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  • Writer's pictureVladimir Chlouba

When Economic Theory and Political Reality Diverge

One of the most captivating debates of the last decade that has engaged academic economists and the general public alike has concerned the propriety of state intervention in the face of economic recession. After the 2008 financial crisis, the so-called Keynesians, following the recommendation of the iconic British economist John Maynard Keynes, have argued that governments should spend massive amounts of money in order to revive their countries’ economies. Scholars such as Paul Krugman, Joseph Stiglitz, Jeffrey Sachs, and many others have proclaimed that at times when the public willingness to spend and consume dwindles, so-called fiscal expansion can fill in the gap and deliver us from unnecessary economic woes. On the other side of the aisle has been a little more heterogeneous group of thinkers, often labeled as neoliberals, neoclassicals, ordoliberals, and so on. This diverse group has argued that increased government spending will have little effect and could potentially cause significant harm. In fact, proponents of austerity – the policy of slashing government spending – have championed an argument that is in direct opposition to the Keynesian logic. At a time when the public has lost faith in the economy and the government’s ability to manage its debts alike, politicians need to cut spending, so that investors regain confidence and the economy as a whole undergoes a temporarily painful treatment which will result in sustainable prosperity in the future.

Although I think there is room for reasoned debate, I have mostly stood closer to the second viewpoint, i. e. I too have concluded that at a time of rising amounts of debt and persistent problems (such as sclerotic labor markets in Europe, where unemployment remains stubbornly high), it is crucial to tackle debt and champion reform, thus aim at the linchpins of future prosperity. This position can be supported by more or less contested economic theory but the chief reason why I tend to distrust increased spending in times of recession is the looming gap between economic theory and political reality. Even if one grants to the Keynesians the argument that increased government spending would indeed help the economy recover (and there is some, although rightfully contested, evidence for that), the politics of the solution rarely adds up. Keynesians argue that governments should spend in times of crises and build up reserves in times of prosperity. The reality often looks different – governments spend in times of crises but they spend just as much in times of prosperity. It is simply very hard for an elected politician to argue that the government should restrict its spending when things are going exceptionally well.

To be fair however, I have recently realized that the above described gap between economic theory and political reality affects many other issues that are of interest. In fact, this realization led me to reexamine some of the arguments that I have made in favor of free markets and capitalism in general.

For instance, think of globalization. It is widely acknowledged that free trade and other aspects of globalization are generally good – they make humanity richer, economies more efficient, and products more affordable. At the same time, it is acknowledged that different people are affected by globalization differently. While the global economy as a whole gains, the gains are not distributed equally. Some win more than others and some even lose. Economists have argued that as long as the winners from globalization compensate the losers, things will be just fine. Unfortunately, things have not necessarily turned out that way. While the winners have enjoyed their victories, there has been less emphasis on the compensation part of the argument. In other words, the economic theory has made complete sense but political reality has not kept up.

Another example was provided by the 2008 financial crisis itself. Some of the greatest risk takers gambled with the knowledge that the government, as it did, would step in if things turned sour. What soon became apparent was the fact that not only do we have an economy in which certain institutions are too big to fail, we also live in a system where some are apparently too big to jail. This is a problem because one of the key features of capitalism is that individuals and firms take their own decisions and subsequently face the music. Only that way can the system work efficiently and only that way can the economy remain self-correcting. The reason why the link between peoples’ decisions and the consequences of those decisions has been broken, is, unsurprisingly, politics. Politically connected individuals have been able to bend the economic logic (and in fact misuse economic theory) to distort market mechanisms and help themselves.

The above cases, I believe, provide some learning opportunities to both economic interventionists and free marketers. First, one has to realize the subtleties that distinguish the said cases. Although they all illustrate a situation in which economic theory and political reality diverge, the argument for government spending in recessions as well as for globalization differs from crony capitalism. While the argument for fiscal expansion as a response to economic recession as well as the one for globalization require politics to do its part for the arguments’ logic to hold up, a reasonably functioning logic of market capitalism requires that politics be kept at bay. This difference is important. While stopping politicians from interfering with the markets in undue ways is hard but possible, ensuring that politicians do something (in this case maintain fiscal discipline in times of prosperity) seems harder.

To be sure, fiscal expansion and globalization differ in the extent to which the absence of the promised political solution is harmful. Whereas the government’s failure to amass reserves during times of prosperity may lead to a complete collapse of national finances, policymakers’ failure to compensate losers from globalization creates disruptions that are significant but temporary. They are frictional (related to temporary changes) rather than structural (related to the underlying nature of the economy). This means, for example, that even American towns which were once known for their manufacturing prowess will eventually benefit from more trade. This, however, will only happen after their economies are transformed. This transformation may be a slow and painful process. Still, this problem is frictional and not structural.

Second, economics and politics are far too often two sides of the same coin and we cannot, either in our analyses or policy prescriptions, act is if they were not. When reaching conclusions and making recommendations, we ought to comment on how the other side of the said coin might work out.

Lastly, it pays off to be very precise in our thoughts and criticism. Far too many critiques emphasize either emotional distaste of capitalism or passionate extolment of free markets. Our discussion benefits from neither, our analyses suffer from both.

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