Before going into detail about these enabling policies, we suggest that what Audretsch claims in the cited passage is true for policy in general, including macroeconomic policy.
Our second claim is that the NE certainly does not imply the end of traditional demand policies and the universal adoption of tight, simple rules; rather, policy rules more often need to be integrated with pragmatic policy moves. On the one hand, governments commit themselves, in principle, to strict rules, such as balanced budgets, derived from what they consider to be a solid theoretical framework. On the other, however, they are often forced, in practice, to break those very rules and to adopt more pragmatic stances to face the challenges posed by a global and complex environment characterized by more frequent shocks. They are actually able to do so because ICT provides more information, making it easier to implement ‘fine-tuning’.
Like other features of the NE, visibility affects stability. The most common view is that the current combination of theoretically based rules and actual pragmatic policy moves, which represent visibility today, is regarded as having mainly positive effects on the stability of the economy. Swifter fine-tuning, more timely ‘piecemeal’ intervention and more flexible interpretation of rules all seem, to many, capable of granting the creation of a stable long-term economic environment (in terms of low inflation and high levels of unemployment). On the other hand, however, there is also reason to believe that the current combination of rules and pragmatism is also likely to increase instability. In particular, one could note that there is a growing potential gap between the official rules adopted and the elusive, complex nature of the NE, which sometimes gives rise to systemic failures, for example, those due to fast global financial markets which dominate slow production processes. This is a gap which pragmatism no longer seems able to bridge. In what follows, we shall focus on both these effects, placing the emphasis on the signs of acceleration or differences of recent trends as compared with past decades.
Monetary policy rules
The tendency to maintain precise policy rules is a crucial part of government strategy in the NE to grant macroeconomic stability. Let us start from monetary policy. That this policy is based on rules is certainly not a new phenomenon. Indeed, as monetary history shows, the control of money has often been pursued by following some system of rules, such as the Gold Standard, the Bretton Woods system of fixed exchange rates or monetary targeting. In particular, the adoption of rules has characterized the behaviour of independent central banks ever since their foundation at the beginning of the twentieth century.1 However, what is relatively recent is the specific rule which characterizes the NE, namely inflation targeting.
It can be argued that this evolution of rules is guided by the attempt to reduce economic and financial instability in the face of changing economic circumstances. For example, leading to the breakdown of the Bretton Woods system was, among other factors, the growing awareness among policy-makers that the goal of full employment which was pursued by Keynesian monetary and fiscal policy in the two previous decades exposed the economy to the danger of rising inflation and market instability (see e.g.
Baker 2003:804–5). The control of inflation thus became the main policy goal and monetary policy, based on the control of the money supply, gradually became the
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preferred instrument to reach it (see e.g. the Economist 28–9–2002:29). The main idea behind this rule, inspired by monetarism and the quantity theory of money, was that changes in the money supply controlled by central banks, in the long run, only generate inflation without influencing employment and the trend growth rate or potential income.
The latter depend upon real factors such as productivity and labour supply growth, which are exogenous, that is, outside the control of central banks.
However, monetary targeting was not a lasting rule. What led, in turn, to its breakdown and the adoption of inflation targeting was instability deriving from a number of sources, such as the uncertain causal links between money and prices, the difficulty of tracking monetary aggregates in the face of financial innovation making the demand for money unstable,2 the lack of uniformity in market expectations concerning both inflation and the conduct of monetary policy and the problem of choice of the appropriate policy instruments for pursuing short-run stabilization.
It is the attempt to solve these instability problems that lies at the heart of inflation targeting. First of all, by focusing on the end of the causal chain, that is, inflation, rather than the beginning, that is, money, this policy rule seeks to bypass the problem of the uncertain causal links between these two variables. One need only note, for example, that monetary aggregates are quite unstable in the NE (because of the faster processes of financial innovation and continuous changes in the forms of money) and that their behaviour may not be related to inflation. A rise in M3, for example, may simply reflect changes in the composition of investors’ portfolio (a shift from shares to deposits) rather than willingness to spend and create inflation.
Second, this policy rule simplifies the choice as to the best policy to pursue macroeconomic stabilization. In principle, stability can be reached in various ways according to the policy goal. If the main goal is full employment, governments could rely on either fiscal policy or exchange rate policy or monetary policy. If low inflation is the main goal, monetary policy becomes the key instrument of macro-economic stabilization, in view of the comparative advantage held by independent central banks in this matter.3 Indeed the current conventional wisdom in the NE is that, by keeping inflation low, monetary policy is the key stabilizer at the macro-economic level, cooling the economy off when it is running too hot (i.e. when actual income grows more than potential income) and warming it up when it is running too cold. In particular, in case of depression or when income grows too slowly to grant sufficient employment expansion, central banks can even act aggressively to restore confidence (see e.g. Baily 2001:249, 256).4
This does not mean that fiscal and exchange rate policy should never be used.
However, many consider these policies to be less effective short-run stabilizers in the NE than monetary policy. In Krugman’s view, for example, monetary and fiscal policy are a bit like aspirin and morphine; it is better to use the former first and the latter in exceptional cases, such as when the system falls into the liquidity trap. The main reason is that monetary policy can operate much more rapidly, as shown by Greenspan’s successful attempts to save the US on several occasions (1987, 1990–1, 1998) by quickly modifying interest rates. While tax cuts require time and cannot be easily reversed, interest changes instead are quickly reversible (see e.g. Krugman 2001:38–9).5
Finally, inflation targeting in the NE is designed to provide an anchor to market price expectations. This point is clearly underlined by Woodford (2001). Unlike authors such
as Benjamin Friedman and Mervyn King, who suggest that the central banks’ power is undermined by the NE because financial innovation reduces the demand for a monetary base and develops e-money, Woodford starts by noting that in the NE monetary policy should be even more effective than in the past—that is, more able to achieve its stabilization goals—because of improved private-sector information (see e.g. Woodford 2001:316–17).6 One reason for this is that successful monetary policy is a matter of affecting, in a desirable way, the evolution of market expectations regarding interest rates or inflation. Clearly, if the beliefs of markets’ participants are widespread and poorly informed, this is difficult. Woodford makes it clear that to influence expectations the central banks must lead the markets and resist the temptation to follow them:
[B]ecause if the central bank delivers whatever the markets expect then there is no objective anchor for these expectations. Arbitrary changes in expectations may be self-fulfilling because the central bank validates them. This would be destabilizing for both nominal and real variables.
(ibid.: 314) It is for the purpose of leading the market that central banks need to conform to a systematic rule of behaviour, and to explain it clearly, in order to improve the private sector’s understanding of the central banks’ current decisions and future intentions:
‘Policy should be rule-based. If the Bank does not follow a systematic rule then no amount of effort at transparency will allow the public to understand and anticipate its policy’ (ibid.). Woodford then stresses that the definition of rules rests on an explicit model of the economy and thus concludes by stating that this is the only objective anchor for market expectations in the NE:
Rule-based policy-making will necessarily mean a decision process in which an explicit model of the economy (albeit one augmented by judgemental elements) plays a central role, both in the deliberations of a policy committee and in explanations to the public… One can only expect the importance of models to policy deliberations to increase in the NE.
(ibid.)
Pragmatic monetary policy
Once the official policy stance is clarified, it is important to realize that it does not necessarily correspond to the actual policy pursued by central banks. As evidence shows, when dangers other than inflation materialize and give rise to market instability, central banks do not always insist on their official targets and adopt a more flexible or
‘pragmatic’ monetary policy; this essentially amounts to taking into account not just inflation but also growth (see e.g. the Economist 28–9–2002). There are two kinds of pragmatic moves. One follows from the fact that inflation targeting is not the unique determinant of the central banks’ behaviour. The evidence suggests that this strategy is not applied mechanically. In practice, there are degrees of freedom that are used, especially in the face of negative events. The second type of pragmatism follows from the
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fact that the official rules are less strictly codified or publicized, so that central banks enjoy some further room for manoeuvre. The European Central Bank (ECB) is an instance of the first approach. Its strategy involves the specification of a clear inflation and money supply target (a certain M3 growth rate). As recent data shows, however, the ECB has often failed to raise interest rates systematically when actual inflation was higher than its 2 per cent target, or actual M3 growth was higher than its 4.5 per cent target (e.g. Talani 2004).7
The FED, instead, is an instance of the second type of pragmatism. Strictly speaking, the FED does rely on theoretical principles of a monetarist kind, such as the NAIRU, As noted by Baker, for example,
it seems clear that the Federal Reserve Board came to view the NAIRU as a guide for its actions. When the unemployment rate began to fall below the range of estimates for the NAIRU in 1988, it raised interest rates.
(2003:814) It fails, however, to specify targets for inflation, and its strategy is much broader than the ECB’s. It is intended not only to pursue monetary stability but also economic stability in terms of income and employment, exchange rate and financial stability, in line with the role of the key engine of growth in the world economy played by the US. From the start, this broader perspective intuitively favours a balanced approach to money management.
It must be noted, however, that the FED’s pragmatism is not always a matter of rational choice or ‘formal’ decisions. Sometimes, it is due to simple error. Stiglitz (2002b), for example, talks about ‘lucky’ errors by the FED, who made wrong estimates of GDP growth and NAIRU in the late 1990s (the actual unemployment rate went below 6 per cent but inflation did not rise) and failed to raise interest rates, thus favouring the boom (see also Baker 2003:819).8 At other times it is linked to the key role of economic leaders like Alan Greenspan, whose informal comments often manage to exercise ‘moral suasion’, that is, to persuade or reassure the markets that the FED will behave in a certain way conducive to stability and prosperity; for example, that it will intervene to face confidence crises or to avoid bankruptcies (see e.g. Banerji 2002:16; DeLong 2003).9 It should be clear that, owing to the key roles played by expectations, trust and rapidity of information in today’s global markets, this kind of intangible aspect of monetary policy is more important than ever before.
Although both types of pragmatism end up taking growth into account (see e.g. the Economist 28–9–2002), the second one seems more successful in achieving stability of growth. According to many economists, recent moderation of the business cycle in the US is due to very important knowledge gained about how to conduct monetary policy more efficiently (see e.g. DeLong 1999, 2003; C.Romer 1999; Clarida et al. 2000;
Blanchard and Simon 2001; Banerji 2002; Baker 2003; Bernanke 2004; Martin and Rowthorn 2004). In particular, the FED has managed to carry out a few key pragmatic moves in the last two decades. DeLong stresses, for example, the ‘FED’s greater success at maintaining its balance: at acting pre-emptively and maintaining an appropriate balance between price stability and maximum purchasing power, rather than careening from one objective to the other…’ (2003), as well as ‘the swift reaction of the FED to 1987, to 1998, to 2001’ shocks (stock market crashes and financial panic).10
Fiscal policy rules
In the NE, fiscal policy is also based on the adoption of rules. In particular, the basic view is that there is no need for active fiscal policy to support aggregate demand. Governments all over the world should stick to the principles of sound finance and balance the budget at least over the cycle. Once again, it must be noted that this view is not a recent one. One need only call to mind the so-called Treasury view in Britain in the 1920s, or the fiscal straitjacket in the 1970s when the so-called Keynesian fine-tuning aimed at averting recessions went out of fashion and was replaced by anti-inflationary policies (see e.g.
Baker 2003) Instead, what differentiates the NE from past stages of capitalist economies is that the balanced budget view is expressed in terms of formalized rules based on a more accurate statement of the reasons why discretionary fiscal policies are ineffective and tend to increase instability, at least in the long run. One set of reasons is quite traditional and has been discussed by economists for years. It has to do with the fact that these policies tend to generate further budget deficits that have some well-known negative effects on the economy. In particular, they may make the debt burden in many countries practically unsustainable, implying either higher taxes or inflation. Moreover, by raising interest rates, they may crowd out private investment (ibid.).
Another set of reasons for fiscal policy ineffectiveness is more closely linked to the flimsy nature of the NE. First, it can be argued that, due to the greater instability of parameters and the rapidity of decision-making it involves, the NE exacerbates the problem of getting the timing of fiscal measures right. It is for this reason that tax cut proposals, such as those recently advanced in the US, are often criticized by economists.
According to Krugman (2001), for example, cutting taxes is not a good idea because these cuts require time and cannot be easily reversed. Moreover, there is a high probability that predictions concerning long-run budgets may be wrong (see also the Economist 28–9–2002).
Second, fiscal policy is best avoided as an instrument of stabilization because it has become redundant, at least in part. In the NE several ‘automatic’ stabilizers still exist, such as income tax, the emergence of unemployment compensation and, more in general, the welfare state, all of which have exercised substantial beneficial effects on the economy since their introduction, especially after the Second World War (see e.g. Baily 2001; Blanchard and Simon 2001:135–6).
Finally, fiscal policy in the NE is less effective than in the past because of the increased openness of economies and greater international capital mobility. In a floating exchange rate regime, expansionary fiscal policies in one country either tend to attract foreign capital inflows and generate a ‘strong’ currency, which crowds out net exports or have the opposite effect if they badly impact investors’ expectations.
For all of these reasons, it is easy to understand why many authors argue that the NE emerged at a time of extraordinary fiscal discipline. According to Baily (2001:256) and Stiglitz (2002b), for example, fiscal discipline (i.e. Clinton’s deficit cut) did not create the NE but it helped start the virtuous cycle going as it benefited the US economy through lower interest rates. Indeed, it is the conventional view, which also underlies the Maastricht Treaty and the stability pact in Europe, that deficit cuts by themselves allow economic recovery and growth in the NE.
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The critique of the use of fiscal policy as an anti-cyclical instrument in the NE does not imply the impossibility of using it for other purposes. Indeed, the current conventional view holds that, in order to grant true economic stability, fiscal policy should be used in a long-run perspective as part of a broader set of supply-side policies seeking to influence the determinants of growth, such as investment, saving, labour supply and innovation. In other words, while it is legitimate to leave short-run stabilization to central banks, it is wise to use tax cuts as incentives for people to work more and save more, take greater risks and expand productive capacity (see e.g. Krugman 2001).11
Pragmatic fiscal policy
Once again, it must be noted that the official policy stance does not necessarily correspond to the actual policy pursued by governments. As the evidence clearly shows, the attempt to balance the budget cannot be maintained as a permanent policy rule, especially in the face of shocks. This is also true in the NE. Indeed, in the past two years, interest in a more flexible fiscal policy has revived both in the US and Europe. Faced with the greater variability of parameters and the persistence of pronounced business cycles, many governments have taken steps to relax tight ‘official’ fiscal stances and adopt expansionary measures to support demand and output in the short run and help the economy move out of recession rapidly. One can distinguish between two types of pragmatic moves for fiscal policy, as well.
The first type can be regarded as pragmatism ‘within’ formal rules, and follows from the fact that adherence to fiscal rules does not uniquely determine governments’
behaviour, but allows some room for manoeuvre. The second type instead is pragmatism
‘outside’ the rules, in the sense that while policy is still based on broad commitments to balance the budget, it is not, however, constrained by specific rules.
An instance of the first type of pragmatism is reflected in current debate concerning the European stability pact. The recent modest reform of the pact in March 2005—
allowing temporary extra-deficits (e.g. 3.5 per cent rather 3 per cent)—reveals the growing awareness by policy-makers of having reached a kind of stalemate. On the one hand, they now realize that full compliance with the original pact would be very costly in terms of short-run output in a context characterized by fundamental uncertainty and sluggish growth. On the other, they suspect that changing it substantially is not a viable political option, at least in the short run.
An instance of the second type of pragmatism can be seen in the US, where the lack of a precise formal rule with which to comply makes it is easier to adopt a flexible stance in the face of adverse conditions than in Europe. One could note, for example, that the tax cuts and military expenditure made in order to avoid recession in the US after the terrorist attacks have rapidly turned the budget from a surplus to a deficit without much discussion. Godley and Izurieta rightly describe this dramatic change in policy stance as a drastic change of view, a swift, silent total volte-face:
Barely a year ago, it was widely accepted…that the US growth rate had been permanently raised, the business cycle had been abolished…fiscal