Rational expectations
[An overview of concepts in macroeconomics and Keynesian economics is provided in the Appendix]
In this section
The political case for macroeconomics
A first principles argument using metaphors, toy problems and moral arguments may be a useful starting point for fresh ideas but fall short of the standard of evidence for policy change. There is sufficient complexity of the interactions of different mechanisms of collective, cooperative behaviors of individuals and the dynamics of the institutional environments they operate in that a separate case must be made to predict the emergent responses to policy on the national scale. Research by the Center for Economic Policy reveals that short term macroeconomic conditions - unemployment, inflation and changes in real income have a direct consequence for political legitimacy (Ward, 2015).
The study performed an original multi-country analysis as well as a review from other studies and determined that election outcomes appear as though voters use their assessment of how things are in their personal life as a proxy for support or disapproval of the incumbent (Ward, 2015). While sense of autonomy and freedom are a factor in satisfaction, they are not sufficient. Macroeconomic variables identified as significant in the models were first income (GDP) growth, followed by inflation and employment. Subjective Well Being was identified as the strongest predictor and suspected to have a role as an intermediate measure in translating the macro-economic outcomes into voters' local assessment of how things are going. So the importance of these macroeconomic measures on political support may be conditional on their relationship to voter’s well-being assessment (Ward, 2015). In order for liberalization advocates to be able to assure policy makers of political support, they may need to be able to explain and predict macroeconomic phenomena.
The unemployment of the Great Depression in the US in the 1930’s triggered an inquiry into the dynamics of unemployment and debate between two economists and their followers - Frederick von Hayek and John Maynard Keynes. The debate included both an explanation of the causes of inflation and unemployment as well as the optimal policy response. Von Hayek’s proposal was that the labor market was self-correcting and behaved as “classical” models would predict - that in the absence of institutional barriers such as minimum wage or collective bargaining powers like unions, in response to downturns unemployed workers would bid for lower wages and re-stimulate hiring. The classical approach asserted that modelling the economy as a set of rational, self-interested agents would eventually be the most accurate predictor of the aggregate response (Jones, 2014).
Short run economy and Keynesian economics
In the long run, we are all dead. - John Maynard Keynes, 1928
Summary of concepts of Keynesian macroeconomics and from Core Economics Chp 15 of how monetary expansion interacts with the business cycle and its relationship to capital markets and trade via the multiplier effect.
According to the Keynesian aggregate demand model the business cycle is a phenomenon of up and down swings in demand for labor, consumption and investments in a semi-closed economy
In the short term the labor demand can be restored by a stimulus of extra spending either by the state or from capital markets
Under standard conditions, expansion of the money supply is one broad based stimulus technique that the state can use that incentivises the capital markets to spend by lowering short term interest rates.
The standard conditions for expansion to be effective is when inflation is modest, interest rates are well above zero, debt levels are modest, there is unutilized slack in the economy
Expansionary monetary policy comes with a trade-off penalty of inflation, a deflated currency and increased public debt.
The effectiveness of the stimulus is dependent on the multiplier effect of the money continuing to circulate and change hands through transactions within the economy. If the money instead “leaks” either through trade, capital flight or savings then the multiplier effect and the stimulus loses its potency and the trade-offs penalty costs are higher
Keynes and Hayek both acknowledged the lag response of wage prices during downturns. Unlike Hayek however, Keynes left open the possibility that market agents were not always rational and could mis-allocate resources from irrational speculation episodes that are not self-correcting in the short run. Keynes asserted that in the short run employment was determined by the aggregate demand, rather than the price signal of labor wages and that demand was the outcome of spending by both the public and private sectors (Jahan, 2014). Keynes’ model of macroeconomics - aggregate demand and the Phillips curve trade-off of inflation and employment were influential in policy from the New Deal recovery in the United States from the Great Depression to well beyond his death in 1946. Neo-Keynesian economists such as Paul Samuelson picked up and refined his models to continue to apply the Phillips curve logic to policy such as the Johnson’s Great Society expansion of the welfare programs in the United States in the 1960’s and 1970’s (Jones, 2014). Fiscal and monetary policy during that period was portrayed by critics as a political balancing act to find the sweet spot compromise of inflation and unemployment that would satisfy the different demands of the time. This approach seemed to work - until it didn’t.
US stagflation and the 1980 Volcker shock
Government is not the solution to our problem, government is the problem. - U.S. president Ronald Reagan, 1981 Inauguration speech
A series of events including the breakdown of the Bretton Woods - a global financial system based on fixed exchange rates - and multiple oil supply shocks in the 1970’s created a condition of high unemployment and high inflation - “stagflation” which the neo-Keynesian models had no remedy to solve (Jahan, 2014). The U.S. president Gerald Ford decided that inflation was the priority and this was also the position adopted by his elected successor Democrat governor of Georgia - Jimmy Carter in 1980. A new macroeconomic theory emerged - Monetarism - championed by economist Milton Friedman which predicted that stagflation would occur due to “rational expectations” that agents in capital markets and the banking system react to policy uncertainty on interest rates, monetary supply and this translates into higher inflation.
The remedy proposed by the Monetarists was to prioritize stabilizing inflation first by sending a clear unambiguous signal of high interest rate policy until the inflation subsided. This was known as the Volcker shock illustrated in Figure D.4 by the evolution of interest rates, federal funds rate and unemployment by the Fed Chairman Paul Volcker. As expected in response inflation subsided and unemployment rose. Contemporary analysis of the series of events during the late 1980’s by both Neo-Keynesians and Monetarists generally agree that the policy makers at the time were mistaken either at poor modelling of the real economic output and in particular the role of energy supply, or a misguided tolerance of high inflation (Collard, ECB, 2004). Whether the shortcomings of these policy makers has any implications on Keynes’ basic economic model is anything but conclusive. Both revised neo-Keynesian and Monetarist models offer different explanations for the same events with similar levels of model accuracy (Collard, ECB, 2004).
Leave it to the markets
Perception is everything. At the time, the events may have been perceived politically however as discrediting Neo-Keynesian economics legitimacy to prescribe a whole range of monetary and/or fiscal policy on it’s failure to accurately predict macroeconomic phenomenon and failure to supply a decisive remedy. This perception may also have promoted influential Monetarists of the time such as Milton Friedman with a political license to experiment with the new liberalization policy ideas (Henwood, 2019).
The significance of the shift to Monetarist policy of fixed inflation targeting was twofold - it removed an important counter-cyclical measure and by discrediting the Keynesian model it may also have influenced other liberalization policy reforms directly or indirectly that further undermined these counter-cyclical measures. When things are working as intended in a Keynesian system, the overall effect is that for a closed or semi-closed economy, monetary expansion in combination with other counter-cyclical policies such as automatic stabilizers, progressive taxes could be used as negative feedback to dampen the effects of the business cycle by periodically shifting the risk taking role between the private capital markets to the state. The implication of liberalization policies of free flow of capital in and out, low trade tariffs, flat tax, balanced fiscal budget and fixed inflation target limit the potential multiplier effect potency of Keynesian counter-cyclical demand management measures.
Carter ultimately lost his re-election (unusual for U.S. Presidents) in 1980 to Republican governor of California- Ronald Reagan. Reagan introduced the liberalization agenda with messages calling for smaller government and “economic freedom” epitomized at his inauguration address (Reagan, 1981). The period that followed which lasted until the financial crisis of 2008 was considered by Core Economics Chp 15 as “the Great Moderation” and expanding political influence of free market ideology around the world. Central banks reformed to a policy of fixed, low inflation rate targeting and governments adopting liberalization policies in other areas from trade to corporate taxation.
Threat of capital flight in international labor and capital markets
Winner-takes-all-dynamics in a liberalized global financial system
The consequences of liberalization and the effect of open trade, free capital flows are further complicated in a globalized financial system. Figure D.5 is a simple metaphor illustration of two countries in an ideal liberalized system each with their own government, labor market and a shared capital market.
In a downturn in the business cycle inflation and output (GDP) go down and unemployment goes up. A monetary expansion by the central bank intended to stimulate output and employment may increase inflation, deflate the currency and increase public debt. The threat of capital flight and uncontrolled leakages make the prospects of monetary expansion less appealing. The move is risky if investors are more sensitive to the inflation risks weary of credit risk of the country’s government ability to make interest payments on debt than the uncertain future gains in output. The risk is the capital leaves in “capital flight” leading to further loss in aggregate demand.
The decision by the investor will come down to how much faith they have in the country's ability to recover strong enough to pay back the investment from future tax revenues. Furthermore, if there is a large component of trade to GDP, then not only is this a potential leakage, but also the devalued currency increases the relative price of imports relative to exports which could result in a balance of trade problem and risk external debt, compounding the effect of the public debt. The investors may prefer instead for the government to lower wages and reduce corporate taxes as an alternative means of stimulus that is on more favorable terms to bondholders and shareholders than a currency devaluation.
While favorable to capital owners, these measures could have the effect of eroding real wage growth and shrinking government budgets, and hence weakening their ability to continue investing in long term development goals and reserves to intervene in future downturns. On the other hand, during the boom period of the business cycle the opposite effects can occur with positive growth in GDP output, lowering unemployment, growing trade surpluses, strengthening of the currency and attracting more capital and more investments from the capital markets and positive pressure on real wages.
Vote with your feet : No easy way out for labor
Hypothetically, if two countries are at different points in the business cycle or otherwise have some structural asymmetries, in an ideal liberalized world model immigration might be the preferred remedy for labor markets to “vote with their feet” to resolve the difference in terms of labor between the two countries as Milton Friedman described the dynamics at the border between Hong Kong and China (Friedman, 1980). It should be common sense however the absurdity of this proposal given that the speed, risks and transaction costs to the capital owner of switching from one country to another is not comparable to that of a life changing decision like immigration. Also for practical realities of nationalist politics in practice liberalization advocates are less effective at fully liberalizing immigration policies than they are in capital markets.
For this and other reasons in the real world there are substantial asymmetries in the barriers of labor and capital markets and for most countries immigration is not a significant remedy to unemployment. Even for Singapore where immigration does play a counter-cyclical mediation it is only one of several dynamics. Typical net immigration rates are <<1% vs swings in unemployment in the range of 3 to 10%. The consequence of this asymmetry could result in a winner-takes-all positive feedback dynamic, whereby the effect of capital flight creates more volatility than stability by deflating countries during downturns and inflating during an upturn. The asymmetry also could result in less favorable terms of labor since the globalized financial system represents capital owners effectively operates as a single interconnected system and negotiates with a comparatively less coordinated labor markets and governments.
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