From Crisis to Confidence: Macroeconomics after the Crash

Since US output peaked in December 2007 growth has been anaemic and output remains below potential. In addition, US unemployment has been persistently high. It increased from 4.4 per cent in May of 2007 to 10 per cent in October 2009 and was still at 6.7 per cent at the beginning of 2014. The post-crash period is quite unlike typical post-war recession periods after which employment has generally recovered within about two years. This pattern has been followed in many EU countries too. The background to the long slump was a boom followed by a bust. Although the Federal Reserve seems to have pursued conventional monetary policy rules until 2002, from that point interest rates were kept too low for too long. This was an important policy mistake during the boom period. As well as mistakes in monetary policy, several complementary government failures ensured that the boom manifested itself disproportionately in the housing sector and encouraged excess risk taking in financial markets. The central underlying fact in the boom period, however, was loose monetary policy. Standard neo-classical macroeconomics does not have an adequate explanation for the slow pace of recovery from the financial crash. Many other economists continue to argue that the problem is a deficiency of ‘aggregate demand’. These economists want us to ‘stimulate’ our way out of the slump. However, repeated stimulatory measures have not effected a complete recovery. In the UK, for example, government borrowing has led the national debt to double in five years while output is still below potential. Arguably, the financial crisis itself should have been sufficient to call into question the standard neo-classical and new-Keynesian economic paradigms. HM Queen Elizabeth II asked economists at the LSE why nobody saw the crisis coming. This was a good question and the answer she received was inadequate. One aspect of economic theory which has been neglected is the concept of ‘animal spirits’ or ‘confidence’. Keynes, and others before him, discussed the importance of these ideas without ever developing a proper theory or explaining why and how confidence or animal spirits might affect the economy. The state of confidence determines whether banks are willing to lend because the costs and risks that banks perceive are made up of both objective and subjective elements. If a weak state of confidence leads banks to over-estimate the costs and risks of lending, then banks will lend less than they otherwise would. Other economic actors are also affected by the state of confidence. Confidence is undermined by policy uncertainty and the ability for ‘Big Players’ to unduly influence the economic system. Big Players include governments, monetary authorities and regulators, though there can also be Big Players in the private sector. Policy uncertainty increased after the financial crash and the evidence suggests that this affected investment and growth. For example, Baker et al. (2013) show that the increase in policy uncertainty in the US from 2006 to 2011 probably caused a persistent fall in real industrial production reaching as high as 2.5 per cent at one point. Also, after the crash, the UK suffered a productivity shock unprecedented in its industrial history. This was coincident with the top 100 British businesses increasing their cash holdings by over £42bn (34 per cent) in the five years to the autumn of 2013. Recent regulatory developments such as the Dodd–Frank Act violate the principle of the rule of law and therefore undermine confidence and increase policy uncertainty. For example, the Dodd–Frank Act will almost certainly be subject to arbitrariness in its implementation and firms will not be able to plan in advance knowing the legal consequences of their actions. In order to restore and maintain confidence, we need an economic constitution. This constitution needs three elements. Firstly, there must be long-term fiscal discipline: investors must know that they can plan for the long term without either taxation or borrowing getting out of hand. Secondly, the role of Big Players must be reduced. Finally, we need monetary competition and regulatory competition. Regulation should not be the responsibility of state bodies with considerable discretionary power.