The Keynesian Corner

By Robert Murphy,

Last Tuesday the Fed announced a surprise rate cut of 75 basis points, the biggest cut in 24 years. Even so, the stock market plunged, with the S&P 500 shedding 1.1% during the session, bringing its total losses to over 10% for 2008.

The Fed has now painted itself into a Keynesian corner. According to old-school Keynesianism, the government faces a Phillips Curve tradeoff. It can adopt a loose monetary policy, which spurs output but leads to price inflation. Or, the government can adopt a tight monetary policy, which keeps prices under control but leads to recession.

The sobering experience of the 1970s demonstrated that this Keynesian orthodoxy was nonsense. Ultimately, printing green pieces of paper doesn’t make a society richer, it just causes prices to rise. Once citizens adjust to the constant injections of new money, unemployment returns along with massive price hikes. Thus the term “stagflation”—meaning double-digit rates of unemployment and inflation—was coined.

READ THE REST