Economic policy as policy action
This book has been designed to give a novel and rather unconventional account of the evolution and changes in macroeconomic stabilization policies and institutions in the world's economies since World War II. It is unconventional because it presents the analysis of the policies and underlying theories in an informal way, so that the reader can easily grasp the main story line, implications, and reasoning behind policies, eschewing formal solution techniques that can be found elsewhere.
The understanding of macroeconomic policy and institutions designed to achieve desirable economic, political, or social goals has greatly changed over time, oscillating between state intervention and a free-market approach. We focus on the tension between these two positions, which is driven by conflicts between the desired goals of economic policy and what is feasible or manageable according to our understanding of the economic system.
Macroeconomics and macroeconomic policies began with J. M. Keynes in the 1930s – although the terms appeared in scientific journals only later, in the 1940s. Before Keynes, the main typical state interventions involved the use of taxes (including tariffs), provision of essential public goods, and money regulation. In some cases, as with antitrust laws, it aimed only at avoiding the limits to competition introduced by firms with excess market power.
After Keynes, policy action started to include interventions of a more traditional macroeconomic type, targeted at aggregate variables such as employment, national income, inflation, and growth. The Great Depression that began in 1929 can be considered as a watershed in the evolution of state intervention in general, and particularly so from the standpoint of macroeconomic policy. The main issue of the 1930s was unemployment. Policies enacted just before and just after World War II targeted that problem directly. Further policies designed to deal with other macroeconomic problems followed in the postwar period: policies for balanced trade, investment flows, productivity, income distribution, inflation, exchange rate movements, and financial policy.The climax of Keynesian macroeconomic policy action was reached at the end of the 1970s. After the second oil crisis of 1979–1980, and to some extent after the first crisis in 1973–1974, the focus shifted from unemployment to inflation. Policies had then to react to the emergence of inflation on a scale that had never before been experienced collectively by developed economies.
Governments, central banks, and money
At the beginning of the nineteenth century, David Ricardo expressed his concerns about entrusting governments with the power to issue paper money. He argued that a government would almost certainly abuse this power and pointed out that central banks must be governed by individuals who should be “entirely independent” of the government, and who “should never, on any pretence, lend money to the Government, nor be in the slightest degree under its control or influence” (Ricardo, 1824). Ricardo anticipated two milestones of the modern theory of central banking: (1) the need to make central banks independent from government and (2) a general prohibition on central banks financing public expenditure.
The rationale of Ricardo's point of view was related to the general habit of kings to finance their Royal Expenditures by printing money without accounting for the consequences of this source of revenue.
The perverse linkage between political power and the absolute sovereignty over printing money eased with the emergence of an independent nominal anchor in the Gold Standard. As a result, at the end of the nineteenth century, due to the massive liberalization of capital movements implied by this first wave of the globalization process, central banks reached a high degree of independence from the government.
After World War I, the Roaring Twenties, and the recovery from the restrictions of a wartime economy, the end of the globalization process imposed wage and price rigidities that contributed to an undermining of the gold standard system. The fall of globalization in the 1930s became the principal threat to financial stability and economic prosperity in a world that was now without well-defined international rules.
The consequent Great Depression led many governments to nationalize their central banks since, as monetary authorities, they had suffered a general loss of public trust. As institutions, they had shown themselves unable to combat the new phenomenon of a major global recession, and indeed had probably helped to make it worse (Foreman–Peck et al., 1992).
The United States had also begun a debate about nationalizing the Fed at this time but ended up with a compromise that strongly reduced the central bank's independence from the government.
The economy of state intervention
World War II and the two or three decades thereafter were imbued with the idea that economic systems can and should be governed by public institutions.
State intervention was first justified by the problems arising from the war economy and later by the need to support employment and the recovery process, and avoid the chaos of the 1930s. Its foundation can be traced back to the theories suggested by John Maynard Keynes and his followers in the 1920s and 1930s (see, in particular, Keynes, 1936) and to the Beveridge Report (see Beveridge, 1942).
Econometric techniques introduced in the previous decade and, to some extent, the practice and apparent success of planning in the Soviet Union also contributed to this phase, justifying an active engagement of the state in the economy, in maintaining full employment and creating government or international institutions.
Public commitment addressed not only full employment and greater social equity but also growth and development. In this respect, the models developed first by Harrod and Domar, and then by Solow and Swan, provided guidance (see Harrod, 1939; Domar, 1946; Solow, 1956; Swan, 1956).
Above all, between the end of the 1930s and the beginning of the 1940s, the complex problems of governance posed by a war economy were addressed in the Anglo-Saxon countries in a more structured way than during World War I, by exploiting the Keynesian conceptual apparatus.
Public spending for military purposes obviously ensured achievement of full employment. As already experienced during World War I, however, prolonged policies of high support for demand stimulated by government spending, while directing the economy toward full employment, could raise problems of a different nature.
The first such problem was inflation and monetary instability. Indeed, the objective of monetary stability was never neglected, at least in the Anglo-Saxon experience, and required adoption of an appropriate set of measures for rationing consumption, as well as other instruments, as Keynes himself suggested (Keynes, 1940). This set of policies was known as the “circuit of capital,” reminiscent of the Marxian idea borrowed by Keynes for a monetary economy (see Dillard, 1984; Aoki, 2001).
An additional problem that arose naturally was that of the public debt accumulated to finance public spending for military purposes.
The consolidation of economic liberalism
A new wave of economic liberalism emerged at the end of the 1960s and took a leading position after the dollar devaluation of 1971. The theoretical underpinnings of this change hail from the clash between the desirability of achieving traditional domestic goals and the need to satisfy financial stability and the external objective of financeable balances. As to practical implications for the international institutions, free trade tended to emerge as the dominant credo, facilitated by successive rounds of tariff cuts.
The underlying reason for liberalization is twofold. First, in the absence of a common commitment to pursue full employment, countries inevitably try to reach their own goals of higher income and growth by beggar-thy-neighbor export-led policies, thus creating pressure for a movement to complete free trade. Second, the support for free capital flows was instead the outcome of the growth of the financial sector, and the need for investment and the higher bargaining power of creditor countries. Progressive differentiation between the positions of various countries then led to the adoption of floating exchange rates.
The era of managed-flexible-exchange rates started de facto in 1971 and officially became the “new regime” in January 1976. At a meeting of IMF members in Jamaica, the articles of agreement of the IMF were amended to recognize flexible exchange rate systems. After that, member nations could adopt an arrangement of their own choice.
The following sections examine the evolution of the international monetary regime in the post Bretton Woods era. Section 12.1 deals with the features of the new system based on floating exchange rates. Section 12.2 illustrates how the flexible exchange rate regime works. Section 12.3 describes the evolution the IMF to this new regime.
Section 12.4 deals with the role played by free capital movements and other pro-market policies promoted by international institutions. In this period, a system – now collectively known as the Washington Consensus – operated to deal with imbalances in their members’ economies.
We then move to the international financial crisis from a systemic point of view. Section 12.5 analyzes the evolution of international payments imbalances that have produced a number of financial crises and threatened financial stability and real activity in the developed and emerging market economies.
Beyond stabilization policies
This chapter extends and complements the analysis of the previous two in a different sphere. Monetary and fiscal policy are not just a mechanical device to manage aggregate demand in specific circumstances, or a means to correct market failures, promote structural reform, or pursue some special interest. All of those things are important. But economic policy can be used strategically to model society in a form that we might prefer – an argument made very clear in the Mirrlees Review (Adam et al., 2010; Mirrlees et al., 2011).
We now focus on further aspects of policymaking considering its capacity to promote risk sharing over different regions and sectors of the economy as well as different ages of the population. We look at its ability to act as a shock absorber when imbalances appear elsewhere in the economy, for example in trade or the financial sector; its capacity to help us to face up to demographic change; and the possibility of using economic policies to address inequality and welfare provision.
The chapter is organized as follows. Section 9.2 introduces the issue of risk sharing and regional stabilization. Section 9.3 looks at the macroeconomic imbalances. Then, Section 9.4 focuses on demographic change and age-related spending. Finally, the last section discusses redistribution, inequality and welfare.
Fiscal federalism and regional stabilization
In a federal regime, some taxes and expenditures are assigned to regional governments and some to central government. This creates a central budget into which regions pay, or receive payments from, on an automatic basis – in each case at rates chosen by the central government.
There will also be separate budgets at the regional level since not all taxes/expenditures are centralized. Those taxes or expenditures will be charged or paid out at rates chosen by regional governments. There may be no grants or discretionary payments made from the center. However, adding an upper level of federalist transfers (creating “vertical imbalances”) to the regions is always possible and would increase efficiency since those transfers will enhance the system's ability to adapt to local conditions and create an ability to undertake long-run redistributions.
Long-term redistributions can also be created by choosing the federal tax and expenditure functions such that there is a net transfer to certain regions on average and, if the central budget is balanced, away from others.
A century of theories and policies
Economic theory and economic policy are characterized by two factors: ideas and techniques. New ideas are not necessarily more powerful than older ones. By contrast, new techniques usually are. Our book has briefly followed the evolution of both over the past century.
An economic policy stance changes as a consequence of a mix of different factors such as changes in the economy and the emergence of new problems, changes in the political orientations of society, and the evolution of the foundations of economic theory. How these factors combine, possibly in very different ways over time, cannot be only the object of economic analysis. It also belongs to the realm of history.
In contrast to physical systems, economic systems evolve and change their rules. Different ideas can then be more appropriate under different circumstances. Economic policies implemented in each historical period respond to the specific needs or “emergencies” of that period but they draw inspiration from the stock of economic ideas and empirical observations that have accumulated over time.
Often, in the unexplored waters of economic changes, economic ideas, whether in policy or theory, suffer from inertia and lags in their implementation and development. This can lead to undesirable outcomes. In addition, economic policies reflect the sentiments, the preferences, and perhaps deeper goals, of society and its representatives, which are also mutable across time.
In a number of cases, which we have explored in this book, old ideas and policy suggestions come back and are revived and are then re-applied in modified forms. A review of the policies implemented in the last 70 years or so – and the theories that supported them – is therefore useful not so much as a historical reconstruction of their evolution but more as a way of assembling and understanding how the toolkit of an economist can be useful for current theoretical as well as applied analytic purposes.
The aim of the book has been to look at the evolution of macroeconomic policies and economic thought in the light of the development of the world economy. We proceeded, in each case, by connecting the development of economic needs and goals, policymakers’ choices, and economic ideas, stressing links and complementarities.
The steps of European integration
The foundations of European integration can be traced from the discussions immediately after World War II (Baldwin and Wyplosz, 2006). The central question was “How can Europe avoid another war?” and the natural answer was dependent on the identification of the roots of the war.
At the time, three main interpretations were proposed: the Germans were to blame as in 1914; the competition for market dominance induced by capitalism (Lenin's imperialism view); and the destructive nationalisms of the early 1900s. Different interpretations called for different solutions: a neutered Germany (Morgenthau Plan, 1944), adopting communism, or pursuing European (political) integration. The latter ultimately prevailed, but this was far from clear in the late 1940s.
The United States tried to promote integration among European countries to counter the emerging power of the Soviet Union at the beginning of the Cold War. Economic, military, and political calculations lay behind the US aid program for European countries (the Marshall Plan), which made aid conditional on effective cooperation among European governments and the gradual liberalization of trade and payments between the European economies (a reasonable stipulation given the rivalries of the 1930s).
The US attempt, however, received a feeble response from a Europe deeply divided after the war. A genuine European economic cooperation began only with the Schuman Declaration of 1950 and the construction of the European Coal and Steel Community (ECSC) in 1951.
This putative European Union was then strengthened and expanded by the Treaty of Rome of 1957, which established the European Common Market and the European Atomic Energy Community between Italy, France, Germany, Belgium, the Netherlands, and Luxembourg (the Six).
Political integration began from the economic sphere and remained focused around economic measures for a long time. The need to introduce Europe-wide policy coordination gradually and the limited scope of the initial approach to economic integration were prompted by the difficulty of proceeding with full political integration as the failure to create a European Political Community, inspired by De Gasperi in 1954, showed.
At the start, the European Common Market was not much more than a customs union, devoted to the lowering of internal duties, the setting of a single customs tariff for countries outside the Market (a common external tariff was adopted in 1968), and a set of specific common policies relating to agriculture, transport, and competition legislation.
Active and passive fiscal policies
Fiscal policy has changed radically since the 1960s and 1970s when it tried to micro-manage, if not fine-tune, all aggregate demand and assumed an accommodating monetary policy; and it changed from the 1980s when it was passive, but was used to strengthen the economy's supply-side responses while monetary policies actively pursued low inflation and stable growth.
The 1990s saw a return to more activist fiscal policies. But this time the policies were designed together with equally active monetary policies to gain a series of medium- to long-term objectives – low public debt, the provision of a certain level of public services and investment, and social equality and economic efficiency. The income-stabilizing aspects of fiscal policy were left largely passive, to act through the automatic stabilizers which are the endogenous part of any fiscal system. Monetary policy, meanwhile, was designed to take care of short-run stabilization around the cycle; that is, beyond what, predictably, would or could be achieved by automatic stabilizers.
The recent financial crisis has again introduced the need for active fiscal policy to complement monetary policy, but in a sense opposite to that traditionally advocated – that is, in the form of austerity policies to remove excess fiscal deficits and reduce public debt. This was based on an undervaluation of the size of the spending multipliers, which have been shown to be quite large in a situation of generalized low demand and low interest rates (and crucially greater than one, so that each deficit reduction leads to a larger loss in national output and hence rising deficit and debt ratios).
The kind of coordination to be sought between fiscal and monetary policy is one of the issues we discuss in this chapter. We suggest that an improved performance can be obtained if fiscal policy “leads” an independent monetary policy. The form of leadership implied here derives from the fact that fiscal policy typically has long-run targets (sustainability, low debt) and is not easily reversible. In fact, it aims to ensure sustainable public services, social equity, and other long-term goals, which often makes it an ineffective stabilizer. Nevertheless, there are also automatic stabilizers in any fiscal policy framework, implying that monetary policy must condition itself on the fiscal stance at each point. This automatically puts the latter into a follower's role.
The financial crisis and the Great Recession
The US stock market experienced a spectacular growth between July 2006 and July 2007. In just one year, the Dow Jones increased by 30%; the value of US corporations rose from $11.5 trillion to $15 trillion. Yet the fundamentals increased at their normal rates; nominal GDP in the United States increased by only 5% ($650 billion).
What happened to the US economy in 2006? As pointed out by De Grauwe (2010), the answer is almost nothing, apart from a change in the “animal” spirits of investors, who somehow began to believe that the US economy had entered a new era characterized by a permanent growth path for an indefinite future. In fact, the US economy entered in to a speculative bubble instead that soon bust and led the United States and the entire world to the most dramatic recession since the 1930s.
Within a year, between 2007 and 2008, stock prices dropped by 30%. The economy experienced a sudden sharp reduction in the availability of credit from banks and other lenders (a credit crunch) and trade and industrial activity reduced dramatically. Millions of Americans lost their homes and jobs; many more saw their retirement and education investments dwindle in value. Soon the US crisis turned global, spreading to Europe and to the rest of the world. Almost 12 million workers had lost their jobs in the Organisation for Economic Co-operation and Development (OECD) countries up to mid 2014.
Bubbles (and crashes) are not a special feature of recent years. They are endemic in capitalist systems; bubbles have existed since capitalism started and usually result from uncertainty, herd behavior, positive feedback, or bandwagon effects (Kindleberger and Aliber, 2005; Reinhart and Rogoff, 2009). A bubble occurs when investors believe in increases in an asset price independently of its fundamentals; asset prices then increase because the surge of demand fuels expectations of further rises, which then become self-fulfilling. However, as soon as the misalignment in prices becomes clear and investors change their beliefs, buyers become sellers. The bubble explodes and prices fall dramatically. Investors lose money and often, as a consequence, market confidence evaporates in all sectors of the economy.
Although bubbles are not special, they are not “white noise.” Their explosion and consequences are strongly related to the institutions (in particular, to financial sector regulation).
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