Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday, 7 June 2015

Austerity as a Knowledge Transmission Mechanism failure

In this post I talked about the Knowledge Transmission Mechanism: the process by which academic ideas do or do not get translated into economic policy. I pointed to the importance of what I called ‘policy intermediaries’ in this process: civil servants, think tanks, policy entrepreneurs, the media, and occasionally financial sector economists and central banks. Here I want to ask whether thinking about these intermediaries could help explain the continuing popularity amongst policy makers of austerity during a liquidity trap, even though there is an academic consensus behind the idea that austerity now would harm output.

In this post I looked at various reasons for thinking there was such a consensus, and one of them was that the framework generally used to analyse business cycles was the (New) Keynesian model. In this Keynesian framework cuts in government spending when interest rates are stuck at their lower bound clearly reduce output, with multipliers around one or more.

Where are these models used in anger? Among academics studying business cycles of course, but also within central banks. As far as I know, pretty well all the core models used by central banks to do forecasting and policy analysis are (New) Keynesian. (This includes the ECB.) An important point about the delegation of stabilisation policy to independent central banks is that expertise on business cycles has tended to shift from civil servants working in finance ministries to economists working in central banks.

Suppose you are a policy maker, who is genuinely concerned about what impact cuts in government spending might have in the period after the Great Recession. Where would you, or your civil servants, go to find expertise on this issue? Given the above, one obvious source, and perhaps the main source, would be independent central banks. One big advantage that independent central banks have over academics as a source for the received wisdom on this issue is that they are a single point of reference. No need to ask the many economists working in the central bank - just ask the central bank governor, who you would expect to distil the wisdom of their own economists.

Following this logic, you might expect to find central banks shouting the loudest about the dangers of austerity. After all, they get the rap for deflation, so anything that makes their job more difficult and uncertain when interest rates have hit their lower bound they should perceive as especially unwelcome. In front of committees of congress/select committees and the like, they should be banging on about how they cannot be expected to do their job if politicians continue to make life difficult by deflating demand. If they did this, some politicians (particularly on the centre left) would have had ammunition with which to counter homilies about Swabian housewives and maxed out credit cards. 

Of course this does not happen. The extent to which it does not happen varies among the major banks. In the US Bernanke did very occasionally (and somewhat discretely) say things along these lines, but he seemed reluctant to do so in any way that might prove influential. In the UK Mervyn King is believed to have actively pushed for greater austerity, and the Bank of England has never to my knowledge suggested that austerity might compromise its control of inflation. The ECB, of course, always argues for austerity. It is one of the great paradoxes of our time how the ECB can continue to encourage governments to take fiscal or other actions that their own models tell them will reduce output and inflation at a time when the ECB is failing so miserably to control both.

So what is going on here? I think there are two classes of explanation, related to the distinction between the roles of interests and ideas in political economy (see Campbell here, for example). The first class talks about why the interests of the elite might favour austerity, and how these interests could be easily mediated through senior central bankers. It could also explore the interests of finance, and their close connections to central banks.

The second class might focus on ideas involving perceived threats to central bank independence. In the US, this might be nothing more than a desired quid pro quo whereby central bankers avoided mentioning fiscal policy so that politicians steer clear of comments on monetary policy. More seriously, amongst other central bankers it may represent a primal (and in the current context quite unjustified) fear of fiscal dominance: being forced to monetise debt and as a result losing both independence and control of inflation. In this context I often quote Mervyn King, who said “Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.”

These ideas are in conflict with the message on fiscal policy coming from the central bank’s own models. In the UK and US, this contradiction is partly resolved by an excessive optimism about unconventional monetary policy. But it can also be resolved through overoptimistic forecasts, given that inflation targeting is in reality targeting future inflation. Although both these mechanisms come with a limited shelf life, they only need to operate for as long as austerity and the liquidity trap last.

The story I like to use about the Great Recession is that it exposed an Achilles’ heel with the consensus assignment that helped give us the Great Moderation. Yes, it was best to leave monetary policy to independent central banks, but the Achilles’ heel is that this would not work if interest rates hit their lower bound. In that situation fiscal policy had to come in as a backup for monetary policy. But if the analysis above is right the creation of independent central banks may have helped make that backup process much more difficult to achieve. By concentrating macroeconomic received wisdom in institutions that were predisposed to worry far too much about budget deficits, a huge spanner was thrown into the (socially efficient) working of the knowledge transmission mechanism.

  

19 comments:

  1. Simon,

    Thanks for a great post.

    I think your diagnosis of what's happening here is too academic, and too anchored in economics and the logic of economic policy. And for that reason perhaps a bit too optimistic. There's psychology going on here. Imagine the same central banks you've cited in a world in which growth was adequate but governments were being irresponsibly lax with fiscal policy. Do you really think the central banks would be as circumspect - or in the case of the ECB as downright paradoxical - as they are being now?

    I'm not accusing central banks of direct right wing ideological bias here, except to the extent that you associate laxer policy with the left (which may be an accurate description, but isn't really a product of the rigorous application of more left wing ideas. Likewise Keynesianism doesn't favour laxity through the cycle, just in downturns, to be counter-balanced by greater fiscal stringency in boom times.)

    It's more that we live in an age where the boundaries of commonsense are dominated by neoliberal memes which are the hard-won ideological ground of neoliberal champions over the last few decades. I used to call myself a neoliberal because I was and still am in favour of a lot of the deregulatory and supply-side reform associated with overthrowing some of the excesses of welfare capitalism of the mid 1970s. But now political and economic debate is kind of deranged by neoliberal commonsense - the way in which neoliberal fears - the problems inflation, deficits, regulation dominate alternative fears - inequality, monopoly, pollution.

    In that environment, arranging your commentary around neoliberal fears with the occasional hippy punching aside is the only way to qualify and remain in the class of very serious persons.

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  2. What need is there to peddle such paranoiac conspiracy theories?

    The fact is that public opinion, not just that of an elite, in many Euro countries is strongly opposed to raising the level of public debt, which is - with the possible exception of Luxemburg - the only way of producing fiscal stimulus.That may change in due time, but not yet.

    Macroeconomists have not been able to convince anybody but themselves that public opinion is wrong.

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    1. Raising public debt the only way of producing fiscal stimulus? Not true. As Keynes pointed out, stimulus can be funded EITHER by extra debt OR by extra new money. Even Robert Mugabe has worked out that one can get stimulus by resorting to the printing press, though he took it too far of course.

      But there seem to be plenty of economists who (like the “public opinion” to which your refer) haven’t worked out that the printing press can fund stimulus, which was why I suggested on a post on my own blog that Mugabe be put in charge of economics at Harvard. That was of course a joke. But then again, look at the pro-austerity so called “economists” at Harvard: Kenneth Rogoff, Carmen Reinhart, Alberto Alesina. It’s quite possible that Mugabe would actually improve things there.

      Delete
    2. Ralph Musgrave7 June 2015 at 05:33

      What an excellent idea to put Mugabe in the right macroeconomic perspective and give him the honour due to him!

      But why are you the only macroeconomist (that I know of) to do so? Why are SWL, P. Krugman, J. Stiglitz et al. silent on the subject?

      Could it be that they think it a crackpot idea? How are you going to convince them?

      Delete
    3. "What an excellent idea to put Mugabe in the right macroeconomic perspective and give him the honour due to him! "
      Last time I checked the UK did not destroy its mainly agriculture-based economy's agricultural capacity by half by not enforcing property rights. Or run deficits or 98%. Or be a small developing country. Or owe foreign currency to the world bank and the IMF.

      Delete
    4. Of course, the reason that Mugabe 'took it too far' with currency printing is that it was not working as a measure to increase the real value of goods and services available in the economy.
      Who would have thought?

      Delete
  3. I wonder how much the process of Quantitative Easing has not been associated with the name of a single person in the way 'Keynesian' stimulus or 'Friedmanite' monetarism has made it seem more like an invisible hand than a conscious process taken by collectives of central bankers?

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  4. SWL means well but.....

    Knowledge Transmission should work like this.

    You take some of the brightest, most privileged kids in the country and send them to the most prestigious elite university. You teach them intensively in small groups using the Socratic method and pack as much implicit knowledge into them as possible. They know what they know, but they don't know why they know it. Then you let them run the country.

    Whoops it's not working.

    This isn't a Knowledge Transmission problem it's an Oggsford problem.

    Lets get a crack team of Ofsted inspectors in to find out what's going wrong with that PPE course, before another generation of these guys is let loose on the world.

    On this one SWL is standing in his greenhouse and throwing stones out furiously.

    Thats it fartig

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  5. Expertise .. I've had a wry chuckle about this. I concede that expertise has moved to central banks but that means we should be even more concerned about what's going on in finance ministries. Famously the current Chancellor of the Exchequer is not a numbers man. The only identity he fully understands and cares about (and then only in a boolean sense) is 331 > 319.

    In the coalition Danny Alexander was the Chief Secretary to the Treasury. Danny benefited from a fine Scottish secondary education, owned a pocket calculator knew how to use a spreadsheet. The fact that he could submit a relatively clean set of expenses when all about him could not speaks volumes. He will be greatly missed at HMT. We now have Greg Hands as Chief Secretary to the Treasury.

    Suffice it to say that we now have two Oxbridge Historians in the top two slots at HMT. Not to worry I hear you say there must be plenty of clued up numbers people in the lower ranks. Sadly I have reason to believe there are in fact only two people at HMT with the requisite spreadsheet skills to run the country. One an economics Phd spends a lot of time plotting a safe return to academe, the other is on secondment from PwC. That's the same PwC that had such a firm grasp of the spreadsheets at Tesco.

    This is a lamentable state of affairs for a G20 nation let alone one of the five permanent members of the UN Security Council. An in depth Newsnight investigation is called for. Surely this is more important than football or athletics.

    One thing is for sure trouble ahead.

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  6. It seems that independent central banks are a good institution for fighting inflation, but we now need new institutions for fighting deflation. I suggest creating a Living Wage Commission which would determine: (a) living wages (per Tony Atkinson) and also (b) a new Living Wage Tax to be collected by tax authorities. Both would be determined by the Living Wage Commission independently of the central bank and the government of the day. The Living Wage Commission could make 5 year Living Wage Determinations and meet once a year to consider whether the Determinations need to be revised.

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    1. PS. By "Living Wage" I refer to the basic income idea endorsed by Miltin Friedman and Tony Atkinson.

      Delete
  7. "Yes, it was best to leave monetary policy to independent central banks"

    Very unwise. Did they really pick up what was going on during the Great Moderation leading to the crash? This lower-bound stuff is starting to sound autistic and a tiring excuse. This is no victory for modern theory. That knowledge is very old and did not need rational choice models.

    And also what about financial regulation?

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  8. Great post, Simon!
    It questions not only the transferability of economic knowledge to monetary and fiscal policy makers, but also the usefulness of the concepts "knowledge" and "policy" as abstractions of concrete scientific, supervising and political actors, their perspectives and their life stories that shaped those pespectives.

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  9. Prof Wren Lewis

    ECB does not always argue for austerity, it regularly asks for more economic reforms. You cannot equate this with a general bias for austerity policies. And sharing a common currency amongst sovereign nations without a fiscal union requires certain ranges of indebtness if the union shall not become a transfer union.

    Yes, Keynesian business cycle models are accepted but this doesn't mean that fiscal expansion is a cure for every economic problem.

    Best example is Greece. After nearly a decade of ultra loose monetary conditions for Greece and fiscal deficits that were more than three times the Eurozone average economic activity became in a way distorted that gdp is so dominated by consumption that the concept of underutilization is simply misleading.

    You may derive 13% free capacity for the Greek economy but this is more or less useless since the trend has been distorted over a decade. Even if you describe this as criminal policy structural issues have to be addressed and the Keynesian theory is not helpful.

    ECB is aware of Keynes but also aware of the limitations.

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  10. Greece has a huge amount of unemployment and unused factors of production; Keynesian stimulus can put them back to work but will do nothing about governmental corruption. It is not one or the other.

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  11. News this morning that the CBI have cut growth forecast. Various reasons cited, but the latest unexpected government expenditure cuts not amongst them. I guess the CBI models aren't Keynesian.

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    1. March 2010 CBI projections...

      2010Q1 0.3
      2010Q2 0.4
      2010Q3 0.5
      2010Q4 0.5

      2.5% in 2011
      “As global demand, consumer spending and business investment strengthen through 2011, the pace of growth should then pick up”

      Now let's compare these projections with the actual figures:

      2010Q1 CBI Projection: 0.3 – Actual: 0.5
      2010Q2 CBI Projection: 0.4 – Actual: 1.0
      2010Q3 CBI Projection: 0.5 – Actual: 0.6
      2010Q4 CBI Projection: 0.5 – Actual: 0

      2011 CBI Projection: 2.5% - Actual: 1.4%

      I think you’re right the CBI model doesn’t appear to be Keynesian.

      I’ll tell you what else it is though: wrong.

      AFZ

      Delete
  12. March 2010 CBI projections...

    2010Q1 0.3
    2010Q2 0.4
    2010Q3 0.5
    2010Q4 0.5

    2.5% in 2011
    “As global demand, consumer spending and business investment strengthen through 2011, the pace of growth should then pick up”

    Actual growth rates...

    2010Q1 CBI Projection: 0.3 – Actual: 0.5
    2010Q2 CBI Projection: 0.4 – Actual: 1.0
    2010Q3 CBI Projection: 0.5 – Actual: 0.6
    2010Q4 CBI Projection: 0.5 – Actual: 0

    2011 CBI Projection: 2.5% - Actual: 1.4%

    I think you’re right the CBI model doesn’t appear to be Keynesian.

    I’ll tell you what else it is though: wrong.

    AFZ

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  13. Maybe, just maybe, if these economists were out on the streets in 2006 saying that we are living in a massive bubble and the whole thing is about to go to shit unless we fix it pronto, governments would be paying attention to them now.
    Alas, no: it is just a lot of 'wise after the event' grumbling.
    The 'economic consensus' has earned the disregard it is getting.

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