Reform the economic system now or the populists will do it

18/12/2016

By Wolfgang Münchau

The interests of the financial sector and the economy at large are different

It is one thing to say, as some of us have done, that the western liberal elites should stop doubling down when faced with a populist threat. But beyond that, what should they actually do?

I would start with a fundamental reappraisal of modern macroeconomic governance — from independent central banks and inflation targeting to deregulated financial markets and fiscal policy targets. Put simply, if we, the liberal establishment, fail to do this, the populists will do it for us.

A President Marine Le Pen, for example, could pull France out of the eurozone and instruct her central bank to fund the expenditures of her government.

But we also need to think more profoundly about the deep links between our institutions, the rules under which they operate and the prevalent macroeconomic theory. Much of what we today think of as normal was established quite recently. Central banks were not always independent. Direct inflation targeting is common today, but was unknown before the 1990s. Medium-term fiscal policy targets are also a modern invention, as are independent fiscal councils. Behind these institutions and policies lie a theoretical foundation — new Keynesian macroeconomics. John Maynard Keynes himself would probably characterise its average proponent as “a defunct economist”.

The theory asserts three key points. One, that a low rate of inflation is consistent with full employment, so it is sufficient for a central bank to target a low rate of inflation. Two, that fiscal policy should not be used for economic fine-tuning but should follow medium-term stability targets. And three, that neither monetary nor fiscal policy make a difference in the long run.

Of course, none of this explains the stuff we see around us: never-ending financial crises; a permanent loss in economic output; persistent imbalances, failure by central banks to meet their inflation targets; zero interest rates. We should not be surprised that people have become sceptical about experts who peddle theories that result in comically wrong predictions and that do not square with the reality they perceive.

These observations are mild compared with those of Paul Romer, chief economist of the World Bank, who has written a devastating critique of his profession, comparing it with string theory in physics. The latter was once criticised by well-known physicists as “not even wrong”.

Mr Romer portrays modern macroeconomics as a racket held together by people who protect their influence. Most of his specific criticisms are technical in nature — and go beyond what I can relay here. He starts off by quoting Lee Smolin, a physicist, who noted in 2007 that physics had made no progress in the last quarter of a century. Mr Romer claims that the state of macroeconomics is worse. It has regressed.

His observations are disturbing in their own right. But what makes them relevant in the context of this discussion is that our economic policy institutions are premised on the idea that these theories are correct. Our independent central bankers are macroeconomists, who were trained in those very models that Mr Romer criticises.

Until the early 1990s, central bank independence was the exception. The Federal Reserve and the Deutsche Bundesbank were independent before 1990 but most other central banks were not. There are good arguments in favour, but a no-brainer this is not. Most people would, for example, probably not support the view that a country’s armed forces must be independent on the grounds that the generals know best what is good for us, and should not be disturbed by the day-to-day fluctuations of politics.

If Mr Romer is right, and macroeconomics has been regressing, those of us who seek to defend the liberal order should consider reclaiming the central areas of economic policy. We should put fiscal policy off the autopilot and challenge the tyranny of the ubiquitous 2 per cent inflation target. And we should start making a distinction between the interests of the financial sector and the economy at large. Failure to do so was one of the reasons for the Brexit vote.

While the case for a challenge of the macroeconomic policy doctrine is overwhelming, I doubt the western policy establishment will do it. As happened during the financial crisis, vested interests will intervene. The macroeconomists who designed the models are the gatekeepers and the beneficiaries of the system. They are the independent central bankers. They are running the independent fiscal councils. Some are finance ministers.

It is no accident that a famous television series in the last decade — The West Wing — featured a Nobel-prize winning economist as a fictional US president. That version of Plato’s philosopher-king is very much out of date today.

With an establishment refusing to draw any lessons from its defeats of 2016, our system is far more at risk of being demolished by the populists from the outside than reformed from within.

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