Macroeconomic forecasting normally takes policy responses and the impact of politics on policy choices and on policymaking institutions as exogenous and focuses on forecasting exercises in which forecasts are conditional on particular policies. The dramatic differences in policy responses and in economic performance during the first year following the respective outbreaks of the Great Depression and the recent global financial crisis illustrate that even ballpark forecasting of policy responses is quite important for forecasting economic developments (see Cukierman 2009a for a systematic comparison of policy responses to the two crises).
Four classes of (partially overlapping) factors affect policy choices: Ideology, policymaking institutions, politics, and accepted economic knowledge. Ideology determines the broad long-term objectives to which policymakers of a nation aspire. Although, due to various constraints, those objectives are seldom fully achieved, they constitute an important input into attempts at forecasting policy responses. For example, the belief in democracy and the allocative efficiency of private enterprise is a core characteristic of Western ideology, while the currently held belief in free enterprise subject to tight control by ruling elites characterises contemporaneous China.
Policies are implemented by means of policymaking institutions like the legislative and executive branches of government and/or by appointed bureaucrats with appropriate expertise. In democratic countries, fiscal decisions are normally initiated by the executive subject to approval of appropriate majorities within the legislative branch of government. Monetary policy is nowadays determined mainly by central banks. Regulation of economic activity in various areas, including inter alia the financial sector, is executed by various regulatory authorities. These bodies may also initiate long-term changes in the structure of regulation subject to ratification by the legislative branch of government.
In the world of a Benthamite social planner with a clearly specified objective function and no distributional leanings, policymakers would just maximise aggregate welfare and the role of politics might be small or even nonexistent. But the world we live in is composed of different constituencies that possess different priorities and different preferences about the distribution of resources. In a democratic society, policy decisions are normally determined by the interaction of an appropriate majority subject to the constraints imposed by legislative rules and the organisation of bureaucracies. Since different constituencies have different priorities, compromises are normally made, injecting politics into the choice of macroeconomic policies.
Last but not least, policy choices are affected by the beliefs of decision makers and their advisors about the impacts of policy decisions on desired objectives. In modern economies with high levels of specialisation and financial intermediation, there is substantial uncertainty about the transmission mechanism between policy instruments and objectives. To attain their objectives subject to a reasonable degree of accuracy, policymaker (and/or their advisors) must rely on economic models that relate their policy decisions to final objectives. Such models are usually broadly based on accepted economic beliefs of the time. Since those models adjust over time in light of major unanticipated economic events and new research, forecasts of policy reactions to various developments should be conditioned, inter alia, on existing economic knowledge.
This column illustrates the importance of those factors for economic developments and macroeconomic forecasts by discussing their roles in the creation of, and the policy responses to, the global financial crisis.
The roles of ideology, politics and institutions in the subprime crisis
The predominant economic philosophy in the US is that private markets should be allowed to operate freely whenever possible. This philosophy underlies the absence of serious attempts by legislators to extend the regulation and supervision of financial institutions to the shadow banking system that grew by leaps and bounds during the build-up of the subprime bubble. This was reinforced by the economic clout of major financial institutions that lobbied against such legislation and the decentralised nature of US regulatory institutions, both of which take their roots in the free markets ideology. It is also likely that the norm of profit maximisation provided legitimacy to the quick-profit frenzy that pervaded mortgage originators, financial institutions, securitisers, and rating agencies.
The same ideology is also partly at the root of the benign neglect for the large and persistent current account imbalances with China on the part of US policymakers. This neglect enabled Chinese authorities to pursue their economic ideology of export-led growth and internal forced savings more forcefully. Thus, the rather opposite ideologies of China and the US created for some time a vigorous symbiotic relationship between those two countries that led to the "global savings glut" (Bernanke 2005).
To help low-income people acquire their own homes, some Democratic representatives proposed the extension of subsidies to such people, but this idea met opposition, mainly from Republican legislators, and was abandoned. As a compromise, Democratic legislators pressured Fannie Mae and Freddie Mac to extend mortgages to such people at rates that were lower than market rates for such risks. This led to a deterioration in the credit-risk quality of the their mortgage portfolios, which accelerated their downfall and ultimately necessitated their bailout in fall 2008.
How lessons from the Great Depression shaped policy responses to the global financial crisis
There is little doubt that the recent vigorous responses of both US monetary and fiscal policies to the global financial crisis are rooted in the experiences of the Great Depression and its academic interpretation. Although not all academic economists subscribe to all the policy prescriptions of Keynesian economics, some broad principles are widely accepted in Western economies. In particular, aggregate policy is guided by the view that government and the central bank should respond with expansionary fiscal and monetary policy when systemic financial stability is endangered to an extent that puts the orderly flow of credit to the real economy at risk. Since this flow is a major determinant of aggregate demand, and hence economic activity and employment, this view is ultimately motivated by the objective of avoiding serious recessions and/or persistent depressions like that of the 1930s.
Several academic publications centred on the experience of the Great Depression played a particularly important role in shaping the aggregate demand responses of US policymakers. Friedman and Schwartz (1963) convincingly argued that restrictive monetary policy by the Fed were largely responsible for widespread bank failures during the first part of the thirties. Exactly twenty years later, Bernanke (1983), building on their work, argued that the destruction of financial records and information about idiosyncratic credit risks of individual borrowers due to widespread bank failures limited the flow of credit to the real economy and substantially extended the persistence of the Great Depression. As a matter of fact, it is not unlikely that the close knowledge of the Fed’s chairman with those circumstances had an impact on the magnitude and swiftness of the monetary policy response following the panic triggered by the downfall of Lehman brothers in September 2009.
This conventional wisdom about the lessons of the Great Depression have been strongly internalised by monetary authorities in the US, the euro area, and, to a lesser degree, emerging market economies. Central bank rates all over the world came down sharply, practically reaching the zero bound in the US, and central bank credit to the financial, real, and government sectors rose to levels seldom observed.1 Fiscal policies were also substantially expanded worldwide. In the US, this took the form of two huge expansionary fiscal packages. The Troubled Assets Relief Program (TARP) was legislated after a two-week debate by Congress on 3 October 3 2008 under President George W. Bush. It empowered the Treasury Department to spend up to $700 billion to absorb “toxic assets” from banks and recapitalise them by taking equity positions in the US banking system. This was followed by the American Recovery and Reinvestment Act under President Obama in February 2009, which appropriated $787 billion for the rest of the economy. Interestingly the package passed under the Bush administration was implicitly directed at the partial nationalisation of the banking system, while the second package was aimed mainly at the stimulation of the real economy and state governments’ finances.
A mixture of economic and political considerations shaped this order of package objectives. The first package was an emergency reaction to the drying out of the interbank and other credit markets in the aftermath of the panic that swept those markets after the demise of Lehman Brothers. This was reinforced by the traditional support of a Republican administration for the financial sector. By contrast, the package under Obama’s Democratic administration included federal tax cuts, expansion of unemployment benefits and other social welfare provisions, as well as domestic spending on education, health care, and infrastructure, including the energy sector. The structure of the second package was influenced by the rising rate of unemployment as well as by the traditional leaning of Democratic Congresses and administrations towards more active government involvement in the economy.
Note: This column draws on Cukierman (2009b), which includes illustrations dealing with the future of the dollar as a key currency, the impact of policy on public expectations, and the evolution of transfer payments in the US after WWII.
1 Between August 2008 and January 2009, the Fed’s balance sheet increased by over 2.5 times
Bernanke B. (1983), “Non-Monetary Effects of the Financial Crises in the Propagation of the Great Depression”, American Economic Review, 73, June.
Bernanke B. (2005), “The Global Saving Glut and the US Current Account Deficit”, Board of Governors of the Federal Reserve System.
Cukierman A. (2009a), “The Great Depression, the Current Crisis and Old versus New Keynesian Thinking –What have we Learned and What Remains to be Learned?” Ben-Gurion University conference on Perspectives on Keynesian Economics, 14-15 July.
Cukierman, A. (2009b), “The Roles of Ideology, Institutions, Politics and Economic Knowledge in Forecasting Macroeconomic Developments” CESifo conference on What’s Wrong with Modern Macroeconomics?, 6-7 November.
Friedman, M. and A. Schwartz (1963), A Monetary History of the United States, 1867-1960. Princeton: Princeton University Press.