Illustration by Tadaomi Shibuya
Published: December 19, 2012
Entering the Bank of England is like walking back in time to the old British Empire. Its brass door is attended by the Pinks, men in black hats and pink tailcoats. Vast meeting rooms are decorated with richly colored carpets, high ceilings with gold filigree and ornate furniture. Between rooms, the marble floors bear monetary-themed mosaics. One depicts the development of the British pound. Elsewhere, the mosaics take the form of constellations — a reminder that the empire and its economy once dominated everywhere you could see the stars at night.
One morning this summer, I went to the bank to visit Adam Posen, a member of its Monetary Policy Committee, the custodian of the pound. With bright red curly hair and a trim beard, Posen, who is 46, stands out in all the M.P.C.’s official photographs. He is “ fatter” and “fuzzier” than the other officials, he joked. Posen also happens to be only the second American economist ever to serve on the committee.
It’s impossible to imagine the uproar if President Obama ever nominated a British academic to work at the highest level of the Federal Reserve. But when Posen arrived, in September 2009, his job was to provide an outsider’s perspective. The bank was trying to steer Britain through the global financial crisis, and Posen seemed like a uniquely perfect fit. In the late 1990s, when he was a 30-year-old economist, his contrarian critique of Japan’s central bank and finance ministry helped that country put an end to its so-called Lost Decade. In the years since, Posen has become a well-respected adviser to (and critic of) many of the world’s key financial institutions. With this appointment, Posen crossed the line from scholar to decision maker. It was the first time that he had real power.
Posen arrived in London after the acute panic of the financial crisis had given way to the long slog we’re still in. At that point, policy makers around the world were given the task of assessing the damage and devising a plan that would best position the economy to function at normal levels. The United States had already responded with a roughly $800 billion stimulus package. In the spring of 2010, British voters went in another direction. They elected Prime Minister David Cameron, who had promised to reset the economy by severely cutting government spending, which would lead to significant public-sector layoffs. The economy’s only chance to return to long-term growth, Cameron argued, would be a painful, but brief, period of austerity. By shrinking the size of an inefficient government, Cameron explained, the budget would be balanced by 2015 and the private sector could lead the economy to full recovery.
Today these two approaches offer a crucial case study and perhaps a breakthrough in an age-old economic argument of austerity versus stimulus. In the past few years, the United States has experienced a steep downturn followed by a steady (though horrendously slow) upturn. The U.S. unemployment rate, which shot up to 10 percent at the end of 2009 from 4.4 percent in mid-2007, has now dropped steadily to 7.7 percent. It might be a frustrating pace, but it’s enough to persuade most economists that a recovery is under way.
The British economy, however, is profoundly stuck. Between fall 2007 and summer 2009, its unemployment rate jumped to 7.9 percent, from 5.2 percent. Yet in the three and a half years since — even despite the stimulus provided by this summer’s Olympic Games — the number has hovered around 7.9. The overall level of economic activity, real G.D.P., is still below where it was five years ago, too. Historically, it’s almost unimaginable for a major economy to be poorer than it was half a decade ago. (By comparison, the United States has a real G.D.P. that is around a half-trillion dollars more than it was in 2007.) Yet austerity’s advocates continue to argue, as Cameron has, that Britain’s economic stagnation shows that the government is still crowding out private-sector investment. This, they say, is proof that austerity is even more essential than was first realized. Once the debts have been paid off and the euro zone solves its political problems, the thinking goes, the British economy will bounce back quickly.
When I visited Posen this summer, he refused to publicly criticize a sitting administration’s policies, but every time the topic of austerity came up, he was unable to hide his frustration. Posen’s term ended in August, and his subsequent nondisclosure agreement expired last month. Now he wants to persuade everyone he can that Britain should abandon its austerity program. He says that he has a solution that would quickly return healthy economic growth. His critics say that his prescription would bring about another financial panic. But whether you think he’s right or wrong depends on what you make of the data.
Economics often appears to be an exercise in number-crunching, but it actually resembles storytelling more than mathematics. Before the members of the Monetary Policy Committee gather for their monthly meeting, they sit through a presentation from the Bank of England’s economic staff. The staff members take the most recent economic data — G.D.P. growth, the unemployment rate and more subtle details gathered from interviews with businesspeople throughout the country — and try to fashion it into a narrative. Does a sudden spike in new factory orders represent a fundamental shift, or is it just a preholiday blip? Do anecdotal reports of rising food prices herald a period of inflation, or is it the result of a cold snap? Which story feels truer?
A few days later, each of the nine members of the M.P.C. puts forth his or her own interpretation. Over two days, the members debate these competing narratives and discuss what the Bank of England should do. Then the committee votes, and the winning policies are implemented.
Soon after Cameron was elected, Posen argued that the committee should endorse a more radical, expansionary approach of economic recovery. He believed that the data indicated the sputtering would end and the economy would grow only if the Bank of England began buying many billions of pounds’ more worth of bonds. This added stimulus would flood the banking system with new cash and indirectly push banks to lend to businesses and citizens. (Banks don’t make money by sitting on cash.) Some of Posen’s colleagues warned that this would lead to inflation. He countered that the economy was operating below its capacity, so there was no reason to fear inflation.
Each month, the committee heard Posen’s advice. Each month, it voted 8 to 1 against him. The bank eschewed his more expansionary suggestions and stuck to a more conservative approach of keeping interest rates low and modest bond-buying. Soon Posen became a famously divisive figure in London’s financial community, alternatively the enlightened genius trying to save the country and the mad Yank who wanted to inflate the pound out of existence. “There was this period,” he remembers, “when I would lie awake at night and think: Am I just crazy? Maybe I’m nuts. It’s like the scene in ‘12 Angry Men.’ I almost wavered. But then I decided: No, no, no. I was convinced: They’re nuts and I’m right.”
It wasn’t necessarily that simple. Over the past several years, the economic data in Britain have been so unusual that they have forced a rethinking of some of the most fundamental assumptions underlying economics. There just isn’t any pre-existing narrative to explain what’s going on. When major market economies have experienced extended periods with little or no growth, like the global economy during the Great Depression or Japan in the 1990s, unemployment always shot up. In sluggish post-crisis Britain, though, unemployment has barely moved for three years.
This detail might seem like a minor quirk, but it poses a huge problem for economists. Every major economic school of thought is based on a few shared principles, and one of them is that companies will fire workers when they become less productive and hire them when they become more productive. This basic idea provides a foundation on which modern theories about economic recovery are built. Left-leaning Keynesian economists support government stimulus, because they think it will increase overall economic demand and give an incentive for employers to hire more workers. Economists on the right counter that paying off debt will actually inspire more confidence and prompt employers to hire. So what do you do when the unemployment rate stays roughly the same even as the economy gets worse? What does it mean when a larger work force, given the population increase, creates less output.
Prime Minister Cameron and his economic team — like many centrist and right-leaning economists — looked at this confusing data and settled on a clear narrative: businesspeople and global investors, discouraged by an expanding and debt-ridden government, had concluded that the economy would remain stuck if nothing changed. And any fiscal stimulus, Cameron argued, would make the government even more bloated. Those mounting debts would be ever-harder to pay off, terrifying global investors. After all, that’s what happened in Greece.
If properly understood, this narrative also contains a projection so dark that it’s almost never uttered out loud. When the housing and credit bubble burst, the thinking goes, it caused such dislocation in the British economy, and raised government and private-sector debt so high, that the entire nation could not possibly produce as much as it used to. Throughout the economy, people had to shift from highly profitable fields, like finance and real estate, into much less lucrative ones. Even if everyone went back to work, and even if businesses and factories produced at maximum capacity, workers would not be able to produce as much value as they could have in 2006.
According to this theory, if the entire economy is less productive, it’s harder for the government — with its lower tax receipts — to pay off its debt. The only choice, therefore, is to make the government smaller: to drastically cut back on social spending and fire public workers. Only then can the economy grow again, albeit from a lower base.
To Posen, this view was not only wrong; it was also dangerous. The data, he told me, showed precisely the opposite. The economy wasn’t irrevocably shrinking. It was experiencing an output gap, or a situation in which the economy is prevented from growing not through any fault of its own but by a failure in government policy. If the Bank of England adopted a more expansionary approach, and if Cameron’s government reversed its austerity program, the economy would bounce back remarkably quickly. Posen knows, he said, because he saw it happen before — in an economy even bigger than Britain’s.
Adam Posen grew up the son of scientists in Brookline, Mass., an upper-middle-class suburb of Boston. “I was a weak kid,” he says. “Classic nerd. Captain of the math team.” Around the time of his bar mitzvah, he told his parents that his dream was to one day work with a policy group dealing with international affairs. By 18, he was a devoted fan of John Maynard Keynes.
After graduating near the top of his class at Harvard, Posen returned to Cambridge to pursue his Ph.D. in political economy. Around this time, he became fixated on central banks in general, and dismantling the self-congratulatory ways in which they perceived their role in particular. Since its development in the 19th century, the modern central bank has been designated to serve as an independent, responsible counterweight to the excesses of the political system. Because politicians tend to think only as far ahead as the next election, central bankers are supposed to protect the long-term value of a nation’s currency and, therefore, the stability of its economy. The modern-day hero of central banking is Paul Volcker who, as the chairman of the Federal Reserve, fearlessly raised interest rates high enough to stop inflation even if that meant hurtling the United States into a recession and arguably costing the man who appointed him, President Jimmy Carter, his job.
In his Ph.D. dissertation, Posen argued that central bankers do not always behave like Paul Volcker. By comparing the ways that central banks behave in different economies, like those of Sweden and Italy, Posen argued that they are, too often, thoroughly enmeshed in the short-term thinking of politics. So much so, in fact, that the decisions central banks make — especially the crucial ones about the supply of money and the availability of credit — are often better understood as interest-group politics in which powerful lobbies battle for control. His research was persuasive, and Posen quickly established himself as a central-bank researcher to watch.
By 1997, Posen was a young economist when an acquaintance at the U.S. Embassy in Tokyo invited him to a conference. Posen had never had any particular interest in or knowledge about the Japanese economy, but he was happy to take a junket and spend a few days in the country that, not long before, was growing significantly and taking over every industry — automobiles, electronics, steel — that it entered.
By the time Posen arrived for the conference, though, Japan had been in a recession for several years. The prevailing wisdom among many of the country’s economists and political figures was that Japan simply grew too much, too fast, and that as long as the central bank and finance ministry protected the core institutions — like its banks — the country would soon grow again. There was also a general view that Japan’s economy — with its rapid growth and unique system of cooperation among large corporations and the government — was thoroughly unlike any other. It didn’t need counsel from outsiders.
In the month before the conference, Posen read up on data pertaining to national G.D.P., employment and banking-sector activity. G.D.P. growth had slowed. Unemployment was rising. Banks were not lending freely. Posen quickly recognized that the data looked remarkably familiar. “I had this aha moment,” he told me. Japan was not going through a unique and inevitable economic slowdown, Posen realized. The country was experiencing something that looked a lot like the Great Depression. And neither the government nor the central bank realized it. Like the governments and central banks of the United States and Britain 60 years earlier, Japanese bankers and policy makers were doing everything wrong to turn the economy around. He began writing a series of recommendations.
Posen diagnosed the problem as a large output gap. The economy, he argued, was fundamentally capable of producing far more goods and services, employing more people and making more money. Bridging that gap between the depressed economy and its potential required that the central bank create a lot more money and get it out into the economy. At the same time, he wrote, the government needed to spend far more, too. To accomplish both of these goals, the Bank of Japan and the government had to stop rescuing the country’s sickest banks, which continued to lend to the oldest and least productive businesses.
Many of the particular issues that Posen raised had been mentioned before, but at that 1997 conference he was the first to put them all together in a coherent alternative narrative. The speech was well received, and by the time Posen returned to the United States, he had decided to focus all of his attention on the issue. Within a year, “Restoring Japan’s Economic Growth,” the monograph that fleshed out his argument more thoroughly, became a key guide to Japanese economic and financial policy. Other prominent economists — notably Paul Krugman and Ben Bernanke — wrote parallel analyses that supported and furthered its central insights. In 2002, Japan implemented many of these recommendations. Soon its Lost Decade of minimal growth ended, and the country’s economy came back. At least until the global bubble burst in 2007.
Posen spent much of the aughts ensconced at the Peterson Institute for International Economics, a prominent Washington policy group, advising central banks and finance ministries around the world. Posen, who developed special expertise in the German economy and the euro, enjoyed the work. (He was among a small group of economists who, long ago, were skeptical about the euro.) But in 2009, when the British government asked Posen to become a voting member of the Bank of England’s Monetary Policy Committee, he leapt at the opportunity. It set up something of a replay of Posen’s arguments in Japan. This time, however, he would be coming at a crisis from within a central bank.
What Posen didn’t expect was that the job would also reinforce his darkest fears about the role of central banks. Leaked cables on WikiLeaks later revealed that during Posen’s first few months in London, Mervyn King, the Bank of England’s governor, was already pressuring Cameron to follow through on austerity policies. In May 2010, the bank issued a report affirming the economic necessity of austerity. In a November 2010 parliamentary hearing, Posen accused King of partisanship. The report, he said, had compromised the impartiality of the bank and was “excessively political in the context of the election.” (King declined my request for an interview.)
But it was too late. After Cameron’s 2010 election, the chancellor of the Exchequer, George Osborne, had already laid out a budget that called for several years of cuts. If they were not implemented, he warned, Britain would experience “higher interest rates, more business failures, sharper rises in unemployment and potentially even a catastrophic loss of confidence and the end of the recovery. We cannot let that happen.”
Every two months or so, each member of the Monetary Policy Committee is encouraged to give a speech outside London. It’s part of an effort to erase the Bank of England’s reputation for seeming uninterested in the concerns of average citizens, or at least those who live far away from the city’s bankers and financiers. And so on the afternoon of Posen’s final speech as an M.P.C. member, it was hard to miss the paradox. He was in a small town on the southeast coast of England delivering an argument directed at a handful of decision makers in the capital.
It was a rainy day in Chatham, the grim place where Charles Dickens spent much of his childhood and where the kitschy indoor amusement park, Dickens World, is now the main attraction. (The park features a flume ride through an ersatz centuries-old London, replete with the actual smell of rotting cabbage.) Posen spoke down the road, at the Universities at Medway, a consortium of local schools open to students “without traditional qualifications.” The audience was made up of a few dozen pensioners, some students, local businesspeople and three wire-service reporters who would pass on whatever Posen had to say to the insiders back in the city. “I’m one of their beats,” he said. “Once I leave the job, who knows if anybody is going to show up to any of my speeches.”
Posen gave the speech, which ran over an hour, with only minimal notes. Much as he did in the bank’s monthly committee meetings, he projected economic data on a screen and explained the narrative that he thought best accounted for what was happening in the British economy. He quickly focused on the core economic riddle — the data showing that worker productivity has fallen while the unemployment rate has stayed the same. It seemed impossible, he said. How do more people make less? “If you’re a worker, you didn’t wake up one day in October 2008 and find your left arm missing,” Posen told the crowd. “You didn’t find yourself lobotomized and forget how to run whatever machine or do whatever it is you do. In November 2008, a business owner did not wake up one day and find that their factory had been bombed in the blitz like their grandparents had. It’s all still there.”
Then Posen’s defense became more technical. He said the problem wasn’t a sudden collapse in the capacity of workers and factories. The problem, more simply, was that there wasn’t enough demand to support full production. The private sector, in other words, was no longer able or willing to spend enough money for the economy to function at its peak levels. If the government or Bank of England could do more to stimulate the economy through any number of tools at their disposal — like more quantitative easing and infrastructure spending — demand would rise, and everyone’s productivity would shoot back to normal.
It was a subtly (but crucially) different way of looking at the problem: the country was not truly less capable. The problem was not one of supply, Posen suggested, but rather of demand. Workers were not less productive than they used to be. They merely needed some help from the government and the central bank — rather than budget cuts — to close the output gap.
To those who follow the economic debates in the Bank of England and Parliament, Posen’s speech was a barely concealed attack on Cameron’s policies. In Chatham, though, the crowd didn’t seem to understand that the polite American enthusiastically pointing to graphs on a projector was declaring that their prime minister was a financial philistine. Posen followed central-bank custom and declined to mention Cameron by name or explicitly critique the government’s policy. (His sharpest and most overt statement — “When your government is cutting its budget deficit, it tends to drag down consumption” — wouldn’t exactly start a bar fight.) Months later, Posen told me that his tenure in England was often enormously frustrating. Next month he begins a new job as the president of the Peterson Institute. He thinks that he can do more to revise the economic narrative from Washington than he ever could from within the Bank of England.
The economics profession advances by one confusing financial disaster at a time. A series of 19th-century banking crises in England and the United States inspired policy makers to create the modern central bank. Then came the Great Depression, a period of economic misery that existing ideas could not explain. John Maynard Keynes and the far more libertarian Friedrich Hayek spent the 1930s trying to make sense of the inexplicable economic data. In the process, they developed the two schools of thought that still dominate economic arguments. The Keynesians overwhelmed public discussion in the United States and Britain until the 1970s, when Hayek, along with Milton Friedman and his Chicago school, became more popular.
By the 1990s, the debates between these two radically different theories seemed to have abated. Economists seemed to have accepted a consensus view of the world, one in which the profession would provide technocratic, nonideological solutions. It seemed like the fulfillment of Keynes’s dream that one day economists would be like dentists: boring practitioners of an uncontroversial and undeniably helpful science.
Then the financial crisis ripped this consensus apart. When Cameron’s government began its austerity program, many of the world’s leading policy makers were behind him. That September, the International Monetary Fund formally endorsed his spending cuts, stating that “the plan greatly reduces the risk of a costly loss of confidence in public finances and supports a balanced recovery.” The British Office of Budget Responsibility also signaled that Cameron’s austerity approach would bring economic growth and reduce unemployment. In the 2010 midterm elections, U.S. voters flooded Congress with Tea Party-friendly candidates. Many carried the mandate to halt further government stimulus.
Since then, though, an increasing number of global economic policy leaders have turned on austerity. Earlier this year, in a remarkable joint statement, the I.M.F., along with the World Bank, World Trade Organization and eight other major economic institutions, warned that austerity was hurting global growth and raising unemployment. They asked the world’s major economies to embrace stimulus. Over the past few months, the I.M.F. and its deputy director, David Lipton, also have issued several suggestions that the British government soften its austerity program. Mervyn King hasn’t entirely disowned his earlier pro-austerity views, but he is no longer the policy’s enthusiastic booster. Toward the end of 2011, Posen finally persuaded the M.P.C., in a unanimous vote, to increase its bond-buying program by 75 billion pounds (about $120 billion at the time). Even King supported him.
Cameron and his chief financial-policy minister, Osborne, say they have only deepened their commitment to austerity. Osborne recently announced that while he had hoped austerity could end by 2015, it now looks as if the policy will continue until at least 2018. That is, if the Tories are in power. Recent opinion polls show that after years in a dead heat, the Labour Party now has a solid lead in popularity, though elections are more than two years away.
As long as it continues, this experiment offers some crucial lessons for the United States. So far, austerity has not significantly improved economic health. The plan to shrink the size of government did not generate a sudden surge of private-sector confidence and investment. For all its differences, Britain is similar enough to the United States to suggest that severely cutting government spending in America wouldn’t be enough to quickly speed up our own frustratingly slow recovery either. Advocates for greater stimulus in the United States frequently point to Britain’s dismal experience as proof that unemployment will fall and economic activity will rise if the government spends considerably more money. But demonstrating that austerity has failed does not prove that stimulus fixes everything. After a few years of growth, Japan’s economy has found itself back in a period of stagnation.
Adam Posen says that the challenge of economic policy at a time when the economic data are so unlike anything that has come before is that no one can be sure what will work. But he says that’s no reason for inaction. Our options, he argues, can be divided into three general categories: austerity, stimulus and doing nothing. He, like an increasing number of mainstream economists, believes we can now scratch austerity off the list. Doing neither stimulus nor austerity — which is basically what’s happening in the United States — isn’t working, either. So, he says, let’s try stimulus, even if we don’t know for sure it’ll do the job. Now he wants to persuade America that it’s the best shot it’s got.