Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday 3 June 2015

The Knowledge Transmission Mechanism and Macroeconomic Crises

Sometimes when people talk about the influence of macroeconomic ideas on policy they seem to have a very simple framework in mind. Policy makers need to understand how the economy works, so they go to academics to find out what the current received wisdom is. In this framework, when things go wrong - in the extreme if there is a macroeconomic crisis - we need to ask why the received wisdom was wrong. In short, to understand macroeconomic crises you need to understand the bad or inadequate theory that generated it.

The archetypal example of this would the Great Depression of the 1930s. Policymakers had a classical view of macro, that had no room for recessions caused by demand deficiency. But similar stories are told about later crises. One story for the inflation of the 1970s is that the received wisdom was that there was a permanent inflation/unemployment tradeoff, and policymakers were attempting to use that to get unemployment a bit lower. However because in reality the Phillips curve was vertical, we got steadily increasing inflation. It is a neat story, but as a description of what was happening at that time it is at best far too simplistic, and probably just wrong.

A simple story about the financial crisis is that policymakers were too dependent on macro models that ignored finance, models which therefore implicitly assumed a financial crisis could not happen. As a result, macroeconomists failed to predict the crisis. This story can be often found in heterodox accounts, but some eminent policymakers have said similar things. The bit about macro models neglecting finance is true, but as an account of why the financial crisis happened it is also probably wrong, as I argue here.

Where the simple idea that crises reflect bad theory comes completely unstuck is for Eurozone crisis of 2010. Here the crisis owed a good deal to policymakers ignoring the received wisdom. This happened on two occasions. The first time was in the fiscal architecture of the Eurozone, where the problem of competitiveness imbalances caused by asymmetric shocks was wished away, and therefore the potential that national countercyclical fiscal policy could have to moderate these imbalances was ignored. I would never claim that had macroeconomic received wisdom been incorporated into Eurozone fiscal rules from the start the 2010 crisis would not have happened, but it certainly would have been more manageable.

The second time that the macroeconomic received wisdom was ignored by policymakers was in the reaction to the 2010 crisis: the subsequent austerity which was the major factor behind the second Eurozone recession. So in both cases policymakers did not act on the prevailing macro theories, but ignored them, and in doing so helped create a crisis.

One way of explaining how this could happen is that policymakers were well aware of the macroeconomic received wisdom, but chose to ignore it. In some cases that may be what happened. However another possibility is that the what I call the knowledge transmission mechanism between academics and policymakers broke down. To explore that possibility you need to think seriously about what could be called ‘policy intermediaries’. Here is a simple diagram.

I want to cast the net of potential policy intermediaries pretty wide. Obvious candidates are the civil service and policy think tanks, or the policy entrepreneurs that Paul Krugman has talked about. However to get a full picture of what went on in 2010, I think you need to also think about economists in the financial sector, the media and especially central banks. Of course central banks are policy makers when it comes to monetary policy, but on fiscal policy issues they can  advise governments. As I hope to argue in a later post, their role in misdirecting policymakers after 2010 may have been very important in at least some countries. 


  1. "The first time was in the fiscal architecture of the Eurozone, where the problem of competitiveness imbalances caused by asymmetric shocks was wished away"

    They were not wished away. The Eurozone was created with the idea that monetary integration would lead to political integration, which would then be able to create the appropriate fiscal architecture. Unfortunately, the European Constitution did not get adopted.

    But somehow, SWL seems to think that in 2010, given that they did not have the right fiscal architecture, eurozone leaders did not "listen" to the wise and wonderful economic theorists that they needed a better one. As if 2010 the architecture could have been rapidly wished into being. The eurozone leaders played the cards with which they were dealt, and they played pretty well. There was no utility value in Anglo-Saxon economists in 2010 saying, "But we told you back in 1992.." There would have been utility value in saying, "This is what you need to do to get the appropriate architecture given the situation in 2010." And there is one and only one way: a more federal Europe. But since SWL objects to that on political grounds, he wasn't able to say it.

    1. I think that most economists, including SWL, agree that an optimal currency zone should have fiscal as well as monetary integration. So, in 2010, economists should have said, integrate the way the US has done or your minetary union is going to continue to be problematic. I think SWL would agree with that.

    2. Your key phrase is surely "Unfortunately, the European Constitution did not get adopted."

      It's all very well creating structures that might perform well if the full structure is in place. But if one part of that structure is not delivered, then it's foolish to continue to behave as though it was there.

  2. I have been reviewing my excessive correspondence with the BBC over the last parliament - I'm not doing this one as well - and I found this from my archive November 2013 of a script transcript for the Daily Politics:

    ‘Please find below the transcript of the link read by Jo Coburn, as requested: “Well, it’s hard enough to get economists to agree on anything, but back in 1981, more than 360 of them concurred that Thatcherite policies would end in financial calamity. Events are generally held to have proved them wrong. A similar debate has been taking place amongst economists in recent years over George Osborne's prescription for the economy. With the flatlining economy, those arguing that his austerity package is similarly flawed had felt vindicated, but have recent signs of promising growth changed the economic weather? Here’s David.”

    To get through to the BBC revision of attitude and culture must start in 1981 not 2008 or 2010: the schism between academic and journalistic presentation started on the 30th of March 1981, and the nationalised BoE was in error in 1981, never owned up to it, and here we are in a continued culture of error and misunderstanding.

  3. Do bear in mind when talking about Europe that Germany is a big part of it, and academic macroeconomics there is a very different beast. It is not a beast I know well -- I don't speak their language -- but from what I do know, the thesis that fiscal contraction is expansionary was already current among them in 1980, and the experience of the subseqent decade cemented it.

  4. Two comments really, one is the media, rarely right, often wrong and the second is events dear boy events.

  5. I'm sorry, but anyone who did NOT account for "intermediaries" is too naive to be anywhere near policy anyway. That this is even a new issue or surprise shows how divorced economists are from reality.Give me political scientists any day and twice on Sundays.

  6. I have two questions. What is the purpose of Economics? And what is the goal of a politician? If they are the same, Economists will be closely listened to; if they differ, the politician will listen to others first.

  7. archtypical = archetypal ?

  8. The Economist and the IMF have been mixed bags, but I liked this (apologies for the length).

    Public debt
    How much is too much?
    Jun 3rd 2015, 17:44 BY S.K. | LONDON

    PUBLIC debt in rich countries exploded between 2007 and 2012, rising from an average of 53% of GDP to nearly 80%. Some people think this is a problem, and say that governments need to do their best to cut it. But that view has been challenged in a new paper from the International Monetary Fund,* which suggests that “paying down the debt” (or in the words of George Osborne, Britain's chancellor of the exchequer, “fixing the roof while the sun is shining”) is not the most sensible approach.

    The IMF's economists reckon that if a government could choose between having high or low debt today, then all else equal they would (and should) choose the latter. After all, when debt is high governments have to impose unpleasant taxes to fund spending on debt-interest payments. These taxes are a drag on the economy.

    But when a government is faced with a high debt load, is it better to impose austerity and pay it down, or take advantage of low interest rates to invest? The answer depends on the amount of “fiscal space” a government enjoys. This concept refers to the distance between a government’s debt-to-GDP ratio and an “upper limit”, calculated by Moody’s, a ratings agency, beyond which action would have to be taken to avoid default. Based on this measure, countries can be grouped into categories depending on how far their debt is from their upper threshold: safe (green), caution (yellow), significant risk (amber) and grave risk (red). It is a decent measure of how vulnerable a government’s finances are to a shock.

    For those countries with no headroom (in the red or amber zone on the chart), the IMF’s paper is not much use: they need to take action to reduce their borrowing levels. But for countries well into the green zone (of which America is a star performer and Britain is a somewhat marginal case), the IMF’s analysis has a clear message: don’t worry about your debt.

    For these countries, the wonks argue that the costs of raising taxes or cutting useful spending to reduce debt levels outweighs any benefits. For countries safely in the green zone, the authors present an example of a country reducing its debt from 120% to 100% of GDP. They calculate that the expected costs of the higher taxation (for instance, from the disincentives to work created by increased tax rates) are likely to outweigh the expected benefits (from the lower risk of a default in the event of a crisis) by a factor of ten.

    What should such countries do instead? The best thing, the paper says, is simply to let economic growth take its course. In the long run, if the economy grows more quickly than debt, the burden of it will fall as a percentage of GDP.

    Their analysis is necessarily simplified; they are much more concerned with long-run dynamics than the effect of borrowing on growth in the short run (which may often be the more relevant question for governments on time-limited electoral mandates). But it is a useful reminder that high public debt should not necessarily cause panic. Indeed, as previous IMF research has shown, the trajectory of debt-to-GDP ratios can matter more than their overall level. Often, the fundamental trade-offs between the costs and benefits of borrowing for investment are underplayed. Perhaps governments should take a more reasoned look at the roof before rushing in to fix it.


    1. Fiscal space is not a ratings agency wet finger in the air. It refers to the dynamic capacity left idle in the economy when monetary policy can not be eased much further, and I to which government can spend without creating excess inflation. As for default, there are no examples of governments that issue fiat non-convertible floating currencies defaulting who have borrowed only in that currency. None.

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  10. I think the diagram also needs to have arrows pointing the other way. This is something you've discussed yourself plenty of times on this blog: there's, at least for UK politicians, clearly an ideological component. That might just mean, as you say in the linked piece, certain advisers appeal more than others so they get selected, but I think that under-estimates how much political power actually shapes the epistemological landscape (urgh, sorry!), rather than just passively selecting from the professional views on offer.

  11. Simon, I heard the chancellor today announcing a further sale of the Royal Mail – his rationale was to use the £1bn raised to reduce the national debt and reduce the interest paid on the debt.

    This tells you what you need to know about how the govt determines macro policy. It is nonsense but it is aimed at the 25% of the electorate that the Tories target. And to them it sounds good. Govt macro policy is determined by what political researchers tell policymakers will resonate with that limited part of the electorate that will vote for them. It does not really have anything to do with choosing a rational macro policy that is optimal for the country as a whole.


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