What Was the Keynesian Alternative to the Volcker Shock?

It is commonly said that the “stagflation” crisis of the 1970s posed a problem to which a hitherto dominant Keynesian economics had no answer. In the end, the inflation was broken by a sharp hike in interest rates (the “Volcker shock”) which resulted in the worst recession since the 1930s. Some latter-day Keynesians, like Paul Krugman, credit Volcker with doing the “hard, unpopular work” of disinflation (along the way, shifting credit for the eventual 1980s boom from Reagan to Carter, who appointed Volcker.) Marxists, on the other hand, also embrace a version of fatalism: the crisis of the 1970s had to be overcome either by a break to the left or by capitalist revanche; with the former defeated, something like the Volcker recession was inevitable.

I have a good deal of sympathy with the Marxist view that liberal political economy was baffled by the crisis of the 1970s, but I have often wondered what Keynesians at the time thought ought to be done. One of the decade’s well-known liberal alternatives, the Humphrey-Hawkins Full Employment Act, enjoyed tepid support at best from the Keynesian elite, precisely because of its ostensibly inflationary effeccts. In the writings of Yale economist and former Kennedy advisor James Tobin, though, I have found two alternative policies suggesting what liberal Keynesians thought might be done:

The first is an incomes policy, which Tobin calls “a conveniently evasive term” including “everything from full-fledged wage and price controls to wage/price guideposts and ‘open mouth operations without legal sanction.” Tobin discusses this as an explict alternative to disinflationary recession:

The disinflationary monetary policies adopted by all major central banks and governments in 1979-80 have significantly lowered inflation, but at heavy costs…I advocated incomes policies, guideposts for wage and price increases with penalties or rewards to induce compliance, as a means of achieving disinflation with less cost in unemployment and real economic growth. In fact, I believe that some types of incomes policy should be a permanent tool of macroeconomic policy, in order to arrest the dismal upward trend in unemployment, apparently regarded by policy makers as essential to avoid risk of new surges of inflation.

The politics of how an incomes policy might have been managed is, of course, another question entirely. Even countries with policies along these lines (like the U.K.) suffered a related crisis in the 1970s. In the U.S., organized labor under the leadership of George Meany resisted an incomes policy, partly out of an ideological commitment to “free collective bargaining” and partly because of the memory of Nixon’s austere version of peacetime wage and price controls. For their part, capitalists naturally would be suspicious of political wage setting, especially if it required them to share information with the government which had been proprietary. In a retrospective on Reagan’s politics, Tobin revealed some sense of these politics:

There had been a stab at incomes policy in the Carter administration in 1979, but it was abandoned just at the crucial time. Rumor was this decision was related to the contest for the Democratic presidential nomination, specifically to the position of organized labor. No incomes policy was conceivable in the new administration, although President Reagan’s tough stand against the air traffic controllers in 1981 taught an exemplary lesson. One could say that the Fed itself was carrying out an incomes policy, albeit one that worked via actual pain and cost rather than by conjectural fears.

The other idea was to change the mix of monetary and fiscal policy. Instead of Volcker’s high interest rates and Reagan’s huge deficits, Tobin would have preferred easy money and a balanced budget. He (and others, including Paul Samuelson) had advocated this mix since at least the Kennedy administration. Here is Tobin reflecting on the 1980s:

For the management of aggregate demand, monetary policy has been the only game in town since 1981. The Reagan administration disabled fiscal policy as a tool of macroeconomic stabilization and dedicated to wholly other goals…Structural budget deficits far beyond previous peacetime experience clouded the environment to which the Fed had to adapt…As early as the Spring of 1982, I suggested a tripartite accord–White House, Congress, and Fed–to shift the policy mix to tighter budget and easier money. It was a good idea then, and it has been a good idea ever since.

Judith Stein’s Pivotal Decade, a critique of Keynesian statecraft largely focused on the need for microeconomic industrial policy, suggests something similar: “Monetary policy might have been less stringent, and therefore the recession less severe, had Reagan’s fiscal policy been more restrained.” Insofar as the Reagan deficits were a result of defense spending, this raises interesting questions about the relationship between the Cold War and the options available for managing a capitalist economy in the 1980s.


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