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Austerity as a Knowledge Transmission Mechanism failure

Author(s): Simon Wren-Lewis

From Pieria:

In this post I talked about the Knowledge Transmission Mechanism: the process by which academic ideas do or do not get translated into economic policy. I pointed to the importance of what I called ‘policy intermediaries’ in this process: civil servants, think tanks, policy entrepreneurs, the media, and occasionally financial sector economists and central banks. Here I want to ask whether thinking about these intermediaries could help explain the continuing popularity amongst policy makers of austerity during a liquidity trap, even though there is an academic consensus behind the idea that austerity now would harm output.

In this post I looked at various reasons for thinking there was such a consensus, and one of them was that the framework generally used to analyse business cycles was the (New) Keynesian model. In this Keynesian framework cuts in government spending when interest rates are stuck at their lower bound clearly reduce output, with multipliers around one or more.

Where are these models used in anger? Among academics studying business cycles of course, but also within central banks. As far as I know, pretty well all the core models used by central banks to do forecasting and policy analysis are (New) Keynesian. (This includesthe ECB.) An important point about the delegation of stabilisation policy to independent central banks is that expertise on business cycles has tended to shift from civil servants working in finance ministries to economists working in central banks.

Suppose you are a policy maker, who is genuinely concerned about what impact cuts in government spending might have in the period after the Great Recession. Where would you, or your civil servants, go to find expertise on this issue? Given the above, one obvious source, and perhaps the main source, would be independent central banks. One big advantage that independent central banks have over academics as a source for the received wisdom on this issue is that they are a single point of reference. No need to ask the many economists working in the central bank - just ask the central bank governor, who you would expect to distil the wisdom of their own economists.

Following this logic, you might expect to find central banks shouting the loudest about the dangers of austerity. After all, they get the rap for deflation, so anything that makes their job more difficult and uncertain when interest rates have hit their lower bound they should perceive as especially unwelcome. In front of committees of congress/select committees and the like, they should be banging on about how they cannot be expected to do their job if politicians continue to make life difficult by deflating demand. If they did this, some politicians (particularly on the centre left) would have had ammunition with which to counter homilies about Swabian housewives and maxed out credit cards. 

Of course this does not happen. The extent to which it does not happen varies among the major banks. In the US Bernanke did very occasionally (and somewhat discretely) say things along these lines, but he seemed reluctant to do so in any way that might prove influential. In the UK Mervyn King is believed to have actively pushed for greater austerity, and the Bank of England has never to my knowledge suggested that austerity might compromise its control of inflation. The ECB, of course, always argues for austerity. It is one of the great paradoxes of our time how the ECB can continue to encourage governments to take fiscal or other actions that their own models tell them will reduce output and inflation at a time when the ECB is failing so miserably to control both.
So what is going on here? I think there are two classes of explanation, related to the distinction between the roles of interests and ideas in political economy (see Campbell here, for example). The first class talks about why the interests of the elite might favour austerity, and how these interests could be easily mediated through senior central bankers. It could also explore the interests of finance, and their close connections to central banks.

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