In what ways is understanding economic theory and political economy useful to making public policy?

 This post is a little less objective than usual, but might be of interest to those doing OCR, pre-U, or CIE-style argumentative essays on economics, as well as of general interest. It will be available as a podcast on one of my other blogs soon. 

A working knowledge of economic theory (and practice) would be useful to policy stakeholders such as executives, legislators, the media, and the political classes, in three ways.

Firstly, economics conveys a sense of the contingency of economic prescriptions, and therefore would help to illuminate policy choices, which could then be made on an informed, balanced, and persuasive basis.

Secondly, a knowledge of microeconomic realities could benefit policymakers in dealing with supply-side matters and labour markets and help to stabilise and improve long-term growth.

Thirdly, a great many economic problems are systemic and cyclical, and yet steady and long-term policies to expand aggregate supply, maintain real interest rates, and improve productivity are consistently associated with stable and effective governance.

Reactive policies that prioritise one macroeconomic objective over all others for a short period of time are apt to be counter-productive and to cause reversals and the worsening of things like inflation, structural deficits, national debt, and market failure. In this, the various credible theories of government failure might also help societies to avoid bad economic policy as measured by past results and current objectives.

 Overall, an understanding that economics is political economy, an humane science focussed on human beings rather than, for instance, physics or chemistry, could help economic theory as well as public policy, in that economics would escape the grip of neoclassical mathematics. This is important because non-mathematical explanations of political economy have provided in many cases more useful predictive analysis of existing dilemmas, and clearer warnings of difficulty, than the alternative, as can be seen by the contrast between the work of Hyman Minsky and Arthur Laffer, for instance.

In terms of the benefits of an understanding of economic contingency, I would begin by pointing to three ideas which arguably misled policymakers who took them as being certain rather than questionable; the application of the multiplier and deficit financing in the nineteen sixties, the idea of crowding out in the nineteen seventies, and the idea that tax cuts in and of themselves have a near-magical power to induce growth which has prevailed since the mid-nineteen eighties in the west.

The period between 1956 and 1967-70 was one of post-war recovery and the beginnings of globalisation. Even post-Stalin Stalinism managed to obtain growth. It was also the period of ‘high Keynesianism.’ Policy makers, some of whom were informed about economics, came to believe that Keynesian ideas were responsible for growth and not the rebuilding. They believed—but could not prove except by faith-based references to economists—that they could ‘fine tune’ and ‘manage’ the economy by managing aggregate demand.

This contrasted with what were then old-fashioned ideas which held that supply tended to create demand, that supply gluts emerged during booms, and that quick, sharp recessions were good for the economy by lowering prices and then costs at the expense of a temporary slowdown. This older view emphasised the need to accumulate savings and to have stable institutions which could facilitate the transfer of those savings to investment, which would grow Long-Run aggregate Supply.

All but a few politicians understood this alternative, and those who did avoided or downplayed it. They escaped a great deal of criticism in doing so because people did not understand the economic theories involved.

Politicians adopted the attractive elements of Keynesian economic theory without reading it. They embraced the idea that Aggregate Demand could be boosted in such a way that incomes led to consumption, consumption led to investment, investment led to jobs, and jobs led to more consumption. In this scenario, inflation was usually temporary, and interest rates did not have much of a role except to curb speculative demand for money. Unemployment with a welfare net, they thought, could ‘stabilise’ downturns which were engineered to stop ‘overheating.’ A whole generation decided that their job was to limit the accumulation of individual wealth, run budget deficits to gain growth in GDP, and to prioritise growth and low unemployment over all other economic objectives. When asked how government spending funded by fiat currency could be better than private investment, such people invoked things like the ‘multiplier and accelerator’ model and the deflation that they associated with the Gold standard after 1931 as justification for their activities.

Some administrations were led by people with a knowledge of economic theory who were ‘true believers’ in this aspect of it, but they refused to entertain questions which arose directly from theory that might have made for better policy. For example, once one cuts through a curtain of mathematics, the accelerator theory is based on the idea that aggregate supply is composed of big machines and that manufacturers buy machines in a ratio to consumption. For instance, 100,000 more items produced means one more machine to add to national fixed domestic capital.

No one who has been near a factory or business thinks that this caricature of capital is how business investment works, though it may have been presented as being accurate in the Victorian era. One has to have a confident grasp of economic theory to know that.

Most did not know that the questions existed. For instance, an approach that sees almost all inflation as deriving from manageable demand-pull forces does not allow for a focus on small business and entrepreneurs; it leaves an economy vulnerable to exogenous shocks; and it encouraged a kind of planning and command system that also sought to tie currencies together, leading to devaluation crises and an inability to use monetary policy to manage the internal economy.

There was remarkable social equity and the provision of public housing (in countries with smaller populations compared to today) and the crises of decolonisation and a global shift in energy regime from coal to oil were largely overcome peacefully.

Yet the very predictable and avoidable consequence was stagflation, corporatism, the growth of large unions and companies, states which were trapped in ‘stop-go’ cycles with structural budget deficits, and higher taxes every year. Few articulated a more manageable, market-based, low tax future in which governments did less, and where few believed in the capacity of technocratic governments to simply adjust inflation via Phillips curves or GDP via the multiplier or negative multiplier. 

‘Crowding out’ was a barely literate pseudo-economic idea created by Her Majesty’s Treasury in the UK in the nineteen seventies which attempted to deal with the consequences of debts, stagflation, and currency decline because of the policies many had followed without applying any knowledge of monetary or supply-side theory in the sixties.

Like the disastrous experiment in monetarism and high exchange rates intermittently pursued soon after, it was essentially pseudo-economic. Crowding out held that there was a ‘pool’ of investment capital in any economy at a given time. It then suggested that government and business had access to it. If the government was running a deficit, it would issue bonds with an attractive coupon, and would ‘sell’ many automatically.

This was because ‘investors’--a class neither defined nor properly explained—would, it was assumed, always buy government over private bonds and loans at times of uncertainty since government could be relied on to repay. That left, in the theory, a smaller segment of the pool for private investors who would subsequently have to pay more for it, raising ‘private’ interest rates and leading to low growth, unemployment, and pressure on government borrowing.

Monetarism was a reaction, which managed to ‘out-do’ crowding out by claiming that money supply could be identified and restricted or eliminated in ways that helped to reduce inflation. This ran alongside very high interest rates in response to stagflation caused by energy rises and the decline of productivity in the previous decade.

A ‘proper’ knowledge of economic theory which integrated the demands of the real world and which understood that economic policy should uphold multiple objectives, and which had applied an understanding of the limits of government and government failure, would not have wasted a good deal of the period from 1976-1986, and nor would the benefits of North Sea Oil have been almost wholly consumed by the unemployment that resulted. UK and US manufacturing industry might not have been ‘hollowed out.’ Governments might not have swung between nationalisations and privatisations and lost sight of basic fiscal and monetary truths that a clear understanding of foundation economics would have allowed for.

In the nineteen eighties and nineties, the idea took hold, which has been dominant until the twenty-twenties, that ‘tax cuts’ of any sort are a good thing which will generally result in economic growth and development. For some forty years, ideas like or similar to the Laffer Curve have been embedded in a popular and therefore policy-based understanding of economics. They have been attached to a world-view.

For most people trained in economic theory, however, this idea is almost as lacking in foundation as crowding out or the existence of an actual measurable multiplier. For instance, some taxes might be a social good, in the sense that redistribution of income leading to a lack of huge inequalities has been shown to allow for savings, investment, stable growth, and the maintenance of small businesses.

In contrast, regressive or very low income taxes and huge inequality not only leads to economic instability and demonstrable periodic bursts of inflation and deflation, but to other self-reinforcing externalities which prevent productivity gains.  If large numbers of rich people do not reinvest their money in domestic economies, but simply seek to net financial gains in tax havens which exist to reinvest in other tax havens, stock buy-back schemes, or unstable derivative markets, very little good bar the creation of dangerous levels of personal credit opportunities arises for most people. 

Similarly, if excise and sales taxes are driven up and placed on most purchases of goods and services so that income and profit taxes are low, working people and those who cannot easily raise their wages or salaries are hurt more than those who can and who already benefit from low income and profit taxes.

 Time has shown that many consequences of such wealth accumulation do little for allocative or productive efficiency in an economy. Superyacht construction, which employs few, marginally benefits, as do Martian colony plans and space tourism, for instance, but infrastructure and merit good problems for the vast majority increase.

A knowledge of economics should instead suggest to policy makers that progressive taxation, sound money, restrained but effective government, national public infrastructure in energy, transportation, and the availability of merit and public goods, and intelligent balanced approaches to taxation based on income and wealth rather than consumption make sense.

People who see that might also be concerned with the limits of policy making, and would be aware of the idea of potential government failure through public choice theory, and the Coase theorem, and the necessity of private ownership, savings, stable real interest rates, and the destructive capacity of personal and national debt.

Such an understanding could inform policy, tackle resource depletion and a gradual shift away from a hydrocarbon-based energy system, and allow for a higher quality of life whilst not taking an antagonistic approach to either public or private sectors. This could in turn lead to fair and effective economic management which could be scaled up or down according to constitutional and societal choices.