For years I have been trying to teach students -- from Econ 101 to PhD students -- that there is a simple linear relationship in the real world of political economy that goes:
Bad Ideas ---> Bad Policies ---> Bad Outcomes
Political economy ain't rocket science. But it is a discipline that forces one to focus on ideas and the implementation of those ideas in public policies. Ideas -- some deeply rooted in philosophy, others focused on more technical propositions about the way the world works -- are weaved together to form more or less coherent frameworks. Those frameworks then suggest solutions to pressing problems (perceived or real) in the economy that in the vast majority of intellectual frameworks guides government action. Bad root ideas become coherent but incorrect frameworks, and the solutions offered therefore are the wrong ones for the problems identified.
Given this argument, the challenge I have is to explain the persistence of bad ideas in the realm of competitive politics. The bad outcomes means that there are proverbial $20 bills lying all over the sidewalks of the political economy space. Why aren't they being picked up?
One of the great strengths of the market economy is the feedback provided by the buying, and abstaining from buying, behavior of the customer. If the Ford Edsel is introduced and the consumer does not buy, then Ford shuts down production and reallocates resources to the production and distribution of a car that better satisfies the demands of the consumer. But the feedback mechanism in the supply and demand of public policies is not as forceful as in the market. Both the demand side and the supply side of politics has distortions that prevent the easy elimination of the $20 bills.
But the "Bad Outcomes" are not trivial when it comes to policy errors. In the 20th century, policy errors led to not only undue suffering by citizens, but in the most extreme forces of policy error the death of millions. In the 21st century, policy errors have threatened security and the very financial stability of the global economy. Why such persistence?
In part, I want to contend, because the debates over policies are confused. In the narrative I would tell for post-1980 economics and economic policy, I'd stress the decline of Keynesian ideas within the economics profession, but the persistence of Keynesian ideas, frameworks and policies (and the institutions that Keynesian economics ushered in during the post-WWII period) in public policy.
Yes, the post-1980 world was one of the ascendency of "relatively" free markets combined with some deregulation, privatization, and open trade. But these policies were always chosen within a broader framework of Keynesian political economy and instituted by Keynesian policy institutions. What we experienced in the UK and the US in the post-1980 world was one of "conservative" Keynesianism, rather than "liberal" Keynesianism, but what we didn't experience was free market economics. In addition, the collapse of communism and the opening of the economies of India, China, and Latin America (and lesser extent Africa) to global trade also reinforced the marginal shift toward "relatively" freer markets and thus the improvements in human well-being.
In short, I am suggesting that there has been a disjoint between the rhetoric and reality of post-1980 political economy. And, I believe this disjoint continues to plague our current policy discourse post-2008. Consider carefully these two recent commentaries by two very significant economic thinkers: Joe Stiglitz and Ken Rogoff.
Stiglitz's article is entitled "A Contagion of Bad Ideas" and the narrative he tells about how in response to the failure of free market policies we needed to respond with a Keynesian stimulus, but that the Keynesian stimulus ballooned budgets, which have now resulted in massive spending cuts. In Stiglitz's analysis will result in wasted resources and undue suffering that will persist for years to come. Again, his framework is coherent, but is it the right framework? It is internally consistent, but is it consistent with the reality it purports to address?
Rogoff's article is entitled "The Second Great Contraction", and it continues the theme from his book with Carmen Reinhart, This Time is Different. The bottom line, the post-2008 situation is not defined by a recession in need of a correction, but instead by a global financial system that is so far over-leveraged that drastic steps at de-leveraging will be required for many years -- default and inflation being among the primary tools. I think Ken Rogoff is a brilliant man, but I honestly cannot buy the cavalier way he talks about 4-6% inflation for several years to set the situation right. The costs of inflation, I believe, are being way underestimated by him and others when they make such suggestions. Again, Rogoff's framework is coherent, but is it the right framework? It is internally consistent, but is it consistent with the reality it purports to address?
Could either Stiglitz or Rogoff make their respective arguments if they saw money as non-neutral, if they saw the capital structure in the economy as consisting of heterogeneous good with multi-specific uses, if they saw the market as a process of ongoing entrepreneurial discovery, learning and adjustment guided by signals and incentives? I often ask my students to think of the capital structure as made up of lego pieces rather than play-doh, and to think about the costliness of mistakes in the construction. Errors with lego constructions require pulling apart piece by piece, carefully setting aside to not lose a piece, and rebuilding piece by piece; errors with play-doh require smashing and remolding with your hands in one-step. One is very costly, the other minimally so. But my lego versus play-doh is just an analogy, not analysis.
At the risk of de-legitimation, I think a major problem with the conventionalist methodology of model and measure in economics is that it blurred some of the major lessons from logic and critical reasoning. Formal modeling was supposed to eliminate confusion in though by making assumptions explicit, and thus eliminating the confusion that results in literary exercises when the same words are used to mean different things, or different words are used to mean the same thing. But as formal tractability became a criteria in theory choice, models became mere instruments. We built toy economies, populated by robot agents. Realism of assumptions was jettisoned. We built coherent frameworks, but sacrificed correspondence to the world we originally wanted to study. Rather than worry about the distinction between validity and soundness, and between good and bad arguments, as matters of critical reasoning; the procedure of testing models against the data would eliminate weak reasoning. It wasn't a matter of philosophic argument, it was a matter of scientific testing.
The post-2008 debates highlight how little we have progressed since 1930 as a discipline. There are $20 bills lying all over the sidewalks. And if we despair over the hopelessness of politics, we must remember Frank Knight's words: "To say a situation is hopeless is to say it is ideal." Obviously, our situation is not ideal, so that must mean it isn't hopeless. Right ideas forged into the right framework can, and will, produce the right public policies that can scoop up those $20 bills and improve the lives of billions of people. But I don't think we get there again until we eschew our preoccupation with toy economies populated by robot actors, and instead work on developing an economics based on the realism of assumptions, populated by capable but fallible human actors, who interact within specified institutional environments that structure incentives, produce a flow of information, and provide disciplinary feedback.
We need ideas, frameworks and policies, but lets make sure they are:
Good ideas --> Good Policies --> Good Outcomes
Political economy ain't rocket science, but it matters a heck of lot more whether we get it right or wrong. As Ludwig von Mises put it:
The body of economic knowledge is an essential element in the structure of human civilization; it is the foundation upon which modern industrialism and all the moral, intellectual, technological, and therapeutical achievements of the last centuries have been built. It rests with men whether they will make the proper use of the rich treasure with which this knowledge provides them or whether they will leave it unused. But if they fail to take the best advantage of it and disregard its teachings and warnings, they will not annul economics; they will stamp out society and the human race.