Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday, 23 November 2014

Left, Right and Macroeconomic Competence

The title of one of my recent posts was a bit of a cheat. It was meant to surprise, because it contradicted the prevailing view, but the post didn’t actually try to answer the question the title posed. This post does try to assess whether a political party’s place on the left-right spectrum might influence its macroeconomic competence.

It should be obvious that, for any individual country, looking at some macro outcome (like growth) and drawing some conclusion can be meaningless. For example, growth under Republican presidents has been far worse than under Democratic presidents, but that could so easily be down to luck rather than judgement. To make headway we need to think of mechanisms and particular instances when they applied.

In the US, for example, there is a belief on the right that cutting taxes will increase tax revenue, a belief that is also clearly wrong. So you would expect Republican administrations that acted on that belief to run up bigger budget deficits than their Democratic counterparts, and that seems to be what they do. That may not be the whole story, but at least it is a mechanism that seems to fit. However it seems like a story that is rather specific to the US, at least for the moment.

Just now you could argue that parties of the right are more prone to austerity, because they want a smaller state than those of the left, and austerity can be used as a cover to undertake policies that reduce the size of the state. In a situation where interest rates are stuck at zero that has the damaging macroeconomic consequences that we are seeing today. However this is a story that is specific to liquidity traps.

An alternative source could be different views about the relative costs of inflation and unemployment. You might expect governments of the left to have higher inflation and those of the right to have higher unemployment. While that mechanism loses much of its force when you have independent central banks, it can resurface in a liquidity trap.

A final left/right difference that might impact on macroeconomic outcomes is different views on the need for state intervention. Those on the right might favour less intervention, leading them to favour simple rules, and to argue against the use of fiscal policy for macroeconomic stabilisation.

Is any of the above helpful in looking at UK policy since 1979? I use this place and period as a case study because I am most familiar with it. In the past I have talked about three major macroeconomic policy errors over this period, all of which occurred when the Conservatives were in power. However that alone proves nothing: Labour was in power for fewer years and might have been lucky. [1] 

The period starts with Margaret Thatcher and the brief experiment with monetarism. Here you could use the inflation/unemployment contrast - the policy succeeded in getting inflation down very rapidly, but at high costs in terms of unemployment, which persisted because of hysteresis effects. A secondary question is whether, given any particular preferences between inflation and unemployment, the policy was inefficient because it attempted to run monetary policy according to a simple rule which failed. Many at the time argued it was, because it put far too much of the burden of lost output on the traded sector, which in turn was because the policy generated Dornbusch type overshooting effects (i.e. a large appreciation in the exchange rate).

The 1990 recession can also be linked to left/right influences. The rise in inflation that preceded the recession (and to some extent made it necessary) was partly down to Nigel Lawson’s tax cuts. I have been told by one insider that the key wish at the time was to cut the top rate of tax, but it was felt that to do this alone would be politically damaging, so tax cuts were made across the board. That was not the only reason for the late 80s boom - there was also the decline in the aggregate savings ratio that in my view had a great deal to do with financial deregulation - but it was a factor.

The macroeconomic failure that everyone knows about from that period was the forced exit from the ERM in 1992, and that was costly because it made monetary policy too tight beforehand. Although you could say fixing the exchange rate is a simple rule that the right might prefer, that would be stretching things: ERM entry was favoured by Labour as well (although with the notable exception of Bryan Gould). According to my own and colleagues analysis at the National Institute the entry rate was too high, which might follow from a preference for low inflation, although it could just have been a choice based on poor macroeconomic analysis.

Inflation targeting followed the ERM debacle, and it was augmented by central bank independence at the start of the Labour government of 1997. One major decision that, if it had gone the other way, we might be scoring as a major error would have been if the UK had joined the Euro in 2003. I have argued that the decision not to was based on an intelligent and well researched application of current academic knowledge (subsequently vindicated by additional but related problems that academics did not anticipate), rather than any left/right policy preference.

Which brings us to George Osborne. I have just finished the first draft of a paper that appraises the coalition’s macroeconomic policy, and an interesting question that arises from that is why the coalition went for austerity despite the liquidity trap. While the 2010 Eurozone crisis might explain the change of mind of the minority partners in the coalition, it does not explain Conservative policy, which was against fiscal stimulus in 2009. If you look at some of Osborne’s speeches (and I’m not sure there is much else to go on), the rationale for austerity was a belief that monetary policy was sufficient to stabilise the economy, even in a liquidity trap (see the second part of this post). At the time that represented a minority view amongst macroeconomists. It could be explained in left/right terms in various ways: a dislike of additional state intervention, taking a risk that would lead to higher unemployment rather than higher inflation, or a devious way of reducing the size of the state.

So we have three major UK macroeconomic policy errors: the monetarist experiment of Thatcher, ERM entry and exit (and the boom that preceded it), and current austerity. In all three cases it is possible to link these to some extent to right wing political preferences. It may be equally possible to go back further and link the increased inflation of the 1970s to a left wing dislike of unemployment, but I cannot do that from memory alone so it would require some additional work going over the detailed history of that period.

However one additional point strikes me. Two of these three errors can be attributed to following a minority academic view. That monetarism was a minority academic view in the UK in the early 1980s became clear with the famous letter from 364 economists in 1981. In UK right wing mythology that episode represents the triumph of Thatcher over the academics. I have also noted that the Labour/Brown period perhaps represented a high point in the influence of academic economists within government, and the analysis behind the 2003 entry decision was an example of that. A belief that fiscal policy is not required in a liquidity trap is a minority academic view.

It may seem odd to some that those on the right might be more disposed to ignore mainstream academic opinion within economics, but of course academic economics can be described as the analysis of market failure. No one looking at debate in the US would dispute that minority academic views, or a more general anti-intellectualism, finds an easier home on the right than the left at the moment. Of course you can also find anti-intellectualism on the left - see here for a recent UK example - and my distant memories of the UK in the mid 1970s suggest that during this period they might have been at least as prevalent as those on the right. What may have happened over the last few decades is that what is currently called the left has become ideology light, and therefore more receptive to academic expertise and evidence based policy.



[1] If you want to call the gradual liberalisation of financial controls that facilitated the financial crisis a macroeconomic policy error that would make four, but I do not think anyone would seriously argue that this occurred under Labour because they were more predisposed to market liberalisation than the Conservatives.

12 comments:

  1. "I have also noted that the Labour/Brown period perhaps represented a high point in the influence of academic economists within government, and the analysis behind the 2003 entry decision was an example of that. "

    Would you say that Blair/Brown ended as an unambiguous success? Perhaps if they did not put so much faith in mainstream economists and rational expectations models and listened to historians it might not have ended the same way.

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  2. "the past I have talked about three major macroeconomic policy errors"

    But you left out the elephant in the room,

    The policies and economic theories that led to the crash of 2008 were the biggest in 80 years.

    And yes it was a failure of economic policy AND economic theory.

    It was delusion and intellectual failure on a truly grand scale.

    ReplyDelete
    Replies
    1. An important question if you want to make this claim is to ask what specific economic policies caused the 2008 crisis and what specific elements of economic theory were used to justify them.

      Delete
    2. This has been discussed on commentary here before and elsewhere.

      MP that concentrates on an overnight interest rate operating target and utilises rational expectations theory and subsequent models to explain and achieve it (a theory which ignores regime shifts). This approach did not pick up indicators of overly easy credit, overlooked asset price inflation and liquidity gluts that were occurring as a result of structural changes in capitalism and the world economy. While this easy credit policy was being pursued there was far-reaching regulation over the financial sector, including the removal of laws that separated wholesale and retail banking.

      Post 1978 economic theory is a failure because it did not pick up these regime shifts and allowed a catastrophe to happen.

      It also did not rescue the economy from its impact. 1936 theory did that.

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    3. Typo correction to above

      "While this easy credit policy was being pursued there was far-reaching DEregulation of the financial sector, including the removal of laws that separated wholesale and retail banking. "

      Delete
  3. If you remember the Saatchi and Saatchi poster 'Labour isn't working', arguing around the 1 million level of unemployment, was used by the Tories going into the 1979 election, so unemployment causing inflation as a Labour-centred policy seems unlikely as the Tories wouldn't have campaigned on it otherwise.



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    Replies
    1. Unemployment in 1979 was high by the standards of recent decades, it's also worth pointing out that unemployment is generally viewed as a fairly universal bad. Finally it's worth pointing out that political campaigning doesn't really have to be consistent with what economic theory says about the effect of given policies. The policies the Tories pursued once in government in the 1980s made the unemployment situation a whole lot worse.

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  4. “…the rationale for austerity was a belief that monetary policy was sufficient to stabilise the economy, even in a liquidity trap..”

    Another important factor that put Osborne off fiscal stimulus, I think, was the Rogoff / IMF belief that, first, deficits necessarily increase the debt. That of course is nonsense: as Keynes pointed out, deficits can be funded either by increased debt or by increasing the monetary base. Second, there was (and still is) the belief that the debt must at some stage be repaid and that that will involve pain / deflation / “financial repression” to use Rogoff’s phrase.

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  5. You have to wonder what planet some of the most famous mainstream economists are on.

    Here one of them says that the central bank issues debt! OK it issues notes to buy debt, but that is really stretching it.

    https://www.youtube.com/watch?v=lzGLcl_5FoU

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  6. "growth under Republican presidents has been far worse than under Democratic presidents, but that could so easily be down to luck rather than judgement."

    Actually, the stock market has done far better under Democrats, and in a well controlled study in one of finance's top journals. The abstract:

    "The excess return in the stock market is higher under Democratic than Republican presidencies: 9 percent for the value-weighted and 16 percent for the equal-weighted portfolio. The difference comes from higher real stock returns and lower real interest rates, is statistically significant, and is robust in subsamples. The difference in returns is not explained by business-cycle variables related to expected returns, and is not concentrated around election dates. There is no difference in the riskiness of the stock market across presidencies that could justify a risk premium."

    See: http://richardhserlin.blogspot.com/2008/08/its-not-just-economy-in-general-thats.html

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