I have structured this as a two-part post, where the second part is about one of the two winners of this year’s Nobel prize for economics. Both parts are directly connected, but I’ve split them because the second part is more of interest to those who know some economics.

The Decline of Knowledge Based Policy

I have written about this before, prompted by a post from Chris Dillow, who has returned to the theme more recently. Rereading all this I think we have a classic problem of overdetermination, by which I mean that we only have one observation - the decline in knowledge based policy over the last two decades - and far too many possible explanations for that observation. So here I want to counter that by putting forward just one story.

My proposition is that the decline in knowledge based policy in the UK is a result of something that happened long before the decline became evident: the adoption of neoliberal ideology by the Conservative party in the 1970s and 1980s. Not a consequence of neoliberalism, but neoliberalism being adopted by the UK’s dominant party of government. The distinction is crucial because in many ways the heyday of knowledge or evidence based policy, at least for social science, was the Labour government of 1997 onwards, and you can legitimately call that government neoliberal in many respects.

Of course neoliberalism was to an extent knowledge based, in that it used parts of economics to argue that markets were best at allocating resources, and certainly better than government. However I would argue that inpractice it was really an ideology of government that put the interests of business and corporations first, and used selected bits of knowledge to pretend that this was equivalent to maximising the interests of society.

Post war Conservative governments before this had of course always been attuned to the interests of business, but they also recognised other interests, and were prepared to overrule business interests if they thought society required that. Trade unions were tolerated, for example, as were the nationalised industries created by the Atlee government. That ended with the adoption by the Conservative party of neoliberal ideology.

In contrast, the New Labour government of Blair/Brown were much more prepared to modify that ideology in specific cases. The minimum wage is a clear example. That was why evidence based policy was able to flourish (comparatively) under that government. Of course not everything proposed by neoliberalism was necessarily wrong, so to many the initial Thatcher period might have seemed like it involved some knowledge based policy, even if some of the ideas they adopted turned out to be horribly wrong (e.g. monetarism).

The belief that steadily grew in the Conservative party under and after Thatcher that neoliberalism was all the knowledge that government needed meant that party lost what little interest it had in knowledge based policy. In particular, it stopped learning from its mistakes, and unlike Labour made no attempt to adjust after electoral defeat. This became very evident when they returned to power (in coalition with the Liberal Democrats) in 2010. Austerity was the opposite of knowledge based policy. It went against basic ideas in macroeconomics that were taught to both first year undergraduates and masters students in nearly all universities in the UK and the US.

In essence, the knowledge we had from both accepted economic theory and empirical evidence was that you don’t cut public spending in a recession, and in particular you don’t do so in a recession where interest rates had hit a lower bound and couldn’t be cut further. Doing so would either make the recession much worse or kill any recovery. The previous Labour government had understood that, which is why it adopted fiscal expansion in 2009. George Osborne and the Conservatives argued against that fiscal expansion, and when they gained power adopted a contractionary fiscal policy. The result was exactly what economic theory and evidence predicted. The recovery that started in 2010 stalled, and the economy didn’t start to show (albeit modest) signs of above trend growth again until 2013.

Osborne ignored macroeconomic knowledge because the neoliberalism his party had adopted argued for a small state and low taxes. The large budget deficits created by the biggest recession since WWII allowed him to scare voters into thinking that cuts in spending had to happen immediately to avoid the bond markets punishing the UK. The media largely cooperated in supporting this myth. They too had little time for knowledge based evidence for reasons that were not just political.

Austerity wasn’t the first time the Conservative party showed its disinterest in knowledge based policy, but austerity was the most obvious and it had a huge impact. Unfortunately this disinterest was rewarded when Cameron won the next election outright, and therefore his disregard for knowledge and evidence appeared validated. It was downhill from there and one year later economic knowledge was labelled ‘Project Fear’. Some on the Labour centre and right drew a similar lesson. (Not the left: John McDonnell as Shadow Chancellor was always interested in new ideas.) As Labour’s current disinterest in the economic viability of the university sector suggests, it’s a long road to get back to the heady days of evidence based policy under Brown and Blair. Conservative party policy making remains hopeless: Jill Rutter recently described their inheritance tax proposals as “myth-based”.

Michael Woodford jointly wins the 2026 Nobel

I’m not going to attempt to fully describe Michael Woodford’s contributions to macroeconomics, because others can do that much better than me. However I do want to correct an impression that some may have got from these tributes, and that is that Woodford’s work was all about monetary policy, and how central banks should operate. A great deal of his work was about this, but Woodford also wrote about fiscal policy, at exactly the time that this work was most needed - 2010.

First some background. In the 1980s and 1990s academic macroeconomics went through what is generally called the New Classical Counter Revolution. At the time the leaders of this revolution hoped to use some new theoretical ideas to end the dominance that Keynesian theory had over macroeconomic policy. Their ideas, and in particular rational expectations and an intertemporal model of consumption, were indeed adopted, but other economists also added simple models of price rigidity to rescue basic Keynesian ideas about the business cycle.

The result was generally called New Keynesian theory. I think it’s fair to say that in his 2003 book, Interest and Prices, Woodford wrote what was then the clearest exposition of the implications of the New Keynesian theory for macroeconomic policy, and the book became a bible for academics and central bank economists alike. For those overly sceptical of the New Keynesian model, I would suggest that the fact that the 2022/3 wage and price inflationary period was brought to an end without high unemployment is evidence in its favour over older Keynesian ideas. Blanchard has argued recently that the last few decades have seen a convergence within the mainstream around this New Keynesian perspective.

New Keynesian theory and Woodford’s book supported the idea that monetary rather than fiscal policy was the key tool that should be used to tame the business cycle. But as Woodford’s book made abundantly clear, monetary policy in this context meant interest rate policy. Monetary aggregates play no role in Woodford’s basic framework, and partly for this reason Woodford talked about his ideas coming from Wicksell rather than Keynes.

Which was fine, as long as interest rates were free to move. The recession of 2009 was so great that interest rates were quickly cut to almost zero, and for good or bad reasons central banks felt they couldn’t cut rates any further. The key tool of monetary policy was broken. Some central banks resorted to expanding the money supply (Quantitative Easing) and buying government debt, but Woodford was very sceptical about how effective that would be. Which left fiscal policy.

In 2010 Woodford published a paper called “Simple Analytics of the Government Expenditure Multiplier”. (It was published in 2011 in AER Macro.) He concluded:

“A multiplier well in excess of 1 is possible when monetary policy is constrained by the zero lower bound, and in this case welfare increases if government purchases expand to partially fill the output gap that arises from the inability to lower interest rates.”

In other words, increases in government spending could be very effective in helping to offset a recession when interest rates hit their lower bound, and should be used to do so. By the same token, austerity in that situation would make the recession worse. To pick up from the first section of this post, the Labour government in 2009 was right, and Osborne was dead wrong.

This result was hardly a surprise to those like myself who had been working on fiscal policy in New Keynesian models, or to those like Paul Krugman who had been looking at Japan, where interest rates had long been stuck at their lower bound. Anyone who bothered to talk to people using state of the art macromodels to analyse fiscal policy would have come away with the message that austerity when interest rates were stuck at their lower bound was very foolish. But the paper was typical Woodford in showing the formal result elegantly and why it was likely to be robust. It also showed why empirical evidence based on periods where interest rates were not constrained was a poor guide to multiplier size.

Woodford is probably this blog’s most frequently quoted living economist. I want to end by looking at another of his major contributions to macroeconomics. One consequence of the New Classical Counter Revolution is that macroeconomic models became much more focused on microeconomic theory, and less on matching empirical data. Whether this microfoundation was good for the discipline is something I used to write a lot about in this blog.

However before Woodford there was a major gap in this microfoundations programme. Although the behavioural equations of the model could be derived from the representative agent maximising utility, the objectives of policy makers were generally assumed to be ad hoc: some combination of minimising deviations of output from trend and inflation from target. What Woodford managed to do was to show what the objectives of a policy maker that wanted to maximise agent’s utility would look like.

Having subsequently worked through similar derivations myself in work with Tatiana Kirsanova and Campbell Leith, in my view this contribution from Woodford was a mathematical and intellectual tour de force. Its impact on academic macroeconomics could be measured in the fact that thereafter most theoretical papers in macroeconomics routinely used a version of Woodford’s derivation. Indeed given the length of this mathematical derivation, you could say his contribution to subsequent work could be literally weighed.

How useful this innovation was to actual policy in the short term was more doubtful, for reasons that I discuss here, but perhaps it might become so. But it would be quite wrong to suggest from this that Woodford was and is just a theorist aloof from practical policy concerns. Quite the opposite really. For example his work played a key role in the debate among central banks about how much to say about future policy (‘forward guidance’). He also wrote (see my summary here) about how much inflation targeting central banks should use interest rates to reduce the risk of financial crises, and the macroeconomic impact of the pandemic.

Michael Woodford has the ability to both do demanding and difficult economic theory, producing path breaking results, and also address current debates in macroeconomic policy that can influence what policymakers do. That is why most macroeconomics thought he was always going to win the Nobel prize. We just need politicians prepared to use some of those insights rather than ignore them.