Posted by: Dirk | June 7, 2010

The Science of ‘Muddling Through’

This is taken from Charles Lindblom:

Suppose an administrator is given responsibility for formulating policy with respect to inflation. He might start by trying to list all related values in order of importance, e.g., full employment, reasonable business profit, protection of small savings, prevention of a stock market crash. Then all possible policy outcomes could be rated as more or less efficient in attaining a maximum of these values. This would of course require a prodigious inquiry into values held by members of society and an equally prodigious set of calculations on how much of each value is equal to how much of each other value. He could then proceed to outline all possible policy alternatives. In a third step, he would undertake systematic comparison of his multitude of alternatives to determine which attains the greatest amount of values.

In comparing policies, he would take advantage of any theory available that generalized about classes of policies. In considering inflation, for example, he would compare all policies in the light of the theory of prices. Since no alternatives are beyond his investigation, he would consider strict central control and the abolition of all prices and markets on the one hand and elimination of all public controls with reliance completely on the free market on the other, both in the light of whatever theoretical generalizations he could find on such hypothetical economies.

Finally, he would try to make the choice that would in fact maximize his values.

An alternative line of attack would be to set as his principal objective, either explicitly or without conscious thought, the relatively simple goal of keeping prices level. This objective might be compromised or complicated by only a few other goals, such as full employment. He would in fact disregard most other social values as beyond his present interest, and he would for the moment not even attempt to rank the few values that he regarded as immediately relevant. Were he pressed, he would quickly admit that he was ignoring many related values and many possible important consequences of his policies.

This was written and published more than half a century ago in 1959. It is as simple as it is clever, outlining problems that policy-makers dealing with complex situations face: start from scratch after coming up with an idea how things should work, or take things are they are and try to improve them step by step. This is the science of ‘muddling through’.

The state of macroeconomic theory can fairly be described as the outcome of a lot of ‘muddling through’. After it was recognized that money supply could not be used to steer the economy (since their influence on interest rates was varying over time), theoretical models started with some level of inflation and took a marginal view – the return of Wicksellian theory to macroeconomic policy-making. Woodford and others used quite complex mathematical models to show how to stabilize inflation, relying on some assumptions.

The assumptions, of course, were critical to the model. Are money and bonds perfect substitutes? How does the central bank steer the interest rate? The answers to these questions (yes; influencing the interest rate via money, which is used for ‘cultural’ reasons) depend on whether one has a clear idea on how a capitalist economy works. This normally would demand to ‘open the hood’ and take a good look at the engine, by which I mean the institutional parts of the monetary system.

By monetary system I mean the system of debt. Money, or credit, is nothing else than debt. Stocks and bonds are debt instruments, as are other financial innovations like derivatives. An understanding of financial markets is something which everybody dealing with monetary policy needs. Since financial markets are connected to the real economy, international trade is also something which should be understood. So, central banks should be full of people knowing how things fundamentally work in a capitalist system.

However, I have the feeling that these institutions did a lot of ‘muddling through’. That’s not a bad thing by itself. However, it should be clear to everybody concerned that the approach cannot be trusted to produce the social optimum. Lindblom continues on p. 80:

For complex problems, the first of these approaches is of course impossible. Although such an approach can be described, it cannot be practiced except for relatively simple problems and even then only in a somewhat modified form. It assumes intellectual capacities and sources of information that men simply do not possess, and it is even more absurd as an approach to policy when the time and money that can be allocated to a policy problem is limited, as is always the case. Of particular importance to public administrators is the fact that public agencies are in effect usually instructed not to practice the first method. That is to say, their prescribed functions and constrains – the politically or legally possible – restrict their attention to relatively few values and relatively few alternative policies among the countless alternatives that might be imagined. It is the second method that is practiced.

So, there is a gap between policy-making (muddling through) and economic science that is outside the mainstream. My guesstimate on what is missing in the central bank playbook is ‘economic imbalances’. The external dimension – current account imbalances and the corresponding capital flows – are either not thought to be important, or they are poorly or not at all understood. How will central banks catch up? Obviously, they might not. In their view, it is corrupt governments piling up huge debts that is the problem, while in reality the latest rises are clearly the result of the economic imbalances between China, Japan and other Asia and the US on one side of the planet and between Germany and the euro zone’s periphery on the other. Paul Krugman writes:

So wise policy, as defined by the G20 and like-minded others, consists of destroying economic recovery in order to satisfy hypothetical irrational demands from the markets — demands that economies suffer pointless pain to show their determination, demands that markets aren’t actually making, but which serious people, in their wisdom, believe that the markets will make one of these days.

Maybe the science of ‘muddling through’ can help to explain the divergence between policy makers and non-mainstream economists? (Those that have ‘muddled through’ have invested heavily in inflation-targeting models, therefore they are unlikely to disagree with policy-makers – more often than not, they are the policy maker.)

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