The case against stabilization policy — why is the discussion in the U.S. often so different from Europe?

The case for (and against certain types of) stabilization policy is a highly disputed issue. This is at least the case in the U.S. but applies to a certain fraction of European economists — this blog is a nice example. If you need another example, just have a look a the new manifesto published by the “old” Keynesian (in the terminology of an JEP’s article by James Tobin on differences between “new” and “old” Keynesians, in terms of freshness of his ideas Solow seems to be as young as he ever was) Robert Solow and some European fellows, see the link here. Even under my qualifications however, it is justified to claim that the debate is much more alive in the U.S. — not among the mainstream of European economist.

I would like to discuss three points in a provocative manner:

  1. Are there any principles and guidelines on which macroeconomists can agree on and how and why does the discussion in Europe differ from other places in the world, e.g. North America?
  2. Are the differences minor — some might say purely semantic — or does a fundamental disagreement exist which might be due to a different historical background?
  3. Does the understanding of what might be an appropriate policy change with a new generation of macroeconomists starting professional careers at universities, think tanks and central banks?

Let me briefly start with the first issue.

Economists can agree on the first theorem of welfare economics — but interpret the results differently as Dani Rodrik discussed. The passage is worthwhile to be quoted here:

You can tell what kind of an economist someone is by the nature of the response s/he offers when confronted with a policy issue. The gut instinct of the members of the first group is to apply a simple supply-demand framework to the question at hand. In this world, every tax has an economic deadweight loss, every restriction on individual behavior reduces the size of the economic pie, distribution and efficiency can be neatly separated, market failures are presumed non-existent unless proved otherwise (and to be addressed only by the appropriate Pigovian tax or subsidy), people are rational and forward-looking to the first order of approximation, demand curves always slope down (and supply curves up), and general-equilibrium interactions do not overturn partial-equilibrium logic. The First Fundamental Theorem of Welfare Economics is proof that unfettered markets work best. No matter how technical, complex, and full of surprises these economists’ own research might be, their take on the issues of the day are driven by a straightforward, almost knee-jerk logic.

Those in the second group are inclined to see all kinds of complications, which make the textbook answers inappropriate. In their world, the economy is full of market imperfections (going well beyond environmental spillovers), distribution and efficiency cannot be neatly separated, people do not always behave rationally and they over-discount the future, some otherwise undesirable policy interventions can generate positive outcomes, and general-equilibrium complications render partial-equilibrium reasoning suspect. The First Fundamental Theorem of Welfare Economics is proof, in view of its long list of prerequisites, that market outcome can be improved by well-designed interventions. Since they have given up on the textbook model, members of this group have an almost-infinite variety of “models” to choose from as they think of public-policy issues.

The first group’s instinct is always to apply the first-best reasoning to the case, ignoring market imperfections in related markets, while the second group almost always presumes some market imperfections in the system. I am over-simplifying a bit, but not a whole lot.

Here is my first hypothesis: Along this line, I would say that indeed it is possible to be a successful economist in the U.S. — publishing in AA journals — and still belonging to the second group, whereas in Europe, being member of the first group is always a save decision, being in the second group is a very seldom accident and risky for an academic career.

Let’s come to the second issue. I observe that there are differences and I would like to mention some observations — let’s say “anecdotical evidence”. I know that this a highly non-scientific exercise, but I would like to provoke answers.

Discussions on appropriate stabilization policies and even the label “Keynesian” was never as much “out-of-fashion” in the U.S. as it seems to be the case in mainstream academic circles in Europe — maybe because it was never used as much in “ideological” way. Having in mind a decade of discussions among German economists but also with several colleagues from European research institutes and universities, I would say, being an economist in the second group of Rodrik’s classification scheme in Europe is often accompanied by being accused to avoid the discussion of “real” issues, i.e. “Eurosclerosis”, labor and product market reforms, banking sector reforms in Europe and being labeled as an “old-fashioned” economist. Without presenting dozens of quotations here — see the discussion in the blogs of “Handelsblatt” or “Financial Times Deutschland” as examples — tone and mode of these discussions are often expressed as: “Whatever happens, we should never fall back into the old sins of the past, i.e. exploding government balances due to unwise politicians (unwise trade unions, …) which was a complete mess” (BTW, the reference to the 1970s always comes in the following style: “as we definitely know, the trial to make macroeconomic fine tuning was a complete mess, we don#t even have to talk about this….”). The problem is comparable to the problem labeled “original sin” — a label used in development economics for the fact, that heavy indebtedness in foreign (hard) currency limits the scope for an independent development path.

Here is my second — provocatively formulated — hypothesis: Being an economist in the second group in Europe you are in general accused of either closing your eyes for the “real problems” or having in mind a manipulative intention to fall into the world of “original sin”. In contrast, the way, Americans might deal with these issues is more pragmatic.

Since I commute using the wonderful ICE connection between Berlin — where I live and work — and Hamburg — where I teach and work — and thanks to modern technology with audio books and iPods I find more time to learn about U.S. history, the self-understanding of U.S. citizen and American pragmatism. American pragmatism seems to me fundamentally different from the way Europeans dealt with issues like government interventions, economic stimulus and the culture of debate in the past.

Here is my third hypothesis: As long as it pays off in terms of economic well-being and voter’s satisfaction, Americans seem to be more willing to accept “the case for” government intervention than (economists) in Europe.

Let’s come to the last point on my list: Is there any hope for change. Well, yes and know. From a European perspective, quite a few economists have seen their profession as a “social science”, where different views exist (but you have to subscribe to one view to be credible!) and the battle of views is shaping the future of the science. In the U.S., economics — especially mainstream macroeconomics — has become a hard science. If you are looking for references, read the nice article by Gregory Mankiw in the JEP, titled: “The macroeconomist as scientist and engineer“.

Here is my last hypothesis on this issue: Indeed, I have the impression, that the new generation of economists finishing high-level Ph.D. courses, coming back after having migrated to the U.S. — here is a nice homepage about “German economists abroad” which shows that this is not a minor issue — are educated as Mankiw explains: “God put macroeconomists on earth not to propose and test elegant theories but to solve practical problems.” This is perhaps not a bad approach at all.

2 Responses to "The case against stabilization policy — why is the discussion in the U.S. often so different from Europe?"

  1. David F. Milleker   March 1, 2008 at 12:04 pm

    Ulrich, this is an interesting point you are making. I’m not so sure, though, whether America’s discussion on macroeconomic stabilisation policy is really that much more pragmatic than Europe’s as your post suggests. My perception is rather that while there might be a much broader centre ground between two groups that are much more in the trenches. Just look at institutions such as Cato Institute, Heritage Foundation or Mises Institute on the side of those opposed to it. Perhaps the broader centre ground is a reflection of the fact that the academic line-up is not that much along political partisan lines than is usually the case in Europe.Two other things you might consider as well: a) The US has a lot less of automatic stabilisers in place than most European countries which makes for a more pronounced case of stabilisation policy. b) most European countries have the individual perception of being small open economies thus being a lot more prone to the original sin problem than the US with its long-standing position of the international anchor currency. Somehow this small country perception has been carried straight over to the EMU stage as collective perception. That might take some time to change – especially since the institutions are still national rather than EMU-wide.All the best, David

  2. Guest   March 2, 2008 at 12:36 pm

    I remember well how the U.S. economy’s success story since the mid-1990s on all fronts (growth, productivity, innovation, fiscal balance, low public debt, full employment) was perceived in Europe as the ultimate proof that the Anglo-Saxon hands-off free market model is superior. I think this shaped policy and the academic discussion in Europe profoundly.