This is a book for all those interested in what shapes, or should shape, economic policy: the major stylized facts that capture the messages from history; the theories that help understand these facts and represent the impact of policy decisions; the controversies surrounding policy choices; the institutions that contribute to determining them; and, last but not least, how experience, theories and institutions interact.
We have been teaching the material that forms the basis for this book in a graduate seminar at École Polytechnique in Paris since 1998, and also at Sciences Po, Ecole Normale Supérieure, Ecole des Ponts - ParisTech and Université Paris-Dauphine. In 2004 a first book in French arose from this experience, followed by a second edition in 2009. This English edition presents completely revised material, drawing on the experience with previous editions and on the policy lessons learnt in the global crisis.
Prerequisites are limited, because we start from facts, introduce theories as needed, and keep formulae in boxes. Practitioners and observers will find in the book what they need to know to understand actual policy issues and discussions. However, graduate students more familiar with models will also learn from the book how to link frontier research to concrete policy developments.
This book also aims to eschew cultural bias. Our analysis starts from policy questions in Europe, the US and the emerging world, and our examples are taken from around the world.
WHY THIS BOOK IS DIFFERENT
This book is based on the premise that the disconnect between theory and practice is detrimental to both good policy and good research. It posits that going back and forth between practice and theory enlightens practice and helps construct better theories.
We have been vindicated in this belief by what we have learnt from personal experience. Each of us has engaged at times in academic research, policy advice and policymaking, at a national, European or international level. This has changed the way we understand and use economic theory.
This is why we have embarked on this project, and aimed at providing a systematic and theory-driven approach to economic policymaking. Economic textbooks typically cover economic theory in a given field - macroeconomics, microeconomics, finance, international trade, etc. Real-life stories are told to illustrate theoretical results. But the representation of economic-policy instruments and of the decision-making process remains very rudimentary and abstract. Conversely, there are many excellent essays on economic policy, but they are more concerned with describing the ebb and flow of new ideas and institutions than with discussing their theoretical underpinnings. Our book aims to fill that gap.
The result is admittedly an unusual book. The blend of facts, theory and practice departs from what is found on most courses. We regard this structured eclecticism as the book’s comparative advantage. Many of our students and colleagues have commented that what they have read throughout the book could not be found elsewhere.
Our aim has been first and foremost to help readers build bridges between the elegant theoretical constructs taught in universities or discussed in seminars and the mere plumbing that constitutes the daily life of economic policymaking in ministries, central banks and international organizations. Usually, economists begin by learning the former and they discover the latter only later in their career. We trust that this book will make a significant contribution to preparing students for the challenges of effective economic policymaking and will increase the policy value of their academic background.
HOW TO USE THIS BOOK
This book summarizes the main theoretical and empirical instruments, old and new, which are relevant to addressing real-life policy issues; it explains how these instruments can be used to identify policy trade-offs and guide policymakers’ choices; and it discusses the theoretical uncertainties, blind spots and controversies that warrant humility and caution when formulating policy advice –and that make the job of economists so challenging and rewarding.
There are eight chapters. The first two chapters set out the general framework of economic policymaking. Chapter 1 recalls the methodological foundations and details of the toolbox which will be used in the rest of the book. Chapter 2 adds a note of caution: it outlines the limits of government intervention in the economy and the political-economy arguments which may render it sub-optimal. Chapters 3 to 7 cover in turn five domains of economic policy: fiscal policy (chapter 3), monetary policy and financial stability (chapter 4), international capital movements, the choice of exchange-rate regimes and exchange-rate policy (chapter 5), long-term growth policy (chapter 6), and tax policy (chapter 7). Finally, chapter 8 covers the 2007-09 global crisis and its lessons for economic policy.
Each of the five central chapters (3 to 7) is structured in a similar way: stylized facts are taken from recent economic history, then the theoretical tools available to policymakers and which they should be mastering well are explained, and finally the main policy options are presented. There are many cross-references between the five chapters, but they are written in such a way that each of them can be read in isolation.
Economists are often blamed for resorting to technical vocabulary as a way of protecting themselves from inconvenient questions. We have tried to unveil the – often simple – concepts behind complicated or abstract expressions such as the output gap, welfare losses or rational expectations. An extensive index lists all these concepts and points to the place in the book where they are defined, explained and illustrated. Additionally, there are extensive bibliographical references so that the reader can dig further by him/herself into any of the issued covered.
This book is by no way comprehensive. Individual behavior, constraints and incentives are deliberately introduced only insofar as they help understand macroeconomic issues. We have thus chosen not to address a number of otherwise important areas of economic policy such as competition policy, procurement rules and auction schemes, public or private ownership of companies, health care and pension planning, and what has generally been referred to as ‘mechanism design’ by Nobel Prize winners Leonid Hurwicz, Eric Maskin and Roger Myerson –that is, designing efficient solutions to collective-decision problems. We have also decided not to write specific chapters on international economic policy, regional (and especially European) integration, or the management of local governments. Chapter 2 summarizes what economic theory has to say on the assignment of policy instruments to different levels of government, and on the difficulties of global governance. However, in any policy domain, some levers are global, some are regional, some are national and some are local, and we have therefore addressed them in conjunction in each of the five central chapters.
What has changed with the crisis
As a science, economics has always leapt forward when new facts could not be explained by the prevailing theories, or when economists had to understand why their advice had failed. Keynesianism triumphed in the aftermath of the Great Depression, which helped in understanding that aggregate demand mattered; the so-called ‘rational-expectation revolution’ of the 1970s prospered when it appeared that Keynesianism could not eliminate stagflation. This is why economics has been striving and will continue to strive to be an intellectual discipline. We have done our best to recognize this and incorporate in each chapter the latest theoretical developments.
However, the global economic, financial and social crisis of the late 2000s has raised disturbing questions. It has forced governments and central banks to take bold, unprecedented measures, and radically revisit their policy frameworks. It initially left the economics profession remarkably silent, as if awestruck. Its impact on economic thinking may one day be compared with that of the Great Depression – or it may not: only History will tell.
Waiting for the judgment call, two kinds of lessons should be drawn. First, operational features of the economy which were considered mere technicalities prior to the crisis, such as liquidity provision techniques or capital requirements for banks, have proven critical to the continuation of economic activity and should therefore be part of mainstream economic knowledge. Second, basic theoretical features such as moral hazard, market efficiency or the assignment of monetary policy instruments have proven more elusive than previously thought, and deserve fresh discussion in the light of this crisis. This has been included in this book where relevant, in particular in chapter 4, which deals with monetary policy, and in chapter 8, which specifically addresses the causes and consequences of the crisis.
We express our gratitude to those who have encouraged us and who have helped make this adventure a reality. We owe a lot to our students, whose questions and criticisms have greatly improved the relevance, accurateness and legibility of this book. We also thank our colleagues and friends who have commented on previous versions. We reiterate our thanks to Olivier Blanchard, whose work has often inspired us, for having agreed to write the preface to this book. Last but not least, we thank our families for their patience and support for this seemingly never-ending (and probably ongoing) endeavor.
Agnès Bénassy-Quéré, Benoît Cœuré, Pierre Jacquet and Jean Pisani-Ferry