This post by Alex Marsh got me thinking. If economic ideas influence policy makers, what happens when the economic ideas turn out to be wrong?
This is not an idle question. Recently there have been three examples of economic ideas that have had huge impact on policy – and that have subsequently been shown to be false.
Expansionary Fiscal Contraction
The first is the idea that fiscal austerity generates economic growth. This is known as the “expansionary fiscal contraction” theory, and was first proposed by Giavazzi & Pagano in 1990. The idea is that government spending “crowds out” private sector investment: over time this causes the public sector to grow and the private sector to shrink, resulting in economic stagnation. Cutting back government spending allows the private sector to expand, generating more economic activity, jobs and growth.
The expansionary fiscal contraction theory was enthusiastically promoted by several economists. More importantly, it was endorsed by politicians – sometimes for deeply-rooted ideological reasons that had little to do with economics. But other economists were worried. IMF researchers, particularly, sounded repeated warnings. This, from 2011, for example:
“Our main finding that fiscal consolidation is contractionary holds up in cases where one would most expect fiscal consolidation to raise private domestic demand. In particular, even large spending-based fiscal retrenchments are contractionary, as are fiscal consolidations occurring in economies with a high perceived sovereign default risk. “
The experience of those countries implementing fiscal austerity with the intention of creating growth at that time –notably the UK – appears to support the IMF’s findings. Far from their austerity measures causing growth, the result was high unemployment, low productivity and poor economic performance. But despite this, fiscal austerity continued in several countries, bizarrely encouraged by the same IMF that had warned about its negative effects.
In 2012 the IMF produced a paper which showed that severe fiscal austerity in the aftermath of the financial crisis caused lower growth and higher unemployment than they had anticipated. This caused something of a storm, since it amounted to an admission that their promotion of fiscal austerity had actually made the economic situation in troubled Eurozone countries worse. The IMF then went on to admit that the severe austerity measures imposed in Greece were a mistake, and to warn the UK that the pace and scale of its fiscal “reforms” needed to be tempered to allow room for growth. It also warned the US and, recently, Australia. Sadly policy makers seem to have harsher views: although the UK’s Chancellor has just produced a stimulatory Budget, he still plans to impose draconian spending cuts after the election. How this is consistent with long-term commitment to growth is something of a mystery.
But of course the UK has a structural deficit of unknown dimensions and a relatively high debt/gdp ratio. And the countries in the Euro zone that are suffering under the burden of severe fiscal austerity have even bigger debts and deficits. So fiscal austerity is still necessary, isn’t it? After all, you have to get that debt under control…..
High Public Debt Causes Low Growth
In 2010, Reinhart & Rogoff produced a paper which purported to show that government debt levels above 90% of gdp damaged economic growth. This was dynamite. Many developed countries already had debt approaching that level or even higher, and most had very low growth. If Reinhart & Rogoff were correct, then something had to be done. Suddenly deficit reduction became fashionable: never mind unemployment, the priority had to be stopping the growth of debt before it hit the 90% tipping point after which you were on the road to hell. Greece’s debt disaster in 2011 only seemed to strengthen Reinhart & Rogoff’s arguments. So EU governments tied themselves into a fiscal compact which prevented them from deficit spending in excess of 3% of gdp and required them to reduce their debt levels to 60% of gdp or less. The UK – already doing fiscal austerity anyway because of mistaken belief that it was expansionary – opted out of the fiscal compact, but has recently published even tougher deficit and debt reduction targets: the Chancellor intends to run an absolute surplus and over time reduce debt to 30% of GDP. And in the US, Congress imposed a series of fiscal austerity measures.
In 2013, Herndon, Ash and Pollin published a paper in which they demonstrated serious mathematical errors in Reinhart & Rogoff’s piece. They concluded that there was no evidence that debt loads above 90% were always a drag on growth. The IMF weighed in:
“we find no evidence of any particular debt threshold above which medium-term growth prospects are dramatically compromised”
And Arin Dube demonstrated that rather than high debt causing low growth, if anything the causation runs the other way: low growth causes high debt.
But the damage had been done. Even now, 90% is touted as a dangerously high debt/gdp level, and policy makers talk about making debt more “sustainable”.
It is unfortunate that one piece of shoddy work from Reinhart & Rogoff should have done such damage. Their other work is excellent. But they will always be remembered for the fatal 90%.
In reality, the poor growth and high levels of government debt in developed countries were mainly caused not by excessive government spending, but by the deepest recession since World War 2. That recession was triggered by the worst financial crisis since 1914. And this brings me to the third, and possibly the most dangerous, economic idea.
The Banking Sector Is Irrelevant In Macroeconomics
Classical macroeconomic models omit the banking sector completely. For example, the IS/LM model postulates a direct relationship between saving and investment: savers lend money to borrowers, who invest in the economy, raising output. This is nice simple modelling that everyone can understand. Banks don’t need to feature, because all they do is facilitate the flow of loanable funds to borrowers. They don’t create “real” money – only credit.
But the exclusion of banks from macroeconomic models makes financial crises very hard to predict or explain, because the role of credit money in the economy is not understood. The so-called money multiplier attempts to explain how banks create new money when they lend, but even this is an inadequate description of how money is really created in the financial system.
Central banks have known for a long time that classical economic models don’t adequately depict money creation and the role of lending. Some economists have, too – notably including one JM Keynes. Researchers at the Fed, the ECB, the Bank for International Settlements and the IMF have all produced papers suggesting that the “loanable funds” and “money multiplier” models of the banking system are inadequate. Heterodox economists have written extensively about the way in which the financial system really works. And now the Bank of England, in its Quarterly Review, has “officially” demolished the conventional view of bank lending and the way in which monetary policy works.
But again, the damage has been done. The absence of the banking sector in macroeconomic models meant that economists failed to notice the excessive growth of bank credit that led to the financial crisis. And inadequate models of the financial sector resulted in over-reliance on poorly understood monetary tools after the crisis. QE, for example, was widely believed to give banks more money to “lend out”: when banks failed to increase lending, policy makers scratched their heads and said “But they’ve got lots of money. Why aren’t they lending”, failing to see that the problem was not lack of money – since banks create money when they lend – but the horribly risky and under-capitalized nature of bank balance sheets and the increasingly tough stance of regulators.
These three examples show how even carefully researched economic ideas can go badly wrong. And when policy makers believe them, the result is policy that, instead of repairing the economy, does terrible harm. But the real tragedy is that policy makers seem even more reluctant to change their minds (and their policies) than economists. And the price of their intransigence is unemployment, poverty and human misery.