Economic Policy Making and the Limits of Hobbesianism

Kaveh Pourvand, 6 February 2013

History has bequeathed us with a healthy and justified scepticism of political projects that aim to improve human nature. The new Soviet man, ‘Homo Sovieticus’, was supposed to free himself of self-interest and totally dedicate himself to the new collectivist Soviet cause. Yet the horrors of the Gulag spelled the end of that way of thinking and since the fall of the Soviet Union, political liberalism has become the dominant ideology, at least in the West. Of course, liberalism is not a unitary set of ideas; there are and have been many liberalisms. Yet, there are certain things in common between them; one being a view of human nature that is diametrically opposed to the utopian idealism that underpinned the Soviet Union. Rather than aiming to create a new virtuous human being, liberals seek to build institutions around how human beings actually behave. Which is vainly and selfishly; as Thomas Hobbes famously argued in The leviathan. He rejected the classical Aristotelian notion that human beings have a certain noble goal that the community ought to help them achieve. Instead politics should deal with human beings as the flawed and greedy beings they are. His form of politics was to give the ruler absolute sovereign power to bring order to a naturally unruly lot.

While we now reject Hobbes’ specific policies, his view of human nature was very influential, anticipating the famous homo economicus found in much of later liberal and economic thought. Ironically, the Hobbesian influence can now be found in the specified rules that have been devised to constrain the power of politicians. It is precisely because of the belief that politicians are self-interested and vain that efforts are made to ensure that the law is applied equally to the ruler and ruled, that politicians have to be elected and accountable to voters, that the powers to make and enforce the law are separated, and so on. In other words, much of the rationale for modern democratic institutions is drawn from the dim view of human nature given to us by Hobbes and his liberal successors. The aim is to constrain the discretionary power that politicians have and are likely to abuse by constraining them with rules and regulations. However, there have also been costs and limitations involved in this view of politicians as being primarily self-interested. There have been areas, particularly in economic policy, where the scope for government discretion and judgement has been reduced and constrained too much. This is the focus of the rest of this entry.

Inflation was one of the great economic plagues of the twentieth century. When it is out of control, it throws out of kilter the system of prices without which a market economy cannot function. Many now argue that the economically disastrous hyper-inflation experienced by Weimar Germany in the 1920s was a key factor leading to the rise of fascism. It has also been argued that inflation held back many developing countries in the two decades following the Second World War. One of the reasons that inflation used to get out of control is that governments used to directly control the printing presses through the ability to set national interest rates. Self-interested governments would often set interest rates artificially low in the run up to general elections to give the economy a short-term boost. Often, the long-term consequence was inflation and monetary instability. The prescribed solution was to transfer the power to set interest rates from politicians to central banks, that were given fixed targets of low inflation to meet – 2% in the UK’s case. Decision making was constrained in relation to interest rates only to take into account the one dimension of inflation and the only role for discretionary judgement was given to central bank officials on setting the rate to meet that target.

On its own terms, the policy was a great success. After central bank independence became the policy norm, occurring in the UK in 1997, inflation was greatly reduced. Some economists even feared deflation by the beginning of the new millennium. However, the reduction of the scope of official discretion in setting interest rate has had very significant costs. It has ruled out policies aimed at securing official employment. As economist John Mills argues in Civitas publication A Price That Matters, one of the key factors inhibiting full employment is the UK’s persistent trade deficits. There is less than optimal demand in the UK because we buy more goods from abroad than foreign countries buy from us. This deficit in turn is largely due to the high UK exchange rate. The only way to reduce the value of the pound is to reduce interest rates and increase the money supply; policies that increase inflation and so can’t be allowed if the only goal is low inflation. Between 1950 and 1973, when the government actively aimed for full employment, UK unemployment averaged 2%, never exceeding one million. Since the 1980s, when controlling inflation became the key focus of policy, it has never fallen below a million and currently stands at 2,490,000.

Furthermore, as Ha-Joon Chang points out, empirical evidence suggests that very low inflation may not be as beneficial as previously thought, and even damaging. Robert Barro has found that moderate inflation of around 10 – 20 per cent has only a moderately negative impact on growth, while inflation of less than ten per cent has no negative impact. Kenneth Rogoff and Carmen Reinhart have found that there were almost no financial crises during the high inflation period of 1950 and 1970 but that the proportion of countries experiencing banking crises increased significantly in the low inflation period of the 1980s onwards, including a 35 per cent rise following the 2008 financial crisis. This may be to do with the high central bank interest rates required to keep inflation low. Central bank rates generally set the interest rates for the rest of the financial markets. If they are high, than so are the returns to financial speculation, which means that monetary stability may encourage the sort of financial exuberance that led to the 2008 crisis.

These recent studies do not imply of course that high inflation is a good thing. No doubt, hyper-inflation remains a social and economic disaster that no government should allow to happen. What recent evidence does imply is that there are trade-offs and judgement involved in the approach to monetary policy, whether this is carried out by central banks or by elected politicians. Inflation should not be so high as to destabilise the economy but also not so low so as to reduce employment or create financial instability.  This requires some official to make a complicated judgement call. Indeed there are signs that this is already happening, with the Financial Times pointing out that Central Banks have started paying attention to other criteria than inflation. In recent years the Bank of England has tolerated an inflation rate far above its government targets as a tolerable price for low interest rates during a time of economic hardship.

Monetary policy is but one area of economic policymaking where the understandable urge to constrain self-interested politicians with rules has led to perverse outcomes. In Britain, it has manifested itself in a one dimensional approach to government procurement contracts and competition policy. Successive British governments have tended to award major government contracts purely to the cheapest bidder. The rationale for relying on this simple metric of the lowest price is that it removes scope for MPs to favour special interests, such as jobs in their constituencies. What it also means is that other considerations, such as developing capacity in British industry or supporting employment at home are not taken into account. Taking these criteria into account may mean favouring domestic firms even if they are not the cheapest bidder. This is not to say that taxpayer value doesn’t matter but that is one consideration among others. As with determining inflation, the role of political judgement and discretion in weighing up conflicting criteria is needed in procurement. In following the lowest price criteria Britain has been less likely to favour domestic firms in such contracts than our major industrial competitors and has consequently failed to use procurement to intelligently support industrial capacity. Similarly, in corporate governance there has been little attempt to make a judgement about the costs and benefits of foreign takeovers of British firms.

Going forward, it would be wise to temper the essential Hobbesian insight that self-interested politicians need constraining rules with an appreciation that effective politics also pre-supposes politicians who have the space to make judgements. It is not true that such discretionary judgement is always abused. Rome suffered at the hands of Caesar but also benefited from the magnanimity of Cincinnatus. Without demanding the exercise of judgement by politicians, without politicising economic decisions, it is going to be even harder than it already looks to recover from our current predicament.