed is keeping them low or that demand for debt might fall rapidly in the future as investors around the world get more nervous about the future solvency of the US government, thereby sharply raising rates.
In a world where government is relatively small and constrained, attempting to run counter-cyclical policy has little consequence (it doesn’t do much good, but doesn’t do much damage, either). But what Keynesianism completely neglects is the crisis in confidence that is occurring as citizens see their government spiraling out of control–spending vast amounts of money on stimulus, creating huge new entitlement programs, and saddling markets with an ever increasing amount of regulation. In the Keynesian world, government is unconstrained; markets fail but government can’t fail. In the Keynesian world, people don’t worry about what government is going to spend the next year and the year after that. All they care about is the present.
But in the real world, people are terrified, with just cause, about the ability of government to meet the rapidly growing pile of obligations on its balance sheets. We know that when those obligations get paid, we (and our children) are the ones that will have to pay them. And we see a federal government that seems so completely unconstrained by constitutional limits or by reason, always willing to make promises it can’t keep, always willing to pass new productivity-killing regulations, always willing to see new ways to creep further into our lives.
In short, the continued health of the economy depends on constrained government and economic freedom. It depends on a renewal of the idea that people are not idiots.
Long live the rational expectations revolution!