Policy in crisis

Post-war macroeconomics: Part 3

By the end of the 1980s, inflation, high interest rates, and currency and debt crisis were all (theoretically) tied to ‘excessive’ budget deficits (see Fischer 1989). The mainstream political and economic discourse was now firmly geared to budget restraint or sound finance, which did not necessarily imply balanced budgets over the cycle.

At this time, Williamson (1990) outlined the prevailing development model of the IMF, World Bank and US Treasury, known as the Washington Consensus. While the term ‘neo-liberal’ had already infiltrated economic and social policy dialogue, there was no operational definition. The Consensus became synonymous with the neo-liberal policy orientation which emphasised market-based reform such as trade liberalisation, financialisation, deregulation, and privatisation and restrained fiscal policy.

High and persistent unemployment among OECD members during the late 1980s and early 1990s motivated the OECD Jobs Study (1994) and subsequent Jobs Strategy (1995). Influenced by the McCracken Report (1977) and the analytical framework set out by Layard et al. (1991), the labour market outcomes were attributed to an inability to adapt to economic and social changes in view of market deregulation, and rapid globalisation and technological change. Unemployment was interpreted as an individual problem arising from supply-side deficiencies such as insufficient skills, training and education, poor attitudes, and rigid labour markets. The IMF embraced this policy orientation (see, for example, IMF 1999).

The introduction of the Euro as legal currency in 1999 marked Stage Three of the European Monetary Union (EMU) formation set out in the Delors Report (1989).1 The Report which followed the Hannover Summit (1988) recommended that monetary policy be conducted by a new independent institution (European Central Bank) charged with the primary task of maintaining price stability; the European Currency Unit should become the single currency in Europe (later called the ‘Euro’); and, budgetary discipline was necessary among member states to strengthen economic convergence. The notion of ‘sound’ budgetary positions was formalised as specific government deficit and debt rules within the so called Maastricht criteria, and monitored and enforced by the Stability and Growth Pact which incorporated financial penalties for non-compliant members.

The 1990s through to the early 2000s were characterised by relatively less volatile economic times, the so called Great Moderation. The apparent economic stability was largely attributed to monetary policy geared to low inflation, passive fiscal policy, and deregulated labour and financial markets.

New Consensus Macroeconomics (NCM) dominated mainstream macroeconomic research. NCM models, such as dynamic stochastic general equilibrium (DSGE) models had been developed in response to the Lucas critique (see Woodford 2003). Drawing on the contributions of real business cycle theory (see Kydland and Prescott 1982) and New Keynesian principles (see Mankiw and Romer 1991), the models were driven by individual agents exhibiting optimising behaviour in the presence of market failures, such as incomplete markets, imperfect competition and asymmetric information. While monetary policy geared to price stability could ostensibly stabilise output and employment in NCM models (see Blanchard and Galí 2007), there was no distinct role for fiscal policy in economic stabilisation (see Fontana 2009).

Krugman (2001, quoted in Nevile and Kriesler 2001:1) asserted that ‘[a]lmost all economists agree that monetary policy, not fiscal policy, is the tool of choice for fighting recessions.’ Lucas (2003:1) declared that the business cycle had been solved, and that ‘the potential for welfare gains from better long-run, supply side policies exceeds by far the potential from further improvements in short-run demand management’ [emphasis in original]. Instead, government budgets were likened to that of a household which reinforced fiscal restraint. Buiter (2004:4) is clear:

‘The definition of (in)solvency of the state is, in principle, no different from that of the (in)solvency of any other economic agent … The capacity to tax and to issue legal tender makes the state an unusual borrower, but below the surface, it is subject to the same pains and joys of borrowing experienced by private sector borrowers.’

Despite the apparent success of New Consensus Macroeconomics, the pre-GFC period was characterised by rapid private debt accumulation and real wage repression particularly in the USA which, according to the earlier work of Minsky (1975, 1986), precipitates financial instability. Households became increasingly reliant on tentative lines of credit as underwriting standards were largely eliminated under the so called originate-to-distribute model of modern banking (Wray 2008, 2010). Speculative ‘bubbles’ were invisible to the NCM models which had been informed by the efficient market hypothesis.2

The Global Financial Crisis (GFC) largely emerged from the subprime mortgage crisis and subsequent liquidity crisis in the USA, following the housing market collapse. As lenders became increasingly risk adverse and tightened underwriting standards, the US short-term debt market practically disappeared (Wray 2010). A chain of events ensued, which in 2008 culminated in the US government takeover of Fannie Mae and Freddie Mac, the sale of Merrill Lynch, the collapse of Lehman Brothers and the bailout of AIG by the US Federal Reserve. The financial crisis quickly became a real economic crisis as consumer and business confidence diminished and the private sector began to net save to reduce burgeoning debt levels. The Great Recession enveloped the global economy.

Low interest rate conditions, particularly in the Eurozone, and unscrupulous lending activities of poorly regulated financial institutions, particularly in the USA, ostensibly caused the GFC. A flawed theoretical framework, however, would severely compromise policymakers’ response to the crisis.



1 The Werner Report (1970) had previously offered blueprints to an economic and monetary union in Europe set out in three stages which included a plan for a fixed exchange rate and common currency among the European Economic Community (EEC) to be achieved within a decade. The EEC, a common market, was established by the Treaty of Rome (1957). However, the proposal for lost momentum in the early 1970s as the supply shocks enveloped the global economy. Instead, EEC members implemented snake in the tunnel exchange rate management after the collapse of the Bretton Woods exchange rate system in 1971. This was replaced by the European Monetary System (EMS) in 1979 which established the European Currency Unit and the Exchange Rate Mechanism. The EMS was a further step towards an economic and monetary union as it attempted to improve monetary stability and achieve closer economic convergence among the EEC.

2 Macroeconomists have, for some time, acknowledged the possibility of speculative bubbles, that is, where asset prices deviate from their intrinsic values. While there are numerous theories of asset price deviations, such as rational growing bubbles, fads and information bubbles, there is no basis for determining when they might ‘burst’.


See here.




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