From the TUC

Political Economy Trumps Macroeconomics

13 Aug 2013, by Guest in Economics

Yesterday Paul Krugman wrote one of the most significant blog posts on economics I’ve ever read.

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.

This follows on from his NYT weekly column last week, which quoted extensively from Michal Kalecki. As Krugman wrote then:

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.

As Simon Wren-Lewis noted yesterday this creating worrying political situations:

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’.

To which one can add Blanchard’s recent comments that we don’t know if macro-prudential policy will work yet.

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.

21 Responses to Political Economy Trumps Macroeconomics

  1. Jayarava
    Aug 13th 2013, 12:32 pm

    Typo in the subheading – Yesterday Paul Krugman wrote *one* of the most significant blog posts on economics I’ve ever read. “one” left out.

  2. bevin
    Aug 13th 2013, 3:54 pm

    An excellent piece which I will copy to others.
    I will check these comments to see what the Social Democrats have to say.

  3. Neil
    Aug 13th 2013, 8:19 pm

    “When I first read this essay, I thought it was over the top. Kalecki was, after all, a declared Marxist”

    My god – of *course* it must be ‘over the top’ if it’s Marxist or Marxist-influenced! We can’t have *trade unions* view of economics and society being influenced by those madmen can we???

    For all the sense of a penny finally beginning to drop in this article [note the impeccable liberal establishment credentials of the sources quoted], one can scarcely believe the depth of the British trade union movement’s political economic conservatism. It only makes sense when one (painfully) accepts that the trade union movement is totally and uncritically supportive of capitalism and in that follows conventional centrist opinion rather than developing intellectual (and political) independence.

    One has got to say what a shower of …. and to think of all the dupes (myself included) who have funded these lackeys!

  4. Agog
    Aug 13th 2013, 8:38 pm

    There’s a reasonable case to be made that Keynes was right, of course, implicit in Brad DeLong’s argument. Influential people are arguing against their own interests, be they Ordoliberals in the Netherlands, Ayn Rand fans in the US, or claret-complexioned Tory squires here.

    Keynes was being hopeful, I guess, that the intellectual tide would continue to flow in the Fabian direction. Unfortunately we’re still having to deal with the flood of Mont Pelerin inspired thinking pushing in the wrong direction. But I’m still hopeful that the tide will turn again.

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  6. Luis Enrique
    Aug 14th 2013, 10:45 am

    I think there’s a lot of truth in all this, but for all those who read this and think “yes! neoclassical economics is wrong! my preferred solution is X” I suspect the political problems that have stopped mainstream fiscal policy being implemented as per the Blanchard prescription, would also interfere with the implementation of X.

    What preferable [to mainstream macro] policies are there, which would not also fall fowl of political constraints?

    and …

    *It is worth noting that in the UK, thankfully the ‘hard money/raise rates now’ position is less wide spread.

    hmm, the Labour party seems to be adopting an inflation hawk position.

  7. Theremustbeanotherway
    Aug 14th 2013, 10:52 am

    Really? The political economy trumps macroeconomics. Well hello it’s nice to learn that you are opening your eyes at last! This is hardly a revelation.

    It suits the vested interests very well to create a large pool of unemployed labour. The battle between “labour” and “capital” has been raging since Adam Smith’s day. The last thing “capital” wants is a more egalitarian society. It took WW2 to enable “labour” to make significant progress in this area. Since the introduction of neo-liberalism, labour’s gains have been steadily eroded,the rentier economy has risen and we have obscene levels of inequality across the world. What will it take to restore the balance again, WW3?

  8. Neil
    Aug 14th 2013, 11:31 am

    “Really? The political economy trumps macroeconomics. Well hello it’s nice to learn that you are opening your eyes at last! This is hardly a revelation.”

    Indeed! The most interesting question in my eyes should be *why* this should be revelation in a trade union movement.

  9. Duncan Weldon

    Duncan Weldon
    Aug 14th 2013, 11:38 am

    It’s not a revelation to me that political economy trumps macroeconomics.

    What this blog is about is what looks like a quite a big change in opinion from many prominent macroeconomists. I thought that was interesting and worth commenting on.


  10. Syzygy
    Aug 14th 2013, 12:43 pm

    Dan Kerwick also argues on New Economic Perspectives (an MMT site):

    ‘..I think Krugman overestimates the damage that has been done to Friedman’s legacy. Aspects of Friedman’s macroeconomics might be in trouble; but Friedman’s broader paradigm for political economy is still, regrettably, too much with us. In fact, Krugman himself doesn’t seem to have moved much outside that paradigm, as I will try to show.’

    ‘The Friedman paradigm must be displaced entirely, and not just modified with tweaks and epicycles and exemptions for special occasions. We need a Copernican Revolution in our economic thinking, which reverses the polarity in the dominant economic framework, puts an engaged democratic citizenry and activist government at the center of things, and leaves to central banks the important but subordinate tasks of regulating and managing the banking system while accommodating the economic policies and strategic direction set by the public through their government. It’s not just that we need to rely more on “fiscal policy” for the task of stabilization. We need to rely more on engaged public activism and invigorated government to move beyond stabilization into transformation, and toward real social progress.

    We are also facing a long, vital battle between the democratic mode of organization and the corporate mode of organization. The ideal of government by equals in the pursuit of social justice and shared prosperity stands on one side if the struggle, and the forces of hierarchical command and control in the service of concentrated private wealth and power stand on the other. I’m convinced this struggle will define the coming century. History hasn’t ended. It’s just getting started.’

  11. Wim Nusselder
    Aug 15th 2013, 10:18 am

    If political economy trumps macroeconomics, economists should become political economists to empower politicians to innovate economy and society despite vested interests.
    It’s not a battle of good versus evil (state versus market, democratic organisation versus corporate organisation, left versus right, Keynesianism versus monetarism etc.), but a matter of creating a better mixture of the economics of belonging (family/ethnic/national mutual support), state-led economics, market economics and economics of persuasion for the jump to the new technological platform.
    See Carlota Perez’ “The financial crisis and the future of innovation” ( and my “Economics of want and greed” (

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  13. Harry Ray
    Aug 15th 2013, 3:56 pm

    Great article. With regards to the update at the end, however, I’m not sure Keynes got it so wrong. it was about 25 years ago, the type of intellectually-lacking type of free market fundamentalism that revolted against the counter-cyclical spending consensus. I tend to see it as at least conceivable that, in the American context at least, those flawed ideas are trumping the vested interests of at least the majority of voters, and probably a great section of industry. Though, on the other hand, very little of the elite isn’t inherently financial at this point…

    another story is that austerity is just a convenient excuse to gut the welfare state and reap the spoils of lackluster private provision of education, and most importanly social security/pensions, so you might just have hit the nail on the head.

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  15. Cantab83
    Aug 19th 2013, 12:44 am

    So what is the big story here? It’s now over twenty years since Paul Ormerod and Hyman Minsky showed why DSGE and the neoclassical synthesis are fatally flawed. Why has it taken so long for Paul Krugman and other economists to wake up and smell the coffee?

  16. Wim Nusselder
    Aug 19th 2013, 8:57 am

    @Cantab83: Ormerod and Minsky apparently weren’t convincing enough to expel general equilibrium thinking from economic curricula and the free market gospel from political thinking.
    The defection of an influential economist like Krugman could help.

  17. Neil
    Aug 19th 2013, 9:37 am

    Wim Nusselder: “Ormerod and Minsky apparently weren’t convincing enough to expel general equilibrium thinking from economic curricula and the free market gospel from political thinking. The defection of an influential economist like Krugman could help.”

    There’s a dangerous illusion around on the liberal left that the capitalist state and capitalist strategists are stupid, do not know what they are doing, and are in fact operating against their own interests. It is only in a perfectly rational world – and our world is of course not perfect in this sense – that the strength of reason shifts ideologies – it is interests and power which in fact do so. And anyone who thinks that different classes interests can be reconciled economically and globally in the long-run – and peacefully – are engaged in self interested wishful thinking. They are of no help to – are not friends or allies of – the working class or the unemployed but their deceivers.

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