Published by EH.NET (June 2009)

John H. Wood, A History of Macroeconomic Policy in the United States. London: Routledge, 2008. xiii + 221 pp. $150 (hardcover), ISBN: 978-0-415-77718-6.

Reviewed for EH.NET by David C. Wheelock, Federal Reserve Bank of St. Louis.

Does macroeconomic theory have any influence on macroeconomic policy? Not much, according to John H. Wood, Reynolds Professor of Economics at Wake Forest University. In his book, A History of Macroeconomic Policy in the United States, Wood argues that U.S. fiscal and monetary policy have been remarkably consistent over the decades and largely uninfluenced by macroeconomic theory. Economists have rationalized more than influenced policy, Wood contends, and the direction of influence between economic theory and practice is primarily from the latter to the former. ?Conservatism in monetary and fiscal policies is … unavoidable in a democratic society of enduring interests,? Wood argues, whereas ?economists [have] gyrated from classical to Keynesian to New Classical theories.?

The book divides neatly into two halves ? one focusing on fiscal policy and the other on monetary policy. Each half has three chapters. The first deals with interests and institutions; the second with ideas; and the third with practice. The section on fiscal policy begins with a history of tax conflicts in the United Kingdom and the United States to illustrate that ?government budgets are political outcomes of conflicts between interests? and that ?tax changes not supported by interests have little chance, including … those advocated by economic theorists.? Wood describes the fiscal tussles between the British monarch and Parliament following the Glorious Revolution, Britain?s unsuccessful attempts to impose enforceable and palatable taxes on its American colonies, and the problems of raising and collecting revenue encountered by the American states. He includes a lengthy description of the history of U.S. tariff policy and a short section on the role of military spending on the U.S. federal budget since World War II.

Next Wood examines the theory of stabilization policy, focusing on how the ideas in Keynes? General Theory were framed and modified by subsequent economic theorists and how those ideas were presented to policymakers. Keynesian policy prescriptions are widely cited as a key reason why government budget deficits have been the rule, rather than the exception, since World War II. However, Wood argues that The General Theory had little influence on policy because of both the evolution of Keynesian economics and, more importantly, the persistent lack of impact from economic ideas on the institutions and interests that determine government spending and revenues. Wood argues that military spending and tax smoothing have been the main determinants of the annual federal deficit historically and explain the size of postwar deficits as well as they do deficits before World War II. Further, he reports regression evidence indicating that the GDP gap had little or no influence on the size of the deficit during 1956-2001, indicating little evidence of systematic stabilization policy. Of course, the absence of systematic stabilization policy does not preclude occasional attempts to use fiscal actions to steer the economy. Wood admits that tax cuts in 2001 and 2008 were justified by ongoing recessions, and the massive economic stimulus package enacted by Congress and signed by President Obama in February 2009 was perhaps the most obvious example of Keynesian stabilization policy ever attempted. Nonetheless, Wood?s contention that economic theory has had only limited impact on the U.S. fiscal position historically is largely convincing.

The second half of the book follows a similar path in describing how interests and politics, rather than economic theories, have driven U.S. monetary policy over time. Again, Wood begins in England. The Bank of England was granted a charter in 1694 in return for a loan to the government, and for many years the Bank?s operations and privileges were intertwined with its lending to the government. By the nineteenth century, the Bank?s focus evolved more toward financial stability, though Wood notes that the Bank never accepted Bagehot?s call for making an explicit commitment to act as lender of last resort.

Next, Wood describes the history of central banking in the United States, beginning with the first and second Bank of the United States. Contrary to conventional wisdom, Wood argues that the Second Bank did not pursue a macroeconomic stabilization policy, but rather acted mainly in its own interest. Further, the Bank?s relative conservatism reflected its favored position and size, which made it the industry leader.

The Federal Reserve was established in 1914 to promote financial stability. Although a product of the Progressive Era, the Fed was dominated by bankers and pursued policies that fostered banking profits. Wood argues that financial stability remained the Fed?s principal goal even after a major reorganization in 1935 that sought to reduce the influence of private interests on policymaking. Wood contends that Federal Reserve policy has been remarkably consistent throughout the institution?s history, arguing that ?the Fed continues to see the world today much as it did in the 1920s.? The Fed?s assistance to financial markets and institutions in 2008, Wood argues, was entirely consistent with its long-standing focus on preserving financial stability.

Wood contends that conflicting interests and pressures on the Fed explain the Fed?s uneven performance over time with respect to price stability. He argues that ?bankers have always appreciated that financial stability requires an environment of price stability? and that the Fed has generally pursued price stability when it was able to do so. However, inflation began to rise in the mid-1960s when the Fed faced intense political pressure to hold down interest rates.

Perhaps I have an inflated view of the influence of economics and economists on recent Fed policy because I have been a Federal Reserve economist for several years. Wood argues that Fed officials were aware of the importance of inflation expectations and policy credibility before those concepts became prominent features of macroeconomic models. However, policymakers seem not to have worried much about expectations or credibility before the 1980s. Moreover, only since the 1980s have Fed officials acknowledged that the rate of inflation is determined solely by monetary policy. That is a stark change from the 1970s when Fed officials, as well as many academic economists, blamed inflation on government budget deficits, energy price shocks, and monopolistic pricing.

As Wood argues, the stability of financial markets, particularly the New York money market, has been a principal goal of Federal Reserve officials throughout the Fed?s nearly 100-year history. Concern with financial market conditions also undoubtedly explains the Fed?s vigorous response to the recent financial crisis, which resulted in a doubling of the size of the Fed?s balance sheet and monetary base in a matter of months. However, unlike the Fed?s response to financial crises during the Great Depression, I believe that the Fed?s recent efforts to stabilize the financial system reflect the desire of Chairman Bernanke (and other officials) to avoid a 1930s-style deflation, rather than to protect the financial system per se.

Although I am not entirely convinced by Wood?s arguments and evidence, especially about the relative influence of economists and economic ideas on Federal Reserve policy in recent years, this book provides considerable insight about the influences on U.S. macroeconomic policy and why economic theory historically has had little impact on policy. Accordingly, the book should be of interest to a broad audience of macroeconomists and political economists, as well as to economic historians.

David C. Wheelock is an assistant vice president and economist at the Federal Reserve Bank of St. Louis. He is the author of The Strategy and Consistency of Federal Reserve Monetary Policy, 1924-1933 (Cambridge University Press, 1991). Among his recent publications is ?The Federal Response to Home Mortgage Distress: Lessons from the Great Depression,? Federal Reserve Bank of St. Louis Review, May/June 2008.