Saturday 27 August 2016

Economics is now a science almost devoid of agreement

Published 13/04/2014 | 02:30

Christine Lagarde, head of the IMF
Christine Lagarde, head of the IMF

THERE was no shortage of scores being settled in Washington this weekend. In the US capital, where the annual joint spring meeting of the International Monetary Fund and the World Bank is being held, finance ministers, central bankers and policy-making bigwigs from all over the planet are assembled. Giving this year's event spice are the serious gripes that some of the biggest beasts attending have with each other. Three spats stand out.

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Mario Draghi, chief of the European Central Bank, is not pleased with his co-hosts, the IMF. Ten days ago, he politely told Christine Lagarde, the Fund's boss, to keep her nose out of Frankfurt's affairs after she had implicitly criticised him for not using his monetary powers more aggressively to prevent deflation in the eurozone.

Draghi, subtly hinting at a pro-American bias at the IMF, went on to wonder aloud if Lagarde's organisation would have had the temerity to speak so plainly to the US central bank, which, as it happens, is located just a few blocks away from the Fund's headquarters.

If Draghi is peeved with Lagarde, her compatriot, France's new left-wing finance minister Michel Sapin, has a bone to pick with Draghi. The ECB man has said that Paris should not be given more time to bring its budget deficit down, as it had hinted at doing in the aftermath of the governing socialists' dismal local election performance two weeks ago. Quite apart from an innate French abhorrence of being told what to do by anyone, especially an upstart foreign technocrat, Sapin suggests that closing the deficit too quickly will be self-defeating as it will kill off the nascent recovery.

And then there is George Osborne, the British chancellor of the exchequer. He, too, has a gripe about fiscal policy advice, but in his case it is with the IMF, not the ECB, and for exactly the opposite reason that his French counterpart is irritated.

A year ago, the British economy appeared to be on the brink of slump and Osborne was fighting for political life. He was being blamed for attempting to close the deficit in UK's public finances too quickly, thereby – it was claimed – precipitating yet another dip into recession. The IMF gave Osborne's political enemies an arsenal's worth of ammunition when it said he was "playing with fire" by implementing austerity measures.

But now, 12 months on, instead of growing anaemically, as the Fund's forecasters had predicted, the British economy is surging ahead. Osborne was suggesting at the beginning of last week that he would bring lots of humble pie to Washington to dish up to the IMF.

Beyond the spectacle of watching world leaders squabble and settle scores, there is a much more serious aspect to all of this. That many of the most powerful policy-makers and most influential economists have such different views on how fiscal and monetary policy affect the real economy illustrates just how little consensus exists on macroeconomic management. And the main reason for that uncertainty is not political advantage or personal ego, nor even ideology. It is ignorance. Economists simply do not know with any degree of certainty what works – in either monetary or fiscal policy.

The case of monetary policy is particularly stark because there is so little evidence to work with. There are only a handful of examples of unorthodox policies, such as quantitative easing, having been deployed in developed economies. Understanding how these policies affect growth is extremely difficult because of the near-infinite number of variables which influence economic performance.

As any scientist will tell you, the more variables there are, the more experiments that are needed to measure the individual effect of each variable. With so few experiments, the debate on the efficacy of unconventional monetary policy will keep economic researchers busy writing academic papers for decades.

The debate on fiscal austerity versus stimulus has been raging much more fiercely and going on for longer. But as the differences between Osborne and Draghi on one side and Legarde and Sapin on the other illustrate, it is nowhere near over. Nor has the academic community helped in clarifying matters. A 2008 study by Carmen Reinhart and Ken Rogoff, which concluded that high public debt levels are detrimental to growth, was found to have data flaws and just last week a new study looking at the fiscal history of more than 100 countries over 200 years found no hard connection between debt and growth. Is it any wonder the politicians are squabbling when the experts are so at odds?

Wading into the debate last week was Larry Summers, among other things a former US treasury secretary. In a comment article in the Financial Times aimed at those attending the Washington meeting, he repeated an earlier warning that the world was at risk of "secular stagnation" if policy makers did not act together on a global basis.

His warning echoes another American economist, Robert Gordon, who suggested two years ago that the rich world was heading for a no-growth era as the technological advances that have driven growth in the past give way to less productivity-enhancing inventiveness.

"The process of innovation may be battering its head against the wall of diminishing returns. Indeed, this is already evident in much of the innovation sector," he gloomily warned. His paper was described – for very good reason – as the "most depressing idea of 2012".

But whether the problem relates to the quality of innovation or some other reason (and, again, economists have not been providing much in the way of answers), there is no doubt that the rich world has been getting richer at a slower pace for decades and that trend long pre-dates the financial crisis of 2008.

Growth of gross national income per person, which is probably the best measure of average incomes in an economy, decelerated in most developed countries in the 1990s and slowed even more sharply in the first decade of this century, as the accompanying chart illustrates.

While much focus has been on low growth in Japan since its crash of 1990, Italians have actually been getting poorer since 2000, an unprecedented happening in the modern history of western Europe. If the future for the rest of Europe is Italian, we're all in serious trouble because our political and financial systems have become dependent on continuous economic expansion.

How can this be avoided? Leftists tend to argue for more investment in infrastructure, education and "key enabling technologies" as a means of pushing economies on to higher growth trajectories, while liberals advocate the freeing up of markets and the use of the proceeds of cuts in non growth-enhancing public spending to lower the most growth-dampening taxes.

A truly radical policy agenda in Europe will require a grand bargain of right and left, so that big and radical ideas from both sides of the political spectrum can be implemented simultaneously. There is no guarantee that any set of policy measures will allow Europe, or the rest of the developed world, break out of the secular slowdown, but such a grand bargain offers perhaps the only hope of doing so.

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