The Collapse of Consensus: the Contemporary Confusion over Macroeconomic Policy

Graham Bird - December 2012


A casualty of the enduring financial and economic crisis that has beset the world since 2008 has been the consensus over the design of macroeconomic policy. For as long as the subject has existed, there have been jokes about the inability of economists to agree and to offer clear and unambiguous policy advice. For many years an example of disagreement was the lively and frequently heated debate between Keynesians and monetarists about macroeconomic theory and policy. However, for a protracted period prior to the crisis, there had been an era of relative tranquillity. Disagreements seemed to have been replaced by a substantial degree of consensus. Old hatchets seemed to have been buried. Peace in macroeconomics seemed to have broken out. Agreement had formed around an eclectic compromise between the polar extremes. It appeared to have become accepted by many economists that economies exhibited Keynesian properties in the short run and new classical ones in the long run.


The crisis of 2008 and beyond has changed all this. Initially consensus was maintained, but it now formed around a more typical Keynesian approach based on expansionary fiscal (and monetary) policy. This was aimed at stimulating aggregate demand and avoiding recession and rising unemployment. The new consensus did not last long. It has been replaced by sharp divisions between those who continue to favour further fiscal stimulation and monetary expansion, and those who argue for ‘fiscal austerity’ and tighter policies to control the supply of money. Clearly the hatchets have not been buried after all. For many outside observers the old jokes about economists seem to be more relevant today than they have ever been. With such sharp disagreements amongst economists coming to the surface, it has become increasingly difficult for policy makers to determine the best path to follow. Life for the macroeconomic policy maker must seem very confusing. What destroyed the consensus on macro policy? Will it be re-established? And what would be the consequences of the divisions remaining? This article examines these questions.


The lay out of the article is as follows. Section 2 briefly discusses past debates over macroeconomic theory and policy. Section 3 catalogues the emergence of a consensus in the period after the late 1980s. Section 4 describes the impact of the global financial and economic crisis on this consensus and the revival of Keynesian ideas. Section 5 examines how and why the new Keynesian consensus evaporated so quickly and discusses the current state of macroeconomics. Finally, section 6 ponders on the future.



Past debates: Keynesians, monetarists and new classical macroeconomics

Debates in macroeconomics are hardly new. Although it may be somewhat of a caricature, Keynesians are seen as believing that recession and unemployment reflect deficient aggregate demand and that, in symmetrical fashion, inflation reflects excess aggregate demand. They believe that governments have a responsibility to manage aggregate demand in a way that avoids high levels of unemployment and rapid inflation.

The main policy instrument for achieving this is fiscal policy, or so-called ‘functional finance’. Monetary policy based on controlling the money supply is viewed as being relatively ineffective, because the demand for money is assumed to be unstable, and the interest rate elasticity of the demand for money is assumed to be relatively high. This implies that the outcome of controlling the money supply will be unpredictable or that it will be neutralised by offsetting changes in the demand for money. It further implies that even if the effects are predictable, they will be small because changing the supply of money will have little effect on the rate of interest. However, the circumstances that make monetary policy ineffective also make fiscal policy particularly powerful.


Monetarism and new classical macroeconomics (NCM) takes a position that is at the opposite polar extreme. Monetarists introduced the notion of a ‘natural rate of unemployment’ which is not sensitive to changes in aggregate demand. Inflation is viewed as purely and simply (or ‘always and everywhere’) a monetary phenomenon. Not only is there little point in trying to manipulate aggregate demand, but in any case there is no scope for doing so. According to monetarists, fine tuning of fiscal policy does not work because of variable lags and because fiscal expansion leads to an increase in the rate of interest that then crowds out private investment. According to new classical macroeconomics, as governments increase their expenditure, people anticipate a future increase in taxation and therefore increase their current saving to meet it. Either way, there is no impact on overall aggregate demand. While the theory of monetarism and NCM ruled out fiscal policy, it ruled in controlling monetary aggregates. Indeed, the focus of policy was on a monetary rule, rather than on the discretionary use of monetary policy which was seen as suffering from some of the same shortcomings as discretionary fiscal policy. A monetary rule that allowed the money supply to rise only in step with the trend rate of growth in the demand for money was presented as providing automatic macroeconomic stabilisation. In a period of recession, for example, sticking to the monetary rule would lead to a fall in the rate of interest which would help to stimulate economic activity.


Each of these polar extremes had their period of domination over actual policy. Thus by the end of the 1960s, President Richard Nixon was declaring that ‘we are all Keynesians now.’ However, as global economic performance turned sour in the mid 1970s there was a reassessment. Keynesian ideas seemed to be inconsistent with the simultaneous existence of high unemployment and rapid inflation (stagflation). Policy makers turned to a theory that put its emphasis on explaining inflation and prescribing a policy to deal with it. Inflation was seen as ‘public enemy number one.’ By the early 1980s, it seemed that policy makers were all monetarists, although they were also influenced by ‘supply siders’ who favoured tax reductions as a way of stimulating economic growth. However, just as a crisis brought down the Keynesian consensus, the global stock market crash in 1987 brought the era of monetarism to an end. It had in fact been faltering for some time beforehand since it had failed to deliver on its promise of reducing inflation without any increase in unemployment.


Once more, macroeconomics had to be rethought. Consensus around polar extremes had not worked. The search was on for something better, upon which a consensus could be formed.



A new consensus based on macroeconomic eclecticism emerges

Having identified weaknesses with theories that lay at the polar extremes, it was perhaps natural to seek out areas of compromise on which there could be agreement. From a theoretical perspective the importance of time came to the rescue. Macroeconomics, and indeed most of economics, is about minding Ps (prices) and Qs (quantities). Keynesians argued that, in circumstances of macroeconomic disequilibrium, it was the quantity of output (and therefore employment) that tended to change. New classical macroeconomics argued that it was the price level that adjusted. The theoretical compromise was to suggest that Keynesians were right in the short run but NCM right in the long run. This left scope for governments to engage in policies designed to influence aggregate demand and to stabilize economies, but only in the short run. Where did the compromise in terms of theory leave the specifics of macroeconomic policy?


As far as fiscal policy is concerned there was broad agreement that the problems associated with lags created difficulties for fine tuning and for its discretionary use. However, it was also acknowledged that, within limits, fiscal policy could (and should) be used in a quasi-Keynesian way to massage aggregate demand according to the stage of the business cycle. In particular, the automatically counter-cyclical properties of fiscal policy were to be welcomed and endorsed. These areas of consensus found expression in ‘golden rules’ that envisaged that fiscal deficits and surpluses should balance out over the cycle, and in the fiscal targets incorporated into Europe’s Stability and Growth Pact (SGP) that allowed for limited deviations from fiscal balance.


As far as monetary policy is concerned there was a general movement away from endeavouring to tightly control monetary aggregates. This recognised the difficulties in doing it. It also recognised the increasing evidence that the demand for money was not as stable as monetarists had claimed and that financial innovation made the velocity of circulation higher and less stable. However, in the belief that expenditure decisions were significantly influenced by the rate of interest, monetary policy underwent a metamorphosis and emerged as ‘inflation targeting’. The rate of interest was set by informally applying some version of the Taylor rule that offered an implicit formula for relating it to ongoing and expected inflation, moderated by the amount of spare productive capacity in the economy.


Macroeconomic policy became based on accepting the parts of Keynesianism that seemed to be valid and discarding the other parts, with much the same applying to monetarism and NCM.


The eclectic approach to macroeconomic policy seemed to work fairly well, and the post 1987 period saw the ‘Great Moderation’ with advanced economies avoiding the instabilities that had characterised earlier periods and enjoying a period of reasonably sustained economic growth. From the mid-to-late 1990s onward, there was what Mervyn King, Governor of the Bank of England, described as the NICE decade, with Non Inflationary Consistent Expansion. But was everything quite so satisfactory? Was the consensus around eclecticism really being implemented as this superficial picture suggested? There is a dissenting point of view. In the early 2000s, and according to some calculations, the US Federal Reserve departed from the Taylor rule and allowed interest rates to fall too low. The intention was to pull the US economy out of the stagnation that it had been experiencing as a result of the bursting of the dot com bubble and 9/11, as well as the appreciation in the value of the dollar which weakened US competitiveness. But some observers argue that this policy decision was unwise and was a key factor in leading to the housing bubble and the crisis in the late 2000s. In Europe, the SGP was ineffective in constraining fiscal deficits. The large fiscal deficit and the related accumulation of debt in Greece proved to be a key factor in triggering the Eurozone crisis. On this interpretation a problem was that the compromise on policy design was not always being applied.


It is often in the midst of a crisis in economic performance that there is a reassessment of macroeconomic policy. This happened to Keynesianism in the mid 1970s and to monetarism in the late 1980s. It also happened to the more eclectic policy approach in the late 2000s when confronted with the global economic and financial crisis.



A Keynesian revival: but not for long

The initial response to the crisis was the formation of a broad consensus around a typically Keynesian combination of macroeconomic policies. Policy makers throughout the world believed that the crisis would result in a global deficiency in aggregate demand as both private sector consumption and investment fell. They believed that this would lead to recession and rising unemployment. There was the threat of a depression similar in scale to that experienced in the 1930s. It was against the backdrop of the Great Depression that Keynesian ideas had been born. It is unsurprising therefore that it was in the context of a potential re-enactment of the Great Depression that there was a revival of Keynesianism.


There was only limited scope for cutting interest rates; they encounter a zero lower bound. While interest rates were cut, monetary policy instead focused on trying to overcome the ‘credit crunch’ by increasing the availability of credit through quantitative easing. There seemed little to worry about in terms of inflation.


Even so, greater emphasis was placed on fiscal policy, where the consensus favoured a fiscal stimulus. This appeared to be a logical response. If the private sector was likely to reduce spending then it seemed appropriate to conclude that a fall in aggregate demand would only be avoided if the public sector increased it. Moreover, the traditional monetarist and NCM criticisms of expansionary fiscal policy seemed less relevant in the economic environment of the late 2000s. There was little danger of crowding out given the commitment of the monetary authorities to keep interest rates low. The concern that fiscal stimulation would only have a lagged effect did not appear to carry weight in circumstances where it seemed highly unlikely that there would be a significant short term increase in economic activity resulting from increased spending in the private sector. A policy response based on Keynesian policies was enthusiastically and unanimously endorsed by the G20 meeting in London in April, 2009. However, the consensus did not last.



The Keynesian consensus evaporates

By the time of the Seoul G20 summit in 2011 the consensus surrounding macroeconomic policy had evaporated. It disappeared as quickly as it had appeared. Emerging economies had been able to sustain respectable levels of economic growth and were concerned that quantitative easing in the US would threaten this by driving down the value of the dollar and therefore driving up the relative values of their currencies. Even within advanced economies some influential academic economists started to strongly express worries about fiscal stimulation and monetary expansion, arguing that fiscal deficits should be relatively quickly brought under control and that quantitative easing should be discontinued. Fiscal deficits and debt accumulation were increasingly presented as leading to future crises, and monetary expansion was seen as eventually leading to inflation in a fairly conventional monetarist way. Against this background, the policies pursued in the immediate aftermath of the global economic crisis were presented as undermining market confidence with this in turn having a negative effect on private sector investment and therefore on economic growth.


Policy makers were now receiving conflicting advice. While there was agreement that policies needed to focus on encouraging economic growth, there were sharp divisions and considerable disagreement over what policy tools would deliver it. While the ‘new school’ argued that it would be best achieved by a period of ‘fiscal austerity’, diehard Keynesians continued to argue that economic growth would be adversely affected by cutting back on government expenditure. Indeed, they argued that economic growth would only be achieved by further fiscal expansion, and that economic growth would itself deal with the problems of fiscal deficits (by increasing tax revenue) and debt (as the capacity of economies to service and sustain debt would improve). If ever there was a good example of ‘two handed economists’ who said ‘on the one hand’ but ‘on the other hand’, then the current disagreement over fiscal policy is it. What is a policy maker to do and how likely is it that the divisions in contemporary macroeconomics will be resolved?



What does the future hold: consensus or confusion?

One way of resolving theoretical disagreements in economics is by reference to empirical evidence. However, in the case of the contemporary divisions in macroeconomics it is unlikely that this holds the key. What evidence is available applies to earlier periods and to different circumstances. Advocates of opposing strategies can each point to some evidence in support of their case. Excessive fiscal laxity can lead to crises. Fiscal correction can have a negative effect on economic growth. Moreover, empirical investigation often encounters the problem of the counter factual. Thus critics of fiscal stimulation argue that there is little evidence to suggest that it has had the desirable effect on output and employment. Supporters claim that things would have been much worse had fiscal stimulation not occurred. They also claim that these things take time to work and that it is premature to reach a negative judgement.


If it is difficult to resolve the disagreement over policy by empirically testing the theories, then a number of outcomes may be anticipated. First, different countries may follow different strategies, with the particular choices reflecting politics as much as (or more than) economics. Thus, left wing or left of centre governments may be expected to favour fiscal stimulation rather than fiscal austerity. However, their freedom to choose will be constrained where they are looking for outside financial assistance. Right leaning governments may opt for the austerity route, with an eye to impressing international capital markets. But they will not want to risk extreme political unpopularity at home, especially if elections are close at hand. Moreover, when there is disagreement amongst economists, politicians will be able to draw on some degree of support for their politically preferred strategies. At the very least, they will be able to claim that the economists cannot agree amongst themselves. A problem with this outcome is that an approach to macroeconomic policy that is uncoordinated internationally, with some countries opting for continued fiscal and monetary expansion and others opting for greater stringency, is likely to make matters worse and accentuate the global economic imbalances that, according to some interpretations, were an underlying cause of the global economic crisis.


A second outcome of the contemporary divisions could be that there will be a macroeconomic compromise. Governments may try to resolve the ambiguities by opting for a combination of relatively loose monetary policy and relatively tight fiscal policy. However, at best this is an uneasy solution that lacks strong theoretical or empirical support. At worst, it may simply turn out that the effects of the two policy instruments cancel one another out with no overall impact on economic growth and employment. It may look as though governments are doing something, but the net result may not amount to much.


A third outcome is that, in effect, governments do nothing at all. If there is deep seated disagreement in terms of the way in which policy should be modified, the inclination may be to opt for the status quo and policy inaction. A form of policy paralysis ensues. Policy makers will inhabit a macroeconomic no man’s land. The problem here is that this is a solution favoured by neither those who believe in fiscal stimulation nor those who see the need for fiscal austerity. Yet it may be the most probable short term scenario.


In the US the future design of macroeconomic policy is particularly intriguing. In the run up to the recent presidential election neither side was anxious to do anything that appeared to be extreme, for risk of losing the middle ground. In the aftermath of the election, and with a rapidly approaching ‘fiscal cliff’, as tax increases and cuts in government spending are scheduled to kick in at the end of the year, there is little evidence of a compromise emerging. Here it could be a political stalemate that in effect dictates policy. In Europe, tighter fiscal discipline is embodied in the so-called ‘fiscal compact’ that is likely to be activated in January 2013. However, it is debatable how much the compact reflects a genuine consensus amongst European policy makers over the design of fiscal policy and the superiority of balanced budgets. The compact may instead represent a desire to calm international capital markets and a way of meeting Germany’s preference for fiscal austerity in order to guarantee further financial support for ailing Eurozone economies.


As far as monetary policy is concerned, politicians may be happy to delegate policy to an independent central bank. But, as noted earlier, the problem here is that interest rates encounter a zero lower band and quantitative easing is unproven. There is a general presumption that tight monetary policy is more effective at dealing with a cyclical peak and at controlling inflation than it is at shifting an economy out of a prolonged trough and encouraging economic growth.


A fourth outcome leads on from this and looks to the longer term. A lesson from the global economic crisis may be that inflation targets have been set too low, reducing the scope for monetary policy in a recession. Some economists at the IMF have suggested that it might it be better to have inflation targets of 4 per cent rather than 2 per cent. The problem here is that politicians will not want to appear to be favouring higher rates of inflation or to be setting out to reform the mandates of independent central banks in ways that could be presented as merely serving political convenience. The central banks themselves will not want to risk losing the gains that have been made by inflation targeting as a way of anchoring inflationary expectations. So it follows that this outcome is unlikely.


If monetary policy is constrained by the lower zero bound and doubts about the effectiveness of quantitative easing (possibly because it is matched by a fall in the velocity of circulation), and there are also debates about the use of discretionary fiscal policy, where does this leave us?  Perhaps the long term solution is to expand the degree of automatic fiscal stabilization by making tax systems more progressive and flexible and by increasing the sensitivity of government welfare payments to the stage of the business cycle. Although there may be a good deal of appeal to shifting in the direction of enhanced automatic stabilization, there are again political constraints in achieving this. Changing tax systems and government policies on welfare payments and unemployment benefit will not be easily achieved, and politicians may be expected to be reluctant to pursue such policies if it damages their electoral prospects.



Concluding remarks

With the range of problems listed above, the conclusion follows that macroeconomic policy is in for a period of disarray. Even where there appears to be consensus, this may serve more of a political purpose than reflect a genuine meeting of minds. Words will be chosen that provide a veneer of agreement but actually hide significant division. Thus the IMF talks about ‘fiscal space’, with fiscal austerity being appropriate only when this space has been filled up. But ‘fiscal space’ is an ill defined concept. For the foreseeable future, the days of a Keynesian or monetarist consensus, or a consensus around a compromise that draws on both of the paradigms have gone and are unlikely to return. Confusion over the design of macroeconomic policy seems likely to persist for some time to come and the consequences will be reflected in inferior global macroeconomic performance.