The Unholy Trinity of Economic Policy Instruments as Applied Today.


All Economies in the world are striving for more growth, especially the ones in the industrial world which have been hit hard by the Financial/Economic Crisis since 2008.

While initially, most of these countries pursued expansionary fiscal policies (instrument 1), after about 2 years they discontinued them, ostensibly for reasons of budgetary discipline in the face of high and strongly rising government debt ratios. In came central banks with extra-loose monetary policies (instrument 2), lowering official interest rates to or close to zero, and “unconventional measures”, including asset purchases and massive liquidity streams into their economies, with the aim to lower government bond yields and to enable firms to invest at relatively low costs. While today there is near-unanimous consensus that these actions may have put a floor under the recession, the objective to stimulate growth is in doubt: there is a lot of criticism that this flood of liquidity has not ended up in the enterprises, but has rather enabled the banks and financial investors to create renewed bubbles in some housing markets and equity markets, in addition to fuelling resource speculations. But, for the past 3 years, central banks have become the main macroeconomic policy tool to stimulate growth, since fiscal policy is hampered by self and outside-imposed (IMF, EU) reticence.

All outside policy advice from the IMF, the OECD, the EU Commission and Council stress a third policy instrument as the most important one: “structural reform” of the labor and product markets. The supposition is that if labor markets are maximum “flexible”, if wages can move downward, if social security contributions can be lowered, if professional services are liberalized and stifling health and occupational safety regulations are reduced and more competition is introduced into the product markets, growth will fall “like manna from heaven” (Don Patinkin). In fact, the mainstream discussion on economic policy today has utter disregard for macroeconomic policies (attempting to influence  total effective demand), putting all its faith into the need for more “structural reform”. Some call this neo-liberal, some call it economics ignorance. Advocates of structural reforms as growth-enhancing believe in the free play of market forces and see all regulations only as cost factors. When these are reduced or removed, the respective economy will be more “competitive”. This can be best illustrated by the reforms requested from Greece where civil service salaries and pensions are reduced, services liberalized, privatizations of government-owned sectors requested and a host of labor laws rescinded. The results are well-known: today, the Greek economy produces a quarter less than 4 years ago, the unemployment rate and especially youth unemployment have sky-rocketed, and the Greek government debt ratio is by …. Percentage points higher than before the crisis.

All EU countries’ authorities have tied their own fiscal policy hands behind their back: EU Council and Commission require all countries to reach their Maastricht deficit ratio of 3% of GDP as soon as possible. This means that the fiscal stimulus for the past 2 years in the EU and the Eurozone has been negative, i.e. taking away total demand from the ailing economies. One does not need to be an avowed Keynesian to understand that when private households are holding back on consumption, repaying their high debts, when private enterprise is intent on lessening their debt levels and reducing their reliance on bank debt, instead of investing (also because they do not see new demand for which to expand capacity) and when most export markets are weak (this is especially true of the EU into which 2/3 of EU member states’ exports flow), that reducing of government demand does the contrary to what would be called for: that in times of lacking private demand it is up to the governments to secure positive growth by temporarily expanding public sector demand, preferably by public investments, but also by public consumption.

Central Banks have become very innovative in searching for  new instruments in order to fulfill their newly consensual mandate of stimulating economic growth. The US Federal Reserve System for a long time has had a dual mandate (fight inflation and secure growth balance), the European Central Bank has recently – surreptitiously in order not to waken sleeping (German) dogs – adopted a growth enhancing stance, as has the Bank of England. Bravest of all, the new Bank of Japan governor – in consensus with the prime minister – has swamped the economy with liquidity “until the inflation rate reaches 2%”. This newly coined “forward guidance” was pioneered by the Fed, recently followed by the Bank of England: they promised to maintain their present expansionary stance, until the unemployment rate falls to 6.5% (Fed), resp. 7% (BoE), in an attempt to assure economic agents that interest rates, asset purchases and liquidity operations will remain where they are until the economy improves. The European Central Bank so far has not followed explicit suit, but last year’s announcement that they would do “anything necessary” to revive the economy is a less explicit, but substantially equivalent “forward guidance”.

With fiscal policy counter-productively incapacitated, monetary policy has become the “growth instrument of last resort”. We need to understand: cyclical policy requires macroeconomic instruments (fiscal and or monetary policies) to increase total demand. Structural policies can help to effectively “fill in” when demand grows, but they can, by their nature, not increase demand. On the contrary, they may often initially lead to growth-impeding situations, especially when they concern losses of labor protection, because remaining workers will spend less, in order to save for worse situations (“precautionary savings motive”).

While finance ministers universally welcome the new activism of central banks (because they think it exonerates themselves from stimulating demand), this may be misguided. Macroeconomic net effects rely on the appropriateness of the “policy mix”, i.e. the interaction of fiscal and monetary policies. If fiscal policies are, as today, contractionary and monetary policies expansionary, the net effect may well be not positive. The very sluggish recovery in the UK and the EU – if what happens there can be called a recovery at all – is testimony to the inappropriateness of the macro policy mix. In recent announcements even the International Monetary Fund, the haven of restrictive fiscal policy and propagator of “structural reform” has warned the EU to relax the overly restrictive fiscal policy stance, in order to stimulate growth.

The industrialized world, still responsible for around 2/3 or world output, is still in the throes of the deepest recession in 90 years. Its present reliance on structural reforms plus monetary stimulus minus fiscal stimulus as “growth policy” is inappropriate. It costs billions in output foregone and jobs lost and persons being kept idle and puts not only the industrialized economies in danger, but their whole societies. Political and social cohesion is lost at alarming rates. Populist parties, especially but not only at the right are mopping up votes of the marginalized, the disenchanted. Voter abstention is rising precipitously. The lessons of the Great Depression of the 1920s seem to have been forgotten, after a short spell in 2008/9 when policymakers gleefully declared “we are all Keynesians now”. Keynes is dead and so is the memory of his prescient crisis policies. Policymakers believe that they are in from the cold because of the new (and positive) activism of the central banks and can forego more fiscal stimulus, but they are wrong, as the most recent growth and unemployment data show. There certainly are more structural reforms necessary, especially concerning the European financial sector. In one or the other country labor laws may need to be modernized, but this and other product and service market reforms by themselves will not bring back growth.

It is high time that a serious and unemotional debate about what specific economic policy instruments can achieve, supersedes the ideologically biased opinion that all it takes is “structural reform”. Much more than that is needed, especially in terms of macroeconomic policy application.

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