Blinder faith.

IVY LEAGUE debutants usually come out in traditional towns like New York, Boston, or Philadelphia, but ex-Princeton economics professor Alan Blinder, recently appointed vice chairman of the Federal Reserve, chose instead to make his maiden speech in Jackson Hole, Wyoming, at a meeting sponsored by the Federal Reserve Bank of Kansas City. But nobody asked him to dance. In front of many of the world's leading central bankers, business people, and economists, Blinder argued that interestrate policies should be aimed at reducing unemployment rather than simply targeting price stability. In so doing, Blinder contradicted the views of his boss, Alan Greenspan, and offended Bundesbank head Hans Tietmeyer, both of whom were present.

As a devout Keynesian, Blinder has always favored a demand-management approach to economic policy. In numerous magazine columns and books, he describes himself as an "inflation dove" with boundless confidence in the efficacy of government; he believes that the U.S. public sector is "emaciated" and the country "undertaxed." During his confirmation hearings for the number-two job at the Fed, Blinder told Congress: "The older I get, the less respect I have for the signals emitted by our vaunted speculative markets."

Reminiscent of the Carter era, Blinder's policy prescription would have the Fed pour money into the economy to keep interest rates low and stimulate demand by consumers and businesses. This demand stimulus, in turn, is expected to create jobs and lower the unemployment rate. Bolstered by government taxing and spending, money manipulation by the Fed is supposed to give the government a near-complete ability to drive the economy by stepping on the gas during recessions or putting on the brakes should the economy overheat into inflation.

Demand-siders like Alan Blinder have never understood the crucial role of supply. People work, save, and invest only if after-tax returns are sufficient, payable in dollars that have real value. Higher tax rates on high-risk investment, personal income, or business payrolls blunt incentives and cause individuals to withhold their supply of capital and labor from the market. Risk-taking, entrepreneurship, good management practices, and plain old hard work are all discouraged by frequent government intervention. Cheap money de-linked from gold or other real assets produced by the economy also causes people to withhold their supplies of capital and labor, since shrinking dollars further reduce the reward for work and risk-taking.

When both inflation and unemployment rose during the late Seventies, the Keynesian demand model imploded. Rather than stimulating demand, easy money drove inflation and interest rates sky high. Rather than holding down inflation, rising taxes weakened incentives and depressed the economy. Smart money and smart people boycotted the U.S. economy because it no longer paid to work and invest. Output and employment fell, while prices and interest rates rose.

Statistically, the demise of Keynesian demand-management policies is easy to chart. As the dollar was unhinged from gold, and as federal taxes and spending steadily moved up, aided respectively by inflation-driven bracket creep and by Great Society entitlements, the U.S. economy entered the stagflation period producing 7.2 per cent average annual inflation and 2.1 per cent real growth from 1968 to 1982. The average unemployment rate was 6.4 per cent. During the end of this period, from 1978 through 1982, industrial production declined 3.2 per cent, while the consumer price index rose 48 per cent. By late 1982, unemployment had risen to 11 per cent.

Contrast this with the early 1960s and most of the 1980s, when the dollar was more closely linked to gold and tax rates were brought down. From 1961 to 1967 real GDP growth averaged 4.9 per cent, yearly inflation 2.4 per cent, and unemployment 4.4 per cent. From 1982 through 1988, as President Reagan ushered in a return to hard money and free-market risk-taking incentives, including across-the-board deregulation and tax cuts, real GDP increased by 3.9 per cent a year, and inflation averaged 3.6 per cent; by the end of the period unemployment had fallen to 5.4 per cent. Under Kennedy and Reagan, the classical economic model of sound money and free enterprise produced strong growth with low inflation and unemployment. There was no Phillips Curve trade-off between inflation and unemployment. Under Johnson, Nixon, Ford, and Carter, the Keynesian model produced low growth with high inflation and unemployment. In all three periods, unemployment and inflation moved up and down together.

Have Blinder and his fellow Keynesians learned anything from the historical evidence? Says Arthur Laffer, one of the principal architects of President Reagan's successful growth policies: "There is no set of evidence that will ever shake their faith in the demandside Keynesian theory of the Phillips Curve."

IF THIS were merely an academic discussion, it would have little consequence. But Blinder is being touted by many as the next Federal Reserve chairman, and even now he is in a position as vice chairman to tilt the center of monetary gravity away from the relatively hard-money policies that have prevailed until recently.

Blinder's monetary liberalism has strong support in Congress. This year Democratic Senators Donald Riegle (Mich.), Paul Sarbanes (Md.), and Jim Sasser (Tenn.)--all members of the Banking Committee--have routinely trashed the Fed's belated interest-rate moves to restrain inflation. "The Fed has launched another salvo of friendly fire upon the economic recovery, despite overwhelming evidence that inflation is no threat," said Budget Committee Chairman Sasser after the Fed's latest rate hike.

At the Jackson Hole conference, however, the presidents and research directors of the 12 regional Reserve Banks were furious at Blinder's remarks, since they have spent years trying to focus Fed policy exclusively on the goal of price stability and away from economic fine-tuning. Indeed, virtually all participants agreed that chronic unemployment, especially in Europe, is a supply-side problem of excessive social-insurance spending and rigid labor laws. With high benefits and high payroll taxes to finance them, work incentives have disappeared, and a reserve army of the unemployed has emerged. Fortunately, the U.S. has not yet gone as far down this road as Europe. In any case, central banks have no role to play in resolving this structural problem.

Yet Fed Chairman Greenspan is still sending mixed signals on the central bank's policy targets. The interest-rate increase in August was accompanied by a statement that the measures "were taken against the backdrop of evidence of continuing strength in the economic expansion and high levels of capacity utilization." In other words, too much growth might cause inflation. Economic policy wonk Jude Wanniski, who has worked hard to gain support for a gold price target, disapprovingly noted that "Greenspan has not lifted a finger to alert markets that the Phillips Curve is not an operative theory."

Greenspan occasionally pays lip service to the use of gold as an early-warning inflation indicator, but he never follows through. Blinder abhors the use of gold or commodities, or for that matter any price signals from global auction markets. This is too bad, since both market prices and government reports are showing an inflation upturn. The widely followed Journal of Commerce industrial commodity index, for example, has just hit a new high, rising at a 25 per cent annual rate this year. Gold is holding around $390, and the dollar remains low in terms of the perennially hard Japanese yen and German mark.

These trends spell trouble for the economy, which is just beginning to suffer from the effects of easy money and higher taxes. The former will drive inflation higher, while the latter will depress growth. Blinder's Keynesian demand obsession will prevent him from understanding how prices and unemployment can rise simultaneously.

The solution can only be found on the supply side, where a dollar as good as gold could roll back inflation and interest rates, while permanent tax cuts on capital and labor (that is, capital-gains-tax and payroll-tax relief) would bring down unemployment. But having blinded himself to the past, the Fed's new man may be even blinder in the future.