Must-Read: A good wrestle with a very tough intellectual problem by the truly excellent Simon Wren-Lewis:
The Knowledge Transmission Mechanism and Austerity: “How do economic policy mistakes happen?…:
…Policy makers want to do the right thing (although they have political preferences), and the academic consensus is correct, but policy makers do not follow it because they rely on imperfect intermediaries….
In contrast to the 1930s, the key features of the current situation are explicable in terms of textbook macroeconomic theory. Governments are actively trying to reduce their budget deficits through fiscal austerity, and this is having a predictably negative impact on economic activity when monetary policy is unable to offset its effects. So the current macroeconomic crisis does not seem to be the result of lack of macroeconomic understanding….
[The] folk story… often told by policy makers [has basic problems. It is that] in response to the Great Recession… some countries had employed a limited fiscal stimulus… this intervention, the recession itself and earlier failures of governments to be fiscally prudent led to a debt-funding crisis. Economies realised that they too could become like Greece, and so were forced to embark on a sharp fiscal contraction, commonly called austerity…. [But] there is no clear evidence that there were serious fiscal problems [outside of Greece] before the financial crisis… debt increased… because of the impact of the recession itself… no evidence whatsoever of a debt-funding crisis outside the Eurozone… if anything a shortage of debt…. How can I blame the second Eurozone recession on fiscal austerity with such confidence?… First, it is what basic macroeconomics – the macroeconomics taught to every undergraduate and post-graduate around the world, including in Germany – tells us. Second, it is what every independent model based exercise that I have seen also tells us….
Things have gone wrong in the Eurozone not because of any inadequacies in macroeconomic theory, but because that theory was ignored by policymakers…. I think it is worth exploring [the] alternative: that policy has gone wrong because the knowledge transmission mechanism (KTM) has failed…. Why might [policymakers] have been getting the wrong advice? One response is that they asked the wrong people…. The expansionary austerity line… appeared to be the one that many policymakers adopted. If the KTM had been working, then this result could only have been a consequence of policy makers willfully choosing to adopt a minority academic point of view for political ends…. Political commentators… unlikely to be economists… relate to… financial bookkeeping. It is… easy… to tell stories about excessive borrowing, but rather more difficult to talk about multiplier effects and the ZLB…. There are also important interactions between economists working in the financial sector and the media…. There is a saying in financial markets: “bond economists never saw a fiscal tightening they didn’t like”….
Among the governors of the three major central banks, only Ben Bernanke seemed prepared to say publicly that a severe fiscal contraction would make his job much more difficult. Central banks also seem far too optimistic, at least when they talk publicly, about the impact of unconventional monetary policy measures…. It seems to me that the main reason why central banks failed to give good advice on fiscal consolidation is that, among their leaders at least, there is a deep seated fear of fiscal dominance. They fear that if deficits are large, then at some stage they will be asked (or required) to monetise those deficits and that inflation will increase as a result. As Mervyn King, Governor of the Bank of England in 2010, once 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.”… ￼￼It possible to argue that King’s role in 2010 was actually quite pivotal…. Central banks therefore played a crucial role in the failure of the KTM in 2010. They were naturally seen as a source for macroeconomic received wisdom, and indeed they were, if those seeking advice had talked directly to those involved in modelling the business cycle. In practice, however, advice was received from central bank governors, and in most part that did not convey received macroeconomic wisdom…
My memory of what the bulk of policy-oriented macroeconomists were saying in 2008-10 is:
- Central banks are not tapped out at the zero-lower bound.
- Even at the zero lower bound, fiscal multipliers are relatively low.
- Debt issued now will have to be refinanced later at high interest rates.
- Hence expansionary fiscal policy can be a temporary bridge, but is not a solution.
- North Atlantic economies recover robustly and rapidly from demand shocks on their own.