Keynes & Hayek on taking back control

Today is President-elect Trump’s inauguration day.  And on Tuesday, UK PM Theresa May announced plans to exit the EU single market.  12 months ago, both events were seen as tail risks.  [Not to mention President Xi’s star turn at Davos this week as the unlikely new leader of globalisation.]  This is the starting gun on what I think will be a significant process of disruptive institutional and policy change.

Although these events are commonly seen as a Western backlash against globalisation, I think there is a different underlying cause. The winning slogans of 2016 were ‘let’s take back control’ and ‘make America great again’. These resonated deeply in the UK and the US, and there are echoes in other Western countries.  But neither slogan speaks directly to globalisation as much as to institutional constraints on national decision-making.

This is not a new issue.  Indeed, the push and pull between policy-maker discretion (political control) and rules-based institutions has been a key debate for decades.  Over 70 years ago, in 1944, John Maynard Keynes and Friedrich Hayek – two intellectual giants of the 20th century – corresponded after the publication of Hayek’s ‘Road to Serfdom’.  They were writing towards the end of a prolonged period of extraordinary economic and political turbulence, and with major unsettled policy issues.  

One of Hayek’s big ideas was the distributed nature of knowledge and the inability of the government to access this information, with the implication that the government should leave decision-making to markets.  Hayek further believed that economic planning was a slippery slope to totalitarian rule and that there should be institutional rules to limit the role of government policy discretion.  

Keynes responded that he was in “deeply moved agreement” with Hayek on his preference for a limited government.  But Keynes also believed that the government had a role in managing the macro consequences of private decision-making in an uncertain world – and that a failure to do so could undermine support for a market-based, democratic system.  Keynes emphasised the importance of discretion in policy-making, perhaps having seen the negative effects of rules like the gold standard in the UK.  

Keynes won the initial argument, through the establishment of the constrained discretion model of the Bretton Woods institutions of fixed exchange rates and national policy discretion.  This model worked very well for a period.  But by the late 1960s, the exchange rate regime was proving unsustainable.  And the country at the centre – the US – decided that it did not want to support the system when it conflicted with domestic policy priorities.
This ushered in a period of discretionary policy through the 1970s and 1980s, with fewer constraints on policy decision-making.  But this approach did not generate good economic outcomes.  

In response, a new intellectual consensus emerged through the 1980s that emphasised the need for rules to constrain political decision-makers and for governments to withdraw (deregulation, privatisation).  From the late 1980s, there was a pronounced move to establish independent institutions (e.g. central banks) and establish policy rules (e.g. fiscal policy).  And as globalisation became more intense and complex, trade deals reached further into domestic economies.  In the EU, sovereignty on a range of issues was pooled (notably migration) and Eurozone members gave up monetary policy discretion.

This bargain – a transfer of decision-making from politicians to central banks, finance ministries, trade ministries, as well as international institutions like the ECB – was politically sustainable while it delivered good outcomes.  And although imperfect, these institutions have made a substantial contribution.  But there is now a growing public sense that institutions and rules are preventing governments from addressing issues such as income inequality and unemployment: that things would somehow be better if not for institutions such as NAFTA or the EU’s fiscal rules.  This sentiment is amplified when decisions are being taken on matters that are seen as political, such as migration policy or bank bailouts.  

My assessment is that the political dissatisfaction is primarily focused on the perceived ‘golden straitjacket’ imposed by these policy institutions rather than on globalisation itself.  Indeed, many Brexiters and Trump supporters argue that they want more freedom to engage globally – albeit on better terms. This was the case made by PM May at Davos on Thursday, although I am sceptical that it will work like this.

The Brexit and Trump votes, as well as growing populist sentiment in Europe, reflect a desire to take back direct political control over issues such as migration and trade deals.  Institutions – domestic and particularly international – that constrain government decision-making are under increasing pressure, as in previous periods when the prevailing institutional regime was seen to be struggling (such as the early 1970s and the late 1980s).  Institutions are context-specific responses to specific challenges; we should not over-estimate institutional permanence. 

The implication is that we should expect ongoing institutional upheaval in large developed countries through 2017 and beyond (for several reasons, I expect much less disruption in small countries).  A return to the 1930s is highly unlikely, but I think that there will be a process of significant unravelling of domestic and international institutions developed over the past 25 years.  Governments will assert greater political and national control over decision-making. The nature of trade deals, currency and migration arrangements, and the future of deep regional integration will change as countries rebalance between global engagement and national policy autonomy.  And significant change is also likely in domestic institutions, such as central bank independence and fiscal rules. This will be quite a different world.

In other words, the West is tilting back towards Keynes. This institutional fluidity, with significant changes to the rules of the game, will have a meaningful impact on national economies and markets.  And perhaps quite soon.  2016 shows that change happens slowly, and then quickly.

David Skilling