This Time Should Have Been Different: The Causes and Consequences of Macroeconomic Policy Failure in the Great Recession

Abstract

The great tragedy of the last decade is that so much of the economic and political turmoil on both sides of the Atlantic has been unnecessary. Needless and excessive fiscal austerity, asymmetric inflation targeting, and the failure to address persistent sovereign and household debt overhangs have turned serious but manageable financial crises into long-term threats to the liberal international order. The real economic consequences have been massive: a “lost decade” for the Eurozone, a Great Depression in Greece, and below-trend income growth in the US and UK since 2008. Macroeconomic policies that might have resolved the crises quickly and accelerated the economic recovery – in particular, large-scale fiscal stimulus, with an emphasis on infrastructure investment generating substantial employment and taking advantage of historically-low (negative) real interest rates – were never even attempted. The political consequences of these fiscal and monetary “own goals” have been equally massive: a marked rightward political shift in many industrialized countries and a surge in populist nationalism, as illustrated most clearly in the cases of Brexit and the election of Donald Trump.

This essay explores the reasons why policymakers failed so spectacularly, as well as the ramifications of this failure for the future of the global economy. It emphasizes two key factors: the persistence and pervasiveness of “bad” economic ideas, and the long-term, negative consequences of central bank independence. In a sort of Gresham’s Law of political economy, macroeconomic policy debates have been dominated by false narratives and discredited ideas, such as the household analogy, the morality of debt, and expansionary austerity. The prevalence of these narratives precluded any serious discussion of meaningful stimulus or debt relief on both sides of the Atlantic. This was especially tragic, given that we knew from history exactly what not to do in the wake of financial crises – and yet, we did it anyway. At the same time, central bank independence – while a successful institutional innovation to the inflationary problems of the 1970s and 1980s – proved to be a roadblock to effective monetary responses to the current crises. In particular, the widespread adoption of 2% inflation “ceilings,” along with the dominance of central bank governing boards by hawkish former bankers and economists, prevented serious discussion of more aggressive monetary policies that might have accelerated the recovery.

This failure of macroeconomic policy and the ensuing era of stagnation has triggered a rising backlash against globalization. At the same time, we may now be seeing a counter-backlash, as those most dependent on cross-border supply chains and globalized financial markets increasingly speak out against Brexit, repealing NAFTA and other trade agreements, and increasing immigration restrictions. Despite fears of a rollback of globalization and the collapse of the liberal international order, the most likely medium-term outcome now seems to be increasing isolation of the US and UK, with the rest of the world’s major economies moving forward with continued trade and financial integration. The greater risk is that we will still not have fully recovered from the past decade's crises when the next major crisis hits – and that we will once again fail to learn from our past macroeconomic policy errors when it does.

Keywords: Global Financial Crisis, Euro Crisis, Monetary Policy, Fiscal Policy, Great Recession, Austerity, Globalization, Central Bank Independence

JEL Classification: E52, E62, F02, F41, F50, G01