Wednesday, 10 October 2012

Another stake in the heart of Classical economics

The OECD and the IMF have recently released some papers that give great pause for thought.

The OECD has looked at micro-economic reform whereas the IMF has looked at macroeconomic policies.

the OECD has come to the view the best thing to do is just to get on and do the reforms HOWEVER there is a big proviso.The state of the economy can affect the short run impact of such programs.
For instance if the economy is in the doldrums then large scale labour market reforms will reduce employment not increase it. Lowering benefits may well increase one's incentive to get a job but if no jobs are available then less money is spent
Reducing job protection will make it easier to get rid of excess staff but a bad economy will mean not many hires.

The best thing to do when the economy is in the doldrums, like Europe, is to start with is reforming the product markets. As the economy improves then one should get 'stuck' into the labour market.

The IMF  has found out that in times of a liquidity trap (my words not theirs but essentially when monetary policy doesn't work) the multiplier is larger, quite larger. See Paul Krugman  for a reasonably good exposition on why this is so.

Classical economics tells us one should always have a balanced budget no matter what the state of the business cycle. In other words it is pro-cyclical.
Keynesian economics , on the other hand, believes in counter cyclical economics when there is a liquidity crisis.

The IMF has again found empirical support for Keynes as it did when it examined whether fiscal consolidation was expansionary and again none for classical econmics indeed quite the opposite.

This simply continues the story we have seen around the world since the GFC. Any countries that adopted classical economic policies either endured a large scale recession or a depression. This didn't happen when a country attempted Keynesian policies.

In ending it is highly ironic that some but all countries now in trouble didn't attempt Keynesian policies in good times i.e. a budget surplus indeed a substantial surplus sometimes.