Bold macroeconomic policy changes for a new government

One of the features of the incoming 1997 Labour government was that it undertook significant and progressive changes in macroeconomic policy. Not only was it right to give independence to the Bank of England [1], but the institutional framework they created for this was innovative and effective. As I have written recently, the fiscal framework established a year later was also clear and progressive compared to past practice and what was being done elsewhere.

So could the government that gets elected in 2015 be equally bold? I think it could be. Furthermore, the suggestions I make below apply to many advanced economies. Yet why look two years ahead now, when recovery from recession is either far from complete, or for many countries has not begun? One reason is that the lags in policy making can be quite long. A new government will not have spent the year before an election working out its policies - it will have been too busy campaigning. Policies get decided much earlier. To have a chance in that decision making process, ideas need to be bounced around earlier still.

On monetary policy, the new government needs to acknowledge that the recession has indicated clear problems with the inflation targeting regime. Three things need to change. First, the medium term inflation objective should be accompanied by an objective of minimising the output gap - in other words the UK should have a dual mandate like the US. Second, nominal GDP should be adopted as an intermediate target, to guide the MPC as to how best achieve these two objectives. Third, the inflation target of 2% is too low, because it increases the risk that we will soon suffer another Zero Lower Bound (ZLB) recession. In the UK the government fixes this target (which is one reason why the 1997 decision was progressive), and it should raise it. All of these changes will assist the process of recovery as well as help in the longer term.

On fiscal policy, we have to distinguish between policies pre and post recovery. If the government inherits an economy where the interest rate set by the Monetary Policy Committee is still at 0.5%, then its priority should be fiscal policies that promote recovery. I agree 100% with Paul Krugman that governments around the world have needlessly confused long term issues involving debt with this short run priority: here is one of many posts I have written arguing this. Yet the incoming government should also have a fiscal strategy post recovery.

This should involve both rules and institutions. Whatever fiscal rule is adopted, it should make three things clear. First, it does not apply at the ZLB. [2] Second, it should focus on a long term objective of reducing the debt to GDP ratio. Third, deficits have to be flexible in response to shocks in the short term. Now how you square these three things is tricky, and I still have an open mind on this, but for the moment you should read this very interesting proposal from Tony Dolphin at the IPPR as to how it might be done. That proposal utilises an enhanced UK fiscal council (OBR), which is the institutional leg of the reform.

Before discussing that, however, I want to say a bit more about why the policy goal should be to gradually reduce debt to GDP. I would give four main reasons. First, it allows room for fiscal policy to support monetary policy if it again hits the ZLB, without worrying about the bond markets. Second, it reduces real interest rates, which should encourage private investment (although the more open the economy the smaller this effect will be). Third, it reduces future distortionary taxation. Finally, future generations will need all the resources we can give them to help cope with their inheritance of hugely disruptive climate change.[3]

In the context of similar proposals from Hopi Sen [4], Chris Dillow recently raised some doubts. Some of these relate to the short term position: yes, investment probably responds more to expected future growth than the cost of capital, but with an active monetary policy, reducing debt to GDP should not inhibit growth. A more serious concern is that reducing real interest rates might increase the risk of hitting the ZLB, which is one reason why I propose raising the inflation target. [5]

The current government should be credited with setting up the OBR, but it did so with a very restricted remit. The OBR is not allowed to crunch the numbers on alternative policies, so it cannot even produce the raw material on which others can propose advice. Perhaps this made sense to avoid throwing a new institution into the middle of a fierce political debate in 2010, but it does not make sense in the longer term. At the very least the OBR should be given the freedom to look at alternative fiscal policies, but its role could go further still, as the IPPR proposal suggests.

[1] I should confess that before 1997 I was very dubious about central bank independence. In retrospect that was because I did not have the imagination to see how that the institutional set-up could be crucial. Despite my recent criticisms, I think the MPC has done much better than elected governments would have done. However my fears were that we would get something more like the ECB, so they were not groundless. I also worried that an independent central bank might be too conservative in the Rogoff sense, and that concern has also been realised. 

[2] Or equivalently, there should be a rule that directs policy in very different ways at the ZLB.

[3] In an ideal world, we would be dealing with climate change now, and perhaps - as I discussed here - using higher government debt to help pay for it. However we are not, and it does not look like this is going to change any time soon.

[4] I obviously disagree with Hopi on how the Labour party should respond to the myth that their fiscal mismanagement was responsible for the UK’s current plight. If you want to get into the apology idea, then it seems reasonable that governments should only apologise for major errors rather than every particular thing they could have done better. As I have argued before, there is no comparison between Labour’s fiscal errors and the current government’s mistakes. Governments that commit errors that go against expert opinion at the time bear a particular responsibility. Few (myself included) raised objections to the constant 40% debt to GDP ratio when it was adopted in 1998.

[5] In the UK I suspect that the main short term impact of a tighter fiscal regime will be a depreciation in the exchange rate rather than lower interest rates. In the context of the last Labour government, I think that would have been helpful.

Multipliers in a monetary union and at the ZLB

For macroeconomists

My recent post reminded me that I had earlier promised to talk about a paper by Farhi and Werning. Its an excellent and very rich paper, but this in my area which means I’m biased, so let me single out one point that should be of general interest to macroeconomists. We all should know, from Woodford for example, that in a closed economy at the zero lower bound (ZLB) the (temporary) government spending multiplier is greater than one. It is tempting to apply the same logic to a member of a monetary union, because if they are small relative to the union as a whole they too face a fixed nominal interest rate. What Farhi and Werning show is that this is incorrect, and I’ll try and explain why. (The authors also focus on this point in their paper, so the first best option is to read their paper, particularly as their intuition for the result is a little different - although I believe quite consistent - with the one I give here.)

Let me first recap on Woodford’s closed economy result. If real interest rates are constant, consumption smoothing ties current consumption to its steady state value, and the temporary increase in government spending has no impact on the steady state. So current consumption is unchanged, and we get an output multiplier of one. (I make the same point in a related two period setup here.) With intertemporal consumption, income effects really do not matter, so we can ignore them. [1] At the ZLB nominal interest rates are fixed, so any increase in output will generate some inflation, reducing real interest rates. Lower real rates will increase current consumption relative to its steady state, so the multiplier exceeds one.

Now why does the same logic not work in a monetary union? The key point is that nominal exchange rates are fixed, which implies that in steady state the price level has to return to its original level to keep competitiveness unchanged. So if inflation rises today, it must fall (relative to the base case) later. With fixed nominal rates, we now have lower real rates followed by a matching period of higher real rates. Working backwards from the steady state, we have a period of rising consumption, preceded by a period of falling consumption, with the impact effect being zero. So in a monetary union, consumption gradually falls, and then rises again, but is always below its initial and steady state level.

Neat isn’t it! Now to relate this to the real world we would want to add lots more things, and the paper does show that with credit constrained consumers the monetary union multiplier can exceed one. But this key difference between a monetary union and a closed economy remains. And of course we are assuming here that consumers realise that in a monetary union higher inflation today will be offset by lower inflation later on, a presumption which some in periphery countries in particular might want to question.

Yet if you think about the logic here, it depends crucially on prices being allowed to rise in the long run in the closed economy case. Suppose instead that the monetary authorities operated a long run price level targeting regime. Now any inflation generated by higher government spending today would require a later period in which inflation was below base to offset it. So lower real interest rates at the ZLB would be offset by higher (than steady state) real interest rates later on as the central bank reduced the price level back to target. We would get something more like the monetary union result. [2]

So the closed economy multiplier is lower with price level targeting. Of course price level targeting (or its equivalent) in itself does help at the ZLB, for exactly the same reason. At the ZLB it is generally assumed that inflation is below steady state, so real interest rates are high, which with inflation targeting just depresses consumption. But with price level targeting, low inflation today will be matched by high inflation and low real rates after the ZLB constraint is lifted, which supports current consumption. Just as price level targeting dampens the impact of a negative demand shock at the ZLB, so it dampens the impact of a positive demand shock like fiscal expansion at the ZLB. The government spending multiplier is still positive, but now below rather than above one. Fiscal stimulus at the ZLB is also beneficial because it reduces the extent inflation has to rise after the ZLB constraint has lifted under a price targeting type regime.

So this is another example of why you cannot assess the potency of fiscal policy without taking into account the monetary policy regime. The other crucial implication for Eurozone policymakers is that in standard state of the art models countercyclical fiscal policy is effective. (I also think its desirable, but I agree effectiveness is a necessary but not sufficient condition for desirability.) But of course they all know that, don’t they! 

[1] Note, however, that the multiplier of one means that human wealth has not changed anyway, because the additional output=income exactly offsets the higher tax bill.

[2] It is not exactly the same, because a monetary union involves forever fixed nominal rates: inflation falls later through competitiveness effects. In a closed economy with a price level target inflation falls, and real interest rates rise, because the central bank puts up nominal interest rates. 

Why Bernanke was right to speak out on fiscal policy

This is a comment on Cardiff Garcia’s post on fiscalists and market monetarists, and also some related criticism of Bernanke’s recent remarks on fiscal policy, criticism which I think is totally wrong. I want to argue that a ‘monetarist’ position which is indifferent to what fiscal policy is doing in current circumstances is untenable. As a result, central bankers have to speak out on the dangers of austerity. [1]

There are two lines that monetarists might take. The first is that unconventional monetary policy, Quantitative Easing (QE), is a perfect substitute for conventional monetary policy. The second is that an appropriate monetary policy regime can, through expectations, undo the restriction imposed by the zero lower bound (ZLB). Let me take each in turn.

The first argument is wrong mainly because of uncertainty. Macroeconomists know little enough, but we do know something about how conventional monetary and fiscal policy works, and we have a lot of data that can help us. We know so much less about unconventional monetary policy. What kind of model we should use is unclear, and we have very little data.

The second argument would be right if we could fix inflation expectations in exactly the same way as we could, absent the ZLB, fix nominal interest rates. Would a nominal GDP target do that? Of course not. I think it would help, particularly compared to an inflation target regime, because the latter actually inhibits inflation expectations rising above that target. That is why I have recently argued that a path for nominal GDP should be adopted by central banks as an intermediate target. Would adopting such a target raise inflation expectations and speed a recovery? - I think it would. Would it raise inflation expectations by enough to negate the need for any fiscal stimulus (or, more realistically, to counteract the impact of fiscal tightening)? There is no logical reason why it should. But let us just suppose it did. Does that mean we can ignore fiscal policy?

Absolutely not. What we are getting in this case is a recovery achieved by raising expected inflation above (in the UK, US and Eurozone) 2%. That is costly, because it means actual inflation must be allowed to go above 2%. The more we deflate demand through fiscal austerity, the higher inflation has to go (or the longer it has to be above 2%). So monetarists who believe in the expectations channel cannot be indifferent to fiscal policy, unless they also believe it has no effect, or that inflation above 2% is costless. (I make a similar point a little more carefully here.) If, as Paul Krugman says, fiscal policy makers are doing the wrong thing, that is a cost worth paying, but it is a cost nonetheless.

This is why it is really important that central banks, like the Fed, make it publicly clear the difficulties that fiscal tightening is causing them in meeting their mandate. Either this is because they are, quite rightly, uncertain about the impact of QE, or they are aware that the more fiscal tightening there is, the more inflation will have to go above 2% to counteract its impact.

The idea that to speak this truth is wrong because it might frighten the horses is silly. I have used the following analogy before. No one wants to hear a pilot tell passengers that they are no longer in control of the plane. However a better analogy in this case would be the pilot not telling the co-pilot, which would be highly dangerous. The horses that matter here are those in charge of fiscal policy, and they need frightening.

[1] Sorry Nick. I have a lot of sympathy for the point that we should not routinely exaggerate with language. The (I think just British) phrase I hate is ‘black hole’ when used to describe a worsening in the government’s accounts. The use of austerity to describe what is happening in parts of Europe and the UK right now is less obviously loaded or misleading, but I’m open to persuasion.

How a Greek drama became a global tragedy

Maybe that title is too strong, but there is an arguable case that what happened to Greece in 2010 was crucial in the move to austerity not just in the Eurozone, but in the UK and US too. As most reasonable people now recognise that the global move to austerity was a terrible mistake, understanding what went wrong in Greece is important. By this I do not mean how Greece came to behave fiscally in a total irresponsible way, interesting and important though that is. These things sometimes happen, but they do not usually have global consequences. What is more important is how the Eurozone and IMF subsequently handled events, which helped turn a Greek crisis into a Eurozone crisis and more.

These events have recently been analysed by the IMF. (Subsequent references are to paragraph numbers.) All credit to them for publicly and critically analysing their role in this affair. In terms of the substance, the facts of the case are not really in dispute. There were two feasible responses to the true fiscal numbers as they began to be revealed by the Greek government. [1] The first was forgiveness, in the form a large fiscal transfer from other Eurozone governments. These governments might have noted that the Greek people did not intend its previous governments to act in such a profligate and deceptive way, and that the Eurozone had failed to put in place effective institutions to stop it happening, and as a result they could have (one way or another) paid off a large part of Greek debt as a gift. That was never likely to happen, and it did not happen. [2]

So the other feasible option was default. As the report also notes (para 55), a number of Fund programs since 2000 had started with some ‘private sector involvement’. Yet initially the Eurozone ruled this out, as the report makes clear and which coverage of the report has widely noted. Why was it ruled out by the Eurozone? The charitable explanation was a concern that once the default possibility became reality, markets would turn on other vulnerable governments. Predictably, they did this anyway. A rather more base explanation was that with default the banks in other Eurozone countries might lose a lot of money, and become even more fragile. There may also have been a bit of pride.

So what we got was a transfer of ownership of a large part of the Greek debt from the private sector to other Eurozone governments, and crippling austerity for Greece. This was not feasible: default was just postponed, but only partial default on the remaining privately held debt. Additional austerity was imposed, and Eurozone governments swore there would be no default on the debt they now owned. And so it goes on.

So why did the IMF not point out that the original plan was not feasible, and refuse to participate? That would have been a hard political call to make, but the IMF is practiced in making such calls when the economics dictates. The report talks about failures in Greek implementation, but it also recognises that the subsequent turnaround in Greece’s underlying fiscal position has been dramatic, so its difficult to believe that plans to do any more should have been taken seriously. The real problem, as I note here, was that projections for the Greek economy were hopelessly optimistic.

Why were they too optimistic? As the IMF acknowledges (para 41) and has acknowledged before, it underestimated the impact on the economy of austerity. It got the multipliers wrong. [3] Yet while the report draws a number of lessons from the episode as a whole, I cannot see any analysis of how this fundamental, and arguably critical, mistake was made.[4] Talk to most people who know anything about the basic theory involved, and they will tell you that when nominal interest rates are fixed, the starting point for the government spending multiplier should be one. [5] In a financially crippled economy there are likely to be a lot of credit constrained individuals around, so the tax or transfer multiplier is also likely to be a lot larger than normal. So numbers based on looking at the past evidence which includes times when monetary policy was able to counteract the impact of the fiscal change were always going to be seriously wrong. You didn’t need to be a nobel prize winner to work this out, you just need to ask people who have worked through the theory of fiscal multipliers. [6] Knowing a little bit about the IMF, I would love to know how this mistake came to be made. [7] [8]

The IMF document is not just about deriving lessons looking back. It also speaks to a real issue that should be being debated in the Eurozone, and that is what are the best institutional arrangements for the lender of last resort to Eurozone sovereigns (hereafter SLOLR)? As Paul DeGrauwe has pointed out, the last few years tell you that you need a SLOLR to prevent a bad equiilibrium where debt crises are self fulfilling. But should the SLOLR be the central bank, other Eurozone governments or the IMF?

What the IMF report clearly shows is that it should not be other Eurozone governments. A good SLOLR needs to be effective (in having the fire power to prevent a bad equilibrium), but it also needs to be able to know when not to intervene, but instead allow default to happen. Eurozone governments failed on both tests: they were never willing to devote enough resources to ensure they were effective, but with Greece they failed to see that default was inevitable. They have the wrong incentives to make the right decision.

You might think that the Greek episode also tars the IMF with the same brush. But as Karl Whelan points out, the ECB does not come out of this episode very well either. Which is a little worrying, because with OMT the ECB is now the SLOLR. It does have back-up, but from those very same governments that got it wrong in the case of Greece. So in a future crisis, does the ECB have the right mechanisms in place to know when it should pledge to buy government debt and when it should do nothing to prevent default? While the IMF deserves credit for being publically self-critical, I cannot help but ask how long will we have to wait for a similar self-analysis of the ECB’s role in this affair?  

[1] As the IMF notes, in October 2009 a new government revised up its estimate of the 2009 deficit from 4% to 12.5% of GDP, and even this was 3% below the final estimate.

[2] In technical terms, this would have amounted to there really being just one set of Eurozone fiscal accounts. If one government gets its people into trouble, the other governments will raise taxes or cut spending to prevent default. When I was writing this paper with Campbell Leith, we ruled out this possibility as unrealistic, but I never imagined that judgement would be tested so quickly.

[3] Assuming a multiplier of 0.5 rather than 1 does not account for all the forecast error. But what remains does sound a bit like ‘we expected the confidence fairy but she did not turn up’. For example, errors “reflected the absence of a pick-up in private sector growth due to the boost to productivity and improvements in the investment climate that the program hoped would result from structural reforms.”

[4] Am I overemphasising this point? Consider this hypothetical. Using the correct multipliers, the IMF just cannot show that the original no-default programme adds up. (As the report makes clear, the actual projections only just did so.) The IMF tells the rest of the Troika that it cannot participate without some initial default. Fearing the impact that such news would have, the Europeans recognise that some default is required. Rather than spending the next year or so putting off the inevitable, the Troika instead focuses on establishing that Greece is a special case, and ensuring there is adequate support for other periphery countries on beneficial terms without crippling austerity (using the right multipliers). The rest of the world increasingly sees Greece as an isolated incident and not the beginning of a worldwide debt crisis. The other possibility, explored by Barry Eichengreen (HT Brad DeLong), is that the Greek government could have insisted on default.  

[5] In a closed economy at the ZLB it is almost certainly above one. In a monetary union, even if the government spending is entirely on domestic goods, in a model with unconstrained consumers it will be below one, but with credit constrained consumers it can be above one (see this paper by Fahri and Werning, and a forthcoming post). Ideally, from a macro point of view, you would choose to cut government spending on goods produced overseas, where multipliers could be negative. The amount that Greece spends on arms, the extent to which it has been part of the fiscal consolidation programme, and the fact that many of these arms come from other European governments is highly controversial.   

[6] Doing the analysis is what is crucial here. In this particular case it just so happens you could have asked a well known nobel prize winner who had also done the analysis. However just asking an academic who has won a nobel prize for macroeconomics but who had not done the analysis could get you into trouble.

[7] Even though the report notes that the assumed multipliers were too low, it also comments (para 46) that “The adjustment mix seems revenue heavy given that the fiscal crisis was expenditure driven”. Yet if you want to protect demand, you should (in the short run) focus on tax increases rather than government consumption or investment. So even within this document, the basic macroeconomic theory behind fiscal consolidation has still not been fully appreciated.

[8] Of course you can say that the numbers were chosen to fit the politics, and the real lesson is that the head of the IMF should not be a past and/or prospective French politician. But those within an organisation like the Fund should try and make it as difficult as possible for politics to overrule economics in this way.

Must we live with a post-truth media?

Something odd but familiar was going on when I wrote this post on Labour’s economic record. The Labour leader and shadow chancellor both made speeches that had apparently been months in the making, and which were (I think intentionally) spun as trying to convince voters that they could trust a future Labour government with fiscal management.

Why odd? Because it presumes that there is some real problem to solve. It presumes that the last Labour government managed the nation’s fiscal affairs very badly, and so today’s politicians have to show they would be different. Yet the paper I wrote tells a very different story. The previous Labour government set up fiscal rules that were both responsible and better than rules subsequently adopted elsewhere. Until the financial crisis, they kept to those rules. Here is the basic data: the top line is the debt to GDP ratio, the bottom line a scaled up current balance to GDP ratio.

Labour Government's Fiscal Record: source OBR

Of course it is possible to find fault, and I do. In hindsight it would have been better if the debt to GDP ratio had been kept nearer 30% of GDP, or even reduced further. But debt to GDP was lower before the recession than when Labour took office, and the current balance was almost zero. Hardly a profligate government. Indeed one of the faults I find, over optimism in Treasury forecasts, has been fixed, to the Conservative party’s credit, with the creation of the OBR.

With the financial crisis everything changed, because this produced the Great Recession. Deficits go up in recessions. There was a small contribution from the government’s attempt to reduce the impact of the recession, an attempt which analysis suggests was successful, so they should take credit for that. It is pretty obvious that you cannot use the fact that the deficit rose in the recession to argue that Labour cannot be trusted with the public finances. Again, the data speaks - look at when the deficit rose in the past.

Of course you could say that the Great Recession was the government’s fault. It should have foreseen the financial crisis coming. It should have known that levels of GDP in 2007 were going to be interpreted, five years later, as a massive economic boom rather than as they appeared at the time as something close to trend. It should have known this, despite the advice it was getting to the contrary from the Bank of England, the IMF, OECD, most economists …. and Her Majesty’s opposition! You can take that idealist view - but not if you were agreeing with all this advice at the time.

So the idea that the last Labour government seriously mismanaged the nation’s finances is a myth. What is more, unlike older myths like the earth is flat, as these charts show it is not something that is generated by perception and which requires expertise to unravel. Unless you are completely naive about the impact of recessions on deficits, a quick look at the data tells the true story. So it is a manufactured myth that distorts what the numbers appear to show. The problem with myths is that after a time, even otherwise good journalists at good places like the Financial Times start believing them.

Now we all know who manufactured the myth. Yet I think most people believe that if a political party started telling a story that was clearly at variance with the facts, it would be found out. In short, people expect journalists and economic commentators to confront politicians who attempt to create and perpetuate myths. In this case they did not. Its also pretty obvious why they did not. The incentive for organisations like the BBC is to stay out of trouble. And who has been making most noise about bias in economic reporting - the government. As any economist will tell you, its all about incentives.

So it really is the duty of academics to speak to truth, as loudly as they can, when it is being ignored by the media. On this topic, the media in general and the BBC in particular have been hopelessly biased in allowing the government to get away with this myth. They have some serious explaining to do.   

Does the Dutch central bank employ any macroeconomists?

Did you think that the policy of fighting recession by increasing austerity was now intellectually bankrupt? No one seems to have told the Dutch central bank. (Hence the deliberately provocative title of this post.) The latest forecast by the Bank says

• The economy will shrink by 0.8% this year, followed by growth of 0.5% next, “accelerating” to 1.1% in 2015
• The unemployment rate will rise sharply, reaching a peak point at 7.2% of the labour force midway through 2014.
• The budget deficit will increase from 3.5% this year to 3.9% next.

What should the government do about this? The central bank says “"The forecast course of the factual and structural deficit in 2014 does not meet the recommendations given in May by the European Commission to correct the excessive budget deficit in the Netherlands. Extra consolidation measures are therefore necessary."

Unfortunately the central bank is being entirely predictable in continuing to urge austerity as the economy weakens. In earlier posts (here and here), I noted how the central bank’s advice was rather different from the Dutch CPB (Bureau for Economic Policy Analysis), which clearly does employ macroeconomists. What is just so depressing is that the central bank seems oblivious to the increasingly overwhelming evidence that austerity during a recession is the complete opposite of what you should be doing in a country without its own monetary policy. Unlike some other Eurozone countries, there is no market pressure forcing policymakers’ hands in the Netherlands.

If you think this is excessively rude, please read my own checklist on the subject. I am not disdainful of those in 2010 who thought austerity was necessary because either a debt crisis was around the corner, or economic recovery had been assured, and have subsequently done what Keynes suggested should be done when the evidence becomes clearer. I think they were wrong back then, and said so, but it was an understandable mistake, and even the best economists make mistakes. But I’m afraid to continue in 2013 to advocate a course of action which anyone can see is doing immense harm to so many people is just inexcusable. If you understand this, and are a macroeconomist working for this or another European central bank with similar views, then you have my sympathy. If you work for one of these banks and think I’m being too harsh, please tell me why in comments. But more importantly, let’s hope that Dutch politicians treat this advice, along with the recommendations of the Commission, with the contempt it deserves.

The last Labour Government: has the influence of economists ever been greater?

The latest issue [1] of the Oxford Review of Economic Policy is devoted to an analysis of the record of the last Labour government (1997-2010). My own contribution is on fiscal policy, but I do not want to talk about that here, as I already have a post covering the main points. Instead I want to reflect just a little on Labour’s entire economic record. One way of characterising this period, which those outside the UK may not be fully aware of, is that it was a government in which the influence of mainstream economics has never been greater.

One of the government’s first acts was to give independence to the Bank of England, under a regime of inflation targeting. Not only was this straight out of the mainstream macro playbook, but its design included elements of transparency and accountability that led economists at the time to label it best practice. (1997 also saw the appointment as deputy governor of the Bank of England of Mervyn King, who in many ways is the central banker mainstream economics might wish for.) In my paper I argue that the fiscal rules that came shortly afterwards were much closer to mainstream academic views than either what had gone before, or what subsequently happened in Europe. Even when those rules broke down after the recession, the instinct to use fiscal policy in a countercyclical way was entirely mainstream. Not to be forgotten is the decision in 2003 not to become part of the Eurozone, which could well have gone the other way if political factors had played a larger role.  

In terms of microeconomic policy, the ethos was generally ‘light touch’ regulation, but with intervention where there was perceived to be a clear market imperfection. There was a particular interest in improving productivity (where the UK had traditionally performed badly in terms of international comparisons), but the interventions were of the kind economists would generally recommend (improving human capital, enhancing competition policies, subsidising R&D), rather than any attempt to pick winners. There was a clear aim to reduce poverty, but again this was done through the tax and benefit system, rather than trying to directly influence market outcomes. (An exception was the introduction of the minimum wage, but that had a lot of support among mainstream economists.) In the public sector there was a continuing trend towards introducing incentives and market processes. There was a deliberate lack of concern about inequality at the top. Now of course not all mainstream economists would endorse all these developments, but I don’t think a newly graduating student of economics would be puzzled by much of this. And of course the fact that these policies reflected mainstream economics did not make them right, as we all found out during the financial crisis.

Why was mainstream economics so powerful? I speculate a bit below, but for this particular administration it may have been in part a political accident - the deal struck between Gordon Brown and Tony Blair, where Blair got to be Prime Minister, but Brown’s Treasury became more powerful than it has perhaps ever been. Of course that does not tell us why Brown himself was so influenced by mainstream economics (his PhD was in history).

So how successful was this ‘government by economists’? As the editors (David Cobham, Christopher Adam, and Ken Mayhew) in their introduction note, if the government had ended in 2007 the verdict would have included many pluses. Over the previous decade the macroeconomy was remarkably stable. Unemployment continued to fall. Although fiscal policy had it failings, the rules had been kept, the budget deficit was not far from a sustainable level and debt to GDP was lower than a decade earlier. The health service clearly got better. As Van Reenan documents, UK productivity continued to improve relative to other countries, and he suggests this cannot be dismissed as just a hangover from the reforms of the previous Conservative government. (See also this CEP paper coauthored with Corry and Valero.) The achilles heel was of course the light touch regulation of the financial markets (discussed in a nice paper by Arup Daripa, Sandeep Kapur, and Stephen Wright). However this too can be seen as a failure of mainstream economics as much as a political error.

It is interesting to speculate whether any government could have avoided having its reputation defined by what happened in 2008. Perhaps it could have: given the recession, the election result in 2010 was surprisingly close. However, once a new government took over, we had the familiar story of the victor rewriting history. To quote from the introduction (but my emphasis), the new Coalition government claimed  

“… that the principal legacy of the 1997–2010 Labour government was an economic policy framework that was both in (large) measure responsible for the financial crisis of 2008 and also unable to address its consequences. As we hope the papers in this issue of the Oxford Review illustrate, this charge cannot be made to stick, and the period of the Labour government was much more interesting and more important for the long-run prospects of the UK economy than this simple ‘external’ narrative suggests.”

I completely agree, but then as an economist perhaps I’m biased.

The last few years have been a painful reminder that there is nothing inevitable about this rising influence of mainstream economics in the UK (or elsewhere? - I would be fascinated by the thoughts of others in other countries.) While it is tempting to link this influence to the colour of the party in power, I would hardly call policies adopted by the Labour governments of the 1970s as reflecting the mainstream economics of the time (e.g. attempts to control inflation through prices and incomes policies). Perhaps a better interpretation is that mainstream economics (which should be neither slavishly pro or anti market) has its greatest influence on less ideological governments of the center, and its just that since the 1980s the traditional political left has been out of the equation. Whatever the linkage, I wonder how long it will be before we again see a UK government so influenced by mainstream economics.

[1] If anyone is reading this late, its the Spring 2013 issue