The dogma of ‘credibility’ endangers stability

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You will not find the word “credibility” in the General Theory of John Maynard Keynes. Nor in Alfred Marshall’s Principles of Economics, the 19th-century doorstopper that led many economists to say: “It’s all in Marshall.” And there is just one reference to credibility in Adam Smith’s compendious Wealth of Nations. Yet Martin Wolf, in his FT column last week, used it 15 times.

How did this term become so central to modern economics? If you continue the word search, you will be led back to a 1979 article by Finn Kydland and Edward Prescott. They start from the premise that the behaviour of companies and households depends on their expectations of the future. If these incorporate all knowable information, and governments lay out consistent fiscal and monetary plans for sustainable public finances and low inflation, the best course for companies and households is to adjust prices and wages to a new equilibrium consistent with prudent budgets and price stability.

The academic argument has had considerable practical influence, as the Swedish committee that awarded Kydland and Prescott the Nobel Prize in economics acknowledged. The case for central bank independence originated in the sensible observation that politicians were inclined to promise more than their economies would deliver, that inflation was a common result, and that a strong central bank governor could help resist this tendency.

Modern economics reframed the issue in the language of credibility: the key to price stability is the credibility of the plan for price stability. Arguments based on faith are impossible to refute: if magic fails, it is because we do not believe enough in magic, if credibility fails to bring about the desired outcome, it is because our commitment is too weak to establish credibility. Since the only markets in which you can immediately see prices adjusting to economic events are securities markets, these markets’ movements provide the test of credibility. The resulting power was why James Carville, Bill Clinton’s adviser, prayed for resurrection in the more influential role of the bond market.

Even in the bond market, however, expectations are rarely formed with reference to all potentially knowable information: sophisticated market participants base prognostication not on a detailed understanding of future public finances but on conventional wisdom, and on what they have just read in the FT or seen on CNBC. Ordinary people’s expectations are derived from Fox News and tabloids. Households may not respond to announcements of future inflation and spending targets by adjusting wage demands and price expectations to market equilibrium. They may instead burn down the central bank or vote the politicians who made these announcements out of office.

The elevation of credibility into a central economic doctrine has turned a sensible point – that policy stability is good for both business and households – into a dogma that endangers stability. The credibility the models describe is impossible in a democracy. Worse, the attempt to achieve it threatens democracy. Pasok, the established party of the Greek left, lost votes to the moderate Democratic Left and more extreme Syriza party because it committed to seeing austerity measures through. Now the Democratic Left cannot commit to that package because it would lose to Syriza if it did. The UK’s Liberal Democrats, by making such a deal, have suffered electoral disaster. The more comprehensive the coalition supporting unpalatable policies, the more votes will go to extremists who reject them.

Adam Smith’s use of the “c” word was prompted by the inept economic policies of Greece and Rome. The savant noted that in these ancient states, “the employment of artificers and manufacturers was considered as hurtful to the strength and agility of the human body”, while restrictive practices and protectionist policies raised the price of manufactures to prohibitive levels. Some classical writers reported prices of manufacture so high that, Smith said, their figures lacked credibility. Perhaps there is continuity after all.

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