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This is why Paul Krugman is wrong about the Federal Reserve

- September 30, 2015
Federal Reserve headquarters on Sept. 18, 2013. (J. David Ake/AP)

The current debates over whether the Federal Reserve should raise interest rates or hold them raises a key question in political economy. Why do we have the economic policies that we do? In a number of columns, Paul Krugman has thundered against the prevailing orthodoxy of cutting spending, raising interest rates and balancing budgets. For Krugman, the key puzzle is why policymakers keep on following economic theories, and pushing for economic policies, that we know to be wrong. Economists – including economists who violently disagree with Krugman on the specifics – have a similar take on the question of economic policy. For them, the smartest guys (and women) have the best advice, and their view ought to prevail. When their views don’t prevail, it’s an enormous puzzle.

Krugman’s theory for what goes wrong involves the influence of what he calls (after the economist-turned-blogger Duncan Black) “Very Serious People” or VSPs. A good idea gets proposed, but “VSPs” discredit it, and it goes down the drain. More spending to reduce employment?  Raise taxes on the wealthy? VSPs don’t like it.   Good ideas get shot down because some unspecified VSPs define what is “allowable” and what is not.

The concept of VSPs is a start in a political sociology of ideas but it is not enough. Who are the VSPs and why do they have influence? VSPs do matter, as do ideas, but we need to know who they are, how they reach their beliefs and why their ideas prevail ? Just noting the existence of VSPs just restates the problem rather than explain it.

Here, it’s necessary to work a little to uncover the political science arguments that underlie economists’ claims. For example, in this column, Krugman asks why so many people in the financial community want to increase interest rates, even though there is little inflation.

Krugman clearly identifies a “who”— the VSPs here are bankers. He also provides a ‘why’ for their preferences, arguing that they want higher interest rates because this will help them to make money. Banks make money by lending; their profits depend on the spread between the cost of the money to them and the interest they charge to the borrowers. A narrow spread makes it harder to make money.

Some political scientists might disagree with the claim that this can all be explained by self-interest (Krugman’s fellow columnist David Brooks surely would disagree too), but self-interest is often a good place to begin explanations of why people want the things that they do.

What still needs to be explained is influence. Why do the preferences of bankers – or other VSPs – prevail and shape policy?

Krugman’s column identifies two mechanisms. The first is the revolving door. In a system where regulators can later get cushy jobs in banking, they have an incentive to please their future employers so that they will get hired when they leave. A professional civil service with a long-term career path might help mitigate this problem, but it wouldn’t solve it.

The second is networking and what political scientists call “epistemic communities”: communities in which people think in the same ways and have the same opinions. Bankers and regulators see each other all the time at meetings, and social functions, talk the same talk, often come from similar backgrounds, and have similar ways of thinking.

Political scientists would extend the analysis beyond the points Krugman notes. They might highlight other mechanisms such as Congress, the influence of the electorate (or of some groups within it), and interest groups. In a recent case, interest groups working through Congress blocked the appointment of Larry Summers as chair of the Federal Reserve.

More research is needed on how these mechanisms work, which was more important when, and so on. Scholars like Paul Pierson have complained that “Americanist” political science, which focuses on the U.S. institutions has been notably weak in investigating this kind of question. “Comparativist” political scientists, who study other countries, have done better, but it isn’t yet clear how much their arguments need to be modified to explain what is happening in the U.S.

The second set of criticisms reflects a more fundamental disagreement between economics and political science. Economists tend to assume that there is a single right answer (even if they disagree bitterly among each other about what the right answer is). They explore what is “correct” from a theoretical point of view and are puzzled when their “correct” ideas are not followed.

Political scientists don’t usually start from the basis that there is a single correct way to do things. Instead, they assume that there is more than one interpretation of what is correct, and try to come up with theories about which “correct” answer is chosen. There is no correct answer when there are competing rival views that are not easily testable in a complex world where one cannot readily carry out controlled experiments with obvious real world interpretations.

Instead, what is “correct” is about judgment and values. It is also about who benefits, who gains, who loses and how. The tolerable levels of unemployment and/or inflation are at some level matters of value, not efficiency.

This is not to say that political scientists don’t have their own hidden assumptions lurking behind their investigations of social reality. But these assumptions may be democratic rather than expert-driven.

A full account of the battles over the Fed policy would require us to step beyond asking bankers and economists what they think and even asking economists what they think. We might instead ask the media to broaden its coverage, by asking a wider range of people about what is “correct” than “just” the economic theorists.

As there is usually more than one interpretation of what is correct, theory is not likely to give us a good explanation of what actually gets chosen. And it is not likely to tell us actually what is best from a democratic point of view, taking into account all the benefits and losses to a wide range of the population.

Instead of relying on expertise, we should figure out what people actually want from policy (and map the forces that block or channel their efforts to express and act on their desires).

Peter Gourevitch is Distinguished Emeritus Professor at the University of California, San Diego, and a senior fellow at the Watson Institute of International and Public Affairs at Brown University.