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Economists still have much to learn as the latest shift in policy shows

It is said that “a crisis should never be allowed to go to waste” as it provides a chance to do new things that could not have been done otherwise. Such seems to be the impetus behind the Biden administration which has gone all out in its spending plans to spur on the post-lockdown economy. With policymakers typically conservative in nature, such boldness is usually limited and as such there is much contention about what will be the impact on the economy. Yet, the outcome of the policies will most probably be inconclusive and politics rather than economics is likely to be the more dominant force over government’s actions in the future.

The background story behind the bolder policy response seems to revolve around two changes over the past decade. The first is the leftward shift of the Democratic Party in the United States with politicians such as Bernie Sanders and Elizabeth Warren gaining large amounts of support. The other change is the lessons learned from how the economic recovery played out following the global financial crisis. At the time, concerns about rising levels of government debt meant a more muted response to the economic downturn which is turn hampered the recovery.

After his experience with Obama as vice president at the tail-end of the global financial crisis, Biden was well placed to see both policy in the making as well as how it played out in practice. The stimulus package back then was relatively limited especially when considering the extent of economic downturn. Measures in regard to other priorities such as infrastructure and social welfare from the Obama administration were also muted by worries about spending too much. The contrast, 12 years later, is stark with Biden unleashing a massive stimulus package followed up by big spending plans for infrastructure.

The contrast is all the greater as Biden brushed aside both concerns about mounting government debt as well as the potential for inflation amid a post-lockdown buying spree by consumers. Just as in the past, how the economy responds will shape what measures policymakers might adopt in the face of future crisis. Whether this shift will mark a return to more Keynesian (emphasising fiscal over monetary) policies depends on whether the spending actually has the desired effect. You might think that how to deal with economic downturns is something that economists would have figured out by now but there has been heated debate over what is expected to happen.

Part of the reason for this is that economic theory actually rests on only a limited number of real-life outcomes when the economy is acting up. Economists do not have the luxury of testing their ideas in a laboratory so rely more on theory than practice. It is difficult to gauge the impact of any policy considering that the economy is so complicated with individuals and businesses reacting to countless risks and rewards with many things happening at the same time. Neither is there much chance to learn from the past in terms of what policies might work best as each economic crisis is different. And with economic policies having profound impact on the lives of millions of people, too much experimentation with policy could be seen as reckless.

Economic policy is not just about finding the best response but is also about fitting in with the politics of the time. Feeble economic growth over the past decade even with relatively aggressive monetary policy suggested that there was an opening for a new approach. The measures taken by the Democratic president in the US are the most proactive amid a general shift towards a greater role for government spending in managing the economy. Even the Tory party in the UK that pushed ahead with austerity a decade ago seems to have thrown caution to the wind when it comes to government debt.

It is too soon to tell whether this change in approach will be a permanent major shift or just a minor tweak of policy. Much (but not all) will depend on what will be the characteristics of the post-lockdown economic recovery. Despite what proponents on either side of the political debate are predicting, the stimulus policies themselves will probably neither see a resurgence in economic growth nor the return of inflation and higher interest rates. The economy will recover as things return to normal but the extent to which government policy has any influence over this will be disputed.

The likely absence of any solid evidence either way will most likely result in politics continuing to hold sway. Either side of the argument over more or less government action will look for whatever might strengthen their point of view. Those hoping for more government spending to bolster the economy during downturns will take heart if inflation remains subdued. Yet, the ability of the government to shore up the economy is limited by the extent to which it can borrow, unless there is a major rethink about how to repay such debt.

It is then strange to think that a discipline such as economics that sees itself as a science is so heavily influenced by the political whims of the time. But part of the reason behind this is that, while our understanding of the economy is improving, there is still much in economic theory that is subjective. Economists also tend to be on the backfoot as their theories tend to rely more heavily on the experience of the past rather than looking more closely at current developments. Thus, in what direction will the economy (and economic theory) be heading is something that economists, like everyone else, will just have to wait and see.