Nine economic policy disasters and what we can learn from them

Came across this interesting book review. The book is titled Wrong: Nine Economic Policy Disasters and What We Can Learn from Them by Prof Richard Grossmanof Wesleyan University.

Prof. Grossman points to nine major policy mistakes:

1) The British decision to strengthen the Navigation Acts shortly before the Revolution;
2) the U.S. decisions to wind up the First and Second Banks of the United States;
3) The British decision to limit aid to Ireland during the potato famine;
4) the decision by the Allies to impose stiff reparations on Germany after World War I;
5) the British decision to return to the gold standard at the prewar parity after World War I;
6) the U.S. decision to raise rates in the Smoot-Hawley tariff;
7) the real estate boom and bust in Japan and the decision to allow Japanese banks to carry bad assets on their books for a prolonged period of time in the 1990s;
8) the decision to adopt the Euro; and
9) the U.S. subprime mortgage crisis.

Further, all these mistakes came from ideology:

Grossman’s main conclusion is that ideology played an important role in these policy mistakes, and that a greater willingness to base decisions on “cold, hard economic analysis” might have led policy makers to avoid them. In the case of the British decision to strengthen the Navigation Acts, Grossman sees the ideology of mercantilism at work. The Second Bank of the United States was done in by Andrew Jackson’s anti-bank ideology. Ireland’s great hunger resulted in part from British adherence to a laissez-faire economic ideology. In the case of Britain’s return to the gold standard, the ideology was simply a faith in the rightness of the nineteenth century gold standard. The subprime mortgage crisis, Grossman finds, was partly the result, again, of adherence to a free market ideology that undermined necessary regulation of the financial sector. Grossman, in other words, has provided abundant additional evidence to confirm Keynes’s famous comment (which Grossman uses as the epigraph for his book) that “the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood.” And his conclusion that we would be better served if policy makers would rely less on ideology and more on economic analysis is hard to dispute.

Grossman does not, I hasten to add, adopt a monocausal explanation of these mistakes. Often special interests must share the blame. This comes out clearly in the Smoot-Hawley tariff when each member or Congress fought for an increase in the tariff that would help producers in his or her district. Sometimes a lack of sympathy for people who were different in terms of culture, religion, or nationality played a role, as in the British failure to aid Ireland during the potato famine and the decision by the Allies to impose harsh penalties on Germany after World War I. Sometimes simple bad luck played a part. Perhaps, Grossman suggests, Keynes simply had an off-night when Churchill gave him a chance to make the case against returning to gold at the prewar parity. Nevertheless, Grossman’s point that adherence to mistaken ideologies played a major role in these mistakes comes through powerfully.

However, why does ideology develop? Why don’t policymakers rely on hard economic evidence instead?

While I find Grossman’s central argument convincing, his discussion raises some additional questions for me; a sign of a challenging book. One is whether it is always possible to distinguish ideology from “cold, hard economic analysis” ex ante. His analysis of the problems of the Eurozone is a case in point. In hindsight, perhaps, it is obvious that the Eurozone was not an optimum currency area, and that even if it managed to survive, the Eurozone was likely to suffer many needless troubles. Some economists recognized this at the time the Eurozone was established. But one of the key supporters of the Euro was Robert Mundell, the brilliant Nobel Prize economist who invented the idea of optimum currency areas. Indeed, Mundell can also be considered the father of the Euro. (If you don’t believe me, try typing “Who is the father of the Euro?” into Google. At least this worked on February 12. 2014.) Mundell believed that adopting the Euro would set the Eurozone on the path to becoming an optimum currency area. When I was in graduate student at the University of Chicago I had the good fortune to take courses from both Mundell and Milton Friedman, who would become a staunch critic of the Euro. I can attest that they were both possessed dazzling intellects, and that both could construct economic arguments that would be hard for mere mortals to demolish.

That brings me to my second question: why do policy makers, and those who hope to advise them, rely so much on ideology when so often ideology leads them astray? I think the reason is that ideology also plays a positive role in economic policy making. It helps policy makers reach decisions when economic science simply does not provide clear guidance. An analogy with medicine will help make my point. When medical science provides a clear answer most practitioners will give the same advice. Someone who is diagnosed with malaria will be given one of a number of drugs that have been shown to be effective. But there are cases where medical science does not provide such clarity: for example, an elderly man diagnosed with a slowly growing prostate cancer. The medical researcher is free to say “I don’t know what the best treatment is; more research is needed.” But the practicing physician may feel obligated to advise the patient. Here ideology, or in the case of medicine let’s say philosophy, plays a useful role. 

…In the same way, economic policy makers who must make decisions about raising and lowering taxes, raising or lowering the minimum wage, increasing or decreasing Federal Reserve asset purchases, confirming or not confirming free trade agreements, and so on, cannot wait until economic science has reached a clear answer on the right policy. Instead, policy makers must inevitably rely on their economic ideologies to guide them.

Policymaking is far tougher than econs make it out to be. The various limitations which econs simply assume come to the fore while making policies. Most econs conveniently change views as economic conditions change, but policymakers don’t have that choice. Moreover, much of ideology comes from some economic idea which may be defunct at that time. As there is no choice at the time pf policy, one just tries hoping it will succeed. 

A classic case is that of deflation in several advanced economies. The experts lectured Japan over how they allowed deflation in Japan and led to a lost decade and so on. Now they face the same battles in their own economies and unable to do much. All kinds of questions come to mind as a policymaker which don’t strike as an economist. 

In a way, we make a big case out of policy mistakes. Much of this mistake business is realised with hindsight on which policymakers do not have much of a choice. Policymakers are far more accountable than economists and do not really make the mistakes for the sake of making them.

The profession needs a serious amount of humility and clearly warn people of the limitations of the policy decisions. There is just no definite way..

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