Politicians should have less, not more power to fight economic crises

A big issue I personally have with the concept of Keynesian economics is that, in practice, it involves way too much discretionary action by people who often really shouldn’t have the kind of economic power they do. The whole thing is part of a wider discretionary vs. rules-based economic policy debate, and something on which I find myself in remarkable agreement with the freshwater school in economics, who often don’t seem to make much sense on other grounds. There is a good argument to be made that when stuck in a liquidity trap (as long as something like that is even the big problem it is often portrayed to be) fiscal policy is the go-to economic tool to help get the economy back on track. Most of the standard arguments against this generally move somewhere between the either claiming it is totally ineffective or that it is so effective that the stimulus always proves to become permanent after a while. Both arguments are mostly wrong. But the real issue I see is that discretionary fiscal spending is, basically by definition, highly uncertain. The recent crisis has shown that when push comes to shove, politicians of all stripes will dig up their own copy of The General Theory and start throwing money at the problem. Yet, even though in theory it would be fairly easy to imagine a fixed rule which would be followed in these situations, in practice both the size and the direction of this throwing of money is highly arbitrary.

This is also one of the reason why modern automatic stabilizers have proven to be so effective. They are in general fairly permanent institutions, which means that politicians can’t screw up too bad even if they wanted to. Sometimes they are tweaked a bit, such as extending the period over which unemployment benefits are paid out, but at their core they remain a key source of economic certainty particularly at times when certainty is lacking the most. An in contradiction to what many commentators on the conservative side of the spectrum generally suggest, recent experience shows that these automatic stabilizers should be much stronger and much more pro-cyclical than they are at the moment, not less so. Unemployment benefits, for instance, do not make unemployment worse, as is generally suggested, but prevent the entire economy from collapsing even more than it did in 2008 and beyond. And if these benefits are tied to people having to actively search for another job, as is often the case, they are might even help make the jobs market more flexible rather than less flexible by preventing people from dropping out of the labor force entirely.

Predictable, rules based policy making becomes arguably even more important – and at the same time easier to pull off – in the realm of monetary policy. Predictability is the whole reason why concept like the Taylor Rule, NGDP level targetting or the Evan’s rule are so attractive – if correctly followed, they greatly reduce the degree of policy uncertainty and thus economic volatility in general. Forget what might be taught in introductory economics concerning central banks having to “surprise” the market in order to actually move the economy. A central bank having to surprise anyone is a central bank failing miserably at doing its job. Europe, for instance, continues to be stuck in recession-like circumstances because the ECB consistently has stated it does not care about the European economy. If it did, Inflation wouldn’t be far below target while unemployment in the double-digits. So while the ECB actually doing it’s job would indeed prove to be surprising, the only reason it would have any effect at all is because it has failed to do so for so long.

The whole concept of central bank credibility is strongly related to this – it means nothing else than the central bank actually doing what it has promised to do, and doing so consistently. Actually, that’s not entirely correct. In reality it means that the market has fairly coherent views on how the central bank will react in different situations, and the central bank doesn’t do anything to prove the market wrong. Credibility is enormously important for price stability, particularly in the presence of issues like the time inconsistency problem of monetary policy, yet in the current situation it seems to actually prove to be a big issue. The ECB has credibly stated that it won’t do more, and even though by ever imaginable measure it should do much more the market believes it and reacts accordingly, and thus in some sense it is the ECB’s high level of credibility that is hurting it. Adhering to and actually following a clearly voiced rule, however communicated, also has the added benefit that it makes the jobs of central banks a lot easier by having the market do much of it for them. That’s the whole point of people trying to make the argument that we need a higher inflation target to get out of this mess and prevent us from falling into this kind of mess in the future: if the central bank can credible promise to do whatever it takes to bring about the higher level of inflation, the market will accept this, and given it’s never a good idea to try and fight a central bank when it has said it wants to print money, will most likely help to bring about a higher level of prices without the central bank actually having to do all that much – and will then also help keep it there.


6 thoughts on “Politicians should have less, not more power to fight economic crises

  1. I’ve always wondered why the debate about whether monetary or fiscal policy is so heated. Does it have to be either-or?

    I think one of the main issues in a severe recession is that expectations are at a low. Consumers and firms are uncertain about whether to invest or spend, because they don’t know how much further DOWN it will go, before it goes up again – if it ever truly will within the next decades.

    Sooooo, if you look at the channels monetary policy operates through (especially in times where the interest instrument is almost ineffective) then I doubt that monetary policy ALONE can actually shift the economy back on track (unless maybe when enough time has passed). The thing with inflation expecations,… well, after all, what is inflation? For inflation to change, prices have to change and who changes those: ultimately, firms. And I don’t see how firms would want to increase prices when they do not face pressure from the cost side (wages and otherwise) and when expectations about the future are more than gloomy.

    Increasing inflation expectations sounds … lovely… but how does that even work? Do we know what actually happened to the money the Bank of England (for example) has injected into the economy so far? Is it lying on bank balance sheets? Did it boost house prices up to their 2007 levels (in the UK)? Is it in the country? Is it abroad fueling inflation in some developing country? I honestly don’t know the answer to that…

    Would love to hear your opinion. Maybe you have a different approach to the whole story.

    Am I saying that deficit spending is the holy grail? Certainly not, but I believe that you need a mixture of fiscal and monetary policy and in our case (where the possibility to do both is severely impaired) we should maybe think more about structural policies.

    And, honestly, after the mess economists have created over the past decades, I’m not sure if politicians are really the most incompetent people on the stage. 😉

  2. Sorry for the late response, have to hand in a seminar paper on Friday and still not quite done with it, but here some quick thoughts.

    In essence you are right to argue that it does not have to be an either-or debate. But in any case the issue remains that fiscal policy is vastly expensive (as we can see in Europe) while monetary policy is, for all intents and purposes, basically free. So logic dictates that if I can choose between achieving my goal by plunging deeply into debt or do the exact same thing by just printing some more money, I print some more money. I also think that the supposed “limits” of monetary policy, particularly at the zero lower-bound to interest rates, are vastly overstated. As you mention, what we need right now is more inflation, and I know of no case where a central bank has tried to create inflation (and not just said it wanted to try) and failed. As Scott Sumner likes to say to make the point, let them buy up the entire world if necessary. There is absolutely no scenario in which, after a certain amount of money printing, prices don’t start to rise – if necessary even only due to the central bank driving up the demand for assets and no one else. And once that happens, firms will indeed face the supply-side pressures you talk about as well.

    Fiscal policy is also deeply political, and I really don’t think politics should have anything to do with economic stabilization. Fiscal policy can redistribute and do whatever it wants that the democratic process decides it should, but economic stabilization, apart from automatic stabilizers, just seems better done (for both practical and theoretical reasons) by monetary policy.

    Your questions on e.g. the bank of England are very interesting, and I unfortunately don’t have a satisfactory answer to them. From what I’ve been reading the issue the BoE is facing is indeed getting banks to ease up lending, and apparently they are not really achieving that with the current policy. Whether the money stays in the country or not is not necessary important as long as it helps – macroeconomics is no zero-sum game. Yet, that e.g. QE can have a considerable impact on developing economies is definitely sure, and often overlooked, you are right.

    And, to name the Reinhart/Rogoff story as an example, that seems to be mostly an honest mistake on parts of economists coupled with tons of wishful thinking by politicians. There were plenty of studies out there claiming the exact opposite – it’s up to politicians to choose which study influences them, and they chose badly. Sure, central bankers essentially face the same problem, but there is atleast some hope (even though it might not seem that way currently) that their choices could involve not just reading the conclusion of some economic paper that seems to fit into ones worldview. In general I really don’t think the economics profession, even before the crisis, performed as terribly as is often stated. We did not necessarily have the wrong ideas, but the wrong ideas at the wrong places, and that is largely due to a political process.

  3. “As you mention, what we need right now is more inflation…”
    Sorry, I may not have been clear about that: I DON’T think we need more inflation and I don’t think that printing more money is necessary cheaper (in the long-run) than fiscal policy.
    Regarding the first one, I don’t think inflation CURES anything. Deflation is a symptom and even if curing the symptom may sometimes help in the short-run to avoid the worst, ultimately you need to find the cause of the illness or your patient is going to be worse. In our case it is probably structural. I don’t think this is a normal business cycle recession.
    Regarding the latter, I don’t buy the “we have everything under control”-stance CBs take. I don’t think they have any idea of what they are doing and printing money is something that is very dangerous. You may be right, if a CB really wants to create inflation, it will. But they will have to alter inflation expectations and there is NO WAY you can predict where that will lead us. You cannot predict expectations.

    “We did not necessarily have the wrong ideas, but the wrong ideas at the wrong places, and that is largely due to a political process.”
    Couldn’t disagree more.
    Our models are cute, but if we sell them to politicians as “well-founded science” then it is our fault if they believe us and use these models. After all we are supposedly the “experts”.Not everything that comes out of mainstream economics is WRONG, obviously, but sometimes a little bit of humility would do us some good. Acknowledging the fact that after hundreds of years of economic research we are still unable to answer most of the really important questions in our field is a starting point.

  4. Well, to put it bluntly, define „the long run“ and tell me why Spain, with 26.7% unemployment, should care all that much about this „long run“. I’m also not sure I’m reading your “we don’t need more inflation” comment in the right context, as I am sure you are not implying that 1.4% inflation (considerably below even the ECB’s target yet the current Euro area rate) should be kept there. We need the ECB to AT LEAST do its job and give us 2%. And that’s even leaving aside that a central bank should target core inflation and not, as the ECB does, consumer price inflation. I also wouldn’t say we need more inflation per se. What we need is higher NGDP growth. Under current circumstances, until RGDP picks up again, that means more inflation. What particularly southern Europe is missing is aggregate demand, not primarily aggregate supply. I highly doubt there is a way to construct a reasonable model of any kind in which Spain’s unemployment is not caused in very big part by a shortfall of AD and which is able to pass any sort of empirical test. Sure, their economy has plenty of “structural” deficiencies, no doubt, and they need to be addressed, but why does an entire generation of people have to be left behind in the process? Of course this is no normal business cycle recession, but just because that is the case does not mean we should just let the patient bleed to death. The Great depression was not solved by “structural” solutions – it was solved by boosting demand, and in considerable measure by changing expectations with regards to monetary policy.

    As you say, deflation is a symptom, and the underlying problem is (in all cases where it would seem to matter) a lack of demand. What inflation does, if kept within limits – and e.g. 4% is still quite far away from any reasonable estimate at which it would start to spiral out of control – is increase demand. Fiscal policy would do nothing different, except less efficiently. I don’t see how 4% inflation is inherently any more dangerous than 2% inflation. If anything it is much less so, since central banks would have 2% more room to go before reaching the zero lower bound next time around. In any case, it all boils down to a cost-benefit analysis. The amount of damage monetary policy would have to inflict to be worse than having almost 57% of Spanish youth unemployed – changing their lives forever for the worse – is far, far beyond at least my ability of imagination. The upside to at least trying, on the other hand, is fairly graspable.

    I would agree with you on part of your second point. From what I can see I would say it seems to be a fact that the ECB truly does have no idea what it’s doing, and suffers from dear in the headlights syndrome. The biggest structural problem we have in the Eurozone is of course that we have a monetary union with no fiscal union. This is an issue completely out of the competency of the ECB – it does not and should not have anything to say in it. What it can do, however, is massively alleviate the imbalances that have built up. Making monetary policy for the average Eurozone member instead of mostly just Germany – in other words, doing a considerable deal of monetary easing, in whatever way they choose to, would be an obvious place to start.

    I’m not sure we’re talking about the same thing with regards to your last paragraph. The biggest policy failure in the past decade in my opinion was not that we “did not see this coming” but that we unlearned everything we had learned from the great depression. Sure, this thing was always going to be bigger than the bursting of the dot-com bubble for example, but it didn’t have to be this big. That massive fiscal contraction and, relatively speaking, a fairly small amount of monetary easing in our current situation is a bad idea does not require anything beyond IS-LM. That thing is almost exactly 80 years old. And it is not like economics is composed of a homogeneous blob of people – every science has considerable differences in opinion within it, and I don’t see it as a problem solely confined to economists that individual researchers in general will tell you that their work, as far as they are concerned, is good stuff! The only difference I see is that the stakes involved in the case of economics are much higher than in many other cases. But again, it doesn’t seem to be a problem we only see in economics. You can unfortunately also find quite a few scientists that will tell you they are certain global warming is not primarily caused by human activities. Is the fact that most of the Republican Party in the USA follows these “experts” a failure of climate science itself or of the political mechanism at work at choosing which results in science are used to make policy?

  5. There is so much in there I would like to comment on, but I fear our answers will get longer and longer, so I’ll just pick two things:

    If we are going back to the Great Depression, what ended the Great Depression was largely the break-up of the gold standard (and, yes, the monetary easing that followed). Those who got off gold first, recovered first. So if we want to learn a lesson then it would seem the lesson is: those who will leave the euro-zone – which has become more and more unsustainable – first and can devalue, will recover first. Do I like hat conclusion? No, I don’t. May this conclusion be wrong? Maybe. I don’t know. But at the moment I believe that as long as Spain and Greece and some other countries stay in the euro-zone, whatever the ECB does is not going to help them much.

    (and I am not saying that you are wrong about monetary policy not being easy enough – you may very well be right about it. I just don’t think it’s the miraculous solution to our problems.)

    I agree on the AD problem. Austerity is making it worse, I would argue. That’s what’s making me much angrier. You’d think they’ve learned anything from the disastrous consequences of austerity measures (for example the ones the IMF inflicted on some Latin American and Asian countries over the past decades), but obviously they haven’t.

    About economics as a discipline… I think we are arguing past each other. I’ll find a paper that explains what I mean. =)

  6. Yeah…I noticed way too late my response was about the length of my average blog post 🙂 I get the same feeling on the economics as a discipline debate.

    One last thing on the Great Depression: I would say it was not so much getting off the gold standard specifically but more just a general regime change. Yes, getting off the Euro definitely qualifies, but I don’t think it’s the only option. Inflation targeting in the strict sense the ECB is doing it might have worked fine for a while, but there’s no reason to stick to it – after all, I’m sure back then we also thought the gold standard had worked fine for a while. Giving the ECB at least a dual mandate like that of the FED would be a fairly easy option, NGDP targeting or something of the sort another one. The fact the ECB – essentially by law – is not allowed to care about unemployment is killing us.

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