politics

MMT: History, theory and politics

Originally published in Spanish as “¿De dónde viene el dinero?” by Política Exterior

Modern monetary theory, or MMT as it is widely known, has achieved remarkable visibility in recent years. Despite the title, MMT can resemble a political campaign as much as a monetary theory, characterised by activists promoting job guarantee schemes alongside more scholarly activity. The core ideas of MMT coalesced in the early 1990s, developed and promoted by a small group who largely bypassed academia, instead using blogs to accumulate a dedicated band of followers. As Bill Mitchell, one of the founders of MMT, said at the recent “International MMT Conference” in New York, “This is the first body of economic theory that has grown through activists”. In recent years that following has expanded substantially, leading to global prominence for key MMT figures, and widespread media coverage and commentary.

The main propositions of MMT are derived from one simple observation: a country with its own currency cannot run out of that currency. The U.S. government cannot run out of dollars because dollars are issued by the Federal Reserve, which is controlled by the U.S government. As a result, the U.S. government will never face a situation in which it cannot find the money to pay the interest on its debt, to hire workers, or to purchase goods and services. This, MMT proponents argue, turns conventional thinking on its head: mainstream economics promotes misconceptions about public debt, imposing false barriers to public spending. In contrast, it is claimed, MMT identifies the true constraints faced by currency-issuing governments, liberating policy-makers from misguided concerns about “finding the money” to pay for government spending.

The reality, as we shall see, is a bit more complicated. But first, some history. The MMT story starts with Warren Mosler, an ex-Wall Street trader who, in the 1980s, founded both a hedge fund and a supercar manufacturer, before relocating to the Virgin Islands, a Caribbean tax haven. In the early 1990s, Mosler took his ideas on sovereign debt to Donald Rumsfeld who sent him to Arthur Laffer (of “Laffer Curve” fame). Laffer told Mosler that the high priests of economic orthodoxy were unlikely to be interested in his ideas, and suggested he instead try the Post-Keynesians: a group of left-leaning non-mainstream economists. Mosler joined a Post-Keynesian email discussion list and found common ground with academics such as L. Randall Wray and his colleagues in the US, and Bill Mitchell in Australia. The group embarked on the project of developing a new synthesis of ideas on monetary economics.

Mosler convinced the group that the commonly held view that taxes provide the funds required for government spending is false. Instead, when a currency-issuing government spends, it creates new money: when the U.S. government makes a payment, new dollars are brought into existence at the point of expenditure. Discussions framed in terms such as “where will the government find the money?” are therefore based on a flawed understanding of the monetary system, Mosler argues.

According to Mosler, the purpose of taxation is instead to create the demand for government-issued currency. In the absence of taxes, Mosler contends, there would be no demand for essentially worthless pieces of paper. But in declaring and imposing the unit (the dollar) in which tax obligations must be discharged, the government ensures widespread use and acceptability of its currency.

These ideas turned out to be compatible with those of Randall Wray, an academic who was working on “Chartalist” ideas concerning the role of the state in defining and enforcing what is used as money. In the Chartalist view, money is not and has never been a commodity such as gold. Instead, money is essentially a system of IOUs that keeps track of credit and debit positions across a society too large and complex to rely on direct credit relationships. While credit theories of money have a longstanding tradition, the novelty of Chartalism lies with the claim that “money is a creature of the state”. By imposing the use of its own currency, Chartalists argue, the government, as monopoly issuer of that currency, attains powers not available to any other economic actor.

The core of MMT is a synthesis of Mosler and Wray’s ideas about government money with elements such as Abba Lerner’s “functional finance”. Lerner argues that government finances are not appropriate targets for government policy. Instead, the government should judge its actions on the basis of real outcomes, such as the level of employment. When combined with Mosler’s assertion that a currency-issuing government is never unable to service its debt, the claim that the appropriate target for macroeconomic policy is full employment appears logical. For MMT, the limit to government spending is therefore not financial but real, imposed by the physical capacity of the economic system to produce goods and services. The limit to fiscal activism is therefore the “inflation barrier” – the point at which increases in government spending generate rising prices, rather than higher employment and production.

The last piece of the MMT puzzle is the “employer of last resort” policy. Functional finance says that government spending should be used to eliminate unemployment – but there is a catch. As unemployment is reduced, inflation is likely to strengthen. It is unlikely that true zero unemployment can be achieved simply by raising government spending: at some point inflation will set in.

The employer of last resort (ELR) is MMT’s proposed solution to this problem. The policy is deceptively simple: the government should stand ready to employ all those who want work, offering a wage set at a level below the prevailing private sector wage rate. The justification claimed is twofold. First the policy will eliminate the social ill of unemployment: all those who want work will have it. Second, by setting wages below the level in the private sector, the ELR will create a “nominal anchor”: the below-market-rate ELR wage will restrain wage demands across the economy, preventing inflation, even in the absence of unemployment. When inflation sets in, the government should respond by reducing total spending, leading to lay-offs in the private sector. These laid off workers will be picked up by the ELR, at lower wages than the private sector. This increase in the “buffer stock” of ELR workers will serve to dampen wage demands in the private sector, reducing inflationary pressure.

These three elements: sovereign money, functional finance and the employer of last resort comprise the theoretical and policy core of MMT.

Before assessing whether this provides a sound basis for policy, we need to first briefly consider some history of the relationship between economic theory and macroeconomic policy. In the advanced economic nations, the post-war years were characterised by rapid growth and very low unemployment rates. By the middle of 1970s, this benign macroeconomic environment had given way to oil price hikes, the breakdown of the Bretton Woods managed exchange rate system and rising labour militancy. Policy-makers switched their focus from employment to inflation: the influence of Milton Friedman’s monetarism led to a growing belief that using macroeconomic policy for anything other than controlling inflation was futile, and that employment should be abandoned as a policy target. Through the 1980s and 1990s, academic economics coalesced around an increasingly mathematical formalisation of Friedman’s ideas (confusingly, this acquired the title of “New Keynesian economics”). While mathematically complex, this boils down to three main propositions.

First, total spending by households and businesses – what economists refer to as aggregate demand – is determined, in the short run, by the rate of interest. Since the rate of interest is assumed to be under the control of the central bank, total spending is therefore under direct policy control. Second, inflation is determined by two factors: firstly by total spending relative to the productive capacity of the economy and, secondly, by expectations about future inflation. In this view, if inflation is too high, the central bank should raise the rate of interest, reducing total spending and thus reducing inflationary pressure. The speed at which inflation will return to target will depend on the “credibility” of the central bank: if households and businesses believe that the central bank is serious about getting inflation under control, even at the cost of higher short-run unemployment, then inflation will adjust quickly. The conclusion – the third proposition – is that the optimal way to implement macroeconomic policy is for an independent central bank to adopt a policy rule, explicitly stating how it will adjust interest rates when inflation is above target. This, it is argued, is the most effective way to ensure that the central bank is credible – and is not susceptible to politicians seeking to temporarily lower unemployment as a way to improve their electoral prospects.

A small group of dissenting “heterodox” economists maintained a position of opposition to the ascendancy of monetarist ideas, arguing that Friedman’s diagnosis relied on an over-simplified view of inflation as the result of “too much money chasing too few goods”. Drawing inspiration from Keynes and his contemporaries Michal Kalecki, Joan Robinson and Nicholas Kaldor, this group adopted the term “Post-Keynesian” to distinguish their position from that of the mainstream. The Post-Keynesians rejected the key monetarist assertion that the central bank can always influence economic activity by adjusting either the quantity of money or the policy rate of interest. As Keynes put it, monetary policy is like “pushing on a string”: tighter policy will dampen economic activity, but looser policy will not automatically act as a stimulus. Fiscal policy is therefore required for macroeconomic stabilisation.

From around the mid-1970s, Post-Keynesian economics was characterised by a transatlantic division of labour. In the UK, with Cambridge at the centre, much attention was focused on growth and distribution. In the US, a closer interest was taken in monetary and financial issues. It was with members of this group of US Post-Keynesians that Mosler formed an alliance in the 1990s. Mosler’s financial backing enabled institutional support at the University of Missouri-Kansas, where several prominent MMT developers gained employment, including a PhD training programme to incubate the next generation of MMT advocates.

While the theoretical core of MMT is close to the ideas of Post-Keynesian economics, MMT stole a march on their Post-Keynesians colleagues in exploiting social media and non-academic activism. With hindsight, however, these tactics turn out to be something of a double-edged sword: success relied on the use of slogans such as “money doesn’t grow on rich people”, “taxes don’t pay for spending” and “money is no object”. These slogans, and the zeal with which advocates adopted them, arguably serve to obscure the underlying ideas, making MMT claims appear more groundbreaking than is really the case.

Take the claim that “taxes don’t pay for spending”. It has long been taught in elementary macroeconomics classes that government spending adds to total national expenditure, while taxes are a deduction. The two variables are treated as moving independently of one another: taxation doesn’t constrain government spending. Since at least the time of Keynes, it has been understood that tax plays an important macroeconomic role in limiting total private sector spending, thus ensuring that economic capacity is available for government programmes. Whether this function should be characterised as taxes “paying for” spending is perhaps semantic.

Textbooks usually explain that the gap between government spending and taxation is covered by issuance of government bonds. MMT goes further, claiming that government spending is not financed by either taxes or bond issuance: Governments first spend, creating new money, then withdraw money from circulation by imposing taxes or issuing bonds. As a result, MMT proponents claim, taxes can be cut dramatically, without affecting the ability of government to spend, while bond issuance can be eliminated entirely.

Does MMT provide a good guide for policy? MMT proponents tend to deny that MMT provides policy proposals. Instead, it is claimed, MMT is a “lens” through which one comprehends the true nature of the monetary system. MMT is not a policy package, it is argued, because MMT is simply a description of how the system already works.

This claim stretches credibility. Putting the ELR proposal aside, MMT proponents do make policy proposals (such as those already noted). The common feature of such proposals is the use of deficit monetisation: issuing central bank money directly to pay for government programmes. For example, Warren Mosler proposes abolishing all payroll taxes, while Stephanie Kelton has argued that the Green New Deal, a massive public spending programme championed by the left of Democratic Party, can be implemented without needing to tax the wealthy.

Complaints by proponents that MMT is mischaracterised as “printing money” are therefore misplaced. The suggestion that MMT claims “deficits don’t matter” likewise causes protest: MMT proponents respond that deficits matter, but what matters is the so-called “real resource constraint”. As a result, as MMT proponents correctly note, deficits can be too small as well as too large – an obvious current example is Germany, where demand clearly falls short of real constraints, and there is substantial capacity for fiscal expansion. Despits this, MMT complaints are again misleading: MMT does argue that there is no financial constraint to government deficits. While it is almost certainly the case that the US and other advanced nations still have substantial fiscal space, despite running large deficits in some cases, the MMT claim is too extreme; at some point, fiscal limits will be reached even in rich nations. For countries further down the international currency hierarchy which face binding externally-imposed constraints related to foreign exchange needs, fiscal limits are very real.

Further, despite MMT proponents emphasising the “inflation barrier” as the true limit to deficit spending, little effort is devoted to the crucial questions of how real resources are to be mobilised: how to ensure that large government spending programmes such as the Green New Deal can be implemented without hitting supply side bottlenecks, capacity limits and political resistance. In framing everything in monetary terms, rather than real economic activity, MMT therefore obscures rather than illuminates important macroeconomic relationships.

Once the esoteric use of language and the more extreme claims are stripped away, there is arguably a rather conventional core to MMT. US economists JW Mason and Arun Jayadev argue that, in policy terms, MMT effectively amounts to a reversal of the “consensus assignment”. This refers to the idea that the two main tools of macroeconomic management, fiscal policy and monetary policy, should each be assigned a single target. The consensus assignment is that monetary policy (setting interest rates and, more recently, quantitative easing) should be used to manage aggregate demand, while fiscal policy is used to maintain sustainable debt-to-GDP ratios. In contrast, MMT proposes the use of fiscal policy to manage demand, and monetary policy (in the form of deficit monetisation and zero interest rates) to manage the public finances.

MMT is usually portrayed as a left-wing economic programme: Stephanie Kelton is an economic advisor to Bernie Sanders and Alexandria Ocasio-Cortez has said that MMT should be “part of the conversation”. But although much of the MMT activist base is on the left, the relationship between MMT and politics is more complex. The line that “money doesn’t grow on rich people” can potentially play well on the right, as much as the left. As already noted, Mosler, a self-described “Tea Party Democrat” proposes the abolition of payroll taxes. Bill Mitchell argues that MMT is politically neutral, and MMT insights can inform either left- or right-wing political programmes. Care therefore needs to be taken when associating government deficits with the political left: US Republicans use deficit scaremongering to constrain public spending by Democrat administrations, but Republican governments are often less fiscally cautious in office — Trump’s tax cuts provide a recent example. Similarly, in the UK, after nearly a decade of government cuts premised on the false threat of a run on bond markets, the Conservative government has decided to embrace deficits, cutting taxes and making eye-catching spending claims.

The ideas of MMT could also be adopted by political groups that combine socially right-wing ideas with activist fiscal policy. In their recent book, “Reclaiming The State”, Bill Mitchell and his co-author Thomas Fazi note the successful use of deficit monetisation in Nazi Germany, while decrying the “tragedy” of the Left’s focus in recent decades on “identity politics”: opposition to racism, homophobia and other forms of bigotry. This, Mitchell argues, serves to radicalise the “ethnocentrism of the proletariat”. This framing of MMT in terms of national sovereignty will have obvious appeal to those wishing to implement nativist policies, such as restricting migration, while using deficit spending to ensure employment for those on the inside.

MMT has had remarkable success in opposing needless deficit hysteria and in popularising more enlightened ideas on macroeconomic management than those prevailing since the rise of monetarism in the 1970s. Recent events have demonstrated the ineffectiveness of monetary policy as a demand management tool: it is now widely accepted that fiscal policy must play a more active role. MMT activists should therefore be commended: they have succeeded where other heterodox economists have failed in popularising these important ideas. But the use of obscurantist language, oversimplification of complex issues and the tendency to make excessive claims ultimately undermines their case.

Time will tell if MMT is destined to become a passing phase or a more permanent “part of the conversation”. What seems more certain is that the days of reliance on monetary policy as the sole macroeconomic stabilisation tool are over: fiscal policy is back on the agenda.

Economics, Ideology and Trump

So the post-mortem begins. Much electronic ink has already been spilled and predictable fault lines have emerged. Debate rages in particular on the question of whether Trump’s victory was driven by economic factors. Like Duncan Weldon, I think Torsten Bell gets it about right – economics is an essential part of the story even if the complete picture is more complex.

Neoliberalism is a word I usually try to avoid. It’s often used by people on the left as an easy catch-all to avoid engaging with difficult issues. Broadly speaking, however, it provides a short-hand for the policy status quo over the last thirty years or so: free movement of goods, labour and capital, fiscal conservatism, rules-based monetary policy, deregulated finance and a preference for supply-side measures in the labour market.

Some will argue this consensus has nothing to with the rise of far-right populism. I disagree. Both economics and economic policy have brought us here.

But to what extent has academic economics provided the basis for neoliberal policy? The question had been in my mind even before the Trump and Brexit votes. A few months back, Duncan Weldon posed the question, ‘whatever happened to deficit bias?’ In my view, the responses at the time missed the mark. More recently, Ann Pettifor and Simon Wren Lewis have been discussing the relationship between ideology, economics and fiscal austerity.

I have great respect for Simon – especially his efforts to combat the false media narratives around austerity. But I don’t think he gets it right on economics and ideology. His argument is that in a standard model – a sticky-price DSGE system – fiscal policy should be used when nominal rates are at the zero lower bound. Post-2008 austerity policies are therefore at odds with the academic consensus.

This is correct in simple terms, but I think misses the bigger picture of what academic economics has been saying for the last 30 years. To explain, I need to recap some history.

Fiscal policy as a macroeconomic management tool is associated with the ideas of Keynes. Against the academic consensus of his day, he argued that the economy could get stuck in periods of demand deficiency characterised by persistent involuntary unemployment. The monetarist counter-attack was led by Milton Friedman – who denied this possibility. In the long run, he argued, the economy has a ‘natural’ rate of unemployment to which it will gravitate automatically (the mechanism still remains to be explained). Any attempt to use activist fiscal or monetary policy to reduce unemployment below this natural rate will only lead to higher inflation. This led to the bitter disputes of the 1960s and 70s between Keynesians and Monetarists. The Monetarists emerged as victors – at least in the eyes of the orthodoxy – with the inflationary crises of the 1970s. This marks the beginning of the end for fiscal policy in the history of macroeconomics.

In Friedman’s world, short-term macro policy could be justified in a deflationary situation as a way to help the economy back to its ‘natural’ state. But, for Friedman, macro policy means monetary policy. In line with the doctrine that the consumer always knows best, government spending was proscribed as distortionary and inefficient. For Friedman, the correct policy response to deflation is a temporary increase in the rate of growth of the money supply.

It’s hard to view Milton Friedman’s campaign against Keynes as disconnected from ideological influence. Friedman’s role in the Mont Pelerin society is well documented. This group of economic liberals, led by Friedrich von Hayek, formed after World War II with the purpose of opposing the move towards collectivism of which Keynes was a leading figure. For a time at least, the group adopted the term ‘neoliberal’ to describe their political philosophy. This was an international group of economists whose express purpose was to influence politics and politicians – and they were successful.

Hayek’s thesis – which acquires a certain irony in light of Trump’s ascent – was that collectivism inevitably leads to authoritarianism and fascism. Friedman’s Chicago economics department formed one point in a triangular alliance with Lionel Robbins’ LSE in London, and Hayek’s fellow Austrians in Vienna. While in the 1930s, Friedman had expressed support for the New Deal, by the 1950s he had swung sharply in the direction of economic liberalism. As Brad Delong puts it:

by the early 1950s, his respect for even the possibility of government action was gone. His grudging approval of the New Deal was gone, too: Those elements that weren’t positively destructive were ineffective, diverting attention from what Friedman now believed would have cured the Great Depression, a substantial expansion of the money supply. The New Deal, Friedman concluded, had been ‘the wrong cure for the wrong disease.’

While Friedman never produced a complete formal model to describe his macroeconomic vision, his successor at Chicago, Robert Lucas did – the New Classical model. (He also successfully destroyed the Keynesian structural econometric modelling tradition with his ‘Lucas critique’.) Lucas’ New Classical colleagues followed in his footsteps, constructing an even more extreme version of the model: the so-called Real Business Cycle model. This simply assumes a world in which all markets work perfectly all of the time, and the single infinitely lived representative agent, on average, correctly predicts the future.

This is the origin of the ‘policy ineffectiveness hypothesis’ – in such a world, government becomes completely impotent. Any attempt at deficit spending will be exactly matched by a corresponding reduction in private spending – the so-called Ricardian Equivalence hypothesis. Fiscal policy has no effect on output and employment. Even monetary policy becomes totally ineffective: if the central bank chooses to loosen monetary policy, the representative agent instantly and correctly predicts higher inflation and adjusts her behaviour accordingly.

This vision, emerging from a leading centre of conservative thought, is still regarded by the academic economics community as a major scientific step forward. Simon describes it as `a progressive research programme’.

What does all this have to with the current status quo? The answer is that this model – with one single modification – is the ‘standard model’ which Simon and others point to when they argue that economics has no ideological bias. The modification is that prices in the goods market are slow to adjust to changes in demand. As a result, Milton Friedman’s result that policy is effective in the short run is restored. The only substantial difference to Friedman’s model is that the policy tool is the rate of interest, not the money supply. In a deflationary situation, the central bank should cut the nominal interest rate to raise demand and assist the automatic but sluggish transition back to the `natural’ rate of unemployment.

So what of Duncan’s question: what happened to deficit bias? – this refers to the assertion in economics textbooks that there will always be a tendency for governments to allow deficits to increase. The answer is that it was written out of the textbooks decades ago – because it is simply taken as given that fiscal policy is not the correct tool.

To check this, I went to our university library and looked through a selection of macroeconomics textbooks. Mankiw’s ‘Macroeconomics’ is probably the mostly widely used. I examined the 2007 edition – published just before the financial crisis. The chapter on ‘Stabilisation Policy’ dispenses with fiscal policy in half a page – a case study of Romer’s critique of Keynes is presented under the heading ‘Is the Stabilization of the Economy a Figment of the Data?’ The rest of the chapter focuses on monetary policy: time inconsistency, interest rate rules and central bank independence. The only appearance of the liquidity trap and the zero lower bound is in another half-page box, but fiscal policy doesn’t get a mention.

The post-crisis twelfth edition of Robert Gordon’s textbook does include a chapter on fiscal policy – entitled `The Government Budget, the Government Debt and the Limitations of Fiscal Policy’. While Gordon acknowledges that fiscal policy is an option during strongly deflationary periods when interest rates are at the zero lower bound, most of the chapter is concerned with the crowding out of private investment, the dangers of government debt and the conditions under which governments become insolvent. Of the textbooks I examined, only Blanchard’s contained anything resembling a balanced discussion of fiscal policy.

So, in Duncan’s words, governments are ‘flying a two engined plane but choosing to use only one motor’ not just because of media bias, an ill-informed public and misguided politicians – Simon’s explanation – but because they are doing what the macro textbooks tell them to do.

The reason is that the standard New Keynesian model is not a Keynesian model at all – it is a monetarist model. Aside from the mathematical sophistication, it is all but indistinguishable from Milton Friedman’s ideologically-driven description of the macroeconomy. In particular, Milton Friedman’s prohibition of fiscal policy is retained with – in more recent years – a caveat about the zero-lower bound (Simon makes essentially the same point about fiscal policy here).

It’s therefore odd that when Simon discusses the relationship between ideology and economics he chooses to draw a dividing line between those who use a sticky-price New Keynesian DSGE model and those who use a flexible-price New Classical version. The beliefs of the latter group are, Simon suggests, ideological, while those of the former group are based on ideology-free science. This strikes me as arbitrary. Simon’s justification is that, despite the evidence, the RBC model denies the possibility of involuntary unemployment. But the sticky-price version – which denies any role for inequality, finance, money, banking, liquidity, default, long-run unemployment, the use of fiscal policy away from the ZLB, supply-side hysteresis effects and plenty else besides – is acceptable. He even goes so far as to say ‘I have no problem seeing the RBC model as a flex-price NK model’ – even the RBC model is non-ideological so long as the hierarchical framing is right.

Even Simon’s key distinction – the New Keynesian model allows for involuntary unemployment – is open to question. Keynes’ definition of involuntary unemployment is that there exist people willing and able to work at the going wage who are unable to find employment. On this definition the New Keynesian model falls short – in the face of a short-run demand shortage caused by sticky prices the representative agent simply selects a new optimal labour supply. Workers are never off their labour supply curve. In the Smets Wouters model – a very widely used New Keynesian DSGE model – the labour market is described as follows: ‘household j chooses hours worked Lt(j)’. It is hard to reconcile involuntary unemployment with households choosing how much labour they supply.

What of the position taken by the profession in the wake of 2008? Reinhart and Rogoff’s contribution is by now infamous. Ann also draws attention to the 2010 letter signed by 20 top-ranking economists – including Rogoff – demanding austerity in the UK. Simon argues that Ann overlooks the fact that ‘58 equally notable economists signed a response arguing the 20 were wrong’.

It is difficult to agree that the signatories to the response letter, organised by Lord Skidelsky, are ‘equally notable’. Many are heterodox economists – critics of standard macroeconomics. Those mainstream economists on the list hold positions at lower-ranking institutions than the 20. I know many of the 58 personally – I know none of the 20. Simon notes:

Of course those that signed the first letter, and in particular Ken Rogoff, turned out to be a more prominent voice in the subsequent debate, but that is because he supported what policymakers were doing. He was mostly useful rather than influential.

For Simon, causality is unidirectional: policy-makers cherry-pick academic economics to fit their purpose but economists have no influence on policy. This seems implausible. It is undoubtedly true that pro-austerity economists provided useful cover for small-state ideologues like George Osborne. But the parallels between policy and academia are too strong for the causality to be unidirectional.

Osborne’s small state ideology is a descendent of Thatcherism – the point when neoliberalism first replaced Keynesianism. Is it purely coincidence that the 1980s was also the high-point for extreme free market Chicago economics such as Real Business Cycle models?

The parallel between policy and academia continues with the emergence of the sticky-price New Keynesian version as the ‘standard’ model in the 90s alongside the shift to the third way of Blair and Clinton. Blairism represents a modified, less extreme, version of Thatcherism. The all-out assault on workers and the social safety net was replaced with ‘workfare’ and ‘flexicurity’.

A similar story can be told for international trade, as laid out in this excellent piece by Martin Sandbu. In the 1990s, just as the ‘heyday of global trade integration was getting underway’, economists were busy making the case that globalisation had no negative implications for employment or inequality in rich nations. To do this, they came up with the ‘skill-biased technological change’ (SBTC) hypothesis. This states that as technology advances and the potential for automation grows, the demand for high-skilled labour increases. This introduces the hitch that higher educational standards are required before the gains from automation can be felt by those outside the top income percentiles. This leads to a `race between education and technology’ – a race which technology was winning, leading to weaker demand for middle and low-skill workers and rising ‘skill premiums’ for high skilled workers as a result.

Writing in the Financial Times shortly before the financial crisis, Jagdish Bagwati argued that those who looked to globalisation as an explanation for increasing inequality were misguided:

The culprit is not globalization but labour-saving technical change that puts pressure on the wages of the unskilled. Technical change prompts continual economies in the use of unskilled labour. Much empirical argumentation and evidence exists on this. (FT, January 4, 2007, p. 11)

As Krugman put it:

The hypothesis that technological change, by raising the demand for skill, has led to growing inequality is so widespread that at conferences economists often use the abbreviation SBTC – skill-biased technical change – without explanation, assuming that their listeners know what they are talking about (p. 132)

Over the course of his 2007 book, Krugman sets out on a voyage of discovery – ‘That, more or less, is the story I believed when I began working on this book’ (p. 6). He arrives at the astonishing conclusion – ‘[i]t sounds like economic heresy’ (p. 7) – that politics can influence inequality:

[I]nstitutions, norms and the political environment matter a lot more for the distribution of income – and … impersonal market forces matter less – than Economics 101 might lead you to believe (p. 8)

The idea that rising pay at the top of the scale mainly reflect social and political change, … strikes some people as … too much at odds with Economics 101.

If a left-leaning Nobel prize-winning economist has trouble escaping from the confines of Economics 101, what hope for the less sophisticated mind?

As deindustrialisation rolled through the advanced economies, wiping out jobs and communities, economists continued to deny any role for globalisation. As Martin Sandbu argues,

The blithe unconcern displayed by the economics profession and the political elites about whether trade was causing deindustrialisation, social exclusion and rising inequality has begun to seem Pollyannish at best, malicious at worst. Kevin O’Rourke, the Irish economist, and before him Lawrence Summers, former US Treasury Secretary, have called this “the Davos lie.”

For mainstream macroeconomists, inequality was not a subject of any real interest. While the explanation for inequality lay in the microeconomics – the technical forms of production functions – and would be solved by increasing educational attainment, in macroeconomic terms, the use of a representative agent and an aggregate production function simply assumed the problem away. As Stiglitz puts it:

[I]f the distribution of income (say between labor and capital) matters, for example, for aggregate demand and therefore for employment and output, then using an aggregate Cobb-Douglas production function which, with competition, implies that the share of labor is fixed, is not going to be helpful. (p.596)

Robert Lucas summed up his position as follows: ‘Of the tendencies that are harmful to sound economics, the most seductive, and in my opinion the most poisonous, is to focus on questions of distribution.’ It is hard to view this statement as informed more strongly by science than ideology.

But while economists were busy assuming away inequality in their models, incomes continued to diverge in most advanced economies. It was only with the publication of Piketty’s book that the economics profession belatedly began to turn its back on Lucas.

The extent to which economic insecurity in the US and the UK is driven by globalisation versus policy is still under discussion – my answer would be that it is a combination of both – but the skill-biased technical change hypothesis looks to be a dead end – and a costly one at that.

Similar stories can be told about the role of household debt, finance, monetary theory and labour bargaining power and monopoly – why so much academic focus on ‘structural reform’ in the labour market but none on anti-trust policy?  Heterodox economists were warning about the connections between finance, globalisation, current account imbalances, inequality, household debt and economic insecurity in the decades before the crisis. These warnings were dismissed as unscientific – in favour of a model which excluded all of these things by design.

Are economic factors – and economic policy – partly to blame for the Brexit and Trump votes? And are academic economists, at least in part, to blame for these polices? The answer to both questions is yes. To argue otherwise is to deny Keynes’ dictum that ‘the ideas of economists and political philosophers, both when they are right and when they are wrong are more powerful than is commonly understood.’

This quote, ‘mounted and framed, takes pride of place in the entrance hall of the Institute for Economic Affairs’ – the think-tank founded, with Hayek’s encouragement, by Anthony Fisher, as a way to promote and promulgate the ideas of the Mont Pelerin Society. The Institute was a success. Fisher was, in the words of Milton Friedman, ‘the single most important person in the development of Thatcherism’.

The rest, it seems, is history.