As we begin the New Year with the hope of climbing out of recession, we are in danger of overlooking – or misunderstanding – one of the lessons we should have learnt from the global downturn.  What the meltdown should have taught us is that economics, as Keynes insisted, is a behavioural science.  It is not subject – like physics – to inexorable scientific laws, nor is it to be captured or foretold through mathematical formulae.  Economics is the attempt to account for and predict how people – with all their foibles - will behave in response to the stimuli that economic circumstances provide to them.

Governments, and economic policy-makers, understand this, even if they say they don’t.  Otherwise, they wouldn’t bother with changing those stimuli in the hope of improving economic performance.  Even monetarists, whose basic attitude is that all governments can do is to hold the ring and let people get on with it, are keen interventionists when it comes to pushing this button or pulling that lever.

What we seem to have difficulty in grasping, however, is that the most powerful economic stimuli are those provided by macro-economic policy – the way in which we manage the economy as a whole.  We insist on treating that as a given, beyond the reach of policy-makers to influence.  “There is no alternative” we are told, either explicitly or implicitly; the ability of governments to influence economic developments is said to be limited to pushing or prodding at specific supposed pressure points.  Even 25 years’ experience of the failure of such measures to raise our overall economic performance does not deter us from pushing on doggedly with new versions of old and usually failed remedies.

But this represents a total failure to understand Keynes’ basic insight.  The most important economic function of government is to adjust the macro-economic context so that – in a market economy – the overall market and the response people make to it will do the job for us.  If macro-economic policy settings allow the market to function efficiently, then much specific intervention will be rendered unnecessary.

Conversely, the less attention we pay to the macro-economy, the greater will be the apparent need and temptation to intervene with specific measures, in an attempt to make up for the deficiencies in economic performance that our macro policy – or lack of it – has made inevitable, and the greater will be the (repeated) disappointment when those measures prove ineffective.

The basic concerns of macro-economic policy should be the overall competitiveness and profitability of our productive sector.  The focus should not be any particular firm or industry but the economy as a whole.  If those concerns were properly addressed, our productive industry would – without specific intervention – help us to balance our current account, invest in new capabilities for the future, provide worthwhile job opportunities to the whole population, pay proper attention to sustainability, produce buoyant tax revenues to the public purse, and generally produce a more successful and easily managed economy and society.

So, set alongside these goals, how does our macro-economic policy shape up?  Does it provide the stimuli that will produce the right responses? 

Well, we begin by defining macro-economic policy virtually out of existence.  We insist that it is really just a question of monetary policy, and monetary policy for a very limited purpose – the control of inflation.  We pay no attention to other policy objectives like competitiveness, profitability or full employment.  We have, in other words, fallen at the first hurdle.

We then engage the limited tools of monetary policy – principally interest rates but also exchange rates as an inevitable concomitant – to do a job they are not designed for.  Instead of helping efficient market operations by providing market-clearing prices, interest rates and exchange rates are used to distort the market in the interests of controlling inflation – and not very well at that. 

Macro-economic policy thereby becomes, not an instrument for promoting the overall economy, but a guarantee that it will not be allowed to prosper.  If, by virtue of superhuman efforts by our farmers and manufacturers, or of strokes of good luck such as the rise in dairy prices, we manage briefly to improve our trading performance, the response of our policy-makers (with the help of the foreign exchange markets) is to stimulate a rise in the exchange rate which will wipe out any gain in profitability.  And that is a problem because unless there is improved profitability which can be re-invested in productive capacity, there is no escape from our disappointing economic performance.

We insist, in other words, on delivering the message to our most dynamic producers that there is no point in investing in New Zealand’s productive capacity because our policy-makers have other priorities.  The power of the overall market forces we set in motion as a result of our neglect of macro-economic policy is such that no amount of poking or prodding at small parts of the economy will have much effect.  Little wonder that Kiwis conclude that housing is a better investment than productive capacity.

The stimuli our macro policy provides to our overall economy are, in other words, the very converse of what Keynes would recommend.  It is time to recognise that the Keynesian approach offers not just the only way of escaping from recession (as is now reluctantly recognised by most commentators) but is also a long-term blueprint for the health of our economy.  If we want a better economic performance, we need to think harder about the “behaviours” that our policies make inevitable.

Bryan Gould

29 December 2009

This article was published in the New Zealand Herald on 4 January 2010.