The old ways of thinking about the macroeconomy have been found wanting, but the alternative is not clear.
Macroeconomics – understanding how the economy as a whole works – appears to be going through a time of exceptionally great turbulence. There is always a robust debate, but today it is more confused. That may not be the impression you get from the commentariat, who echo the past conventional wisdom, but it is the reality for more sophisticated economists.
It is even difficult to set out exactly what is going on, especially within the limitations of column space. Perhaps a key issue is that since the 1980s there has been a tendency to assume that the economy works in a way in which fiscal policy and monetary policy can be operated independently of one another. That meant that monetary policy could maintain price stability while fiscal (tax and public spending) policy could focus only on medium-term stability of aggregate production. Fiscal interventions could do little about short-term fluctuations which was beneficial in the medium term. We might call this paradigm ‘Monetarism’. On the other hand, Keynesians have an account of the economy which led to the policy conclusion that fiscal and monetary policy should be co-ordinated.
It is a long story about how we got to the 1980s and after, but part of the background is that as American economics became hegemonic, the particularities of the US institutional framework were assumed. Because of the way that the Fed, Congress and the presidency are organised it is practically difficult to coordinate fiscal and monetary policy in the US. This is not as true in New Zealand and many other jurisdictions.
Another factor is that Monetarism raises the significance of banks who have an interest in promoting their self-importance. Abhijit Banerjee and Esther Duflo were not alone when they wrote ‘[t]he “economists” in public discussion ... on TV and the press – chief economists of Bank X or Firm Y – are, with important exceptions, primarily spokespeople for their firm’s economic interests who often feel free to ignore the weight of the evidence.’ So the public perception is distorted, especially as journalists do not know any better.
While Monetarism was the dominant policy framework, many economists remained Keynesian. Some on them in policy positions would even confess ‘actually I am a Keynesian’ and try to moderate policies from this perspective. They were able to compromise because, the odd shambles aside, the policy recommendations were not that different during the Great Moderation of the affluent economies 1990s and early 2000s.
That is no longer true. The serious fracturing began at the time of the Global Financial Crisis. It is claimed that no one predicted it. That is true among the Monetarist commentariat but there were numerous Keynesians who did expect a financial crisis – even me. (We just could not predict when it would happen.) The Monetarists froze in disbelief so it was the Keynesians who led the response. (Sadly neoliberals used the crisis to reduce the size of some states with the redistributional consequence of increasing inequality.)
The standard prescription for stagnation is to reduce interest rates in order to stimulate investment (and borrowing for consumption). Now the rates are getting very low, that it seems they may need to be be negative; that is difficult to do (but not impossible, to a limited extent). In any case, low rates do not seem to be stimulating the economy much.
The Keynesians went for ‘quantitative easing’ (in former days it was called ‘open market operations’, although it did not usually operate to the extent it does today). QE requires a degree of cooperation between fiscal and monetary policy. Essentially it involves the government injecting spending power by tax cuts and expenditure increases and the monetary authority funding the resulting public deficit.
This means the public is increasing its holdings of highly liquid government assets. It is uncertain what the effect will be in the long run. (If you are certain, you have not been following closely enough.)
And so the world economy staggered though the post-GFC decade, which ended with the Covid Crisis. That has disrupted supply chains (as in the case of tourist operators not having any business.) An aside, both the standard Keynesian and Monetarist models use a single commodity, which tacitly assumes that resources, production and labour can be relatively quickly and smoothly redeployed. In practice they can’t.
So we have had governments intervening at much a more micro-level – reminiscent of the Muldoon era. That is true for this government. The National Opposition does not seem to disagree although it argues over which interventions; ACT has been largely silent rather than critical. The government’s additional spending, much of which is income support (and easily reversed when prosperity returns) is funded by borrowing.
So recent operations contradict the assumptions that were made in the 1980s – that fiscal policy should not try to deal with short term fluctuations, while monetary policy should not try to operate independently of fiscal policy.
The size of the head-space shift is extraordinary. A recent Economist briefing simply takes the previous paragraph as given without a skerrick of a mention of the Monetarist paradigm. But if ‘the covid-19 pandemic is forcing a rethink in macroeconomics’ the subtitle of the article is a chilling ‘It is not yet clear where it will lead.’
The briefing well illustrates the problem because, while it implies that the Monetarist dominance is over, it offers a confusion of possible policy responses. Moreover, by focusing on policy, it does not pay much attention to why the world economy is in so much difficulty – why, for instance, the economic growth rate has slowed down (which, presumably, is related to why low interest rates are not leading to an investment boom). Also, and dangerously, there is not much attention to the role of the external sector which plays a fundamental role in small open economies such as New Zealand.
If it is any comfort, during the 1930s ‘Keynesian’ policies were being pragmatically implemented before the Keynesian paradigm had been properly articulated.
What I am reporting then, is progress. We are no longer trapped into the Monetarist thinking framework, although there are still a lot of parts of it which are implicitly accepted or on which our institutional arrangements are based, Meanwhile much of the the commentariat use a Monetarist framework.
The discussion on the rising level of government debt and the need to get it down echoes crude Monetarism. Of course we should be concerned about the level of public debt and have a strategy to restrain it in the long run, But if the strategy is followed too early, as popular prescriptions propose, the economy will stagnate. Much as it did over the last decade when the immigration boom and private sector borrowing boom are excluded.
On the other hand we do not yet have a coherent alternative. Instead we are making a series of ad hoc decisions, some of which are probably right, some of which may get us into dreadful problems in the future.