It was not pre-ordained that the economies of Europe, the US, and the UK would perform as poorly as it they have over the past two years.

There were better policy options available which would have lowered unemployment (currently close to 8% in the US and the UK, and nearly 12% in Europe), fostered stronger growth, and left official debt in better shape. The US and the UK might have struck a better balance between the need for short-horizon fiscal stimulus and, simultaneously, the need for a credible commitment to medium-term fiscal sustainability. Europe might have accepted in 2010 that Greece was bankrupt, written off the debt and shored up the other peripheral countries against contagion. 

Why were the superior options not chosen?

The best explanation may be found in the no-man's land between economics and politics, where policy is determined beyond the discipline of economic theory but not exclusively in the territory of the vote-counters, quorum-builders, lobbyists and focus groups.

This is the territory where differences of opinion (which are stock-in-trade for economists) encourage prevarication rather than resolution and political 'realities' (ie. compromise) produce third-best solutions. Vested interests thrive, and majority opinion has trouble being heard. Unresolved political processes (like the US debt ceiling and the European peripheral debt) generate continuing economic uncertainty, creating jittery financial markets and stifling the animal spirits on which economic growth depends.

Let's agree that the last couple of years have been a difficult environment for policy-making. The world economy rode out the global financial crisis well enough considering the melt-down in the financial sector, and seemed to recover quickly in 2010, helped by near-universal fiscal stimulus. World growth, at over 5%, was above average, although not quite the snap-back to full capacity characteristic of a perfect 'V' shaped recovery. Looking back, this policy period seems easy: when the economy is collapsing, budget stimulus gets wide support.

Then growth ran out of steam in 2011 and 2012, with the advanced countries falling to half the 2010 rate. The GFC legacy quickly boosted official debt-to-GDP ratio, partly through bank rescue costs (Spain and Italy Ireland), but more widely through the fiscal drag of the on-going downturn. High-profile economists analysed a century of disparate experience and confidently pronounced that many economies had now reached a critical universally-relevant debt threshold, beyond which debt would be unsustainable. Others thought that households had to atone for their years of balance-sheet expansion with years of austerity to grind down their excessive borrowing. No promise of a quick fix here.

Meanwhile, the small-government lobby (whose extreme form is the US Tea Party, but parallels are found everywhere) saw the opportunity to promote their 'starve the beast' advocacy, where cutting government spending is always good, whatever the phase of the cycle. Simple extrapolation of expenditures (eg. US entitlements) backed the case. Their economic acolytes argued that strict austerity would promote growth through raising confidence.

Economists have always been known for their disagreements, but now the differences get more public coverage, via blogs and the 24-hour news cycle. There is a premium on strongly-held views. In the name of 'balance', nutters get air-time.

This cacophony of disparate nostrums doesn't help. When economists were asked about the net benefit of the 2009 US fiscal stimulus (a specific example of what is perhaps the central macro-policy issue of the past few years), there was a babble of voices, with less than half saying that the stimulus was beneficial. Moreover, the same survey suggests that even when economists agree (which is not that rare among practical policy-makers), the public is quite likely to have a firmly-held contrary view. Most economists agree that the US stimulus lowered the unemployment rate, but less than half of public respondents agreed.

The key problem is the political process: who could argue that it was a good idea to take the US debt-limit confrontation to the edge of default, and yet that happened in 2011 and may happen again. The succession of decisions 'kicked down the road' reflects a dysfunctional system, 'vehemently adversarial' and 'scornful of compromise'.

What to do? There may be guidance in the precedents where good economics was also good politics. There have been some remarkable successes. The public is unconvinced of the benefits of free trade and yet there has been huge progress in opening up international markets. Deregulation (particularly the enhancement of competition and the reduced role of state monopolies) has changed the business environment in many countries, without wide public support.

What were the key enabling characteristics of these successes? Sometimes international peer pressure helped (GATT/WTO on trade, OECD on deregulation, the IMF on flexible exchange rates). Sometimes the key was institutional reform. The classic case (currently under vigorous discussion) is central bank independence, which distanced monetary policy from the political arena. Some argue that putting fiscal policy into a similarly independent institutional framework is the answer. Perhaps a rule or binding commitment would help. Maastricht didn't ensure European fiscal rectitude, but a Golden Rule (budget balance over the course of the cycle) sometimes nails down waverers and shifts the recalcitrants.

Agreement among economists is not in itself essential for good policies. But good policies rarely come out of lowest-common-denominator compromise or arm-wrestling trade-offs between strongly differing models or ideologies. Institutional fixes (central bank independence) and decision rules (the budget Golden Rule) don't last forever, and have some element of democratic deficit. But they take the decisions beyond the gridlock of doctrinal differences and the excessive power of vested interests.

Meanwhile, economic forecasts will be based at least as much on politics as on economics. 'Political risk has entered our vocabulary. Whether staring over the fiscal cliff, battling the eurozone crisis, trying to profit from a rising China, or taking cover from the Middle East; around the world, politics has come to dominate market outcomes.'

Photo by Flickr user mikemcsharry.