EDITORIAL: The art of economic policy

Why do central bank interest-rate hikes sometimes fail to curb inflation? Why might households begin cutting back on spending even before a recession begins? These questions fit into the central theme of the research of this year’s winners of the Nobel Prize in Economics, Americans Robert E. Hall and Michael Woodford. Their research helped explain how household expectations of future income and companies’ business forecasts influence economic trends. They found that effective macroeconomic stabilization depends not only on policy implementation, but also on how central banks communicate with the public and incorporate the expectations of households and companies.

The Royal Swedish Academy of Sciences on Monday last week recognized Hall, 83, a professor emeritus at Stanford University, and Woodford, 71, a professor at Columbia University, for their research establishing the “microeconomic foundations of macroeconomic stabilization,” which showed how economic models can be reconstructed to bolster stabilization policies, such as interest-rate adjustments and other measures that governments and central banks use to control inflation and maintain stable economic activity.

The idea of using stabilization policies to smooth economic cycles was popularized by British economist John Maynard Keynes during the Great Depression in the 1930s. However, that framework broke down during the oil shocks of the 1970s, when surging oil prices caused economic stagnation and further fiscal expansion led to higher inflation. As inflation and unemployment rose, developing into stagflation, governments realized that Keynesian models might not always work.

The weakness in early Keynesian models lies in the lack of a comprehensive microeconomic foundation and limited analysis of how households and businesses adjust their behaviors to economic policy changes. Another challenge facing traditional stabilization policies is the time lag between policy formulation and implementation, which causes the effectiveness of measures to fall short of expectations. Hall and Woodford aimed to address the shortcomings of traditional Keynesian models by analyzing how households decide on spending and saving, and how firms set prices.

Taiwan’s decisionmakers should incorporate the Nobel laureates’ research when formulating macroeconomic policy. For example, Hall’s research found that people do not decide how much to spend based solely on current income, but rather on their expectations of their financial situation. Other research suggests that when income rises, higher-income households tend to save a greater share of the increase, while lower-income households tend to spend a greater share. In other words, focusing support on low-income groups could have a stronger effect on overall consumption than a universal welfare approach.

Meanwhile, Woodford’s research revealed that when setting product prices, firms often consider future costs and competitors’ prices, rather than just current conditions. His work on monetary policy and inflation expectations also provided a theoretical basis for the “forward guidance” used by many central banks. That is, when central banks communicate their expectations for interest rates, households and businesses might alter their behavior even before the rates actually change. If policymakers communicate to the public what they plan to do, households and companies might adjust their expectations accordingly, and the economy could experience fewer drastic changes.

In the past few years, rising geopolitical risks, supply chain restructuring and a K-shaped growth pattern have challenged economic policymakers. Factors affecting economic development are not limited to inflation, unemployment and production, but also include people’s income expectations and corporations’ business outlook. Therefore, when drafting policies, governments cannot simply throw money around and rely solely on increased spending to stimulate the economy during downturns; instead, policymakers must consider how households and firms would react and how their responses could shape the economy. If consumers and manufacturers are optimistic about the future, they might take actions that support the economy.

The research honored by this year’s Nobel economics prize is valuable for central banks seeking to improve their forecasts and explain policy decisions to anchor market expectations during global interest-rate shifts or inflationary pressures. It also directly contradicts US Federal Reserve Chair Kevin Warsh’s communications strategy, such as ending the Fed’s forward guidance, and shortening its post-meeting statements and news conferences. In contrast, the award appears to defend the value of transparent communication and the argument that ambiguity harms households, businesses and the economy.