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Op-ed

How Economics Managed To Make Amends

by Arvind Subramanian, Peterson Institute for International Economics

Op-ed in the Financial Times
December 28, 2009

© Financial Times


In 2008, as the global financial crisis unfolded, the reputation of economics as a discipline and economists as useful policy practitioners seemed to be irredeemably sunk. Queen Elizabeth captured the mood when she asked pointedly why no one (in particular economists) had seen the crisis coming. There was no doubt that, notwithstanding the few Cassandras who correctly prophesied gloom and doom, the profession had failed colossally.

What is striking about the influence of economics is that similar policy responses in the fiscal and monetary areas, and nonresponses in relation to competitive devaluations and protectionism, were crafted across the globe.

The totemic symbols of this failure were, of course, the two most important policymakers, Alan Greenspan and his successor as chairman of the US Federal Reserve, Ben Bernanke. They, among many others, helped create a belief system that elevated markets beyond criticism.

But crises will always happen and, even if there is a depressing periodicity to them, their timing, form and provenance will elude prognostication. Most crises, notably the big ones, creep up on us from unsuspected quarters. As Keynes wisely observed: "The inevitable never happens. It is the unexpected always." So, if the value of economics in preventing crises will always be limited (although hopefully not nonexistent), perhaps a fairer and more realistic yardstick should be its value as a guide in responding to them. Here, one year on, we can say that economics stands vindicated.

How so? Recall that the recession of the late 1920s in the United States became the Great Depression, owing to a combination of three factors: overly tight monetary policy; overly cautious fiscal policy (especially under FDR in 1936, when tightening led to another sharp downturn in the US economy); and dramatic recourse to beggar-thy-neighbor policies, including competitive devaluations (as countries went off the gold standard in the 1930s) and increases in trade barriers. The impact of this global financial crisis has been significantly limited because on each of these scores, the policy mistakes of the past were strenuously and knowingly avoided.

On monetary policy, Mr. Bernanke was true to the word he gave to Milton Friedman on the occasion of his 90th birthday: "Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again." The preeminent student of the Great Depression, Mr. Bernanke found conventional and some very unconventional ways of not doing "it" again. At the peak of his interventions, the Fed came to resemble the Soviet Gosbank, as much a microallocator of credit as a steward of macroeconomic policy.

On the fiscal side, policymakers enacted huge stimulus packages. They took their cue from Keynes, providing public demand for goods and services where private demand had collapsed under the weight of indebtedness and nonfunctioning credit markets.

Most surprisingly, despite the unprecedented collapse in trade, few countries resorted to beggar-thy-neighbor policies. For sure, there were big currency swings, but these were mostly market driven—except in the case of China, where the hand of policy in manipulating competitiveness has been more evident. It is also true that several countries raised trade barriers. But these were small in magnitude, limited in geographic scope and product coverage, and mostly consistent with World Trade Organization rules. The exception was the large-scale assistance to the financial and auto sectors, especially in the United States, which at least had the extenuating argument that the assistance was aimed at averting extinction rather than providing a competitive boost. Overall, however, it was clear that the general forswearing of beggar-thy-neighbor policies stemmed, in large part, from the awareness of their devastating consequences.

What is striking about the influence of economics is that similar policy responses in the fiscal and monetary areas, and nonresponses in relation to competitive devaluations and protectionism, were crafted across the globe. They were evident in emerging-market economies and developing countries as much as in the industrial world; in red-blooded capitalist countries as well as in communist China and still-dirigiste India. If ever there was a Great Consensus, this was it.

If the Great Depression had not happened 80 years before, there may not have been a "natural experiment" to draw upon, and perhaps 2009 might have turned out differently. But the fact of the Great Depression was only a necessary condition. We were not condemned to repeat the mistakes of history because the economics profession had learnt and distilled the right lessons from that event.

For sure, we have not learnt all the lessons; we may even have learnt some wrong ones. It is also probable that we are setting the stage for future crises, not least because we are still groping for ways to tame finance. So, economics is bound to fail again. But the avoidance of the Greatest Depression that could so easily have happened in 2009 is an outcome the world owes to economics; at the least, it is the discipline's atonement for allowing the crisis of 2008 to unfold.


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