Jean-Bernard Chatelain* and Kirsten Ralf
- This article was originally published in the September 2020 edition of the 5 papers…in 5 minutes.
Economic stabilisation policies aim to reduce persistent deviations in production, prices and risks from their average trend. To achieve this, in case of recession, falling prices or increased risk, public policy makers lower the key interest rate, increase central bank liquidity offers, increase public spending, and or reduce income taxes. In the case of a boom, they do the reverse. This is called a “negative feedback” mechanism, used to stabilise changes over time in simple or complex systems, human or natural, in domains ranging from physics, biology and ecology to economics and management. At the end of the 1950s, a scientific field was established to study this negative feedback mechanism. It came out of mathematics applied to engineering and had multidisciplinary applications (1). For most economists, questioning the effectiveness of economic stabilisation policies is inappropriate at the present moment, but that was not so in the 1970s and 1980s. Friedman, Hayek, Lucas, Kydland and Prescott (2) all demonstrated that radical impossibilities obstructed public policy makers’ negative feedback mechanisms and argued that the negative feedback of supply on demand in private markets will always be more efficient in stabilising the economy.
In this article, Ralf and Chatelain show that the importation of methods from the scientific domain by macroeconomists studying stabilisation policies was fast and intense in the 1960s. However, such transfers of methods, which contribute to scientific progress, slowed down for 15 years during the next two decades. They also show that the proofs offered by those who held that it is impossible for public policy makers to use negative feedback mechanisms come from two findings that were exaggerated to the extreme.
The first finding, called the Lucas critique, showed, in 1976, that it is, in principal, impossible to evaluate the parameters of negative feedback, which would lead to two-way causality (3). However, the so-called instrumental variables method can address that thorny question. The authors note that the two-way causality also arises in the private sector in relation to supply and demand feedback.
The second finding, called “time inconsistency” (Kydland & Prescott 1977), (4) pushes the extreme proposition that it is impossible in principal for a public policy maker to have any credibility: he might go back on his decision at any moment. Another variant, by Barro and Gordon (1983) further assumes that central bank preferences will always be, in principal, to demand lower unemployment than frictional unemployment, and more inflation than the equilibrium inflation target. An article by John Taylor (1993) put paid at least in part to this controversy in the academic world. He rehabilitated the thesis of the effectiveness of monetary stabilisation policies. Taylor demonstrated a rule whereby the key interest rate responds to inflation and production gaps with arbitrary parameters that roughly predict the Fed’s key interest rate. However, his scientific method is fragile: he relies on just 24 three-monthly observations between 1987 and 1992, he overvalues the interest rate’s reaction to inflation during that period, and he does not take into account the effect of the interest rate return on inflation (which would have answered the Lucas critique).
The scientific method has been much discussed in the search for a treatment for Covid-19 in France. In macroeconomics controversies, as in other sciences, it is quite normal that the scientific method should sometimes be mishandled during challenges to methodological principles and bold projections.
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(1) This scientific domain obtained new and spectacular results in the 1960s, contributing to space exploration and GPS navigation, among thousands of other applications.
(2) Various contributions that validated the ineffectiveness of economic stabilisation policies saw their authors win the Nobel Prize (Friedman, Hayek, Lucas, Kydland and Prescott).
(3) We could not, for example, measure the transmission of the key interest rate effect on inflation because the key rate itself also reacts to inflation in the opposite direction when there is negative feedback from the central bank.
(4) Takes a mathematical result from a test run by Simaan and Cruz in 1973.
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References
Original title of the article: How Macroeconomists Lost Control of Stabilization Policy: Towards Dark Ages
Published in: European Journal of the History of Economic Thought (Dec. 2020)
Available at:
https://www.researchgate.net/publication/336103794_How_Macroeconomists_Lost_Control_Towards_Dark_Ages
* PSE Member
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