Making Sense of Current Policy-Making

Dear Brad,

I understand your frustration about the current state of macroeconomic policy-making. You write:

"Today, we face a nominal demand shortfall of 8% relative to the pre-recession trend, no signs of gathering inflation, and unemployment rates in the North Atlantic region that are at least three percentage points higher than any credible estimate of the sustainable rate. And yet... leaders in Europe and the US are clamoring to enact policies that would reduce output and employment.

Am I missing something here?”

Allow me to attempt to ease your distress and self-doubts about what you call your “understanding of the world”. I think that you have fallen into a simple and very common trap for economists: you are imputing the wrong objective function to politicians. Think Helpman and Grossman, "Protection for Sale". Policy-makers may care to some degree about national economic welfare... but they often care as much or more about being reelected. And voters do not always (or even often) correctly assign plaudits or blame for the condition of the economy. Once you embrace these assumptions, all becomes clear and the world makes sense again.

Consider the following:

• Congressional Republicans (and their public mouthpieces) reason that a poor economy in 2012 will improve the prospects for Republicans in the next election, since the President is almost always most directly held responsible for the condition of the economy. Hence they have a strong incentive to enact contractionary fiscal policies. Similarly, they will take every opportunity to apply pressure on Ben Bernanke to cease his efforts at expansionary monetary policies. The “intellectual” and “academic” arguments in favor of contractionary fiscal and monetary policies (the ones so enthusiastically parroted by Republicans in Washington right now) are convenient to them; but the complete lack of intellectual consistency on the subject is evidence to me that they are nothing more than convenient talking points.
  
• President Obama faces a tradeoff. He would like to enact expansionary policies (both to improve his reelection chances and because, I believe, national economic welfare does enter significantly into his own objective function), but he also recognizes that his ability to do so is very limited. Given that, it is reasonable to suppose that there are a substantial number of swing voters that will appreciate him more (and be more likely to vote for him in 2012) if he appears reasonable and conciliatory with Congressional Republicans.
  
• Angela Merkel enjoys a reasonably robust economy in her own country, but faces substantial voter displeasure over perceived subsidies to the periphery of the EU. In fact, I think one could reasonably argue that German voters are far more likely to penalize her party for allowing the wasteful periphery countries to escape unpunished for their wasteful ways than they are to penalize her for any knock-on contractionary effects her policies have for Germany. She therefore has every reason to attempt to force policies on the rest of the EU that minimize the perception of German largess – i.e. to advocate fiscal contraction across much of the EU.
  
• Governments in the troubled periphery countries of the EU do face a genuine (even classic) crisis of investor confidence. Given the lack of German assistance, it is a rational response for them to decide that the total collapse in investor confidence would be worse than the contractionary effects of their employment-reducing fiscal policies.
  
• Ben Bernanke, I would argue, is probably one of the few significant policy-makers who really take national economic welfare as his own objective function. I honestly believe that the US’s 9% unemployment rate screams at him every single day that he is at work. And he has responded by being as expansionary as he is able.
  
• And David Cameron? Okay, you’ve got me there. Can we allow for the possibility that policy-makers also sometimes simply get it wrong? And/or that they may be susceptible to a bandwagon effect? After all, since everyone else seems to be so vociferously arguing for fiscal contraction...

To help clarify this point with respect to the US, let’s conduct a simple thought experiment. If we were slowly, slowly emerging from a recession, job creation was far from satisfactory, and elections were coming in the next year or two... and a Republican were President... do you really believe that Congressional Republicans would be behaving in the same way that they are today?

Oh wait, we don’t have to conduct such a thought experiment. We just have to look back to 2003.

Sincerely yours,
Kash