A thinking deficit

This book by Martin Prachowny is a two-pronged assault on recent thinking about demand management. This has argued that monetary policy should be devoted to inflation control, while fiscal deficits should be brought down to low levels so that the ratio of debt to national income can settle at a sustainable rate; meanwhile both monetary and fiscal policy should permit automatic stabilisers to work -- interest rates and net tax revenues should rise and fall with the business cycle. "Activist fine-tuning", to push unemployment down aggressively for example, should be avoided.

Against this view the first prong of the Prachowny assault is that in the United States -- his exclusive focus in this book -- there is a "robust" relationship between inflation and unemployment, which may have shifted in the 1970s and 1980s but remained intact after adjusting for the shifts. Hence the US authorities could have kept unemployment at the "natural rate" (ie that at which there would be no inflationary pressure) by "accommodating core inflation". Translated into plain English this means allowing the underlying inflation of the time to continue at whatever rate it had reached. Prachowny believes such a policy would have been justified by the usual social trade-off between inflation and unemployment: policy would have an expansionary bias with low inflation and unemployment below the natural rate and a "slight" contractionary bias at double-digit inflation with unemployment above the natural rate.

This quite extraordinary comment comes at the end of a long critical narrative concerning the Reagan demand policies. The author in effect denies any link between policy (to reduce unemployment below the natural rate, at which inflationary pressure builds) and the "core" inflation rate. Yet the latter is conditioned by expectations and therefore cannot be immune to policy on any reasonable theory.

If it is generally believed that inflation will be built into the economy in this way, expectations of inflation would rise and so also would inflation. The inflation implied by the Prachowny rule once people had cottoned on in this way, is 5.7 per cent at a natural rate of 4 per cent and 8.6 per cent at a natural rate of 6 per cent (the rate thought to have prevailed in the Reagan period). Hence the suggested rule would have led to sustained inflation well above what Americans apparently voted for.

This leads us to Prachowny's second prong. He regards as dangerously misleading the idea of an appeal to an average or "representative" household as the basis for these "social" preferences, because of wide differences in household characteristics. Specifically, in the labour market "insiders" with seniority in the firm will care less about unemployment: as the median voter will be one of these, Prachowny suggests that policy will tend to be tougher on inflation -- with less emphasis on cutting unemployment -- than the logic of the last paragraph. On the other hand in fiscal policy the median voter may lose more as a worker from the contraction of public spending than he would gain from any expansion in private spending -- because he works in the public sector, according to an interesting computation. Prachowny concludes that cutting deficits may be politically impracticable.

This analysis is an attempt to apply public choice theory (ie political economy) to demand policy. However it is of doubtful success. Take the deficit calculation: here Prachowny locates the median voter as the worker who has the median net loss. If this was the only issue on which he was voting as in a referendum that would be right: but in an election with many issues the median voter group is defined by an overall preference on all issues combined. The right question is whether for that group -- say lower middle class households -- cutting the deficit is a problem. Furthermore it should look further than the direct job effects, namely at future tax cuts made possible by lower borrowing. The evidence of government behaviour does not support the view that deficits do not come down: for example the UK had surpluses in the late 1980s, the Irish cut their deficits sharply in the middle of that decade, American deficits have been cut recently and even the Italians are doing so after a voter revolt partly on that issue.

As for demand management, why should the voter not be tough on inflation once he realises that there is no long-run trade-off between inflation and unemployment (because unemployment cannot in the long run deviate from the natural rate)? Prachowny argues that government should be frank about the existence and likely value of the natural rate. But it is then unclear why the voter should not, if following his interests in the rational way Prachowny assumes, work out that from his viewpoint demand should be geared to price stability, apart from short-run response to shocks. Again the evidence supports this view -- witness the low inflation around the world now, after a severe tightening at the end of the decade when inflation in the Organisation for Economic Cooperation and Development rose towards only 5 per cent.

This book's attack on current thinking therefore fails on both fronts. However in spite of its strangely half-baked logic it contains many details that are interesting, such as the Reagan narrative and the voter calculations. Provided the reader is safely immunised, the book can be read with some profit.

Patrick Minford is professor of applied economics, University of Liverpool.