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.