Economic Policy: Theory And Practice

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i

Economic Policy
ii
iii

Economic Policy
Theory and Practice
SECOND EDITION

Agnès Bénassy-​Quéré, Benoît Cœuré,

Pierre Jacquet, and Jean Pisani-​Ferry

1
iv

1
Oxford University Press is a department of the University of Oxford. It furthers
the University’s objective of excellence in research, scholarship, and education
by publishing worldwide. Oxford is a registered trade mark of Oxford University
Press in the UK and certain other countries.

Published in the United States of America by Oxford University Press

198 Madison Avenue, New York, NY 10016, United States of America.

© Oxford University Press 2019

First Edition published in 2010

Second Edition published in 2019

All rights reserved. No part of this publication may be reproduced, stored in

a retrieval system, or transmitted, in any form or by any means, without the
prior permission in writing of Oxford University Press, or as expressly permitted
by law, by license, or under terms agreed with the appropriate reproduction
rights organization. Inquiries concerning reproduction outside the scope of the
above should be sent to the Rights Department, Oxford University Press, at the
address above.

You must not circulate this work in any other form

and you must impose this same condition on any acquirer.

CIP data is on file at the Library of Congress

ISBN 978–​0–​19–​091210–​9

9 8 7 6 5 4 3 2 1
Printed by Sheridan Books, Inc., United States of America
v

Contents

Foreword vii
Preface xi

1 Concepts 1
2 Issues 58
3 Interdependence 109
4 Fiscal Policy 148
5 Monetary Policy 237
6 Financial Stability 323
7 International Financial Integration and Foreign Exchange Policy 410
8 Tax Policy 504
9 Growth Policies 574

Index 667
vi
vi

Foreword

This book is a book I would have loved to write. Indeed, this is a book I long
wanted to write. I wanted to do so out of guilt. For a long time, I have felt
that my graduate textbook written with Stan Fischer sent the wrong message.
We had made the choice to present models and their logic rather than their
applications. The justification was a perfectly good one—​namely, that we
wanted to show the intellectual structure of macroeconomic theory first. But,
de facto, the lack of serious empirics sent another message: that theory was
largely divorced from practice and from facts. That message is wrong: theory
without facts is much too easy and of very little use. I also wanted to write
such a book out of a desire to share with students my excitement about
moving between theory, facts, and policy. It is traditional to do so in under-
graduate textbooks, at least in the United States. Those textbooks are full of
discussions about policy debates—​about the effects of policy choices on the
economy. I thought it would be even more fun to do so with graduate students
who have more tools, both theoretical and econometric, at their disposal.
Agnès Bénassy-​Quéré, Benoît Cœuré, Pierre Jacquet, and Jean Pisani-​
Ferry have beaten me to it. I am happy they did so because they have done a
better job than I could have hoped to.
To give a sense of what they have achieved, I shall take one example,
the creation or reform of fiscal frameworks like the European Stability and
vi

viii Foreword

Growth Pact (SGP). To come to an intelligent set of recommendations, think

of all the elements you need to put together:
• You need to understand what sustainability means in theory and
in practice, what the costs of not abiding by sustainability are, and
how to assess sustainability. When does a debt-​to-​gross domestic
product ratio become truly excessive? What happens then? How
fast can you reach that threshold? How fast can you move away
from it?
• You need to understand the long-​term effects of deficits and debt on
output and its composition. How do deficits and debt affect output
in the medium and long run? How do they affect the interest rate,
the net foreign debt position, the capital stock? What is the cost in
terms of lost consumption in the future? Which generations gain,
which generations lose?
• You need to understand the short-​term effects of deficits and how
countercyclical fiscal policy can help in the short run. Do deficits
affect activity in the same way, whether they come from tax cuts or
spending increases? How important are expectation effects? Can the
anticipation of large deficits in the future lead to a decrease in con-
sumption and investment and a decrease in output today? When is
this more likely to happen?
• You need to understand the macroeconomic costs of decreased
policy flexibility. Are constraints on deficits and debt consistent
with an appropriate response of fiscal policy to shocks? What
explains sustained divergences within the euro area during the first
10 years? Were such divergences avoidable? Then you need to de-
termine whether and to what extent fiscal policy is the right tool to
deal with country-​specific shocks and to what extent it can (should)
substitute for the lack of an independent monetary policy. Finally,
you need to figure out how much policy space is left to governments
after they have fought the new Great Recession and rescued
their banks.
• You need to think about how to define the rules in practice. How
should debt be defined? How should implicit liabilities, coming
from Social Security and other promises to future generations, be
treated? If rules are defined in terms of deficits and debt, what are
the most appropriate definitions of the two concepts for the ques-
tion at hand? How should rules deal with privatization revenues?
Should rules apply to gross debt or to net debt? Should the budget
be separated between a current account and a capital account?
Should the deficit rules apply only to the government current ac-
count? Can rules be enforced by politicians, or do we need to set up
independent committees?
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Foreword ix

• You need to think about political-​economy issues. Why are

rules needed in the first place—​to protect people from their
governments, or to protect the governments from themselves?
How can a particular set of rules be manipulated or distorted by a
national government? How will sanctions against a misbehaving
government be imposed? Will these sanctions be credible ex ante?
Is international coordination, such as in the G20 framework, an ad-
vantage or a diversion from every government’s duties?
To answer these questions, you need many conceptual tools. Among them are
a dynamic general equilibrium model with overlapping generations, a model
of short-​run fluctuations with careful treatment of expectations, political-​
economy models to think about the case for rules, and agency models to help
you think about the design of specific rules. In each case, with guidance from
theory, you need to look at the evidence to get a sense of which theoretical
arguments are more relevant. This is not easy to do. Courses will typically give
you the theoretical tools without much incentive to apply them and leave you
to use them on your own without much practical training. This is not what
this book does. It motivates you to use tools, gives you the tools, and shows
you how they can be employed.
Last, but not least, this book is among the very first that offer students
a rigorous and comprehensive treatment of the global financial crisis and
the Great Recession that followed. The authors do not try to cast a veil over
the conceptual difficulties economists face when they reflect on the causes
of the crisis, on the limitations of traditional approaches that the crisis has
uncovered, maybe on the excessive faith in theory, and on the need for more
theoretical work to better understand the crisis and make sure it does not
happen again. But they do not throw the baby out with the bath water and
claim that economists have “mistaken beauty for truth,” as was suggested by
Paul Krugman. On the contrary, they show how existing theories can be used,
cross-​fertilized, and replaced in a historical context to understand the crisis
better. This is the way forward.
In short, this book trains you to be a good macroeconomist—​a good
economist. It instills the right attitude and gives you the right methodology: to
build solidly on theory, to use the theory to look at the data, and then to
go back and forth between the two until a coherent picture forms. As I was
reading the book, I felt again the excitement that comes with doing research
on macroeconomics. I hope this excitement is contagious, and I wish you a
very good read.

Olivier Blanchard, C. Fred Bergsten Senior Fellow,

Peterson Institute for International Economics
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xi

Preface

This is a book for those who are eager to find out what shapes, or should
shape, economic policy: the major stylized facts that capture the messages
from history; the theories that help make sense of these facts and analyze the
impact of policy decisions; the controversies that surround policy choices; the
rules and institutions that contribute to determining them; and, last but not
least, the way experience, theories, and institutions interact.
The first edition of this book—​in French—​dates back to 2004. This is
the second English edition. Meanwhile, Italian and Chinese translations were
published, and the fourth French edition (prepared in parallel to the English
one) was released in late 2017. Each vintage has been noticeably different from
the previous one. The original book arose from a seminar designed to build
a bridge between the students’ theoretical baggage and economic policy-​
making, which many of them planned to embrace as a profession, and this
second English edition follows the same approach. Not only is this new edi-
tion more insightful, more precise, and more comprehensive than the previous
one, but it also incorporates the new analytical insights and new practical
responses developed in response to the major economic policy challenges
that arose in the past 15 years and that have revisited the way many issues are
looked at and many problems are approached.
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xii Preface

Over the past decade, the world has been hit by the global financial crisis
and the Great Recession (uppercase letters reflect the trauma it has caused),
prompting a rediscovery of finance by an economic profession that had long
assumed that the financial plumbing was flawless; Europe’s currency area has
come through a near-​death experience; inflation has almost disappeared,
while forgotten deflation concerns have reemerged; public debt has soared,
and the threat of sovereign insolvency that was regarded as the sad privilege
of developing countries has reached the advanced world; emerging countries
have come of age; income inequality has risen to the forefront, first of political
controversies and, gradually, of policy discussions; and the nature of labor has
structurally changed. New questions have prompted new research and called
for new responses rooted in theory and informed by practical experience.
This new edition fully takes this major renewal into account. It provides
the reader with an up-​to-​date overview of economic policy as it is discussed,
designed, and implemented. All chapters have been thoroughly reviewed,
some have been entirely rewritten. A new chapter on financial stability has
been introduced. The result, we believe, is a book like no other.

The Interaction Between Research and Practice

This book stands at the crossroads between theory and practice. Our premise
is that the all-​too-​frequent disconnect between them is detrimental to both
good policy and good research. We posit that going back and forth between
practice and theory enlightens practice and helps construct better theories.
All four of us are teachers; all of us combine, or have combined, research
and policy advice: we have been advisors, experts, members or chairs of con-
sultative bodies, senior officials, central bankers, researchers in think tanks,
and commentators at a national, European, or international level. We have
been confronted with the reality of economic policy-​making in different
places—​and this has changed the way we understand, teach, and use eco-
nomic theory.
We have learned from experience that research can be the victim of its
own internal logic and ignore important, sometimes even vital, economic
insights. We have also learned that ignorance of the lessons of History and
neglect of theoretical advances can make policy ineffective, even toxic.
The global financial crisis will have a long-​lasting effect on policy-​making
and economic theory. Some of the mechanisms at play before and during the
crisis had been identified and studied in the aftermath of previous crises,
while others have been updated or altogether uncovered. In a first step, in
order to fight financial disruption, to revitalize the economy, and to design
new crisis-​prevention schemes, economists tapped knowledge which had
been buried deep in economic textbooks, drawing lessons from economic his-
tory; they attempted to avoid repeating past mistakes; and they rehabilitated
models which had been considered mere theoretical curiosities. In a second
xi

Preface xiii

step, new research was initiated. Some of it was very theoretical and aimed to
identify sources and contagion channels of financial fragility and to renew our
approach to risk management; some of it was empirical and aimed to sharpen
our understanding of the impact of economic policy or to explore previously
overlooked dimensions, such as income inequality or systemic risk. In this
book, we survey this research and discuss its contribution to economic policy,
in particular in Chapters 4–​6 devoted to fiscal policy, monetary policy, and
financial stability.
In Europe, the crisis has uncovered specific deficiencies in the way eco-
nomic thinking and policy-​making interact. The creation of a supranational
currency was an undertaking (one may say, an experiment) of unprece-
dented ambition. Many of the pitfalls that were encountered could have been
foreseen, at least in part. Heterogeneity within the currency area, inadequate
adjustment mechanisms to asymmetric shocks, self-​reinforcing price diver-
gence, and weak incentives to fiscal responsibility, to mention but a few, were
well-​known issues. They had been identified from the outset by academics,
and their significance could be inferred from historical experience. Other
challenges related to the non-​pooling of bank risk or the lack of a lender of
last resort to governments had been identified by some but had not been
subject to a complete diagnosis. A deeper, more genuine dialogue between
researchers and policymakers could have helped anticipate and prevent the
euro area crisis. Unfortunately, however, policy complacency set in after the
launch of the euro, and, for long, policymakers seemed more interested in
the analyses that justified their choices than in those that questioned them.
A genuine dialogue intensified only when it appeared that the euro was under
mortal threat.

The Responsibility of Economists

The more theory and policy interact, the greater the responsibility of
economists. This raises several issues related to their integrity, their intellec-
tual openness, and their ability to debate.
Let’s face it: The crisis has cast suspicion on the economic profession.
Economists have been blamed for being blind, complacent, or even captured.
They have been charged with intellectual conformism, excessive trust in
market mechanisms, being too close to the world of finance, and being
weak with the powerful. After the euro area crisis, they have been accused of
drawing biased conclusions on the costs and benefits of monetary integration
(that is, underestimating the former and overestimating the latter). They have
been diagnosed with an acute myopia which leads them to take interest only
in social interactions with a pecuniary nature, to focus on the accumulation
of wealth more than on its distribution, and to ignore the damage caused by
growth and the political forces that shape economic institutions. And they
have sometimes been blamed for focusing on specialized, “elegant” models
xvi

xiv Preface

at the expense of understanding a complex reality—​for mistaking beauty for

truth, as cogently expressed by Paul Krugman.
As for integrity, it is fair to acknowledge that professional economists,
while lecturing others about the importance of incentives, have for too long
turned a blind eye to their own conflicts of interests. Beyond the pecuniary
dimension, which should not be overlooked, economists must be aware that
being too close to any professional constituency—​including politicians and
government technocrats—​risks blunting their critical sense. After the crisis,
their professional ethics have been questioned. This has already prompted
greater disclosure, for example in professional journals, an effort which needs
to be further advanced. Full transparency on potential conflicts of interest
must be ensured.
As for the criticism of being intellectually blind, it is often based on a mis-
taken preconception. Economic theory is not the Trojan horse of free-​market,
small government, minimal redistribution mindset some believe it is in liberal
circles. Several recent recipients of the Nobel Memorial Prize in Economics
have devoted their research to inequalities, poverty, and government inter-
vention, or to the limited rationality of economic agents. Economists do re-
gard the market as an efficient tool to allocate resources, but they are equally
concerned with its failures and unequal distributional effects, and they have
designed instruments to identify and correct them.
Democracy would benefit if participants in the public debate made a
better (and more informed) use of economic analysis. Economists are not
ideologues: they devote an increasing part of their time to empirical work and
experiments, tapping a rapidly expanding trove of data. Nowadays, unlike a
few decades ago, the bulk of research published in top economic journals is
empirical. And theory remains essential to identify the key parameters which
will make a policy successful and to guide empirical analysis beyond the sur-
face of pure statistical regularities.
Some economists may see themselves more as advocates—​of market ef-
ficiency, of economic openness, of price stability or of (de)growth—​than as
scientists or engineers. And when confronted by politicians, civil society ac-
tors, or experts of other disciplines, some cautious and balanced researchers
may also tend to simplify their points excessively and overplay their so-
cial role. Policymakers often make a biased use of the outcome of research,
placing an excessive weight on work that merely confirms their priors. In the
mid-​2000s, scholars of finance or of the euro too often struck a Panglossian
tone, while those who struck a note of caution were largely ignored. In such
cases, admittedly, the culprit is less research than the relationship between
research and policy, and economists share the blame. And methodological ar-
rogance is unwarranted. When it comes to the myopia and apparent irration-
ality of individuals, economists often hide behind Elinor Ostrom or Richard
Thaler (both Nobel-​Prize winners) who have endeavored to understand non-​
monetary interactions, non-​pecuniary incentives, and collective action. And
they emphasize that concepts such as utility, intertemporal maximization, or
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Preface xv

social welfare give them all the necessary instruments to build a multifaceted
approach to public action, far from the simple religion of growth. This is all
true but easily misleading. Economists should be more open to the finding of
other social sciences. The strength of their discipline does not come from any
inherent superiority of what George Stigler once celebrated as the “imperial
science,” but from the blend of analytical rigor and empirical relevance that
their profession has been able to develop. They should heed Keynes’s invita-
tion to model themselves on the humility and competence of dentists.

A Unique Structure

Economic textbooks typically cover economic theory in a given field—​

macroeconomics, microeconomics, finance, international trade, etc.—​and
use real-​life stories to illustrate theoretical results. Their representation of ec-
onomic policy instruments and of the decision-​making process often remains
rudimentary and abstract: the decision-​maker is supposed to choose without
constraints the interest rate or the level of public spending, whereas in real life
such decisions involve complex processes.
Conversely, many excellent essays on economic policy are more con-
cerned with describing the ebb and flow of new ideas and institutions than
with discussing their theoretical underpinnings. They are informative but
frustrating. Our book aims to fill that gap. We present the main analytical
tools—​theoretical and empirical instruments, or old and new—​that are rel-
evant to addressing real-​life policy issues; we explain how these instruments
can be used to identify policy trade-​offs and guide the policymakers’ choices;
and we discuss the theoretical uncertainties, blind spots, and controversies
that justify cultivating humility and caution when formulating policy advice
and that make the job of economists so challenging and rewarding. We hope
that this book will provide the reader with the necessary tools to understand
and participate in the debates which will develop in the years to come.
There are nine chapters. The first three set out the general frame-
work of economic policy-​making. Chapter 1 describes the methodolog-
ical foundations and toolbox essentials that will be used in the rest of the
book. Chapter 2 adds a note of caution: it outlines the limits of government
intervention and the political-​economy reasons that may render it sub-
optimal. Chapter 3 introduces the plurality of policy-​making within and
between sovereign nations. Chapters 4–​9 cover six domains of economic
policy: fiscal policy (Chapter 4), monetary policy (Chapter 5), financial sta-
bility (Chapter 6), international capital integration and foreign exchange
policy (Chapter 7), tax policy (Chapter 8), and long-​term growth policies
(Chapter 9). Chapter 6 is entirely new and benefited from comments by
Laurence Boone, Lorenzo Cappiello, Anne Le Lorier, and Peter Praet,
whom we would like to thank here. Each of these six chapters is struc-
tured in a similar way: the first section outlines stylized facts derived from
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xvi Preface

recent economic history, the second section introduces the theoretical

models policymakers should have command (or at least a knowledge) of,
and the third section presents the main policy options. There are many
cross-​references between the six chapters, but they are written in such a
way that each of them can be read on its own.
This book is by no means comprehensive. We cover macroeconomics in
a broad sense, focusing successively on money, the budget, finance, exchange
rate, taxation, and growth. We have chosen not to address, or address only at
the margin, a number of otherwise important areas of economic policy, such
as competition policy, social protection, labor policies, international trade, or
climate change. We have also decided not to write specific chapters on inter-
national economic policy, regional (and especially European) integration, or
the management of local governments. Chapter 3 summarizes what economic
theory has to say on the assignment of policy instruments to different levels
of government and on the difficulties of global governance; however, in any
policy domain, some levers are global, some are regional, some are national,
and some are local, and we have therefore addressed them in conjunction in
each of the six thematic chapters.
Economists are often blamed for resorting to technical vocabulary as a
way of protecting themselves from inconvenient questions. To help the reader
overcome semantic barriers, we have been careful to define all key concepts at
least once in the book and to signal these terms with italics. The index at the
end of the book provides a complete list of keywords with the corresponding
pages where they are defined and illustrated.
Additionally, we have parked most mathematical developments in tech-
nical boxes. We see mathematics neither as the purpose of economic science
nor as the instrument that would allow us to draw a line between truth and ide-
ology. As Paul Romer once noted, mathematics can be used in support of ide-
ology, and, conversely, some seminal theoretical articles mentioned in this book
do not show any equations. Mathematics is nevertheless unique in mapping in
a coherent and rigorous way a set of assumptions into conclusions. It is also the
basis for statistical tools allowing us to confront assumptions with real-​world
data. As a language, it is, however, fitter to expose a flow of rigorous reasoning
than to explain it and present its conclusions. We give examples of how it can be
used, but we also make the reasoning explicit in more literary ways.
As “reading assistance,” each chapter includes many charts and tables be-
cause our approach fundamentally relies on facts. It also includes theoret-
ical and descriptive boxes. Additionally, there are extensive bibliographical
references so that the reader can dig further into any of the issues covered.

Conclusion

We express our gratitude to all those who have encouraged us and who have
helped make this joint endeavor a reality. We owe a lot to our students, whose
xvi

Preface xvii

questions and criticisms have greatly improved the relevance, accuracy, and
legibility of this book. We also thank our colleagues and friends who have
commented on previous versions. Writing on economic policy requires us to
update data and facts tirelessly. For this last edition, we have benefited from
particularly effective assistance by Paul Berenberg-​Gossler, Pranav Garg, and
Amélie Schurich-​Rey. Without them, this book would be less caught up with
today’s debates.
​Paris, Florence, Frankfurt, New Delhi, March 2018
xvi
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Economic Policy
x
1

1
Concepts

1.1 A Primer on Economic Policy

1.1.1 The economist and the Prince: Three alternative approaches
1.1.2 What do policymakers do?
1.2 The Whys and Hows of Public Intervention
1.2.1 The three functions of economic policy
1.2.2 Why intervene?
1.3 Economic Policy Evaluation
1.3.1 Decision criteria
1.3.2 Experiments and ex post evaluation
1.3.3 Collateral effects
Conclusion
Notes
References

Practical men, who believe themselves to be quite exempt

from any intellectual influences, are usually the slaves of some
defunct economist. Madmen in authority, who hear voices in
the air, are distilling their frenzy from some academic scribbler
of a few years back. I am sure that the power of vested interests
is vastly exaggerated compared with the gradual encroachment
of ideas. Not, indeed, immediately, but after a certain interval;
for in the field of economic and political philosophy there are
not many who are influenced by new theories after they are
twenty-​five or thirty years of age, so that the ideas which civil
servants and politicians and even agitators apply to current
events are not likely to be the newest. But, soon or late, it is
ideas, not vested interests, which are dangerous for good or evil.
​John Maynard Keynes (1936; chapt. 24, part 5)

The last sentences of The General Theory of Employment, Interest and Price by
the famous British economist are a fetish quotation for economists who take

1
2

2    
Economic Policy

them as an acknowledgment of their social role. Yet they also express the com-
plexity of the links between theory and economic policy. They suggest that
economic expertise can neither be regarded as the servant nor as the master of
political decision. It does influence it, but in an indirect way and with delay.1
However, Keynes (1931, part V, chapt. 2, last sentence) also expressed de-
tached irony about the economists’ pretense to determine the policymakers’
choice:

If economists could manage to get themselves thought of as humble, compe-

tent people on a level with dentists, that would be splendid.

The interaction between economic ideas and political motivations was aptly
characterized in the classics as political economy.2 This type of interaction be-
tween power and knowledge is certainly not specific to the economic disci-
pline. It arises in all fields where public decision relies at least partially on
scientific or technical expertise. For reasons we develop later in this chapter
and throughout the book, however, it is more pronounced in economics and
more general in the social sciences than, say, in geology or biology.
This chapter introduces the main themes of economic policy analysis. We
start in Section 1.1 with a discussion of the various approaches to economic
policy an economist can adopt. In Section 1.2, we discuss the arguments for
and against public intervention, both from a micro-​and a macroeconomic
standpoint. Finally, Section 1.3 is devoted to the evaluation of economic policy
choices and deals with both criteria and instruments.

1.1 A Primer on Economic Policy

1.1.1 The economist and the Prince: Three alternative approaches

An economist can adopt diverse attitudes vis-​à-​vis policy decisions: she or he

can limit herself to studying their effects on the economy (positive economics),
she can seek to influence them through recommendations that draw on her
expertise (normative economics), or, finally, she can take them as a topic for re-
search and study their determinants (political economy or political economics).
All three approaches coexist in today’s economics.

a) Positive economics

In positive economics, the economist takes the point of view of an outside

observer and aims to determine the channels through which public decisions
affect private behavior and outcomes. For example, she analyzes the effects of
a tightening of monetary policy, an increase in public expenditure, a tax re-
form, or a new labor market regulation. Economic policy choices are regarded
as entirely exogenous, meaning that they are not determined within the model
3

Concepts     3

that explains the economy and whose variables—​such as prices, incomes,

output, and the like—​they influence.
Positive economics therefore approaches economic policy with the same
concepts and methods as those used to study other economic phenomena: for
example, there is hardly a difference between studying the effects of a rise in
the central bank money lending rate on nonfinancial agents and analyzing
the effects of an exogenous rise in the risk premium which banks require for
lending to private agents; similarly, the effects of a rise in the minimum wage
can be analyzed within the same framework and with the same tools as those
of a strengthening of the bargaining power of trade unions.

b) Normative economics

The second approach is called normative economics. The economist here

adopts the posture of an adviser to a supposedly benevolent Prince—​or polit-
ical master—​and examines which set of decisions can best serve explicit public
policy purposes, such as reducing unemployment, improving the standard
of living, or safeguarding the environment. The public decision-​maker is
regarded as a social planner and the economist as an engineer who tells him
or her how to select adequate means for reaching certain ends, meaning how
to design policies and then how to implement them. Economists are certainly
not short of policy advice, and they generally do not need a request from the
Prince to express their views. In all cases, however, they make explicit or im-
plicit assumptions about social preferences that cannot be derived solely from
economic theory.
Normative economics relies on the knowledge base of positive economics
to assess the effects of different possible decisions. However, it also requires
a metric within which to compare alternative situations. Assume that a gov-
ernment wants to reduce unemployment and suppose that two competing
policies may lead to this result but at the price, for the first one, of a lowering
of the employees’ average wage income and, for the second one, of an increase
in wage inequality. Choosing between these two solutions requires assessing
the social cost of each of those policies against the social benefit of lowering
unemployment. This implies defining a preference order between situations,
each characterized by the unemployment rate, the average wage income level,
and a measure of inequality. Constructing such a ranking raises considerable
conceptual and practical difficulties.
Furthermore, normative economics frequently implies giving up the first-​
best solution that would be reached in the absence of informational, insti-
tutional, or political constraints for a second-​best solution, one that respects
those constraints.3
Let us take the example of carbon dioxide emissions, which governments
have committed to limit to curb global warming. A first-​ best solution
consists in creating a global carbon dioxide tax to incite companies to use less
4

4    
Economic Policy

carbon-​intensive energy sources. The carbon tax, however, hurts powerful

special interests, such as those of car makers or oil-​producing companies;
requires international coordination and implementation; and is disputed on
equity grounds by developing countries. The climate agreement reached in
Paris in December 2015 therefore leaves participating countries free to choose
the means they intend to rely on to reduce emissions.
Some governments consider making existing government policies
“greener,” say by restricting public tenders to companies which meet carbon
dioxide emission standards. Such a second-​best solution, however, bears sig-
nificant unintended consequences. It distorts economic choices by making
the implicit price of carbon dioxide differ across the economy, and, moreover,
due to limited competition among providers, taxpayers may ultimately bear
the cost of the policy in place of the owners of the companies—​who would be
better placed to steer their behavior.
Economists involved in public decisions face many such constraints.
The question they face is typically not “how can unemployment be
reduced?” but “in view of the stance and prejudices of the main players—​
government departments, majority and opposition in Parliament, and var-
ious stakeholders—​what is the most cost-​effective proposal consistent with
the government’s overall policy philosophy and commitments already pub-
licly undertaken?” This second question obviously is a very weak version of
the first one, but major economic decisions are very often taken this way.
Economists may understandably be tempted to abstain from participating in
such decisions. But, as Herbert Stein, a chairman of the Council of Economic
Advisors under US presidents Richard Nixon and Gerald Ford, used to say,
“Economists do not know very much [about economics. But] other people,
including the politicians who make economic policy, know even less” (Stein,
1986, p. xi). Returning to the ivory tower may thus be an undesirable option.
Second-​best recommendations nevertheless raise important difficulties.
The second-​best optimum can in fact be inferior to the initial situation in wel-
fare terms. An example of an inferior second-​best solution can be found in
trade policy: liberalization on a regional basis only can divert trade from an
efficient global producer to a less efficient regional partner, which worsens the
allocation of resources in comparison to a situation of uniform tariff protec-
tion.4 What is perceived as a small step in the right direction therefore does not
necessarily improve upon the status quo; on the contrary, it can reduce welfare.
Beyond this disturbing result, modern public economics emphasizes
the equally formidable difficulty associated with the existence of asym-
metric information between the public decision-​maker, the agents in charge
of implementing policies, and those who bear the consequences. Not un-
like Soviet central planning, the traditional approach of economic policy
postulated that the decision-​maker had perfect information (in fact, he or she
was frequently assumed to know better than private agents) and perfect con-
trol over the implementation of his decisions. The reality, of course, is that the
5

Concepts     5

decision-​maker has both an incomplete knowledge of reality and an imperfect

command of policy implementation. Take the regulator in charge of a specific
sector (e.g., telecommunications). He gets information on costs, returns on
investment, or demand elasticity largely from the companies that he is re-
sponsible for controlling. For the latter, this information has strategic value.
They have every reason not to be fully transparent or to provide biased in-
formation. When dealing with them, the regulator therefore suffers an infor-
mational disadvantage even when he supplements the information provided
by the regulated companies with indirect indications derived from observing
market prices and quantities.
Likewise, government bodies responsible for policy implementation are
not flawless transmitters: they often do not pass on adequate information
from below or instructions from above. For example, even if teachers from
the education ministry have first-​hand knowledge of the situation in their
classes, the minister in charge may not have accurate overall information,
which obviously affects the quality of his or her decisions. Reciprocally, the
minister’s policy may not be considered adequate by the teachers who have
their own views on education policy, and this affects its implementation and
effectiveness.
The importance of information asymmetries for private markets was first
highlighted in research by 2001 Nobel laureates George Akerlof, Michael
Spence, and Joseph Stiglitz, but it was Jean-​Jacques Laffont5 and Jean Tirole
who worked out their consequences for public economics. They initiated re-
search on the design of contracts that encourage agents to reveal the infor-
mation which they would otherwise keep for themselves (thereby allowing
regulators to take more appropriate decisions). Such contracts are examples of
mechanism design, meaning the design of optimal institutions or procedures
to deliver social outcomes. Mechanism design covers issues ranging from
auctions of public assets, voting procedures for public decisions, regulations
to curb private behaviors, or contracts between the government and private
contractors. All such mechanisms should be designed in a way that delivers
the expected outcome while overcoming the government’s lack of informa-
tion.6 Key to this outcome, as explained by Nobel Prize laureate Eric Maskin,
is incentive compatibility:

Because mechanism designers do not generally know which outcomes are op-
timal in advance, they have to proceed more indirectly than simply prescribing
outcomes by fiat; in particular, the mechanisms designed must generate the
information needed as they are executed. The problem is exacerbated by the
fact that the individuals who do have this critical information—​the citizens
in the public good case or the buyers in the asset-​selling example—​have their
own objectives and so may not have the incentive to behave in a way that
reveals what they know. Thus, the mechanisms must be incentive compatible.
(Eric Maskin, 2007, p. 3)
6

6    
Economic Policy

c) Political economics

Like positive economics, of which it can be regarded as an extension, the po-

litical economy approach refrains from making prescriptions and takes the
viewpoint of an external observer. However, instead of considering the po-
litical decision-​makers’ behavior as exogenous, it treats it in the same way it
treats private agents’ behavior; that is, as endogenous (determined by the state
of the economy itself). The government is therefore no longer regarded as a
Deus ex machina that monitors and steers the private economy in the name of
the general interest but, instead, as a machine directed by politicians (i.e., by
rational players whose behavior follows specific objectives and faces specific
constraints). The simplest models of politically motivated behavior often draw
on the simplistic assumption that the politicians’ only objective is to hang
on to power and therefore to maximize their reelection chances. However,
more elaborate models also recognize the need to fulfill electoral campaign
pledges (which become a constraint after election); partisan preferences; the
role of special interest groups, which may dwell on the need to maintain long-​
term relationships within a social group; and—​at the extreme—​corruption
and bribery. The political economy approach also endeavors to represent the
behavior of technocrats within government or of those in charge of public
agencies (central banks, independent authorities, international institutions)
and to determine how the external and internal governance and the mandate
of these institutions influence economic performance.
A political economy approach is evidently essential to the analysis of gun con-
trol policy in the United States. But it is also required in fields like trade policy,
to explain why protection varies across sectors, or labor market policy, to under-
stand why the employment performance varies considerably across countries.
Political economy does not exclude normative judgments, but it does have
implications regarding their scope. James Buchanan, one of the initiators of
modern political economics, claims that such judgments are valid only if
applied to the framework (often called policy regime) that determines eco-
nomic policy: the constitution and, more largely, all the rules, procedures, and
institutions surrounding economic policy decisions. To draw on a distinction
introduced by Robert Lucas (see, e.g., Lucas, 1976), the choice of an economic
policy regime involves normative considerations, but the actual economic
policy decisions are the result of political processes within the framework of
this regime. It would therefore be pointless to exercise normative judgment
on what must be regarded as endogenous variables. According to Buchanan,
“the object of economic research is ‘the economy,’ which is, by definition, a so-
cial organization, an interaction among separate choosing entities. . . . [T]‌here
exists no one person, no single chooser, who maximizes for the economy, for
the polity. . . . That which emerges [from the decision-​making process] is that
which emerges from results, and that is that” (Buchanan, 1975, pp. 225–​226).
The role of the economist is to study the functioning of these processes and
the incentives they create for public decision-​makers. It is to discuss whether
7

Concepts     7

these incentives create a political bias or help align the outcome of the deci-
sion process with the public interest. It is not to give advice to the Prince or
his marquis.
During the last decades of the twentieth century, the political economy
approach was strengthened by two concomitant developments. First,
the theory of rational expectations7 developed in the 1970s (in particular
by Robert Lucas) emphasized that private agents do not react to stimuli
as automatons, but rather use their reason to anticipate policy decisions.
A good example of such behavior is provided by exchange-​rate crises. As
developed in Chapter 7, such crises can only be understood by considering
the strategic interaction between private speculators and official authorities.
These crises often occur because private agents know the public decision-​
makers’ preferences and constraints (or at least guess what they are) and
therefore can assess the probability of a currency devaluation. While not
directly related to the political economy approach, the theory of rational
expectations thus challenged the idea that the State dominates and steers
the private economy. It resulted in integrating into economic models a rep-
resentation that makes public decision-​makers react endogenously to en-
dogenous events rather than behave exogenously.
The second development of research on political behavior was a reaction
to failures of government intervention in areas such as macroeconomic man-
agement, employment, or development. While some of these failures could
be ascribed to genuine policy mistakes, insufficient knowledge, or simply
bad luck, in other cases there was a need to provide explanations for a per-
sistent inability to learn from past mistakes and from international experi-
ence. Why are certain regulations maintained even though they obviously
lead to outcomes that contradict stated policy objectives? Why have some
developed countries returned to full employment more rapidly than others
after the 2009 global crisis? If this were simply a matter of identifying appro-
priate policies and institutions, some form of learning should be at work, and
less-​successful governments could be expected to learn, even slowly, from
successful ones. Since some do not, there is a need for political economy
explanations.
The choice of a regime regarding product, capital, and labor market
regulations involves preferences and trade-​offs between, say, efficiency and
equity; economic interests, which can differ between, say, incumbents and
newcomers; and representations of how the economy works, on which various
players may disagree.8 From a knowledge perspective, it is therefore impor-
tant to identify the source and understand the nature of these disagreements.
From a policy perspective, recognizing and explicitly considering the intel-
lectual and political environment of public decisions becomes as necessary as
determining what is the first-​best solution. Political economy then becomes
essential both from a positive point of view (to understand why economic
policy does not achieve its objectives) and from a normative one (to evaluate
the chances of success of various reform strategies).
8

8    
Economic Policy

Positive economics, normative economics, and political economics thus

coexist, and the modern approach of economic policy draws on all three
methods. Positive economics remains indispensable to the understanding of
the likely effects of public decisions. Normative economics brings intellec-
tual discipline to policy choices and helps address the trade-​offs they involve.
Both, however, face limits and are increasingly complemented by political
economics.
Avinash Dixit (1996) once observed that the traditional approach of ec-
onomic policy envisaged the ultimate policymaker—​the Prince—​as an om-
niscient, omnipotent, and benevolent dictator. The economics of imperfect
information taught us that he or she was not omniscient. Second-​best theory
was developed in recognition of the fact that he or she was not omnipotent.
Political economy tells us that he or she is not always benevolent. This should
not be a cause for policy nihilism—​only a motive against policy naïveté.
The remaining sections of this chapter will focus on the traditional
approach whose shortcomings are then discussed in Chapter 2.

1.1.2 What do policymakers do?

The main tasks of economic policymakers can be grouped into six categories:
1. Set and enforce the rules of the economic game. Market structures and
property rights are not preordained. They are social and historical
outcomes shaped by power relations between interest groups, and,
if left unchecked, they are fraught with abuse and fraud. Economic
legislation provides the framework for the decisions of private agents.
Enforcement covers the protection of property rights, competition
policy, labor law, and the supervision of regulated markets such
as banking and insurance. Economic legislation increasingly has
an international dimension (through international treaties and
agreements)—​especially, but not only, in the European Union.
2. Tax and spend. Government spending amounts to about one-​half of
gross domestic product (GDP) in continental European countries
and one-​third in the United States and Japan. Budgetary decisions
affect households’ and firms’ income and behavior through taxation
and social insurance; they affect productivity and long-​term growth
through infrastructure, research, and education spending; and they
affect aggregate demand through changes in spending or overall
taxation (including negative taxation such as subsidies).
3. Issue and manage the currency. The choice of a monetary and
exchange-​rate regime is one of the most important single decisions a
government can make. Defining and implementing monetary policy
is the function of the central bank, an often independent branch of
government that is responsible for setting interest rates, maintaining
Another random document with
no related content on Scribd:
 DECORATIONS awarded to Norman Prince by the French Government
CROIX DE GUERRE (Red and green ribbon)
Star, won for being cited in L’Ordre du Jour of his Division for having been the only
one of twenty-five aviators to reach Douai in 1915.
First Palm, won for being cited in L’Ordre du Jour of the French Army for having
brought down an enemy avion.
Second Palm, for having brought down two enemy avions on the same day—at
the same time receiving the
Third Palm, cited in L’Ordre du Jour for having brought down a fourth enemy avion,
and for meritorious service in a raid on the Mauser ammunition works at
Oberndorf—at the same time receiving the
MÉDAILLE MILITAIRE (Yellow and green ribbon)
CROIX DE LA LÉGION D’HONNEUR (Red ribbon)

Rev. Dr. Endicott Peabody of the Groton School wrote: “I must tell
you how deeply Mrs. Peabody and I sympathize with you in
Norman’s death. He gave his life in a great cause. That will be a
comfort to you both, and he met his death with the courage that is
characteristic of his family. Even with these considerations, I realize
that your hearts must be heavy. It will please you to know that one of
Norman’s classmates at Groton, who had followed his career in
France with keen interest, has sent a contribution toward a memorial
that he desires established at the school.”
Speaking for the Harvard Class of 1909 of which Norman was a
member, its Secretary, Francis A. Harding, said: “On behalf of the
Harvard Class of 1909, I wish to express the very deep regret which
every Harvard man, and especially every classmate of Norman’s,
has felt after reading the announcement of his death in France. To
those of us who knew Norman intimately, the news of his death
comes as a distinct shock, and every member of our class feels
proud to have known and to have been affiliated with one who had
the courage to give in such a noble way everything he possessed to
the great cause in which he believed.”
From South Carolina Senator Tillman wrote: “Your son gave his
young life in defense of what all of us know is a sacred cause. He
was a twentieth century Lafayette, a modern knight errant whose
statue will yet grace the capital of France. Prince? Yes, a Prince
indeed—‘sans peur et sans reproche.’”
Many other thoughtful and tender messages came from others,
friends and strangers, at home and abroad, testifying their
commingled sorrow and admiration. Senator Henry Cabot Lodge
telegraphed from Washington this tribute:

“Nothing could have been more gallant than his life—

nothing finer than his death in a great cause, dear to his
heart.”

An eloquent and fitting epitaph!

TO NORMAN PRINCE
From a Boston Boy, in France, American Ambulance Field Service,
October 20, 1916.

Gone is the honored boy bird

He’ll fly no more for France,
His spirit though,—a silent word
That over all the Earth is heard,—
Commands her friends Advance!

His courage and devotion tried

Must all the world convince
He was, as all of us decide,
And France, for love of whom he died,
In name and deed—a Prince.

The Riverside Press

CAMBRIDGE. MASSACHUSETTS
U. S. A
*** END OF THE PROJECT GUTENBERG EBOOK NORMAN
PRINCE ***

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