Political Economy Trumps Macroeconomics
He argues that the neo-classical synthesis – the dominant model of post war economics (which essentially combines aspects of Keynesian macro with classical micro and is closely associated with Paul Samuelson) – has broken down.
As he writes:
But the experience of the past 6 years, since the financial crisis began, has blown apart not just Friedman’s position but much of Samuelson’s as well.
First of all, the liquidity trap is real; conventional monetary policy, it turns out, can’t deal with really large negative shocks to demand. We can argue endlessly about whether unconventional monetary policy could do the trick, if only the Fed did it on a truly huge scale; but the fact is that the Fed hasn’t ever been willing, or felt that it had sufficient political room, to do that experiment.
Second, while the evidence from austerity programs strongly suggests that fiscal policy does in fact work, with multipliers well above one, the political economy of policy turns out to make an effective fiscal response to depression very difficult.
So the neoclassical synthesis — the idea that we can use monetary and fiscal policy to make the world safe for laissez-faire everywhere else — has failed the test. What does this mean?
He goes on to say:
What’s more, you have to ask why, if markets are imperfect enough to generate the massive waste we’ve seen since 2008, we should believe that they get everything else right. I’ve always considered myself a free-market Keynesian — basically, a believer in Samuelson’s synthesis. But I’m far less sure of that position than I used to be.
Coming from arguably the world’s most prominent ‘free market Keynesian’ this is big stuff indeed.
First, however, I want to recommend a very old essay that explains a great deal about the times we live in.
The Polish economist Michal Kalecki published “Political Aspects of Full Employment” 70 years ago. Keynesian ideas were riding high; a “solid majority” of economists believed that full employment could be secured by government spending. Yet Kalecki predicted that such spending would, nonetheless, face fierce opposition from business and the wealthy, even in times of depression. Why?
The answer, he suggested, was the role of “confidence” as a tool of intimidation. If the government can’t boost employment directly, it must promote private spending instead — and anything that might hurt the privileged, such as higher tax rates or financial regulation, can be denounced as job-killing because it undermines confidence, and hence investment. But if the government can create jobs, confidence becomes less important — and vested interests lose their veto power.
Kalecki argued that “captains of industry” understand this point, and that they oppose job-creating policies precisely because such policies would undermine their political influence. “Hence budget deficits necessary to carry out government intervention must be regarded as perilous.”
When I first read this essay, I thought it was over the top. Kalecki was, after all, a declared Marxist (although I don’t see much of Marx in his writings). But, if you haven’t been radicalized by recent events, you haven’t been paying attention; and policy discourse since 2008 has run exactly along the lines Kalecki predicted.
Essentially Krugman’s (and indeed Kalecki’s) point is this – we have the macroeconomic tools to restart a robust recovery and get unemployment down but these tools are not being used for political reasons.
This has been clear for some time. Back in June 2010, the IMF’s Chief Economist Olivier Blanchard wrote ten ‘golden commandments’ for how to do a fiscal adjustment. This was as close as the technocratic economic centre came to a ‘how to repair the public finances’ guide.
It was roundly ignored in the UK and across Europe with a front loaded, aggressive, unfair consolidation in complete contrast to what the IMF was advising.
This caused many prominent macroeconomists to begin reassessing what they knew of the world. Brad DeLong wrote in the November of that year:
For decades, I have confidently taught my students about the rise of governments that take on responsibility for the state of the economy. But the political reaction to the Great Recession has changed the way we should think about this issue…
Still, here we are. The working classes can vote, economists understand and publicly discuss nominal income determination, and no influential group stands to benefit from a deeper and more prolonged depression. But the monetarist-Keynesian post-WWII near-consensus, which played such a huge part in making the 60 years from 1945-2005 the most successful period for the global economy ever, may unravel nonetheless.
We are all relearning an old rule – political economy trumps macroeconomics.
So in the Netherlands and elsewhere in Europe, on the issue of the stupidity of pro-cyclical fiscal policy, it is only the views of politicians on the far-left or far-right that matches those of the majority of macroeconomists. Given the social, economic and political consequences of declining real wages and rising unemployment, which fiscal austerity only makes worse, this is both a very sad and rather dangerous state of affairs.
If DeLong is right* then we risk returning to a pre-Great War political economy. This echoes an FT article from Adam Posen last week which argued that the world may be returning to the Victorian Old Normal (available here):
There was little or no response to recurring spasms of protest or calls for radical change by low-skilled workers in the 19th century, except when mass movements were assimilated into mainstream political parties with support from the elites. Something similar is at work today, with the protests of southern Europe and the demands of the Occupy movement largely ignored by policy makers catering to the voters of the (older) bourgeoisie.
The Old Normal is thus a tale of the global economy returning to unfettered markets in many ways, and – at the national level – to more volatile economic conditions with slower average growth as a result. This is a situation which I am predicting, not endorsing. While domestic politics and international relations have changed greatly since 1914, the creation of safety nets and welfare states (even if now curtailed), and the development of nuclear deterrence among the major powers only strengthen the status quo bias of the current governments.
The Old Normal is not nice, but it is likely to last.
This description certainly tallies with the trends Krugman, Wren-Lewis and DeLong have observed.
More evidence comes from the Washington Post’s Ezra Klein, who asks if there is a ‘doom loop’ economic and political inequality? He quotes recent academic evidence that confirms Posen’s Old Normal theory:
Larry Bartels, a political scientist, quantified the deafness in a study of voting patterns in Congress. “In almost every instance,” he wrote, “senators appear to be considerably more responsive to the opinions of affluent constituents than to the opinions of middle-class constituents, while the opinions of constituents in the bottom third of the income distribution have no apparent statistical effect on their senators’ roll call votes
So where does this leave us?
Krugman argues that:
At the very least it means that we need “macroprudential” policies — regulations and taxes designed to limit the risk of crisis — even during good years, because we now know that we can’t count on an effective cleanup when crisis strikes. And I don’t just mean banking regulation; as the authors of the linked paper say, the logic of this argument calls for policies that discourage leverage in general, capital controls to limit foreign borrowing, and more.
His logic is straight forward – if there are political problems with using macroeconomic tools to mop up the mess after a crisis then better to focus on preventing crisis, which presumably is less subject to political objections.
I’m not so sure. The UK is currently providing a case study in the practical difficulties of macro-prudential policy. As I’ve noted before the BOE is concerned about bank capital levels whilst the Treasury seems keener and keener on stoking up house prices:
[We have] a messy situation. Partially it has arisen because the FPC was designed as part of a ‘new economic model’ based on rising business investment, savings and exports. The problem now is that Osborne has abandoned his attempt at rebalancing and is instead focussing on something that looks rather like the ‘old economic model’.
As one recent IMF paper has argued:
Taking account of the political economy of regulation is likely to be especially important for macro-prudential policy. If authorities find it hard to resist forbearance towards individual institutions, they are likely to face even stronger headwinds in dealing with the financial sector as a whole…
From a political economy perspective, macro-prudential policy is most challenging to implement when it is of the greatest use. Macro-prudential instruments are likely to be most useful when they are able to target a particular sector at times when the financial cycle diverges from that in other sectors of the economy.
The overall lesson to take from this was perhaps best put by CRESC’s Karel Williams in a Guardian piece (on forward guidance and bank lending but I think the point stands more generally) last week:
Restoring the mechanisms of credit transmission is quite futile in the UK because our credit system is geared to lending on property, manufacturing is enfeebled and infrastructural investment comes via a private sector that wants high returns without risk. We need political reframing, not technical guidance to tackle those problems.
It is worth remembering that many of supposed macroeconomic problems are not intractable, the problem is as much one of political economy as of economics. This lead me to think that policies that take into account the wider politicial economy environment – and seek to change it – are more likely to succeed that policies which rely on traditional macroeconomic tools.
UPDATE: To simplify this all, the basic point is that this is one of the things Keynes got wrong. He famously wrote that:
I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.
Of course ideas matter, but never underestimate the power of vested interests.
*It is worth noting that in the UK, thankfully the ‘hard money/raise rates now’ position is less wide spread.