Yes, economic policy did fail

Tony Yates today criticises Paul Krugman’s argument that economics had the answer to how to respond to the crisis, but policy failed to follow the prescription. As I completely agree with Paul Krugman on this, let me say why I think Tony’s criticism is completely wrong. 

The argument he is criticising is that, following the recession, we had a demand deficit that fiscal stimulus could have tackled, but from 2010 policy went for fiscal contraction instead. How do we know that we had a demand deficit? Because interest rates went to their zero lower bound pretty well everywhere. Monetary policymakers had to go for largely untried and untested Quantitative Easing to try and plug the demand gap. Fiscal stimulus is a much more reliable method of achieving the same goal. That logic is, in my view, unassailable.

Tony’s first argument is that, despite this, we got lucky. If you look at inflation, “conventional demand-side fiscal policy was roughly on track”. So, when economists in twenty years time look back on the 2008/9 recession, Tony thinks they will describe it as a textbook example of how policy should deflate the economy in response to an inflationary shock. Policy did good - the recession was just what was needed to stop inflation going higher. Somehow I really doubt that is the story they will tell.

Tony defends this argument by invoking the social welfare functions implied by New Keynesian models, where inflation is much more costly than non-zero output gaps. At which point I do worry about what today’s macroeconomists actually believe. These social welfare functions may capture the costs of inflation - or at least the costs due to relative price distortions - but they certainly do not capture the costs of output gaps at all. We have a huge amount of evidence that tells us this. Just because we have not yet microfounded why people hate being unemployed so much does not mean they really don’t mind.

Tony acknowledges this, but then says “But, with the models thus binned, you are in the dark about what should be done.” That is just silly. New Keynesian models do not stand and fall according to the accuracy of the social welfare functions they imply. After all, many NK models have a labour market that clears. Economists use them not because they think the labour market actually clears, but because they give answers about output gaps and what to do about them that are not too far off. So there is absolutely no problem using a NK model with an ‘ad hoc’ social welfare function where weights follow the evidence rather than the model. If we do that, and use other measures of inflation besides consumer prices (as theory suggests we should), then 2009-13 does not look like an optimal response to an inflationary shock.

Then Tony falls back on the argument that there is so much we still do not understand about the financial crisis, so how can anyone argue that the economics is clear.

“PK seems to be backing away from all these intractable debates about the detail, and saying that we can ignore it.  Big picture, demand was weak, public demand had to be stronger.  Politicians did not get this message clearly enough, and were able to ignore it.  End of story.  Well, maybe.  Maybe not.  Perhaps only great minds can see the wood for all these unfinished modelling trees.”

No, you do not need to be a great mind to do this, and I should know. You just need to assess whether the things we do not understand can seriously compromise what we do know, which was that we had deficient demand and we knew how to deal with that. The only possible factor was - briefly - the Eurozone debt crisis, but then a balanced budget fiscal expansion could have been used to avoid increasing debt.

So Tony’s argument that the reason for this “policy failure is that our economics profession had not yet come up with clear answers” is not tenable. As he knows, monetary policymakers cope with uncertainty all the time, but we still tell them (or at least most of us do) that you cut rather than raise interest rates in a recession. For exactly the same reason, you undertake fiscal stimulus, not contraction, when interest rates are at the zero lower bound. It really is that simple.