The pitfalls of dollar hegemony

handle easily.”

In hindsight, Kindleberger’s comment is uncanny, considering that central banks have since become economic policymaking’s “only game in town.”

Fed Chair Paul Volcker’s 1979-82 interest-rate shock, which halted the high in ation of the 1970s, was followed a decade later by the ideological and policy triumph of “central bank independence,” with Fed Chair Alan Greenspan becoming something of a nancial industry folk legend.

During the 2008 global nancial crisis, central banks took charge again. Under Ben Bernanke, the Fed extended “swap lines” of dollar credit to other central banks around the world, and these were soon followed by “unconventional” monetary policies like quantitative easing – trillions of dollars in asset purchases over the course of more than a decade. In 2012, the president of the European Central Bank, Mario Draghi, famously backstopped the euro by pledging to do “whatever it takes” to ensure its survival.

All these unconventional and extraordinary measures turned out to be merely a dress rehearsal. When COVID-19 struck, central banks unleashed even larger waves of liquidity, and most governments opened the scal spigots. But then came the in ationary surge of 2021, and monetary authorities have found themselves tasked once again with restoring price stability, à la Volcker.

THE MIT CONNECTION

Neither Kindleberger nor anyone else could have seen all this coming. Back in 1965, the only game in town was scal policy: the US economy was roaring in the wake of President Lyndon Johnson’s vaunted income-tax cut ( rst proposed by his predecessor, John F. Kennedy). This is also the moment that economist Alan S. Blinder chooses as the start of his A Monetary and Fiscal History of the United States, 1961-2021. In the late 1960s, Blinder was a doctoral student in the MIT economics department, where he presumably took Kindleberger’s classes in economic history. Today, Blinder warns that economics has become ignorant of its own past. Since his student days, the discipline has become more mathematical and less historical, and Kindleberger has been read less and less.

Following his retirement in 1976, and until his death in 2003, Kindleberger devoted himself to writing history. According to Mehrling, “Charlie” (as he calls him) knew something fundamental about how the global economy works that many mainstream macroeconomists have never absorbed, partly because they have insisted on viewing macroeconomics within a strictly national context. Here, he has in mind those generations of economists who earned their PhDs from MIT in the decades after World War II under the supervision of lions of the discipline like Paul Samuelson, Franco Modigliani (Draghi’s doctoral adviser), or Robert Solow (Blinder’s doctoral adviser, and a member of Bernanke’s dissertation committee).

Back in those days, MIT was the center of American Keynesianism, and its economics PhDs were poised to rise to powerful government positions – as Draghi, Bernanke, and Blinder’s career paths all attest. Yet, as Mehrling shows in his own subtle critique of this school, even if Kindleberger’s economics is not what men like Draghi and Bernanke profess, it is what they practiced as central bankers – thereby creating the world we live in today.

Mehrling, by contrast, has never occupied a government post. Instead, he has tirelessly developed his own distinctive “money view,” claiming Kindleberger as a direct antecedent.

Though his positions are not obscure (he has a substantial following in nancial and online circles), they tend to receive much less consideration within mainstream economics departments, such as at Princeton, where Blinder has long been based.

Hence, in his recent book, Blinder has 19 citations to works by the conservative University of Chicago economist Milton Friedman – the foil to his own liberal Keynesianism – but no reference to Mehrling’s scholarship, and only one passing mention (in a footnote) of Kindleberger’s 1978 classic, Manias, Panics, and Crashes: A History of Financial Crises.

So, while both books are about the same subject – monetary policy and history – they are like ships passing in the night. The question, then, is what might be learned from reading them together. If Mehrling’s book is a love letter to Kindleberger, Blinder’s book could be called a love letter to Kindleberger’s MIT colleagues – that is, to Blinder’s teachers and the architects of post-war American Keynesianism. These men, Blinder contends, basically got it right.

THE OTHER GAME IN TOWN

Fiscal policy is a powerful instrument, and it is often an appropriate way for governments to intervene in the business cycle to manage macroeconomic conditions. When national economies are in recessions (or depressions), a “ scal multiplier” validates countercyclical government spending aimed at increasing aggregate demand, output, and employment. According to Keynesian theory, each dollar of additional scal stimulus (spending or tax cuts) will yield more than a dollar in economic output, because the extra dollars in people’s pockets will create demand for even more products and services. But, of course, scal-led expansions run the risk of causing ination. Thus, the job of monetary policy is to manage the tradeo – depicted in the classic “Phillips curve” – between price stability and employment by positioning the economy at a point on the curve where there is neither too much in ation nor too much unemployment. This is the admittedly simplistic distillation of both post-war American Keynesianism and Blinder’s view. In his book, Blinder goes much further to o er a judicious assessment of the many historical events and intellectual fads in mainstream economics that have challenged its basic framework between the 1960s and the 2020s. Through it all, he concludes, the original framework held: “Rival doctrines to Keynesianism have come and gone over the decades covered in this volume: monetarism, the new classical economics of ‘rational expectations,’ supply-side economics, and others. But only one survived.”

Competitors to Blinder’s Keynesianism either stumbled on their own, like Friedman’s monetarism, or were absorbed into the “New Keynesianism,” which incorporates rational expectations. Today, supply-side economics lives on only as an embarrassing political canard. MIT Keynesianism survives, but with an important twist: the game shifted from scal to monetary policy. The three milestones were the in ation of the 1970s, President Ronald Reagan’s budget de cits in the 1980s, and the triumph of “central bank independence” in the 1990s, which set the stage for the “unconventional” monetary policies that have de ned the post-2008 era. In macroeconomics, the double-digit in ation of the 1970s was a boon for monetarism, which held that “in ation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Blinder counters this famous remark by Friedman by noting that the in ation of the 1970s resulted largely from energy and food “supply shocks.” Still, other critics of Keynesianism, like Robert Lucas of the University of Chicago, correctly criticized its standard models for not su ciently considering the expectations of economic agents.

When Volcker was appointed Fed chair in 1979, in ation had been running high for almost a decade. In a show of resolve, he pivoted US monetary policy toward Friedman’s preferred approach: managing the quantity, or stock, of money. By targeting a lower stock, Volcker relinquished the Fed’s discretionary control over short-term interest rates, which duly skyrocketed. But Volcker soon abandoned that e ort, partly because the US economy had fallen into a steep recession by 1982, and partly because it had proven practically impossible to measure – let alone adjust – the stock of money. After all, the quantity of money is determined as much by the elusive demand for it as by its raw supply. Although price in ation was reined in, monetarism was discredited, and liberal Keynesianism learned to appreciate the importance of “in ation expectations.”

THE DEFICIT FACTOR Volcker ended his term as Fed chair under Reagan, who subsequently appointed Greenspan. Reagan’s focus was not on monetary policy but rather on taxes. Invoking the supply-side gospel, he promised that tax cuts would increase business investment and lead to higher rates of productivity, economic growth, government revenue, and hence lower budget decits. But none of this happened after Reagan’s 1981 tax cut. Instead, budget de cits ballooned.

When Bill Clinton took o ce in early 1993, Blinder joined the administration as a member of the White House Council of Economic Advisers, and the budget de cit took center stage. Robert Rubin, a former co-chair of Goldman Sachs, took charge of Clinton’s economic team and convinced the president to balance the budget to assuage the bond market. A bond-market rally, he reasoned, would cause long-term interest rates to fall, inducing greater private investment in the “New Economy” of high tech. Clinton balanced the budget, and investment surged, owing partly to accommodative monetary policies from the Greenspan Fed, which wisely bet on the power of the New Economy to increase productivity growth.

It was in this context of catering to nancial markets that the Clintonites trumpeted “central bank independence.” Blinder, defending his brand of Keynesianism, insists that the 1990s boom was an exceptional occurrence, while many liberals, like Rubin, mistakenly took it as an indication that the scal multiplier was “negative,” implying that it is always best to balance the budget to win private investors’ con dence.