Discussion Paper
No. 2016-50 | December 12, 2016
Thomas Palley
A Theory of Economic Policy Lock-in and Lock-out via Hysteresis: Rethinking Economists’ Approach to Economic PolicyMukherjee

Abstract

This paper explores lock-in and lock-out via economic policy. It argues policy decisions may near-irrevocably change the economy’s structure, thereby changing its performance. That causes changed economic outcomes concerning distribution of wealth, income and power, which in turn induces locked-in changes in political outcomes. That is a different way of thinking about policy compared to conventional macroeconomic stabilization theory. The latter treats policy as a dial which is dialed up or down, depending on the economy’s state. Lock-in policy is illustrated by the euro, globalization, and the neoliberal policy experiment.

JEL Classification:

D7, E6, F5, H3, L5

Links

Cite As

[Please cite the corresponding journal article] Thomas Palley (2016). A Theory of Economic Policy Lock-in and Lock-out via Hysteresis: Rethinking Economists’ Approach to Economic PolicyMukherjee. Economics Discussion Papers, No 2016-50, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2016-50


Comments and Questions



Neil Lancastle - Technology vs power
December 13, 2016 - 11:38 | Author's CV, Homepage
I really enjoy your work, and this article is no exception. I agree that Arthur's framework (1989) works well to explain how inferior technologies (e.g.: VHS, Windows) get 'locked-in': consumers want better technology, but aren't prepared to pay the switching costs. The trouble with Arthur's framework is that it largely assumes the consumer, and therefore the market, is making the technology choices. I would suggest balancing Arthur with Stigler's 'producer power' theory of regulation (1971) and/or Pistor's legal theory of finance and markets (2013). Technology choice (in this case, a choice of economic policy) is also driven by the supply side, in the form of powerful vested interests using their influence to get regulations that benefit them and lock out competitors. In terms of economic policy choices, there are many more case studies to choose from when you include producer power: tax laws that benefit large multinationals over SMEs; tax advantages to debt over equity; bespoke fiscal policies in response to threats to relocate large businesses; low interest rates that benefit leveraged firms and investors; and so on. Peltzman (1976) extends Stigler to include supply side factors as 'consumer power'. With 'producer power' you also have a theory of market failure, where consumers demand public goods - clean air and water, forests, a stable climate, peace, poverty elimination, and so on - but because there is no profit, there is no producer power, and the goods are not supplied. If you included this framework, you might also discuss Keynesian intervention as a particular type of consumer power where there is an otherwise unassailable cost hurdle to overcome the 'lock-in' and market failure.I hope these comments help. Happy to discuss further if you'd like to - feel free to get in touch.Best regards,Neil

Thomas Palley - Lock-in via IO
December 14, 2016 - 13:42
Thanks for your comment. I agree with you regarding these industrial organization (IO) ways in which firms lock-in technology by design choices and by manipulating tax and regulatory policy. The latter policy manipulations are implicitly addressed in Figure 2 in which the economic environment (e.g. oligopoly capitalism) feeds back to impact policy outcomes.

Romar Correa - Comments
December 16, 2016 - 09:07
Thomas Palley (TP hereafter) is a special member of the tribe of heterodox economists because he stretches the vocabulary of the group and does not feel shy to borrow the idiom of the mainstream to script the paper on hand. Always simple and clear, he makes my reservations easy to voice. I take off, as TP does, from the classic papers on lock-in by Paul David and W Brian Arthur. Recently, Professor David has elaborated upon the theme in articles co-authored with Cristiano Antonelli. Time must be an axis and that arrow moves in the familiar direction. For the present theme, a long line must be earmarked. Among the surprises that history throws up are episodes wherein bad social choices are made. Neoclassicals would find it difficult to explain Pareto-inferior outcomes that tend to persist. Learning and corrective mechanisms seem absent. It is clear, though, that the elements that come together to lock societies into one big error are varied and tiny but that accumulate over time under the skin to deliver economies into the vice-like grip of an irredeemable suboptimal trajectory. Professor Arthur refers to lock-ins by small historical events, almost accidents. Social scientists of a broader bent have come up with a set of metaphors like “the butterfly effect” and “tipping points” to draw in and develop related ideas. Indeed, lock-in is a metaphor. Choice is not central and both social processes and individuals/classes codetermine the bad outcome. As academics, we may enter at any point in time and denote the present “wealth and income distribution (as intial) endowments” (p.9). These initial conditions might be marked by grotesque inequalities with workers having only their labour power to sell and capitalists having no more than their capital to lend. A Myrdal or a Wicksell would draw causal chains from the plans made by these classes and the outcomes of acting on those plans which we could record as terminal conditions. The latter might not be a general equilibrium with nice properties but another set of initial conditions and the economy blunders on. ‘Irreversibility’, in short, is essential to lock-in. The term suggests the open-endedness and uncertainty about the future. TP’s extension of the idea of lock-in to lock-out is difficult to grasp on this count. We cannot know that superior technologies might have evolved in the absence of that fatal choice. Indeed, the chosen technology might be the best of worse possible worlds to come, judgements about which cannot only be made with hindsight. My feeling is that the combination of lock-in with hysteresis clouds the conceptual horizon. The latter is part of mainstream macroeconomics which is a recursive dynamic structure. TP’s point about policy transforming the economy and vice versa in an iterative process was the Lucas critique. Only there, the market process was supposed to weed out inferior outcomes, locking the economy into the dominant solution. The points on the time axis are drawn on a page and we can move right and left. The time frame is short. The next quarter might not be too different from the same period last year. The target is inflation and the instrument is a short-term interest rate. Hysteresis is the persistence of an unemployment equilibrium calling for the use of microeconomic policy instruments like on-the-job skilling or a payroll tax rebate. A Taylor rule does not transform an economy. However, if the policy is regarded as a component of a policy regime, then the combination of a set of policies reacting to as well as actively creating a particular social economy is an object worthy of study. Thus, an inflation-nutty Central Banker might, over years, destroy both inflation and the economy. TP might have been better off seeking inspiration from the variants of the “regimes of accumulation” approach to the subject. Thus, from some time since the middle of the 1970s, competition in finance transmuted from putative healthy forms to an arena of gargantuan manipulation and theft. Policy and politics was both cause and effect. Many of TPs examples are illustrations of the switch from one regime to another. Thus, the imperialism of finance went hand-in-glove with the dismantling of the checks and balances that constitute a vibrant competitive system. A ‘consensus’ view of the market gave way to a dog-eat-dog ideology. The comradeship and revolutionary possibilities of working class solidarity were killed ((b) on p 12). The qualifications of the basic theorems of general equilibrium economics were forgotten in stances towards “mergers and deregulation ((c) on p 13). Returns in the financial circuit exceeded returns in the real circuit leading to deindustrialization ((b) on p 12 again). Government budgets were supposed to mimic private budgets. With reduced taxation, reduced expenditure had to follow ((d) on p 14). The way to counter a parasitic regime is to craft another regime as a ‘strange attractor’ (another metaphor) like FDR’s New Deal. Different elements will have to be worked out and connected with each other and the welfare enhancement of capitalists and workers and the welfare reduction of rentiers will have to be compared with and ticked off against the comparable elements in the current dispensation. The details between progressive taxation and dynamic fiscal policy need to be written up and that sub model will have to mesh with State Investment Banks (SIBs) supporting green and employment-generating projects cherry-picked by governments and so on. TP’s backward-bending Phillips curve would most likely be an equation in the structural model.

Thomas Palley - Hysteresis, Lucas critique, and Taylor rules
December 19, 2016 - 16:27 | Author's Homepage
Romar, thanks for your comment.(1)I agree that lock-in can be via accumulation of small event effects, but it can also be via discrete policy choices.(2) There may be some semantic confusion. I regard hysteresis as the general phenomenon (engendered either by chance or choice). Policy lock-in and lock-out are specific applications of the hysteresis phenomenon.(3) The Lucas critique is a distraction regarding policy lock-in and lock-out. The Lucas critique is that econometric estimates of the effects of policy may be unreliable because a change of policy may change agents' behaviors, thereby changing the effects of policy. That change may (or may not) be fully reversible if policy reverts to its initial setting. Lucas was not concerned with the issue of policy lock-in and lock-out.(4) Likewise, the discussion of Taylor rules is a distraction. They are usually discussed in terms of the standard "dial up - dial down" policy metaphor. However, they may (or may not)have hysteretic impacts. For instance, if unemployment generates hysteresis effects, then Taylor rules can generate hysteresis by impacting unemployment. If unemployment is not associated with hysteresis, then the Taylor rule will not generate such effects.(5) "Strange attractors" can be consistent with hysteresis. A large shock or policy induced change may shift the economy into the orbit of a new attractor. The question is what happens if the shock is reversed. If it remains locked into the new attractor, then the initial change was hysteretic: if not, it was not hysteretic.

Gian Cesare Romagnoli - Invited comment
December 27, 2016 - 01:00
Thomas Palley’s paper takes off from the “Lucas Critique” which, he pretends, can be used on purpose to generate lock-in policies, provided that their outcomes may be correctly predicted. The paper offers many examples of lock-in and lock-out policies. I notice, though, that some of the examples of lock-in policies are well taken while others are not. Among the former, the paper correctly underlines the costs of loosing the productive skills, as in the case of trade contraction, when manifacturing may not come back (p.12). Among the latter, the actual ripatriation of offshore investments, either in Europe or the United States, contradicts the Author (p.12). Furthermore his claimed asymmetry between Greece and Germany confronting the euro exit does not take into account the German costs of a new Deutsche Mark revaluation (p.12). On the contrary, the asimmetry applies for expansive fiscal policies. Of course there are plenty of economic policy lock-in via hysteresis: sunk costs, dominant exchange rates, wage drifts, price changes expectations, decentralization, liberalization, public goods production, etc. In fact, whatever policy measure tends to produce them since it changes the income distribution.However, one of the main points of the paper, i.e. his critique to the Rodrik trilemma (p.18), does not hold. In fact, totalitarian regimes may escape globalization by disattending its rules as, for example, China does. International institutions try, but do not succeed, in constitutionalizing the world.Finally, there is no doubt that policies are not exogenous to the economy, in fact they tend to be proned to it (p.20). But there is no advantage in nailing down policies that are difficult to reverse in the future event of unfavourable political change. This approach recalls the Kydland- Prescott’s view which asks for “rules vs discretion”. In fact, whatever boat with a nailed wheel is doomed to find a rock.

Thomas Palley - Reply to Gian Romagnoli
January 17, 2017 - 15:21 | Author's Homepage
Dear Professor Romagnoli, Thanks for your interesting comments. Below is my reply and thoughts in response to them.. (1) Relationship to the Lucas critique. The Lucas critique (Lucas, 1976) is about econometric estimates of the effects of policy. Lucas (1976) analysed a situation in which policy could be costlessly dialed up and down and agents’ behaviors reverted to their original setting if the policy change was reversed. His critique was that econometric estimates, which failed to take account of the fact agents would change their behavior rule in response to policy change, provided a poor guide to the impact of policy change. Lucas’ article makes no mention of the issue of hysteresis and policy lock-in or lock-out, but a loose connection can be made. Policy hysteresis arises because initial changes in policy create “new facts on the ground”, as illustrated in Figure 2. Those new facts may concern the economic condition of private agents, and/or they may concern the conditions governing the policy process. In both cases, the creation of new facts may induce hysteresis whereby reversal of the shock that generated the initial policy change does not result in a return to the initial policy position. The failure to return to the initial position may be because changes in the policy process block policy from reverting to its initial setting, and/or it may be because changes in agents’ economic conditions mean policymakers do not want to restore the initial policy setting. Policy hysteresis concerns a substantially different world from that envisaged by Lucas, and it generates a substantially different problematic. Lucas’ analysis is situated in a world of reversibility and his focus is agents’ decision rule. Policy hysteresis is situated in a world of irreversibility and the focus is the evolution of policy in response to an initial shock that subsequently reverses. (2) I do not understand the comment about “actual repatriation of offshore investments”. In the framework I discuss repatriation is clearly possible if economic conditions move from “switch on” to “switch off”. Yes, there would be costs to a German exit of the euro (e.g. creating a new money), but these costs are orders of magnitude smaller that a Greek exit. Not only would Greece have to create a new money, it would also have to bear the costs of debt-deflation.The exit of creditor and debtor countries is fundamentally asymmetric. That was my point. (3) I do not understand the defense of Rodrik’s posited trilemma. Democracy and authoritarianism are about the “political process” governing policy choice. Globalization is about “policy space”. A democracy can vote to exit globalization, just as an authoritarian regime can choose to exit globalization. But both regimes face constrained policy space if they choose to participate. For both regimes there is no trilemma, just a dilemma between the benefits of globalization vs. the costs of diminished policy space. (4) Policy lock-in and optimal policy. I reject the claim that “there is no advantage in nailing down policies that are difficult to reverse in the future event of unfavourable political change”. The claim of “no advantage” reflects the conventional way of modelling policy in which there is a single social welfare function and a single true model. In such a world it is as if there is only one political party and only one way of understanding the economy. Consequently, except in instances of time inconsistency (Kydland and Prescott, 1977), there is no advantage to policy lock-in which would be tantamount to a form of self-imposed handcuffs. However, in a world in which political parties have different social welfare functions, incumbent parties have an incentive to consider policy lock-in. Policy lock-in can serve as a way of protecting against the event that an incumbent loses power and its political rivals try to replace existing policies. Similarly, if political parties hold different views of how the economy works (i.e. hold different models), there is also an incentive for optimal policy to consider lock-in. Again, the reason is the incumbent party has an incentive to protect against the event that it loses power and prevent its political rival from imposing a new policy mix based on an alternative model of the economy. Real world politics is characterized by political parties having different social welfare functions and different views of how the economy works. That argues for a place for policy lock-in and lock-out in design of optimal policy in a politicized world. A real world example is provided by Obamacare which has provided benefits to 20 million uninsured Americans and is now proving very difficult for Republicans to reverse.

Gian Cesare Romagnoli - A Rodrik dilemma?
December 27, 2016 - 01:07
Invited comment
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Thomas Palley - Addendum - Policy lock-in and optimal policy
January 17, 2017 - 15:46
Palley (Journal of Post Keynesian Economics, 1993, 16(1), p.3-18) discusses the implications of different agents believing different models of the world.

Anonymous - Referee Report 1
January 17, 2017 - 08:11
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Anonymous - Reply to Referee #1
May 18, 2017 - 15:53 | Author's Homepage
Dear Referee, Thanks for your very helpful report. (1) Your suggestion that the paper explicitly discuss the mechanisms of hysteresis is useful. I think this can be done by adding a short section identifying those mechanisms, and then linking the later case studies/instances of lock-in back to those mechanisms. (2) You are right that the examples have a "neoliberal" flavor to them & that lock-in can apply to policies from the other political side. The choice of examples reflects the fact that the last 30 years have been significantly dominated by neoliberalism. I plan to add some examples from the other side. (3) The relationship of hysteresis to multiple equilibrium needs clarification, and this can be done in the theoretical section describing and discussing hysteresis. In my view, the two are different.

Anonymous - Invited Reader Comment
January 23, 2017 - 09:26
The basic idea of the paper is that the effects of some economic policies are either completely irreversible or nearly so. This is correct and important. However, there are other policies which fit into what the author describes as conventional macroeconomic stabilisation theory that can be dialled up or down, e.g. interest rate changes. I can think of no obvious way of quantifying how many policies fit into each category. What is important is that for any proposed change one should consider the possible longer run effects, both intended and unintended, that may result in more fundamental changes than just the apparent justification for the policy. Other than that, I only have some presentational quibbles. I think that the overall introduction to the paper’s thesis is clear, and little is added by the ‘theory’, e.g. the diagrams. Some of the statements which seem to stem from the author’s political/economic outlook are over-stated in a way which may unnecessarily discourage casual readers with different views from treating the main argument seriously. (Obviously this comment reflects my own outlook.) For example, in footnote 2 “The hegemony of neoliberalism means establishment economists all assume neoclassical economics provides the “true” model of the world, and the club of elite academic economists exclude all who disagree.” This is debatable at best. Examples: some winners of the Nobel Prize do not assume that neoclassical economics provides the true model of the world; and some who work on behavioural economics are in “top” economics departments.

Anonymous - Referee Report 2
March 27, 2017 - 07:55
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Anonymous - Reply to Referee #2
May 18, 2017 - 19:47 | Author's Homepage
Dear Referee, Thanks for your helpful report. (1) The parallels between strong/weak hysteresis (Cross, 1993) and standard hysteresis/permanent lock-in will be noted. It seems there is a parallel here with "ratchet effects" that should also be discussed. (2) Figures 3 and 4 are intended to provide a graphical formalization of the descriptive concept of "policy space". This is a concept that is widely and usefully used in discussing the effects of globalization on policy. The figure describes a world where countries' policy possibilities are described by a policy index (P) which determines the amount of policy space they have. Higher values of P give countries greater policy space, which yields a broader feasible range for the policy target (X). G is a globalization index. The policy index (P) declines as G increases, which reduces the feasible range for the policy target variable. In Figure 3 there is a single policy target (which enables two dimensional graphical representation). In reality, there is a vector of policy targets, and globalization can be viewed as reducing the feasible target space. (3) The minor issues are noted. Thanks.

Thomas Palley - Author's response to referees' comments
June 06, 2017 - 08:59
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Thomas Palley - Revised Version
June 06, 2017 - 09:00
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