Economic Science and the EU

June 22, 2013

Every few decades or so we are brutally reminded that the global economic system can experience serious dysfunctions and that the science called upon to find the necessary remedies is rarely, if ever, up to the task. The latest controversies among economists regarding austerity policies or possible solutions for dealing with sovereign debt are a case in point.

The head of the IMF’s research unit and potential Nobel-prize recipient, Mr Olivier Blanchard, has recently revealed that his institution is partly responsible for botching the rescue of Greece and, by miscalculating the impact of austerity policies, for plunging Spain, Portugal, Italy, Ireland and even the Netherlands into recession (Alternatives économiques).

In a parallel development, a 2010 study by former IMF chief economist Kenneth Rogoff and Carmen Reinhart of Harvard University has stirred up a huge controversy involving three economists from Amherst University and Nobel-prize laureate Paul Krugman. The study claimed to have found a connection between economic growth and public borrowing: whenever government debt rises above 90 percent of GDP, the data available seems to indicate that growth slows down, although the authors freely admit that they are not entirely sure if higher debt leads to slow growth or whether it is the other way around (The Economist).

Almost as influential among EU finance ministers is a second Harvard study, “Large Changes in Fiscal Policy : Taxes vs. Spending “, authored by Alberto Alesina and Silvia Ardagna. According to it, deep cuts in public spending generally lead to economic expansion, not to contraction. As the two have explained during a meeting in the spring of 2010 with Ecofin ministers, austerity policies give the private sector the confidence it needs to increase their investments, which compensate for the budget cuts . The study found a convert in Jean-Claude Trichet, who claimed the same year that

[…] the ideea that the austerity measures could bring about stagnation is incorrect […] I am firmly convinced that in the current circumstances such policies that inspire confidence would reinforce, not affect the economic recovery because today’s essential factor is confidance.” (as quoted by P. Krugman in New York Times)

This is all academic, one might say. Only, in an unfortunate turn of events, Mr Rogoff’s or Alesina’s studies determined the European Union’s neoliberal-leaning politicians to adopt stringent austerity policies aimed at reducing public debt, thus bringing about the current recession on the continent. As Mr Rogoff argues, however, his recipe for debt reduction involved not austerity, but writing down bank debt, allowing for some inflation and using “financial repression” techniques.

This, of course, is not the first time that the IMF’s policies have gone tragically wrong, or that macroeconomists’ advice has fallen short of expectations. The ‘dismal science’ – a nickname for economics that many Asian, Latin American and European nations would readily approve as appropriate – is after all relatively young and imperfect.

In fact, during the discipline’s two and a half centuries of evolution, the most influential theorists were actually members of entirely different professions. As we know, Adam Smith was initially a customs agent and a professor of moral philosophy; David Ricardo – a stockbroker; Thomas Malthus – a pastor; Quesnay and Juglar – medical doctors; Marx – a philosopher; and Leon Walras – a mining engineer and journalist. As a rule of thumb, policy recommendations by economists have not been consistently successful to date, when they were not ignored by governments on ideological grounds. Even well-known policies such as Roosevelt’s New Deal were discontinued before they could produce their full effects, such as solving mass unemployment in the US. The latter, as J.K. Galbraith pointed out, was solved not by the adoption of macroeconomic policies, but inadvertently by Hitler, who decided to wage war on the West.

The current economic climate tends to lend full credibility to Keynes’ stagnationist thesis, as it bears many similarities to the long period of stagnation following the 1929 crash. His thesis is again influencing business people and social scientists alike, making economic recovery a distant and uncertain prospect, especially within the EU.