Originally published at Project-Syndicate | Aug 18th, 2023
Since the 2008 global financial crisis discredited the old liberal orthodoxy, the door has been open for simplistic policies, in part because most people tend to focus only on a policy’s first-order effects. Unfortunately, everyone will have to learn the hard way why such policies fell out of favor in the first place.
CHICAGO – Even in the best of times, policymakers find it difficult to explain complex issues to the public. But when they have the public’s trust, the ordinary citizen will say, “I know broadly what you are trying to do, so you don’t need to explain every last detail to me.” This was the case in many advanced economies before the global financial crisis, when there was a broad consensus on the direction of economic policy. While the United States placed greater emphasis on deregulation, openness, and expanding trade, the European Union was more concerned with market integration. In general, though, the liberal (in the classical British sense) orthodoxy prevailed.
So pervasive was this consensus that one of my younger colleagues at the International Monetary Fund found it hard to get a good job in academia, despite holding a PhD from MIT’s prestigious economics department, probably because her work showed that trade liberalization had slowed the rate of poverty reduction in rural India. While theoretical papers showing that freer trade could have such adverse effects were acceptable, studies that demonstrated the phenomenon empirically were met with skepticism.
The global financial crisis shattered both the prevailing consensus and the public’s trust. Clearly, the liberal orthodoxy had not worked for everyone in the US. Now-acceptable studies showed that middle-class manufacturing workers exposed to Chinese competition had been hit especially hard. “Obviously,” the accusation went, “the policymaking elites, whose friends and family were in protected service jobs, benefited from cheap imported goods and could not be trusted on trade.” In Europe, the free movement of goods, capital, services, and people within the single market were seen as serving the interests of the EU’s unelected bureaucrats in Brussels more than anyone else.
After the old orthodoxy was found wanting, and after its proponents had lost the public’s trust, the door opened to unorthodox solutions. But while thinking outside the box can produce good outcomes, policy prescriptions also need to be easily understood by the untrusting layperson. Therein lie the roots of bad populist policies.
If we need to create jobs, why not erect tariffs to protect workers? If we need to spend, why not just print money (as Modern Monetary Theory dictates)? If we want to revive manufacturing, why not emphasize the danger of depending on China, and offer subsidies and other incentives for firms to reshore or friend-shore operations? If we need to make the financial system safer, why not raise capital requirements on banks still further?1
Because the liberal orthodoxy has been discredited in the eyes of the public, many such policies that were anathema to it have now re-emerged. But, equally important, the appeal of populist policies, however unsound or unsuccessful in the past, is that they seem obviously true and are easy to communicate. As the American essayist H.L. Menken famously quipped, “for every complex problem, there is an answer that is clear, simple, and wrong.” After all, who cannot see that import tariffs will protect at least some domestic jobs? Though the jobs saved by new steel tariffs will raise the cost of manufacturing cars domestically, leading to potential job losses in that industry, this point requires an additional step of reasoning that is harder to communicate.
Similarly, replacing a supplier from China with one in a friendly country would seem to make a supply chain more resilient to a potential China-US conflict; but it also may create a false sense of security, considering that many friendly suppliers still rely on China for key inputs. Analogously, raising capital requirements may have made banks safer after the global financial crisis; but to continue raising them will only increase banks’ costs of funding and reduce their activities, leading to a migration of risk into the unregulated, opaque shadow financial sector.
According to the nineteenth-century liberal French journalist Frédéric Bastiat, “There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.” But when there is no trust, warnings by policymakers and economists about unseen second-round effects simply will not be believed. Those urging fiscal restraint, for example, will be tagged with the Dr. Doom epithet and dismissed – at least until real (inflation-adjusted) interest rates increase to the point that servicing the bloated public debt requires austerity. Seeing is believing, but it comes too late.
Emerging markets and developing countries have been through such cycles before, which may be why some of them have emerged as proponents of orthodox liberal macroeconomic policies this time around. Yet the temptation to pursue unorthodox populist policies remains strong, especially now that rich industrialized countries have embraced them.
Hence, India, despite its terrible experience with the so-called License Raj, recently started requiring licenses to import computers – in part to support domestic production, and in part to reduce its dependence on Chinese imports. But what about the negative consequences for IT service exports (India’s greatest source of export revenue) and for Indian business more generally? Argentina, an addict to populism, seems to be shifting its affections from the left-wing Peronists to a right-wing libertarian, who promises to cure inflation by, among other actions, adopting the US dollar (again!).
It is hard not to be pessimistic nowadays. In industrial countries, the pendulum has swung from excessive faith in the liberal orthodoxy to faith in populist policies, until their deficiencies become obvious once again. The best we can hope for is that, unlike what seems to be happening in Argentina, it will not then swing too far back toward the other extreme, and that we will have learned some lessons along the way.
Raghuram G. Rajan: Former governor of the Reserve Bank of India, is Professor of Finance at the University of Chicago Booth School of Business and the author, most recently, of The Third Pillar: How Markets and the State Leave the Community Behind (Penguin, 2020).