An economic ‘orthodoxy’ is a policy, plan, a principle or a set of principles that is widely accepted as valid by the economics profession. Orthodoxies can change over time, and need to do so as economic circumstances and the nature of economic problems change. ‘Orthodoxies’ may also fall out of flavour as new knowledge or empirical investigation disprove their effectiveness. Examples of ‘orthodoxies’ include: globalisation, twin-deficits theory, neoclassicism, Keynesianism, Dutch disease, central bank independence, fiscal austerity, quantitative easing, etc.

An economic policy ‘paradigm’ is also a policy, plan, a principle or a set of principles, but paradigms are not necessarily accepted by all. New ‘paradigms’ often form the foundations for challenging and changing ‘orthodoxies’.

As time passes and economic circumstances change, and as theoretical advances, modelling and statistical investigations provide new knowledge and insights into the functioning of the economic system, then long-held policy views often need to be abandoned or adjusted. History has demonstrated that some policy orthodoxies can be applied successfully for years or decades, but, particularly when circumstances change fundamentally, clinging to policy frameworks and policy instruments that are no longer relevant, or which have an ever-decreasing influence on the policy target, can drag economies down. On the face of it, such forces are arguably at work today.

There are often long time lags between a change in economic circumstances and the adoption of new, more relevant policy paradigms. The main reason for this long lag is that, once embraced by the profession, orthodoxies become solidified within institutional knowledge systems, and become regarded as the ‘gospel truth’: belief in them is usually profound and widespread, so much so that economists are unwilling to quickly abandon them. New generations of economists often accept orthodoxies without question: this behaviour can contribute to unhealthy ‘group-think’.

Fortunately, in their daily work, many economists — officials, and those in the private sector and universities — contribute to the ongoing renewal of relevant theoretical models and practical policy frameworks. Even so, changing policy orthodoxies and economic paradigms is not straightforward and can be very challenging, particularly when leading politicians have capital invested in them.

For those individual economists who work inside governments the first task is to recognise when orthodoxies are failing. They need to recognise when fundamental changes in economic circumstances occur, and identify through analytical and statistical analysis, the benefits that might be derived from a proposed new plan. Then the new plan has to be developed for practical application. In turn, colleagues need to be persuaded that change is necessary, and that the new policy approach is the right course to embark upon. Finally, when consensus within the government department is established, senior officials need to explain the plan to Ministers and seek their government’s agreement to adopt the plan. Legislation is often required.  Then relevant officials have to work with government to sell the new plan to the business sector and to the community generally.

When there is a need to change orthodoxies across a large number of countries, for example across the European Union, or globally, then the difficulty of the task is multiplied many times. Particularly in an integrated world economy with liberalised capital markets, it is essential for policy makers, particularly those in the larger economies, to take a global perspective.

Failing policies and the global crisis

At the time of writing the global economic crisis is entering a decisive stage. The author believes that many of the orthodoxies that guided policy development before, or during, the crisis are now no longer appropriate, or are at highly questionable — including, inter alia, the mechanistic and narrowly-based Taylor rule, quantitative easing, minimal (longer-term) interest rate policies, forward interest rate guidance, fiscal austerity and bond financed budget deficits. The deeply held belief in Germany — that monetisation of the budget deficit should never be tolerated — represents another misplaced orthodoxy in a world of inadequate demand, low inflation/deflation and high public debt. The view that printing ever greater amounts of new money is necessarily stimulatory is also naïve.  Assuming new money is to be created; the policy maker must ask the further important question: what is the best way to deploy the new money in order to increase aggregate demand?

The author proposes a new policy paradigm involving much greater coordination between monetary and fiscal policy — deficit monetisation — as a means to stimulate economies without increasing public debt or inflation (see CEPR Policy Insight, No. 62, 31 August 2012).  The author also recommends that a prices and incomes policy also be considered as a replacement for austerity policies for some countries suffering a loss of competitiveness.  There are, of course, separate banking sector problems:  these are best resolved by regulatory reform, rationalisation and improved supervision.

There are, therefore, essentially three basic macroeconomic problems impacting Eurozone periphery countries — deficient aggregate demand, high public debt and inadequate competitiveness: at least three policy instruments are required to work in close coordination, and with appropriate sequencing, to resolve these problems.

Never before during the last eight decades, has it been so essential to change a number of current orthodoxies.  The application of some current orthodoxies in the Eurozone, in particular, are doing little, or nothing, to raise aggregate demand, and they may conceivably be decreasing it; and they are increasing public debt.  Policy mistakes, and misjudgements, have arguably been made across the globe.

Policy principles

The successful development of new policy paradigms can never be assured.  This task requires the exercise of great judgment, the adoption of the broadest possible view, and an ability to take all attendant facts, considerations, options and economic consequences into account.

Viewing the experience of the past four years, there appear to be a number of desirable general policy-making principles that have particular relevance today:

i)                   Clear analytical/statistical analysis that identifies the central policy problems and policy objectives;

ii)                 Simplicity in policy design and the avoidance of complexity;

iii)               Appropriately matching an adequate number of policy instruments to targeted policy objectives in order to strike optimality in policy design and to achieve maximum effectiveness and efficiency in the application of policies;

iv)               For large-scale crises, close coordination between monetary, fiscal, exchange rate, structural, and prices and incomes policies is likely to be essential, and may prove decisive.  Monetary and fiscal policies, in particular, should not be developed independently in separate silos;

v)                 Avoid policy dissociation when more than one policy objective or more than one policy instrument is involved. This will ensure consistency, the avoidance of discordant policies, the rejection of policy combinations where different policy instruments are pulling policy targets in different directions, and the avoidance of situations where action with one policy instrument to correct problem A compounds problem B.  Such policies serve to deepen, rather than resolve, the underlying economic problems;

vi)               Be willing to accept that orthodoxies can run their course, particularly when underlying economic conditions and the nature of policy problems change fundamentally.  At the same time, accept that failed orthodoxies may need to be replaced by improved policy paradigms;

vii)             In developing new policy paradigms, be prepared to think ‘outside-the-box’ (that is, outside the existing orthodoxy);

viii)           The scale of policy action needs to be proportionate to the magnitude of the economic problem or imbalance.  Consequently, policies need to be pro-active, effective and decisive (that is, aimed to correct or remove economic problems), not simply ‘defensive’ (that is, they should not be aimed at merely ‘buying time’; or at maintaining, or perpetuating, or facilitating the resurgence of an economic problem or imbalance);

ix)               Particularly where crises are unfolding rapidly, and could deepen if left unattended, avoid policy procrastination and delays in government approval of policy actions;

x)                 Policy instruments are scarce: avoid reliance on instruments or policies that may have doubtful value, or that do not impact directly on the policy target;

xi)               Creating new money should only occur when it will be effective in raising demand, or avoiding deflation.  New money is a precious resource: it should not be frittered away in unlimited, open-ended operations, particularly when policy interest rates are already at their lower bound.

xii)             When private demand is deficient and economies are in recession, or in depression, then public demand must be increased to stimulate private demand and to protect employment.

xiii)           When public debt is already grossly excessive, and there are on-going budget deficits to be financed, then these budget deficits are best financed directly by creating new money rather than issuing more government bonds (public debt).

xiv)           Avoid currency wars and beggar-thy-neighbour policies.

References

Wood, R., Centre for Economic Policy Research, ‘The Economic Crisis: How to Stimulate Economies Without Increasing Public Debt’, Policy Insight No. 62.

  RT Banks and Risk Management, RT Current Account, RT Eurozone, RT Monetary Policy and Inflation