This is my first entry in TPMCafe Book Club’s discussion of Eric Rauchway’s book, The Great Depression and the New Deal: A Very Short Introduction. Eric’s post to start the discussion asked two questions, (1) why was there a Great Depression in the first place?, and (2) what happened to the principle of countervailing power after the New Deal?
Here’s the post:
Countervailing Power Vacuum: I want to come back to Eric’s first question in a later post, the question of how depressions come about, and turn to his second question, “what happened to the principle of countervailing power after the New Deal? Did it remain a core concept of American politics, and if so, for how long?”
The idea that countervailing power is needed to balance labor markets has faded over time, and I think the movement toward deregulation in the 1970s is part of the reason for this, and that economists were one of the driving forces behind this change. We hear a lot about the role that Nixon and the Republicans played in bringing about a push for deregulation, a push that found success, but we hear less about the role that the economics profession played in setting the stage for the deregulatory phase that began in the 1970s, a phase that continued for decades and has only recently been muted – perhaps – by the present crisis in the US and world economies. Thus, I’d like to focus on changes within economics that set the stage for the anti-union movement and gave intellectual credence to this movement.
Two changes within the profession that provided the intellectual foundation for the deregulatory movement come to mind (and I’ll be interested to hear other takes on this). The first big event was the failure of the Keynesian model to provide an adequate framework for understanding and responding to the economic events and turmoil of the 1970s. The model did not have an adequate theory of supply, it had a relatively naive view of expectations, and it did not have much to say about inflation, a key question in the 1970s.
The failure of the Keynesian model left a void in the profession, and it was quickly filled by the Chicago School’s New Classical model, a model that dragged a good deal of ideology about government intervention into the public discourse. The model was hailed as a great intellectual and scientific leap forward. It was claimed to have microfoundations unlike it’s ad hoc Keynesian predecessor, i.e. it was based upon optimizing behavior of households and firms. In addition, unlike the Keynesian model which simply imposed things like rigid wages without thinking through whether such arrangements were consistent with optimizing behavior, the model was built from the ground up and hence was based upon defensible economic principles. The Keynesian model could not make such a claim (not so for the New Keynesian model used today, microfoundations are one thing that separates the New Keynesian model from the Traditional Keynesian model). And finally, the Keynesian model had a very naive model of expectations that was no match for the rational expectations embedded in the New Classical structure. So Keynesianism, and it’s belief that government intervention could make things better, gave way to a new paradigm.
A key element of the New Classical model was its ability to explain why money and output appeared to be correlated in the data without admitting that government intervention could be useful in stabilizing the economy. The ability to explain this correlation was one of the Keynesian model’s triumphs over the older Classical model that existed before the New Classical revolution. In the old classical model, money is neutral – it does not change real variables such as output and employment – so prior to the New Classical model, classical economists had a difficult time explaining why money and output appeared correlated (and causal) in the data. The New Classical argument was that any policy that can be anticipated in advance will be offset by private sector responses to the policy – it will be completely ineffective – unless the policy is unexpected. So policy rules that move money in predictable ways – up in recessions, down when there is inflation – will be useless. But if the policy is unexpected, in which case it is non-neutral and does change real output and employment, it makes people worse off rather than better off because it drives us away from the optimal full information solution.
The result of this was the idea that government intervention always makes us worse off. Policy rules don’t work, and unexpected random policy is counterproductive. The best thing the government can do is to provide transparent, certain policy so that nothing unexpected ever happens. Best to just let the money supply grow at a fixed, known rate than try to manage the economy by manipulating the money supply. To buttress the result that government intervention was counterproductive, the New Classical economists also began to challenge the idea that fiscal policy could be used as a stabilization tool in place of monetary policy. The government, in this way of thinking, has no business whatsoever intervening in markets. It always makes us worse off, never better off, so the best thing to do is to simply get out of the way and leave it to the private sector to take care of itself.
The other factor was an assault on the idea of monopoly power in markets. For example, one idea that emerged was the idea was that markets, even markets that looked relatively concentrated, were actually quite competitive, i.e. they were contestable. That is, as soon as a firm in a top heavy industry begins trying to exploit its monopoly power, even when it is the sole or one of the few producers in markets, another firm waiting in the wings will quickly enter and contest the market (the nature of capital is important here, it needs to be able to move into these markets quickly). This discipline by the firms waiting to pounce at the first opportunity, it was believed, was sufficient to ensure that markets that appeared highly concentrated would in fact be competitive in terms of pricing and other behavior. (Globalization of markets was another factor that led people to discount market power at the firm level.)
I don’t want to oversell the contestable markets story, it was but one of many developments, but the point I am making is that there was widespread belief that markets that appeared to be quite top heavy were, in fact, quite competitive. And, importantly, if they weren’t competitive, an automatic self-correction mechanism would take care of the problem, there was no need for government to do anything, natural forces would intervene as needed and solve the problem.
The point, then, is that economists by and large began to believe that markets were self-correcting, even with respect to monopoly power, and anything governments do, from intervening to break up monopolies to supporting union power, gets in the way of this natural, self-correction process. Thus, unions were not needed as a countervailing force, markets would take care of the problem until there was nothing left to countervail, i.e. markets would naturally produce a competitive marketplace. All government had to do was step aside and watch the magic happen. Market power was bad, whether it be in the hands of firms or workers, and since firms operated in competitive markets, there was no need for unions to balance power. They would just make things worse by causing departures from competitive ideals and making it harder for business to compete in world markets.
We have now observed how well the idea of self-correction and self-regulation worked in financial markets – it didn’t work well at all – and I see no reason why it should work any better in bringing about a competitive labor market where one does not exist previously. I don’t think the self-correction ideas lived up to their promise, there was and still is an imbalance of power in labor markets with firms surely having the upper hand, and some means of balancing the negotiations between laborers and firms is needed. The only question for me, and it’s one I don’t have the answer to, is whether the old institutional structure supporting unions is the best possible institutional structure going forward in a highly globalized, interdependent, and flexible world economy. I’m not sure that it is, but I do believe that more balance is needed in labor markets, and until we have something better, unions will certainly more than suffice.[Note: I’m not sure this is the main reason behind the change, so please feel free to offer other theories for the decline of the principle of countervailing power.]