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Wednesday, May 25, 2011

Economic Analysis and the Great Society

Although the Great Society should be understood as primarily a political phenomenon—a vast conglomeration of government policies and actions based on political stances and objectives—economists and economic analysis played important supporting roles in the overall drama. Even when political actors could not have cared less about economic analysis, they were usually at pains to cloak their proposals in an economic rationale. If much of this rhetoric now seems to be little more than shabby window dressing, we might well remind ourselves that the situation in this regard is no better now than it was then.

Regardless of how political actors in the 1960s might have sought to exploit economic analysis to gain a plausible public-interest rationale for their proposed programs, the most prominent body of economic analysis in those days—the sort taught by the leading lights at Harvard, Yale, Berkeley, and the other great universities—virtually cried out to be exploited in this way. During the mid-1960s the so-called Neoclassical Synthesis achieved its greatest hold on the economics profession.

This term “synthesis” refers to the combination of a microeconomic part, which contains the theory of individual markets that had been developed over the preceding two centuries, and a macroeconomic part, which contains the ideas about national economic aggregates advanced by John Maynard Keynes in his landmark 1936 book The General Theory of Employment, Interest, and Money and further developed by Keynes’s followers during the three decades after the book’s publication.

On the microeconomic side, the Neoclassical Synthesis incorporated the so-called New Welfare Economics that had been developed during the 1930s, 1940s, and 1950s. In this form microeconomic theory advanced a general-equilibrium theory of the economy’s various markets, identified the conditions for the attainment of equilibrium in this idealized system, and demonstrated that various “problems”—springing from external effects, collective goods, less-than-perfect information, and less-than-perfect competition, among other conditions—would cause the system to settle in a state of overall inefficiency: The value of total output would fall short of the maximum that would have resulted from systemic efficiency, given the economy’s available resources of labor and capital and its existing technology.

Attainment of such an inefficient state was characterized as a “market failure,” and economists expended enormous effort alleging the existence of such market failures in real-world markets and in proposing means (mainly taxes, subsidies, and regulations) by which the government might, in theory at least, remedy these failures and thus maximize “social welfare.”

Had economic theorists rested content with using the microeconomics of the Neoclassical Synthesis strictly as a conceptual device employed in abstract reasoning, it might have done little damage. However, as I have already suggested, this type of theory cried out for application—which, in practice, was nearly always misapplication. The idealized conditions required for theoretical general-equilibrium efficiency could not possibly obtain in the real world; yet the economists readily endorsed government measures aimed at coercively pounding the real world into conformity with these impossible theoretical conditions.

Closely examined, such efforts represented a form of madness. As the great economist James Buchanan has observed, the economists’ obsession with general equilibrium gives rise to “the most sophisticated fallacy in [neoclassical] economic theory, the notion that because certain relationships hold in equilibrium the forced interferences designed to implement these relationships will, in fact, be desirable.”

Great Society measures such as the Elementary and Secondary Education Act (1965), the Higher Education Act (1965), the Motor Vehicle Safety Act (1966), and the Truth in Lending Act (1968), as well as many of the consumer-protection and environmental-protection laws and regulations, found ready endorsement among contemporary neoclassical economists, who viewed them as proper means for the correction of purported market failures.

The assumptions that underlay these economic interpretations and applications, however, could be sustained only by wishful thinking. Economists presumed to know where general equilibrium lay, or at least to know the direction in which the quantities of various inputs and outputs should be changed in order to approach general-equilibrium efficiency more closely. But neoclassical economists cannot move the earth with a mathematical lever because they have no place to stand—no “given” information about (presumably fixed) property rights, consumer preferences, resource availabilities, and technical possibilities. What neoclassical economics takes as given is, in reality, revealed only by competitive processes.

If the microeconomic side of the Neoclassical Synthesis fostered government measures to remedy a variety of putative market failures, its macroeconomic side endorsed government measures to remedy the greatest alleged market failure of all—the economy’s overall instability and its recurrent failure to bring about a condition known as “full employment.”

The supposition that mass unemployment constitutes or reflects a market failure came easily to economists who had reached maturity during the Great Depression. By the early 1950s Keynesian ideas had entrenched themselves among the leading lights of the mainstream economics profession. Since then, some species of Keynesianism has been either in the professional saddle or clamoring to get there.

In the 1960s few economists disputed this general framework of analysis. Even critics such as Milton Friedman accepted it, arguing only that certain second-order aspects of the model differed from what the Keynesians assumed.

Few macroeconomists looked to monetary-policy changes as important means of pushing an economy out of what they viewed as a mass-unemployment equilibrium. For the typical macroeconomist of those days, fiscal policy—changes in government spending, taxing, and borrowing—held the key to keeping the economy on a steady growth path. By employing these instruments policymakers could effectively select from a menu of inversely related rates of inflation and unemployment, a tradeoff schedule known as the stable Phillips Curve. As if to certify the completeness of Keynesianism’s conquest, in December 1965 Time magazine put an image of Keynes on its cover and featured a long, laudatory article titled, “We Are All Keynesians Now.”

The Great Society programs, whether for microeconomic remedy of alleged market failures or for macroeconomic fine-tuning, had an important element in common: the presumption that technocrats possessed the knowledge and the capacity to identify what needed to be done, to design appropriate remedial measures, and to implement those measures successfully. In short, the Great Society amounted to social engineering—or worse, to sheer, groping social experimentation—on a grand scale. People ought not to have been surprised when its attainments failed to match its pretensions.