The hole at the heart of economics
AMERICA has a debt ceiling. It’s a statutory limit on how much debt the federal government can issue. For most of its existence (the ceiling will turn 100 next year) Congress has simply voted to raise the limit when borrowing threatens to hit it. In 2011 and 2013, however, Republicans in Congress chose a different approach. They threatened not to vote to raise the ceiling unless various budget demands were met. It was a dangerous course of action; had the ceiling not been raised the government would have found itself forced to choose between default—potentially triggering a massive financial crisis—or large, sudden cuts to spending of all sorts, triggering a deep recession.
In both 2011 and 2013 the brinkmanship concluded with a deal. Before those deals were cut, as the moment of doom loomed, some economics writers argued that the Treasury should make use of an obscure loophole in a law designed to allow the government to create platinum commemorative coins to issue a $1tn coin, which could then be used to fund government operations without violating the debt ceiling. The measure seemed legal but sounded completely barmy. At one point during the debate, I asked, on Twitter, just when “it just isn’t done” is a valid reason to oppose a particular policy choice. Dan Davies, a financial analyst and internet commentator, responded saying that, “‘it just isn’t done’ is basically the central organising constitutional principle of the UK.”
He was right, and not just about the UK. It was Republicans’ violation of the “it just isn’t done” principle that landed America in its debt-ceiling crisis in the first place. As Donald Trump prepares for his presidency, Americans are learning just how useful and valuable a constraint “it just isn’t done” was in past administrations. And in other contexts; “it just isn’t done” is one of the things which keeps people from feeling entitled to hurl racial epithets at others, or spraypaint threatening messages on their homes, or openly embrace Nazism. “It just isn’t done” ought not be an inviolable principle; evolution in the sorts of things proscribed by it has been critical in establishing social equality for women, religious and ethnic minorities, and LGBT individuals and couples. But “it just isn’t done” matters; it is a critical piece of social infrastructure that helps keep society running.
Economists would call this an institution. Institutions are organisations or patterns of behaviour built by societies to help solve social or economic problems which the law or private markets cannot fully address. Economists have not entirely ignored them. Thinkers like Ronald Coase, Douglass North and Elinor Ostrom won Nobel prizes for their work on institutions in economics, and institutions continue to play an important role in research in economic history, development economics and industrial organisation, among other subfields. Yet for many of the most important questions within economics, economists have chosen to act like institutions simply do not exist.
Consider, as an example, the debate over fiscal stimulus. Economists have spilt vast amounts of ink over the last eight years debating whether countercyclical fiscal policy is a useful thing, and when and how it ought to be applied. These debates have covered a lot of ground. What factors affect the multiplier on fiscal stimulus, for instance? When is fiscal stimulus a necessary complement to monetary stimulus? How does government debt affect long-run economic growth (and how does fiscal stimulus affect government indebtedness)? Economists had incredibly intense and occasionally nasty debates about these questions. And yet, with the benefit of hindsight, we can see that the crucial question regarding whether or not to use fiscal stimulus was a completely different one—which is more corrosive to the legitimacy of the institutions which make the prosperity of a liberal, global economy possible: a long economic slump, or a short-term stimulus so large that it inevitably leads to spending on low-return projects or lines the pockets of government-friendly firms? We were all tying ourselves in knots working out whether the multiplier on infrastructure spending was 0.7 or 1.2 or 2.5, when what we ought to have been asking was: what course of action is most likely to avert a crisis of institutional legitimacy that will leave everyone much worse off.
It is understandable why these sorts of macroinstitutional questions might be ignored. It is very hard to say what exactly they are, for one thing. It seems reasonable to argue that bail-outs for banks amid broad woes for workers led to a loss of confidence in the system. But what is that “confidence in the system”? How does it work? What is the relationship between an individual’s confidence and the public’s as a whole? How is it cultivated? How does it interact with other institutions, macro and micro? Can we measure it? But lacking the tools or theory to think through something does not mean that something isn’t important. It certainly doesn’t mean that academic economists should pour massively more effort into research describing the smallest details of models which assume macroinstitutions aren’t important, than into an effort to figure out how they function. There has been some work done on these issues in recent years: such as the line of research investigating the political consequences of financial crises. Big-picture books by Daron Acemoglu and James Robinson, Thomas Piketty, and Branko Milanovic move gingerly in the right direction. Much more is needed.
And what work has been done rarely finds its way into policy discussions; arguments about financial-sector regulation rightly focus on the growth and efficiency effects of stricter regulation. They wrongly ignore the risk crises pose to the broad social fabric supporting the modern global economy—as well as the small-scale corrosive effects of state subsidies to too-big-to-fail banks, or even to enormous paycheques for executives at failing firms. One can mount a perfectly sensible economic defence of big bonuses paid to workers at banks that lose massive amounts of money and require state support, and one can also argue that the public should be smart enough to understand such payments and not let them stick in its collective craw. But they’re going to stick; that’s how people work. And that effect on macroinstitutions, whatever they are, ought to be considered in some way.
These sorts of questions arise in lots of economic contexts. Take regional inequality. The economic literature is pretty clear that moving people from low productivity places to high productivity places is very good for both the people that move and the economy as a whole. It’s also pretty clear that place-based policies designed to rejuvenate regions which have lost their economic reason for being tend not to work very well. And one logical conclusion to draw from these lines of research is that government ought to care about people rather than places, should focus aid to struggling places on things like cash transfers or retraining schemes or efforts to boost the housing capacity of booming regions, and should not be sentimental about the prospect of once proud industrial cities emptying out. And maybe that logical conclusion is the right one. But maybe that’s not the right conclusion at all. Maybe the right question, once again, is which is likely to be more corrosive of the legitimacy of valuable macroinstitutions: the long-run decline of whole regions of advanced economies, or the inevitable waste and inefficiency that would accompany an effort to revive those declining regions. And perhaps benign neglect would win that argument. Yet the argument ought to take place; economists should not ignore the relevance and importance of macroinstitutions and assume that the inefficiency is the clinching argument.
A particularly bruising insult to hurl at an economist is that he is guilty of “partial equilibrium thinking”: of drawing a conclusion about an intervention while holding other things equal, when other things clearly would not remain equal. To get the right answer, in most cases, it is important to work through the general equilibrium, in which everyone’s behaviour has adjusted to the intervention and the responses of others. General equilibrium thinking helps us avoid making big mistakes when guessing the probable effect of policy changes. But underlying just about every piece of economic analysis out there, general equilibrium or otherwise, has been a great big assumption of “other things equal”: that the supporting institutions within advanced economies do not change over time, and certainly not in response to economic shfits. That assumption, which appears to be good enough in answering individual questions over short periods of time, fails miserably over longer stretches.
That should be obvious after the experience of the last decade. And the fact that such dynamics are woolly and defy easy efforts at modelling or measuring cannot be an excuse for continuing to ignore them. Economists will never understand the world if they cannot explain how institutions work and why they sometimes fail us.
This is from Nov 22nd 2016, 15:28 by by R.A. | WASHINGTON