Is a major change in policy thinking imminent? Will Hutton’s piece in Sunday’s Observer focused on the question of quite what the Labour party stands for. It is relatively clear what it is against, but its positive project is rather less obvious. And it needs such a project if it is going to counteract Conservative economic strategy. In the course of his discussion, Hutton argues that we can expect a change in the Coalition’s approach to deficit reduction some time soon and the recent less than congratulatory OECD report on UK policy is evidence in support of the case:
George Osborne’s calculation was that the combination of dramatic early austerity, very low interest rates, subsequent recovery and pre-election tax cuts as rewards would do the trick. He genuinely believed the free market, sound housekeeping story. Now he is not so sure. He is discovering, as Bank of England chief economist, Spencer Dale, recently acknowledged, that the government knows a great deal less about how the economy works than it thought.
The OECD could never have written its report raising questions about the government’s strategy without Treasury clearance. Its argument that there had to be more flexibility in the way the deficit reduction programme is implemented, reflecting the condition of the real economy, reflects the way the internal argument is going. Gus O’Donnell, the cabinet secretary, is on record as urging a plan B. The Lib Dems have been given the wink that they should not desert the ship; there will be some give on fiscal policy and on the NHS. Increasingly, the only question is in what form and how it is to be sold.
I read this article while finalising the draft of a piece on ‘economic approaches’, which seeks to compare mainstream orthodox economics with selected alternative schools of economic thought. Hutton’s observation that Obsorne “is discovering … that the government knows a great deal less about how the economy works than it thought” resonated strongly.
One of the great failings of mainstream economics is its misplaced certainty. Many economists exude unshakable confidence in the veracity of their analysis. Closer scrutiny suggests greater circumspection would be wise. For the economy to be predictable and manageable in the way the orthodox economists of the Treasury would wish it to be it must be understood primarily through mechanical metaphors. Relationships between key economic variables are stable, fixed and of known magnitude. The various components fit together as the moving parts of the ‘machine’ that is the economy. The economy is a closed system involving well-defined feedback loops. It oscillates around equilibrium. We may never return to the 1960s heyday of Keynesian fine-tuning, but there remains a belief that there are policy ‘levers’ that can be pulled to regulate the economy in well-defined ways and get it ‘back on track’.
Alternative schools of economic thought would change the root metaphor. They might perhaps favour something altogether more organic. The economy is an evolving, open system embedded in historical time. Learning, creativity and discovery are crucial. Irreversibilities are everywhere. Economic agents must act, but in the face of radical uncertainty. Market sentiment, habit, imitation and convention play a significant role in shaping behaviour. Through their actions economic agents transform the structure of the economy. Economic processes are non-ergodic: the future will not be like the past, even if there is a family resemblance. With this understanding of the economy, economics becomes qualitative and interpretative rather than a hard mathematical science. There is skill – an art, even – in reading the economy, but it isn’t something that is easily quantified. You only have to think of how frequently economic forecasts are revised, even just a few months after they are made, to realise that what we are typically being presented with is a veneer of technocratic expertise and spurious precision.
One of the first posts I made over at Liberal Democrat Voice, back last summer, expressed scepticism about the Chancellor’s deficit reduction plans. In the course of that post I observed:
One issue we face is that our understanding of the economy and how it will respond to the Coalition strategy is rather less well-founded than it might first appear. Macroeconomic policy is a matter of judgement rather than science, as anyone who has read the minutes of the Monetary Policy Committee will see only too clearly.
The sort of models used by the Treasury and others to estimate the impact of policy interventions struggle to account adequately for more qualitative factors like household confidence and expectations about the future. There is limited room for hopes and fears, the reactions of consumers to unknown but possibly negative events, the ‘animal spirits’ that Keynes considered fundamentally shape the fate of investment and the economy more generally. The economy is not a well-oiled and predictable machine to be finely tuned, it is a much more organic and irrational beast.
I’m not feeling any particular schadenfreude. The misfortune is shared. I am glad if Mr Osborne has woken up to the point. Yet, while these might be interesting theoretical excursions into economic ontology, the key question is what difference it makes in policy terms.
Confidence is key. But instilling and sustaining confidence is a complex business. In my view the Chancellor was right to focus upon the way in which his plans were received and whether they were judged to be credible. But he was wrong to focus attention almost exclusively on appeasing the bond markets – those which Paul Krugman has disparagingly dismissed as mythical ‘bond vigilantes’. The way in which his plans were received by every business and household in the land is just as important. And the way in which they are received is as much about how they are narrated as about how things – such as after-tax income – actually change. The government is not entirely in control of that narrative. If economic agents have a policy-induced lack of confidence in their own future then that will carry implications. As I continued my LDV post:
The narrative of the near future is tailor-made to undermine confidence: swingeing public sector job cuts, restrictions in benefits, generally very choppy economic waters. It is not surprising that many are fearful. That leads households to hunker down and reduces effective demand. Rational private sector suppliers trim their sails accordingly.
Equally, we cannot ignore the brute fact that the government is withdrawing significant amounts of money from the economy. If fiscal tightening is not accompanied by an increase in confidence sufficient to boost private investment and generate private sector jobs then it will more likely lead to a vicious circle than a virtuous spiral.
‘The economy’ is a beast that is not easily tamed. Economic policy makers may have felt they were in control. But that was always an illusion. Some may feel it is a necessary illusion when instilling confidence is so important. It is an illusion nonetheless. It appears to be an illusion that, in No 11 at least, is finally being dispelled. The first step on the path to enlightenment.