Dušan Vujović, Professor at FEFA, Former Minister of Finance: New Balanced Economic Policy Paradigm

Global financial crisis of 2008 led to demands for thorough examination of market institutions and economic policies associated with slower growth performance, declining real incomes, and increasing inequality. The Covid-19 pandemic elevated this criticism further as it unleashed a crisis of monumental proportions causing widespread economic disruptions, concerns about environment, technology and common goods, and mounting risks for businesses and individuals
Dušan Vujović, Professor at FEFA, Former Minister of Finance

The international policy responses to Covid-19 pandemic considerably broaden the conventional policy agenda both in terms of the size and scope of fiscal interventions supplemented with monetary easing and the use of unconventional instruments (such as asset purchasing). The new policy advice included new measures for post-pandemic revival of the supply side, normalization of labor markets through job-retention, and worker reallocation and retraining schemes in light of the challenges posed by the ensuing fourth industrial revolution in general and automation in particular.

It recognized longer term concerns regarding adverse impact on the environment and climate change, need for selectivity in supporting economically viable firms, addressing growing inequality issues and a dire need for international cooperation on vaccinations and public health issues in general.

But it stopped short of addressing the causes and systemic consequences of excessive globalization and unregulated capital mobility, insufficient provision of local, national and global public goods, as well as important linkages between economics and other social sciences in harnessing democracy and human well-being. In other words, it predictably failed to move beyond neoliberalism offer a new economic policy paradigm for the future.

Historically, economic policy paradigms changed infrequently and, almost always, as a result of three factors:

  • Existence of theoretical alternative (new school of thought) in response to weaknesses in existing theories;
  • Real crisis that could not be addressed within existing paradigm or, simply, a need to address an emerging economic problem (industrialization, urbanization, economic growth etc.); and
  • Political support embracing the new theory and related policy interventions.

Liberal economic policy paradigm, which ruled during the 1870-1930 period, was pivoted on ideas of laissez-faire, free flows of goods, capital and labor, national and international macroeconomic stability, and balanced general government budgets. The period of prosperity lasted only until WWI. In the 1920’s the liberal ideas were challenged by the reintroduction of trade barriers, while the Great depression showed that markets will not self-correct in response to the crisis.

This opened the way for Keynesian policy paradigm based on active role of the state in reaching full employment through aggregate demand management. It gained acceptance with the New Deal and came to dominate the economic policy making of the so called post-WWII consensus which underpinned rebuilding the world economy in the 1950’s, and the postcolonial economic development efforts in the 1960’s and 1970’s.

The dominance of Keynesian policy paradigm gradually weakened over time and ran out of steam after the 1972 collapse of the original Bretton woods system of fixed exchange rates guaranteed by the Gold Standard, slower economic growth, and declining macroeconomic performance (stagflation) both in advanced economies and developing countries.

Conservative victories of M. Thatcher in the UK and R. Regan in the US opened the door for the new neoliberal policy paradigm to enter the economic policy arena. With this, all three ingredients of the policy paradigm shift were met: there was a real economic problem demanding solution (stagflation, protectionism, stalled economic reforms); a body of alternative theory and set of neoliberal policies has been fully developed; and political and institutional support to legitimize the policy change ex ante and defend the results/outcomes ex post has been secured through electoral victories in leading countries.

Neoliberal policy paradigm aimed to reconstruct economic and policy conditions prevailing during second industrial revolution

Neoliberal policy paradigm aimed to reconstruct economic and policy conditions prevailing during second industrial revolution (the “Golden age of capitalism”) characterized by: unlimited entrepreneurship; unregulated and flexible labor market; macroeconomic stability; free flow of labor, goods and capital; absence of significant state ownership; absence of market regulation (including financial markets); and the absence of economic strategies and industrial policy.

Selective neoliberal memory did not recall that A. Hamilton, one of the founding fathers of the USA and the first minister of finance, favored “infant industry protection” and introduced tariffs of 45-55% which lasted from independence till modern times. Likewise, the state often owned substantial land and natural resources, infrastructure, real and financial assets, and it actively advanced education, health, and infrastructure, and create conditions for private sector investment (crowd-in).

Prevailing social conditions were also very different. Widespread entrepreneurial drive and desire to participate in a unique march of the second industrial revolution suppressed all reservations regarding the lack social safety or labor protection. Predatory and monopolistic behavior of commercial enterprises were not effectively controlled by the laws or moral norms. The dark side of the original liberal world view almost completely faded over time in favor of unprecedented global progress in industrialization, urbanization and modernization.

This explains why neoliberal policy and reform programs, known as the Washington Consensus, advocated: massive privatizations, price liberalizations (irrespective of market imperfections); liberalization of foreign exchange rate, foreign trade, and capital flows; deregulation of labor markets; relaxation of environmental standards; under-provision of public goods (health, education) and social services; and radical deregulation of the banking and financial sector, relaxation of supervisory and fiduciary controls, and interest rate liberalization.

In terms of macro-policies, the neoliberal approach placed strong emphasis on price stability and tight fiscal policies, but in reality opted for lower taxes leading to fiscal deficits and public debt build-up.

The economic profession has come to question and critique the failed performance of neoliberal policy agenda

Between 1980 and mid-1990’s, new neoliberal policy and reform agenda had many commendable achievements at the national and global level including: improved price stability; free trade and globalization of economic activities; and free movement of capital. But it also created huge income and wealth inequalities within and across countries, and deep labor market disruptions caused by automation and real income stagnation. It directly caused the 2007 Global financial crisis due to a deliberate lack of policy, regulatory and supervisory effort to control open and hidden risks of the increasingly complex financial sector.

With a relatively long delay, the economic profession has come to question and critique the failed performance of neoliberal policy agenda and demand a major theoretical and policy paradigm shift in economics to better respond to the present needs and challenges through greater reliance on experimental data and behavioral economics, as well as the use of empirical results in measuring inequality and key economic outcomes.

The most prominent initiative along these lines comes from leading economists in top US universities: Naidu (Columbia University), Rodrik (Harvard University), Zucman (UC Berkeley), and Acemoglu (MIT). After decades of disappointing results, they claim, it is now clear that neoliberal policy framework has failed economists and all social scientists, and, more importantly, has failed the society. As a way out, they suggest a concept of “inclusive prosperity” to improve the quality of policy recommendations across a wide range of key economic issues (including labor markets, public finance, international trade and finance). It is based on a new vision for economic policy as a genuine alternative to the market fundamentalism that is often – and wrongly—identified with economics.

Their approach offers to correct many neoliberal “errors of commission” such as a trade-off between efficiency and equality, i.e. the need to sacrifice equality for growth (efficiency); or the negative impact of minimum wages on employment, as neither of these claims is supported by empirical evidence or good economics. Over time, the inclusive prosperity initiative is expected to generate a growing body of new theoretical and empirically tested proposals that would address real life policy problems without resorting to theoretical stereotypes with predictable recommendations which may or may not offer plausible and defendable solutions.

In conclusion, the new innovative approaches in the design of expansionary fiscal support measures and accommodating monetary policy in response to the pandemic, clearly go outside the traditional separation of fiscal and monetary policy, and violate the full independence of the central bank as seen through the subordination of monetary expansion to the fiscal support, as well as the use of government asset (permanent) purchasing actions to provide free monetization of fiscal deficit.

The new policy paradigm offers a way of balancing reliance on markets and state actions, and overcoming inherent policy limitations in the treatment of: local, national and global public goods; excessive globalization; and unregulated financial markets and full (unconditional) capital mobility. It provides a stronger basis for integration with other social sciences, especially in the coherent treatment of poverty, inequality and other consequences of proposed economic policy interventions. The potential theoretical and empirical advances within the inclusive prosperity framework initiative provide an opportunity to substantively expand economic policy framework beyond neoliberalism, by harnessing principles of democracy and human well-being fully consistent with sustainable development goals through balanced conduct of economic policy, efficient and adequately regulated markets (as needed), and responsible and transparent state actions.

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