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.
