ARENA Working Papers
WP 98/17

 

 


Policy Continuity, Policy Change, and the Political Power of Economic Ideas



Ton Notermans
Department of Social Science and ARENA, University of Tromsø



 


Abstract

Because far-reaching changes in macroeconomic policies are generally accompanied by the adoption of a new theoretical framework informing policy-making, economic ideas are frequently assumed to have a causal influence on policy innovation. It is argued here that macropolicy regime changes are mainly driven by developments in labour and financial markets, which serve to confront the existing regime with intolerable deflationary or inflationary dynamics. The adoption of new economic ideas in regime changes hence is primarily driven by the need to provide a justification for exogenously determined change in policies which is compatible with the particular ideological convictions of the main political groupings. Ideas are argued to exert a causal influence over policies though by promoting policy continuity despite changes in the underlying circumstances, which originally justified such policies.


1. Introduction

The convergence of macroeconomic policies on a neo-liberal pattern in Western Europe during the seventies and eighties, continues to haunt the traditional explanations of economic policy-making. The spectacle of governments of different political hues embarking on essentially similar macroeconomic policies obviously is incompatible with an explanation, which stresses the importance of the political balance of power. Similarly, relatively rapid policy convergence is hard to square with the institutionalist emphasis on incremental change and path dependence.

In response, economic ideas have received increasing attention. [1] To focus on ideas would seem theoretically and empirically promising. In order for interests to be translated into policy demands, a theory is required which specifies the relation between policies and outcomes. Changes in the theory employed hence might account for policy changes without underlying changes of interests or institutions. Historically processes of rapid policy convergence indeed were oftentimes accompanied by dramatic shifts in ideas. The policy changes of the last two decades are often characterised as a transition from Keynesianism to monetarism. The regime change in the wake of the Great Depression is commonly understood in terms of Keynesian views replacing the older neo-classical theory.

New ideas, in this view, can be seen as discoveries which changed policy makers' perceptions of the effects of certain measures hence leading to a novel set of policies. Yet, a closer look at the history of macroeconomic policy and macroeconomic ideas in Europe since the interwar period suggests that such an interpretation is wrong. The cross-national convergence of macroeconomic policies in the wake of the Great Depression and the last two decades was not matched by convergence of ideas. Rather the pattern was one of similar policies being justified on the basis of different economic theories. The recent regime change has been justified both on the basis of the neoclassical concept of neutrality of money as well as on the basis of the Keynesian notion of the impossibility of expansionary policies in an internationalised economy. Similarly, the expansionary macroeconomic strategies, which emerged from the Great Depression, have been justified on Keynesian as well as neoclassical grounds.

Moreover, although the precise theoretical justifications given by economists like Keynes and Friedman were original, the actual policies derived from their models were not unknown. However, if the policies which were justified on the basis of a specific, and novel economic model, were neither unknown nor unique to that model, it becomes difficult to hold new ideas responsible for new policies.

This paper will argue that the hypothesis that new economic ideas determine the character of the new policies reverses cause and effect. More specifically, three main hypotheses are advanced:

(1) Ideas exert an independent causal influence on policies by providing for continuity rather than change because economic policy makers display a pronounced tendency to adhere to the ideas and policies which were adopted in response to a traumatic event, even if the original constellation justifying such policies is long gone.

(2) The changes in macroeconomic policy regimes during this century have been driven, not by new ideas, but by the need to correct cumulative price level disturbances. An expansionary macroeconomic strategy aimed at full-employment is only viable if it can rely on financial and labour market institutions to prevent cumulative inflationary pressures. Conversely, a restrictive regime, which uses unemployment as a means to prevent inflation is only viable as long as financial and labour market institutions, are able to stem deflationary pressures. Put differently, a reasonable degree of price stability functions as a selection criterion, which determines the viability of macroeconomic strategies independently of the priorities of the policy-makers.

(3) Because the timing and character of a regime change is determined by developments in financial and labour markets, it is largely exogenous to the political system. The role of new economic ideas in regime changes hence was confined to providing a justification for exogenously determined policies of price stability which is compatible with the tenet that economic policies strive to promote growth and employment, and with the particular ideological convictions of the main political groupings.

The structure of the paper is as follows: Section two reviews the main approaches to the role of ideas in economic policy-making. Section three argues that the historical pattern of macroeconomic ideas in Western Europe since 1918 is characterised by the continued coexistence of competing economic theories, but by convergence on restrictive macroeconomic policies on times of inflation and expansionary policies in times of deflation.

Section four provides a “Darwinian” model of the role of ideas in macroeconomic policy-making centred on the notion of the primacy of price stability in a monetary economy. Section five concludes.


2. Some Problems With Using Ideas as an Explanatory Variable

2.1 Falsification and the Duhem-Quine Thesis

Although economist frequently profess to adhere to a falsificationist methodology, it is widely accepted that it provides a poor guide to the actual development of economics. [2] The reasons for the limited practical relevance of the falsificationist methodology follow from the so-called Duhem-Quine thesis of the jointness of hypothesis testing. [3] Any empirically testable hypothesis necessarily includes a host of auxiliary hypotheses, e.g. the ceteris paribus conditions. Since it is impossible to test a single hypothesis in isolation, the results of empirical testing do not allow for a clear-cut conclusion with regard to the truth content of the underlying theory.

The Duhem-Quine thesis has spelled the demise of a monolithic view in which theories are either unfalsified or rejected in favour of a more differentiated and dynamic view. Theories, in this perspective, can be seen to consist of a so-called hard-core of logically connected and logically consistent statements, which, by decision of the advocates of the theory in question, are protected from empirical falsification. Contrary empirical evidence instead is accommodated at the expense of the auxiliary hypotheses in the so-called protective outer belt. [4] Accordingly, the scientific process of empirical testing cannot be relied upon to eliminate all but the correct model of the economy.

The relevance of the Duhem-Quine thesis for economic policy can easily be illustrated with respect to the main approaches to macroeconomics, namely Keynesianism and the neoclassical view. The hard cores of the respective theories can be summarised in the propositions of macroeconomic (Keynesianism) versus microeconomic determination (neoclassics) of the level of economic activity. In the Keynesian perspective the level of GDP is demand determined. Equilibrium requires that the withdrawals from the stream of incomes equal the injections, which in a closed economy with no government implies that savings should equal investment. Equilibrium hence does not necessarily imply full-employment. Inflation, in turn, is mainly a phenomenon which originates in the labour market under tight demand conditions. Neoclassics instead hold that unobstructed markets will fully and optimally employ available resources. Equilibrium unemployment cannot exist because market forces will drive down the price of the good in excess supply until markets clear. Historical instances of persistent unemployment hence result from obstructions to market adjustment. Inflation in the neoclassical view is purely a function of the money supply. Because the money supply is controlled by the central bank it is at heart a political problem.

Some of the hypotheses derived from each theory have been falsified empirically. For example, the monetarist prediction that any change in M1 with a lag of up to two years will be reflected in a proportional change in the price level, has been proved incorrect in the seventies and eighties. Similarly the Keynesian belief that it is always possible to eliminate unemployment by means of deficit spending has failed the empirical test in the seventies. Yet, neither historical episode implies that the hard cores of each theory must be incorrect. Rather each school of thought can account for these failures of its predictions to be empirically validated by pointing to violations of the auxiliary hypotheses. Monetarist can accommodate the contrary empirical finding on relations between M1 and the price level by switching to different monetary aggregates, by changing the assumed lag structure etc. Similarly, Keynesians may accommodate the failure of deficit spending by, for example, pointing to adverse international conditions.

Consequently, economic theories are not periodically replaced by more recent ones as a result of empirical testing. Although specific theories enjoy different degrees of popularity over time, the coexistence of competing schools of thought is the common pattern. As Charles Kindleberger (1987: 6) has pointed out, the debate between monetarists and Keynesians “did not have its origin in the 1920s or 1930s, as many students of the subject think, but can be traced back to the seventeenth century and beyond.”

2.2 Ideas and Interests

As the change in theories, which come to inform policy-making cannot be explained with respect to their truth content, the door is opened for externalist interpretations, which recur to extra-scientific criteria. [5] Going back at least to Marx' dictum that the ruling ideas are always the ideas of the ruling class, political scientists have frequently considered power and interests as explanatory variables . Economic ideas in this perspective are used instrumentally to help increase the political acceptability of specific policies by cloaking particularistic interests in the language of science and objectivity. [6] As Mark Blyth (1997: 233) e.g. has argued: “In attempting to overturn existing economic and political institutions and policies, economic ideologies are a resource used by agents to attack and restructure existing institutional and distributional arrangements.”

Such an approach has a strong intuitive appeal because the main macroeconomic models display distinct affinities with specific parts of the political spectrum. Keynesianism tends to be most popular amongst the centre-left of. Keynesianism can be interpreted so as to lend support to what probably is the core conviction underlying leftist political outlooks namely that free markets are unstable and inefficient and hence need to be complemented by a substantial dose of regulation and intervention. The postulate of demand determined unemployment allows the political left to protect its trade union clientele from demands for wage an social security cuts while at the same time satisfying its public sector clientele's preference for higher spending. The neoclassical / monetarist tenet that untrammelled markets will tend towards a Pareto equilibrium and that the real world deviations from this equilibrium can in large part be attributed to market obstruction, in turn, is much more amenable to the core convictions of the centre-right of the political spectrum. That unemployment is either voluntary or a function of trade union's obstruction to downward real wage adjustment obviously is an attractive proposition for those who stand to gain directly from lower wage costs and to those who are and expect to remain net contributors to the welfare state.

Yet, the argument that ideas are used instrumentally to cover up political interests, would seem to run into two logical problems: (1) If interests motivate the adoption of ideas, then ideas are entirely irrelevant to policy decisions. Actors with different interests will adopt different ideas and steadfastly refuse to be swayed by competing views, making the whole camouflaging operation rather futile. Decision-making instead is determined by the relative political strength of the relevant interests. Accordingly, to save the “ideas as cloak” argument some form of elitism must be introduced. Some actors must be able to arrive at a decision concerning their preferred policy on the basis of their interests, whereas, the majority of actors must be influenced quite substantially by the ongoing discourse while determining what their preferred policy course. Yet, in this case, the reference to interests becomes irrelevant and the position becomes essentially similar to the argument that ideas have an independent influence on policy formation. To point out that the “true” motives for advocating a specific theory were of a political nature may provide a convenient platform from which adherents of given theory can launch moralistic attacks on their opponents. Yet, on the assumption that in a democratic polity the viability of a given set of policies depend on the ability of policy entrepreneurs to convince a majority of the electorate, the motivation of those who originally advanced a specific view has no relevance for explaining what views come to inform policymaking. Rather the dominance of a theory, in this perspective, would be explained by its ability to influence the policy preference formation of the electorate.

(2) More fundamentally, it seems doubtful that macroeconomic policy preferences can be derived directly from interests. The purpose of theories is to specify what effect policies will have. Accordingly, it would seem impossible to determine whether a given macroeconomic strategy is in one's interest without recourse to a theory. The standard way out of this dilemma is to limit the choice situation to the static allocation of a given set of resources. Accordingly a clearly specified zero-sum distributional constellation can be defined in which, actors do not need recourse to always contested and uncertain macroeconomic theories in order to arrive at their preferred policies. For example, one can depart from a static model in which profits and real wages are always inversely related in order to arrive at a definition of conflicting interests between employers and wage earners. Restrictive macroeconomic policies, which increase unemployment hence, may be interpreted to serve the distributional interest of employers because they weaken labour's bargaining position. Keynesian policies in turn may be said to benefit the distributional interests of wage earners, welfare recipients, and those employed in the public sector.

Yet, there is no good reason for assuming that actors will only consider static distribution effects and neglect the possible macroeconomic outcomes when establishing their policy preferences. Keynesian strategies have attractive shot term distributional consequences for labour but if neo-classical macroeconomics is right they will result in a major unemployment crisis. Similarly monetarism may hold out the promise of weaker unions but if Keynesian macroeconomics is right it will imply a major slump and permanently lower growth.

2.3 Ideas and Policies

It hence seems that economic ideas strongly influence policy making independent of political preferences or truth content of the relevant theory. Yet, the Duhem-Quine thesis also has serious consequences for the “ideas matter” approach, because it undermines the assumption of an unambiguous link between ideas and policy prescription. If different policy prescriptions can be derived from the same theory, then decision-makers adherence to that theory cannot be a sufficient evidence of the causal effects of ideas. In this case namely, it will always be possible post hoc to attribute a given policy to a certain theory, yet because such an approach has no predictive power it lacks explanatory power. Similarly, if the same policy can be pursued on the basis of different theoretical justifications, then showing that a specific policy was informed by a certain theory is not sufficient to conclude that the theory in question had an independent effect. [7]

However, from the Duhem-Quine thesis it follows that almost any policy prescription can be derived from a given theory by a skilful use of supporting assumptions. [8] If a theory can be upheld in the face of unfavourable evidence by means of choosing the correct auxiliary conditions, then for any desired outcome the correct choice of auxiliary conditions should allow for a wide variety of policy prescriptions on the basis of the same theory.

Commonly the competing macroeconomic theories are associated with sharply different policy prescriptions. Keynesians advocate discretionary demand management, in particular budget deficits, and cheap money, in recessions. Neoclassics instead favour tight money and balanced budgets, while seeking the remedy for recession and unemployment on the supply side, i.e. in eliminating those obstacles, which prevent markets from adjusting optimally. Yet, such a characterisation would seem inaccurate because it is possible to derive “Keynesian” policies from neoclassical models and vice versa.

General Equilibrium theory, the hard core of neoclassical theory, is unsurpassed in its logical rigour as well as its level of abstraction. But because of its high level of abstraction an almost infinite number of policy conclusions can be derived from it by selecting some assumptions from the pure model, which do not hold in the real world, and adjusting the conclusions accordingly. It hence becomes possible to justify discretionary demand management starting from the notion that unemployment is due to real wage rigidity. The assumption, required is that money illusion exists (in an unspecified short run), i.e. that wage earners do not perceive the real wage cut resulting from a higher price level at constant nominal wages. In this case, inflationary demand policies bring about the reduction in real wages required to clear the labour market. Hence, policy convergence with Keynesians is established without accepting their theoretical framework.

The so-called fundamentalist Keynesian interpretation, i.e. the only interpretation which can make the claim that Keynesianism provides an alternative theory rather than the short term version of neoclassical theory, has always sought to avoid the conclusion that discretionary demand management is advisable because wage adjustment, though superior in theory, is not available in practice. [9] Instead, it maintains that even in theory only discretionary demand management is an effective measure against recession and unemployment. To arrive at `neoclassical policy prescriptions' from this starting point it is necessary to argue that demand management, though superior in theory is unavailable in practice. Commonly this is done by maintaining that the Keynesian model was formulated for a closed economy and that openness significantly changes the conclusions. A high degree of trade openness implies that a large portion of a fiscal stimulus will leak abroad. Moreover it can be argued that international financial investors prefer tight, disinflationary macroeconomic policies. [10] To avoid an exodus of capital restrictive macroeconomic hence will need to be pursued policies even under conditions of unemployment.

The assumption of openness introduces a microeconomic element in the otherwise macroeconomic Keynesian models. Keynesians have accepted that one single firm can increase the level of employment by reducing wage costs, but have denied that such a recipe can work in the aggregate. By analysing the national economy as part of an international system it possible for Keynesians to, in a logically correct manner, advocate supply side policies aimed a cutting (relative) domestic costs as a remedy for unemployment. Hence, policy convergence with the (long-term) neoclassical model is complete: macroeconomic policies need to prioritise price stability and unemployment is to be tackled by supply side policies.

The implication is that if ideas are to have an influence on policy, the notion of ideas should not refer to the hard core of different theories, as is commonly the case, but to the auxiliary assumptions used in combination with them. It is not primarily the switch between Keynesian and neoclassical views which leads to radically different policy prescriptions, but switches between the short run focus on nominal rigidity and the long run focus on nominal flexibility within the neoclassical school, and between domestic orientation and the theoretical assumption that internationalisation frustrates discretionary demand management within the Keynesian school.


3. The Historical Trajectory of Macroeconomic Ideas

If the influence of economic ideas cannot be reduced to other factors like the balance of political power or truth content, then the success and failure of macroeconomic ideas and policies should display a more or less random pattern driven by the vagaries of intellectual production and the rhetorical skills of policy entrepreneurs. Yet, historically a clear pattern can be discerned. Although especially Keynes is frequently said to have advocated entirely novel policies during the Great Depression, the basic policy ideas of discretionary demand management, or rule-bound monetary policy have a long lineage. Keynes and Friedman may have provided novel theoretical justification but they did not provide genuinely novel policy prescriptions. In periods of inflation those views, which advocated tight monetary policies, irrespective of their theoretical provenance, have gained a dominant influence over policy making. Conversely, in the wake of the deflation even neoclassical scholars came to advocate discretionary demand management. [11]

3.1 Keynesians and Monetarists Avant La Lettre

No sophisticated economic reasoning is required to arrive at the Keynesian conclusion that increased government demand for the products and services of the private sector will alleviate the plight of at least some firms and workers during a crisis. Especially those industries that could hope to benefit directly from state procurement would hardly need to wait for the formulation of Keynesian theory to advocate increased state spending without tax increases. Also for the state loan-financed countercyclical spending could seem attractive as recessions are generally characterised by lower interest rates, lower wages and lower prices.

It is certainly not correct that Keynes advocated the entirely novel strategy of expansionary demand management during the Great Depression whereas neoclassical economists insisted on wage cutting and balanced budgets. Indeed, Mark Blaug (1986: 245) has called this the “Walt Disney version of interwar-economics”, because, at least for the USA and the UK, it can be shown that the overwhelming majority of economist advocated expansionary macroeconomic policies.

In Britain, the Minority Report of the Royal Poor Law Commission (1909) has long been recognised as a forerunner of countercyclical government spending. Also in 1909 the British government accepted the principle of countercyclical investment spending in the Development and Road Fund Act. [12] Proposals for countercyclical public works were already contained in the Labour Party's 1918 programme Labour and the New Social Order and in the pamphlet Unemployment: A Labour Policy (1921). [13] In Sweden, where according to some the social democrats invented Keynesianism independently in the late 1920s, the principle of countercyclical fiscal policy had already found the support of a majority of parliament and the government before the First World War. [14] In 1912 the opposition social democrats obtained a parliamentary majority for increased spending on public works so as to alleviate unemployment. Before 1914 most influential Swedish economists believed in the usefulness of countercyclical policies. In Germany Chancellor Bismarck had already advocated countercyclical fiscal policies already in the 1880s. [15] After the war the ministry of economic affairs formulated an explicitly anticyclical spending programme. [16] In 1926, the German government even embarked on an explicit programme of deficit spending in order to alleviate unemployment. [17]

Similarly the neoclassical belief that expansionary monetary policies cannot durably affect the level of economic activity but will only create inflation, had been formulated long before Friedman's monetarism. That printing coloured pieces of paper (money) cannot create wealth is a conviction deeply rooted in the moral underpinnings of Western economic thought. People like Marx and one of his fiercest critics Ludwig von Mises, could both agree that the monetary sphere was merely a veil which hid the true driving forces of the economy. [18] Inflation accordingly was the result of an excess supply of money and its elimination would not interfere with the production of wealth. The earliest theoretical formulation of the Quantity Theory dates back to the mid-eighteenth century, namely to Hume's essay Of Money. Its first formal representation was given by Irving Fisher in 1911.

3.2 Macroeconomic Policies since 1918

At the end of World War I the view that discretionary demand management can positively affect growth and employment was generally dominant amongst west European policy makers, albeit for different reasons. Yet when inflation, contrary to expectations continued to increase rapidly, the view that macroeconomic demand management is inflationary without having long term effects on the real economy replaced the earlier `Keynesian' views in the early twenties. Centre-right parties commonly justified such a policy shift with reference to the traditional quantity theory. The repaid post war inflation in this perspective was the result of ill-guided attempts to mitigate domestic distribution conflicts by means of fiscal expansion and the printing press. The post war inflation also convinced the political left that the problems of unemployment and recession could not be solved by macroeconomic means. But whereas the right generally explained depressed economic conditions in terms of excessive union power and government intervention, for many on the left the persistent mass unemployment of the twenties constituted proof of the Marxist contention that capitalism is inherently crisis prone. As the decade progressed, however, the theme of external constraints became more important for the left. With the rapid deterioration of the economy towards the end of the decade, the argument that expansionary macroeconomic policies would only provide short-term relief became much less effective as a counter-argument to such policies. Instead, the ever-present danger of capital flight came to function as one of the main argument against even short-term relaxation of macroeconomic policies. In early 1931, e.g. the recently elected British labour government of Ramsay MacDonald implemented severe cutback in unemployment benefits in order to balance the budget and thereby prevent a run on Sterling.

In the turmoil of the Great Depression the strategy of restrictive macroeconomic policies and downward price, adjustment came to be considered deeply flawed. Rather than improving economic performance, rapidly falling prices seemed to aggravate problems of over-indebtedness and insufficient demand. Consequently West European governments increasingly came to regulate markets in an attempt to halt prices, and abandoned the Gold Standard in favour of cheap money policies.

Ideologically the left found it relatively easy to embrace such policies, as they seemed to confirm that capitalism needed to be tamed by political intervention. After a brief flirtation with the argument that the new policies were the prelude to a socialist reorganisation, the left generally settled on a Keynesian interpretation. But the centre and right of the political spectrum seemed equally ready to recognise the bankruptcy of Laissez-faire. Indeed, in several countries like Sweden and Britain, it were the Liberals and Conservatives who initiated the new policies. Ideologically, however these policies were not so easily assimilated. Initially many conservative and liberal parties justified regulation and macroeconomic expansion as short-term exceptions. After the war, they generally came to accept the need for discretionary macroeconomic policies, but on the neoclassical grounds that obstruction to market adjustment made such policies necessary.

When inflationary pressures mounted since the late sixties, this policy consensus was rapidly undermined. Starting with the Bundesbank's policy turn in 1974, Milton Friedman's argument that the seemingly intractable inflationary problems in fact demonstrated nothing less than the correctness of the quantity theory was accepted by many centre-right governments. Also the political left fairly soon came to support the new policies. Although generally interpreted as a defeat of Keynesianism, the rise of monetarism in fact only implied a defeat for the Keynesian interpretation, which derived the possibility of discretionary demand management from the presence of money illusion. There was no need for the political left to admit that the experiences of the seventies had indeed shown that extensive public intervention in the economy was counterproductive. Instead, the left responded by resurrecting the theme of external constraints on domestic macroeconomic policies. The Austrian Social Democratic government's decision to subordinate monetary policy to the fixed exchange rate with the DM rather than to domestic growth and employment in 1979, the sharp tightening of German policies under the social democratic Schmidt government during the early eighties in response to a sagging DM, and finally the famous U-turn of President Mitterand in France, now came to be cited as proof that Keynesianism, though theoretically by no means dead, had become practically unfeasible. By the mid-nineties, then, the macroeconomic debate had become rather reminiscent of the late twenties.


4. A “Darwinian” Theory of Economic Ideas

Although it is not possible to reject a theory because policy measures derived from it failed to have the predicted effects, this does not imply that, any macroeconomic policy is viable. Indeed, the fact that the changes in macroeconomic regimes, in the early twenties, during the great Depression and in the seventies and eighties, led to similar policies in a large number of countries fairly irrespective of the respective domestic political balance of power indicates that governments at times have found only a fairly narrow set of policies viable. The pattern of cross-national policy convergence on the basis of rather different theoretical justifications hence suggests the usefulness of a “Darwinian” argument in which viable practices are selected according to a criterion of which the respective actors may not be aware.

Darwinian arguments have been introduced in modern economic by the so-called `Chicago Defence' of the theory of profit maximising firms. [19] In response to empirical evidence on firm decision-making which seemed to contradict the neoclassical theory, the Chicago school responded, that although individual firms might not be aware of the theory of profit maximisation, only those firms would survive in the market which, for whatever motives, behaved in accordance with the criteria set out by the theory. Although the application of such Darwinian argument to behaviour of firms may be problematic, it will be suggested here that they can be usefully applied to macroeconomics. Section one discusses the applicability of such arguments to social science. Section two argues that price stability function as a selection criterion irrespective of the intentions of the respective governments. Section three interprets the divergence of theoretical discourse as driven by the need to provide different political groups with ideologically acceptable justifications for the same policies Section four argues that the influence of ideas on policy is mainly manifested in policy continuity.

4.1 The Problem of Reflexivity

The idea that in a market economy the pursuit of self-interest results in the optimal employment of resources is one of the ideological pillars of modernity. Although it dates back to the 18th century, it continues to underpin many modern views on the economy. Yet, the concept of an uncoordinated, decentralised system tending towards a predetermined equilibrium may be appropriate for the physical sciences where an environment, which is independent of the actions of the individual elements, can be assumed. In the social sciences, where the environment the individual actor faces is basically the sum of the actions of the other individuals, the notion of an uncoordinated system tending towards a predetermined position is simply inappropriate because an exogenously given point on which convergence can take place is lacking.

In terms of the `Chicago defence', this implies that unless all possible types of behaviour are always present at any point in time the market will select only those firms which perform better than their competitors with no guarantee that those firms actually behave in the way prescribed by the theory of profit maximising. More important, even if a firm should stumble across the optimal behaviour there is no guarantee that that behaviour will subsequently come to dominate the market because, as the firm in question expands it changes market conditions and hence the conditions of optimal behaviour. [20]

Although the fact is often ignored neoclassical general equilibrium theory in fact recognises that the problem of reflexivity implies that a general equilibrium only by pure coincidence. [21] In order to arrive at the conclusion that a predetermined, i.e. the technically identifiable unique Pareto optimal equilibrium will result general equilibrium theory hence needs to eliminate reflexivity. This can be done by assuming perfect foresight, i.e. assuming that each individual is perfectly informed about the actions other individuals will undertake in future. But apart from being obviously unrealistic this device is logically questionable to the extent that in order for each individual to decide upon a course of action the decision of all other individuals most already be known. [22] Alternatively economic theorists have introduced a so-called the auctioneer as a (fictitious) co-ordinating agent who operates outside of the market and who is assigned the task of determining the vector of prices that will establish equilibrium and make it known to market actors before trade takes place. However, this implies that the theory ceases to be applicable to market economies.

The reflexivity of social interaction would hence seem to make the behaviour of individual agents and hence the specific equilibrium established largely undetermined. A market system may, severely constrain the options of any individual at any point in time, but it does not, determine the behaviour of the system in the aggregate. Nevertheless, Darwinian-type arguments can be successfully applied to macroeconomics. Reflexivity implies the possibility of constellation of cumulatively destabilising process of interaction between individual market actors. On the assumption that governments need to be able to demonstrate some degree of control over the economy in order to survive, only those policies will prove viable which succeed in halting such cumulative spirals.

4.2 Co-ordination and Price Stability in a Monetary Economy

Introducing an auctioneer may be a theoretically elegant way to arrive at a single predetermined equilibrium, real world markets, however, have no access to such a device. In the real world, the behaviour of market actors is primarily co-ordinated by means of money, as it is the only medium through which signals can be sent to all other actors. [23] And because economies are co-ordinated via the medium of money, price stability enjoys a privileged position amongst the goals of economic policy. Problems like mass-unemployment and low growth while politically and socially rather disagreeable, as such pose no threat to the functioning of a market economy. Serious disturbances of price stability, however, disrupt the co-ordination mechanism and tend to spark off vicious circles, which may bring the whole process of market interaction to a standstill.

Although economists frequently hold that full wage and price flexibility implies the absence of unemployment, especially the experience of the Great Depression has shown that the attempt to fight major crises by means of downwards nominal adjustment may be counterproductive. Since wages are part of the flexible costs of firms generalised wage cuts are likely to depress the price level. Occasional instances of deflation may be fairly harmless. Expectations of ongoing deflation instead will aggravate any crisis because it reduces the demand and supply for investment. For industrial borrowers, investment becomes less attractive because deflation increases their real debt and additionally reduces profitability due to the time, which elapses between the purchase of raw materials, and the sale of finished goods. For borrowers deflation makes financing productive investment less attractive both because simply holding money now earns a yield and because the increased risk of debt default. Less investment, however, implies more unemployment. If the labour market reacts to more unemployment with nominal wage cuts, the vicious circle is complete. [24]

As Tobin (1980:18) suggests, inflation can be interpreted as the mirror image of deflation. Tight labour markets will generally result in higher nominal wages, and as long as monetary authorities are committed to full-employment, to higher prices. Inflation however initially increases the demand for and supply of investment. Inflation increases profitability because of decreasing real indebtedness and the time lag between the start of production and sales and makes borrowing more attractive. Similarly, the erosion of the value of money and the reduced risk of debt defaults make lending more attractive as compared to the holding of money. More investment, in turn means more employment While initially inflation will stimulate activity, the longer term result is a flight out of money, in which all wealth holders try to liquidate financial assets and money for real assets and where speculation becomes a more promising way of increasing and safeguarding wealth than productive investment.

In sum, because once labour and financial markets adjust to expectations of de-or inflation no self correcting forces exist which will prevent a cumulative choices governments will eventually be left with little choice but to address the problem of prices stability. Although the present policy orthodoxy claims rather the opposite, whether an economy is (financially) open or closed poses much less constraints on macroeconomic policies. Without a commitment to a fixed exchange rate, expansionary macroeconomic policies can also be pursued in a restrictive environment. However, currency depreciation in order to defend a more expansionary macroeconomic policy stance is not a viable option for countries already plagued by inflation because deprecation further fuels inflation, not only because it increases import prices and removes a potentially powerful constraint on wage bargaining. Continued inflation in an open economy will most likely prompt a switch to a more stable foreign currency. Yet such a run on the currency is simply the manifestation of a desire to change portfolio allocation, which would have taken the form of a flight out of money and into debt and real estate. Given the dominance of inflationary problems in the seventies and eighties it is hence not too surprising that, especially leftist, governments would complain about powerful external constraints while simultaneously moving to abandon exchange controls and to commit to a fixed exchange rate.

4.3 Policy Changes and Changing Ideas

The political hue of the government, as political scientists have frequently argued [25] exerts a significant influence on economic policies. There are important cross national policy differences, which are related to differences in the balance of political power. Yet such power politics operates within clearly defined limits, given by the ability of financial and labour market institutions to assure the compatibility of a given macroeconomic policy program and the requirement of price stability. The present argument accordingly can be understood as Darwinian in the sense that, while it may not be possible to predict at any point in time what policies will be pursued and with what theoretical justification, only those policies which satisfy the criterion of price stability will eventually prove viable.

Growth and full-employment are crucial goals for leftist governments. Not only because full-employment is crucial for the welfare of wage earners, but also because mass-unemployment makes financing the welfare state increasingly tenuous. Growth and unemployment however can only be maintained by means of an expansionary macroeconomic regime in which the labour market parties are able to contain inflationary pressures. Cumulating inflation will generally also rob leftist governments of support. Trade unions increasingly come to dislike the devaluation of their wage contracts resulting from inflation. Rampant financial speculation leads to call for restrictive measures especially from the lower paid wage earners who do not have the means to speculate in financial markets. And since, it is generally, but mistakenly believed that a reduction in inflation can be had by slowing down the economy somewhat, without creating a major recession, unions are likely to sooner or later defect from a government that cannot stop a runaway inflation. Increasing inflation will also come to be seen as a serious threat by savers and pensioners and others who receive non-automatically indexed money transfers. If the economy is open, runs on the currency may provide additional incentives for an anti-inflation policy.

Yet, even without a significant loss of support, even leftist governments will have sufficient incentives for changing course. Runaway inflation implies the loss of control over financial and labour markets. But if the available choice is between loosing all ability to steer the economy and regaining control, although at the price of having to pursue some policies which are not considered too desirable, the latter alternative will commonly be preferred. In the extreme case where the fear of the recessionary consequences of a disinflation preclude any restrictive measures a hyperinflation will develop, with the result that the domestic currency ceases to be accepted and productive investment comes to a standstill. But at the point where it ends in mass-unemployment, the last available motivation for tolerating inflation is removed. [26]

Conversely, rightist governments cannot pursue indefinitely with a restrictive macroregime, which relies mainly on domestic cost cutting if they lack the appropriate institutions to contain deflationary pressures. The unemployment consequences of such a constellation may prompt leftist governments to change policies at an earlier stage. Yet at the latest when a massive flight into money ruins the banking system and bring the real economy to a standstill also business and farmers will start to have grave doubts about the wisdom of deflation. Again. this leaves Liberal and Conservative government's the option of changing their policies or being elected out of office.

Although governments, which cannot hold inflation or deflation in check, have no choice but to change course, they face a potentially infinite menu of choices for justifying the policy change. The choice of explanation, however, will have to satisfy at least two requirements: (1) it must be possible to interpret the new policies as promoting overall economic prosperity. (2) It must be possible to interpret the new policies in terms of the core ideological convictions of the respective political groups.

The democratic constitution of the polity requires, as a rule, that political parties, which wish to enlist a political majority, must present an economic policy program which is said to promote growth an employment. The expansionary macroeconomic policies required to break a deflationary constellation will require governments to abandon the view that such polices in the somewhat longer run will only have inflationary consequences. The restrictive policies required to combat inflation in turn will either require a resurrection of this view or some kind of argument which holds that the government, due to forces entirely beyond its control, is not able to pursue expansionary policies.

In addition, successful political competition requires that political parties distinguish themselves from their political opponents, which means that they should be able to justify economic policy strategies in terms of the general philosophy on which they are said to be founded. In general terms, this means that the Liberal tradition must find an explanation for regime changes, which somehow makes reference to the superiority of market forces. For the political left the task is to find justifications which do not violate the conviction that markets need to be tamed and that political intervention and interest organisations potentially promote prosperity.

To avoid misunderstanding, it is not argued that politicians consciously advocate new ideas, which they know to be false in order to defend their political interests. Politicians, like most others, will conduct the search for new policies, which becomes necessary as de- or inflationary spirals increasingly demonstrate the inappropriateness of the old regime, on the basis of their prior theoretical and ideological convictions. Only if satisfactory explanations cannot be found the necessity of a fundamental adjustment of core beliefs will be contemplated. Yet, the Duhem-Quine thesis implies that it will almost always be possible to find satisfactory explanations.

The liberal and Conservative sides of the political spectrum generally adjust to inflationary constellations by resurrecting the neutrality of money doctrine. By postulating that there simply is no trade-off between growth, employment and inflation, and that, therefore, a political debate about the relative priorities to be attached to these goals is simply pointless, the required priority of anti-inflation policies can be achieved without openly violating the political requirement that economic policies may not be seen to reduce growth and employment. Moreover, the quantity theory implies that the inflationary problems must be attributed to political mismanagement.

The expansionary macroeconomic policies which eventually become necessary to break a deflationary cycle, in the liberal perspective, are generally interpreted in a theoretical framework which derives the possibility of effective macroeconomic policies from the presence of, mainly union-inspired, nominal wage rigidities. Whereas the neutrality of money argument stresses the long run effects, it is now the short run, which becomes the focus of attention. Ideologically such an interpretation has the obvious advantage that it can justify discretionary macro management without having to reject the conclusion that a free market would produce optimal outcomes, or that strong trade unions constitute a problematic feature in a market economy.

Such a justification of restrictive macroeconomic regimes is unattractive to the political left as it implies that policy mismanagement; welfare state arrangements and trade unions are to blame for the economic dislocation. A much more attractive argument is that restrictive macroeconomic policies are imposed on reluctant (leftist) governments by internationally mobile capital. Superficially, such a view seems plausible because the flight out of money accompanying ingrained inflationary expectations may be manifested as a flight out of the national currency. But, as argued above, such an argument reverses cause and effect. Ideologically the advantage of the external constraints view is that does not require the rejection of the idea that expansionary demand management policies in principle should be employed to correct the inherent deficiencies of market economies, while nevertheless allowing practical policy to concentrate on fighting inflation.

The switch to a restrictive macroeconomic regime implies that for both the political left and right unemployment now becomes primarily a microeconomic problem. It is on the level of supply side policies, and on the basis of a prior commitment to restrictive macro policies, that interests come to play a clear role in the choice of ideas. For the centre-right of the political spectrum the depressed conditions generally resulting from restrictive macropolicies point to the need to increase business profits by means of cutting wages, social security contributions and taxes, and by generally increasing flexibility in labour markets. With a constituency, which consists disproportionately of private sector wage earners and public sector employees, such a conclusion is politically unacceptable to the left. Since, however, as a result of its macroeconomic choices it is also forced to accept the argument that improving business competitiveness is the best way to promote more employment, the only logical solution is to argue that cost cutting, in the somewhat longer run of course, will actually threaten competitiveness. The presently most popular form of that argument is that, in the long run, the resistance of unions against wage cuts benefits competitiveness as it forces firm to `rationalise', the liberal supply-side views could be given a genuinely social democratic answer. But as continuos unemployment increasingly makes wage earners at the firm-level willing to trade off income against employment, such an argument threatens to become a rhetorical device which is useful for the leadership of leftist parties and unions but which has increasingly less practical relevance.

4.4 Learning, Ideas and Policy Continuity

Since economic behaviour does depend crucially on the reigning expectations (about what others will do) it cannot be expected that `objective' signals set by economic policies will always elicit the same response. Accordingly monetarist and Keynesian approaches which postulate that a increase in the volume of money will always lead to a proportionally higher price level of that, at least in a closed economy, an increase in the budget deficit will always lead to a predictable increase in aggregate demand, are fundamentally misguided. It also follows that, because they can change expectations, economic policy changes alter their own preconditions. The upshot of this being that the experience of the last crisis may not necessarily be a good guide to the next one. If Keynesian demand management seemed to work the last instance it was applied it does not follow it will work in future. Similarly higher inflation in response to more expansionary monetary policies does not imply that monetary policies will only have nominal effects.

However, policy makers generally interpret the situation that they face in terms of an analogy with the previous major crisis. The events that give rise to a regime change generally constitute a trauma, which becomes the frame of reference for economic policy makers for a long time to come. It is at this point where ideas start to exert an independent causal role on policies. The new theoretical framework which is adopted in response to de- or inflationary problems comes to inform policy making in the new regime, even when such policies may no longer be appropriate because the constellation giving rise to the has disappeared. And because unexpected empirical outcomes cannot serve as disproof, the inappropriateness of the policies, as long as they do not set of another cumulative process, cannot bring about a change in course. Accordingly policies itself may become a source of the problems leading up to the next crisis.

As Peter Temin (1989) has argued, one of the main reasons for the depth of the Great Depression was that governments, in the midst of deflation were pursuing fiercely restrictive macroeconomic policies for fear of a re-emergence of the inflationary pressures of the early twenties. In our times, one might argue, West European macroeconomic authorities seem to be guided primarily by the fear of a new inflationary cycle despite mass-unemployment and oftentimes falling unit labour costs.


5. Conclusion: The Politics of Ideas

By wholeheartedly embracing the hypothesis of external constraints on macroeconomic policies, the political left has moved itself into a rather unpleasant cul de sac. The argument did provide a leftist justification for pursuing macroeconomic policies that looked suspiciously like monetarist ones. And as long as the left could hold out its version of supply side policies as a viable alternative, the postulated lack of macroeconomic alternatives was politically not too problematic. By the late 1990s, however, leftist supply side policies increasingly seem bankrupt also to many on the left. In Germany, whose highly productive and successful export sector has long been considered proof of the thesis that strong unions may actually benefit economic performance [27], open unemployment exceeds 11%. At the same time the US and, to a lesser extent the British economy are booming.

One could argue that the British and American success is strongly related to a much more pragmatic monetary policy than pursued by the EMU members, [28] but the external constraints hypothesis precludes such an argument. Accordingly it would seem that weak unions and cost-cutting is the only viable strategy for promoting prosperity. At that point the left has the option of either admitting the complete bankruptcy of its economic policies, or calling for projectionist trade policies in order to save the continental European model from foreign competition. Yet the latter alternative, although strongly suggested by the left's current analysis of economic problems, is not a viable policy alternative either in the highly integrated economies of Western Europe. [29] In addition, the economic policy impotence of the left seems to drive increasing numbers of its traditional voters into the camp of xenophobic right wing parties. Finally, the external constraints argument increasingly ceases to be a distinguishing argument of the left. Whereas the neoclassical / monetarist view recognises that, in the short run, expansionary macroeconomic policies would have beneficial effects, the external constraints argument maintains that even in the short-run governments face no choice. [30] However, as mass unemployment persist and the short run may turn out to be very long indeed the neoclassical interpretation may increasingly fail to convince as an argument against expansionary policies. For those on the centre-right who fear a relapse into Keynesianism the external constraints argument has accordingly become increasingly attractive.

Consequently, the external constraint hypothesis by a gradually increasing number of actors on the left comes to be considered an undesirable political constraint. It is in this connection that the study of economic ideas has received its main new impetus. If it can be shown that the neo-liberal policies of the seventies and eighties were actually based on the power of (faulty) economic ideas, then expansionary macroeconomic policies again seem an option. [31] The development is not unprecedented. After expansionary monetary policies were accepted as the new orthodoxy in the wake of the Great depression, many wondered why policy makers for such a long time had so tenaciously clung to obviously misguided ideas. How was it possible that maintaining a fixed exchange rate or having a heap of unproductive yellow metal in the vaults of the central bank was considered more important than stimulating growth and employment?

From a social science perspective, studies attempting to link the recent change in macroregime to economic ideas promise few new insights. They may provide a more detailed reconstruction of economic policy discussion in specific countries, but they will be unable to explain the sudden cross-national attractiveness of neo-liberalism even to leftist policy makers. [32] From a political perspective, such studies seem more promising. Although inaccurate as an actual explanation, the hypothesis that the advent of monetary disinflation actually came about because of the power of misguided economic ideas over a small elite of policy makers may help strengthen the case for cheaper money. For the 19 million European unemployed, such a change can only be for the better.


6. References

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Footnotes

[1] See, for example, Blyth 1997and Hall 1989.

[2] See Hands 1985:2 and Blaug 1986. Indeed, if Popperian falsificationism provided a correct positive theory then science would be characterised by the absence of theories because, as Lakatos observed: “all theories are born refuted.” Quoted in Hands 1985:2.

[3] See Cross 1982, also Lakatos 1972: 101-2.

[4] See Lakatos 1972

[5] It should be noted that this does not imply that externalist interpretations are necessary. Indeed the central point of Lakatos' work is that, despite the Duhem-Quine thesis externalist explanations are not required to explain the development of the (natural) sciences. Blaug (1986:257) argues that Lakatos' view also holds for economics.

[6] See also Shepsle 1985: 234.

[7] For example, if one is to count the turn to restrictive policies of Margaret Thatcher as an example of the causal influence of (monetarist) ideas, one should make a plausible case that a labour government would not have embarked on similar policies with a reference to external constraints.

[8] See also Patinkin 1982: 167, and Lawrence H. Summers 1991: 144. In contrast Blyth (1997: 233): ” By definition, different economic ideologies propose different policies.

[9] See, for example, Davidson 1994: 27-29 and chapter 11.

[10] See Stewart 1983.

[11] See Kindleberger 1985: 41 and Forsyth & Notermans 1997.

[12] See Winch 1969: 53-55.

[13] See Skidelsky 1967: 40.

[14] See Öhman 1970: 35-52 and Steiger 1971: 99-110..

[15] See Steiger 1971: 110-1.

[16] See Held 1982: 98-99.

[17] See Blaich 1977 and Clingan 1994.

[18] See Von Mises 1980: 111-112.

[19] See Alchian 1950; Friedman 1953 and Elster 1984: 31

[20] See Elster 1985:135-6.

[21] See Hahn 1984: 125.

[22] Robinson (1972: 4) points out that to arrive at the conclusion that markets tend towards equilibrium ”either the whole of future time is collapsed into today or else every individual has correct foresight about what all others will do, while they have correct foresight about what he will do, so that the argument runs into the problem of free will and predestination.”

[23] See Shubik 1975: 563.

[24] For a more detailed account of the real effects of nominal flexibility see Keynes 1963: 168-90, Tobin 1980 and Riese 1986.

[25] See, for example, Garrett & Lange 1991 and, for the interwar period, Simmons 1994.

[26] This was how the German hyperinflation of 1920-23 eventually ended.

[27] See Streeck 1991.

[28] For a critique of the Bundesbank along these lines see Filc 1998.

[29] For some cautiously protectionist arguments see Scharpf 1996.

[30] For a similar argument see Mishra 1996: 317.

[31] See Blyth 1997.

[32] See Blyth 1997.






[Date of publication in the ARENA Working Paper series: 15.10.1998]