The writer is a former central banker and a professor at the University of Chicago
President Donald Trump recently met Federal Reserve chair Jay Powell, seeking to persuade him to lower interest rates, reminiscent of the political pressures US presidents applied to the Fed in the 1970s.
Some investors may worry that US economic institutions are being eroded, which could lead to macroeconomic volatility. Yet those fears will probably be assuaged by the Fed holding steady on rates.
There is still reason to worry, however — not about US institutions weakening, but about the changing political environment in which they operate.
To understand the role of institutions in economic folklore, we have to go back to the 1990s, when it was easy to distinguish emerging market economic policies from those of industrialised countries.
The former were “procyclical” — countries spent freely when times were good, adding to debt and inflation, only to be jerked back to reality when times were bad and their ability to borrow dried up. In contrast, developed countries adopted stabilising policies; the US ran large fiscal surpluses during the high-growth late 1990s.
Economists argued that institutions explained the difference. Independent central banks in industrialised countries targeted inflation, while their parliaments followed fiscal rules that limited excessive spending, and even required budgets to balance over the cycle. Institutions were a straitjacket keeping political expediency in check.
Cracks soon emerged in this explanation. Through the 1990s, multilateral organisations like the IMF urged emerging markets to adopt such institutions. Yet even when reformers heeded the advice, policies continued to be procyclical, culminating in a series of emerging market crises.
But starting in the early 2000s, macroeconomic policies in some EMs became more stable, as institutions began having more policy traction. Fernando Henrique Cardoso’s government initiated inflation targeting in Brazil, but the central bank became truly credible only when his leftist successor, Luiz Inácio Lula da Silva, maintained the bank’s independence.
The institutions didn’t change but the political consensus behind them did. Growth, partly driven by the commodity boom, provided budgetary surpluses to aid the neediest. Programmes such as Bolsa Família enabled direct transfers to the poor, while others improved access to education, healthcare and housing.
Precarity fell. The incentive for Lula’s Workers’ party to indulge in political radicalism decreased, which allowed a broad national consensus on macro-stable policies to emerge. Institutions started working. While prolonged periods of weak growth do put pressure on the consensus, in many EMs it still holds. The mistake in urging institutions on EMs in the 1990s was there wasn’t yet a political consensus.
In contrast, developed countries have arguably become more procyclical. The US spent hugely even as the recovery from the pandemic was well under way, contributing to inflation that the Fed is still trying to control.
Trump’s “big beautiful bill” threatens to expand the already unsustainable US fiscal deficit. France and Japan are also struggling to narrow debt-to-GDP ratios of over 100 per cent — something unthinkable in the 1990s.
It is unlikely that the Fed is institutionally weaker. It was quick to reaffirm its independence soon after the Trump-Powell meeting. Indeed, regardless of who replaces Powell next year, it is unlikely Fed policies will be pliant. Moreover, it’s not implausible that the Trump administration would welcome having a scapegoat in case the economy goes south.
The political consensus in the US, however, has changed. The Fed today probably does not have the political room to tackle inflation as vigorously as it did in the era of Paul Volcker. Similarly, fiscal rules in the US by and large have not changed. The political willingness to respect their spirit has.
That’s because precarity and inequality have increased in developed economies. The disappearance of well-paying middle-class jobs for the moderately skilled due to technological change, and to a lesser extent trade, is the obvious cause.
By contrast, the highly educated have benefited as globalisation has brought greater opportunities to those in white-collar industries. For those left behind, radical politicians offer the persuasive message that self-serving elite policies are responsible for their plight.
As a result, the political consensus behind macro-stable policies has weakened, with even GOP fiscal hawks abandoning their opposition to spending.
Balanced budgets require compromises. But when politics is so polarised, few are willing to make them, and runaway spending becomes the norm. For some industrialised countries, sudden stops, when markets become unwilling to fund their governments, could be on the horizon.
Institutions do not assure countries a ticket to macroeconomic nirvana — and they cannot create political consensus. That requires citizens to believe economic outcomes are fair. This necessitates structural reforms that enhance opportunities for those falling behind.
Perhaps developed countries need to start emulating what emerging markets did.
