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Economic Policy
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Economic Policy
Theory and Practice
SECOND EDITION

Agnès Bénassy-​Quéré, Benoît Cœuré,

Pierre Jacquet, and Jean Pisani-​Ferry

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1
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© Oxford University Press 2019

First Edition published in 2010

Second Edition published in 2019

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ISBN 978–​0–​19–​091210–​9

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Printed by Sheridan Books, Inc., United States of America
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Contents

Foreword vii
Preface xi

1 Concepts 1
2 Issues 58
3 Interdependence 109
4 Fiscal Policy 148
5 Monetary Policy 237
6 Financial Stability 323
7 International Financial Integration and Foreign Exchange Policy 410
8 Tax Policy 504
9 Growth Policies 574

Index 667
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Foreword

This book is a book I would have loved to write. Indeed, this is a book I long
wanted to write. I wanted to do so out of guilt. For a long time, I have felt
that my graduate textbook written with Stan Fischer sent the wrong message.
We had made the choice to present models and their logic rather than their
applications. The justification was a perfectly good one—​namely, that we
wanted to show the intellectual structure of macroeconomic theory first. But,
de facto, the lack of serious empirics sent another message: that theory was
largely divorced from practice and from facts. That message is wrong: theory
without facts is much too easy and of very little use. I also wanted to write
such a book out of a desire to share with students my excitement about
moving between theory, facts, and policy. It is traditional to do so in under-
graduate textbooks, at least in the United States. Those textbooks are full of
discussions about policy debates—​about the effects of policy choices on the
economy. I thought it would be even more fun to do so with graduate students
who have more tools, both theoretical and econometric, at their disposal.
Agnès Bénassy-​Quéré, Benoît Cœuré, Pierre Jacquet, and Jean Pisani-​
Ferry have beaten me to it. I am happy they did so because they have done a
better job than I could have hoped to.
To give a sense of what they have achieved, I shall take one example,
the creation or reform of fiscal frameworks like the European Stability and
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viii Foreword

Growth Pact (SGP). To come to an intelligent set of recommendations, think

of all the elements you need to put together:
• You need to understand what sustainability means in theory and
in practice, what the costs of not abiding by sustainability are, and
how to assess sustainability. When does a debt-​to-​gross domestic
product ratio become truly excessive? What happens then? How
fast can you reach that threshold? How fast can you move away
from it?
• You need to understand the long-​term effects of deficits and debt on
output and its composition. How do deficits and debt affect output
in the medium and long run? How do they affect the interest rate,
the net foreign debt position, the capital stock? What is the cost in
terms of lost consumption in the future? Which generations gain,
which generations lose?
• You need to understand the short-​term effects of deficits and how
countercyclical fiscal policy can help in the short run. Do deficits
affect activity in the same way, whether they come from tax cuts or
spending increases? How important are expectation effects? Can the
anticipation of large deficits in the future lead to a decrease in con-
sumption and investment and a decrease in output today? When is
this more likely to happen?
• You need to understand the macroeconomic costs of decreased
policy flexibility. Are constraints on deficits and debt consistent
with an appropriate response of fiscal policy to shocks? What
explains sustained divergences within the euro area during the first
10 years? Were such divergences avoidable? Then you need to de-
termine whether and to what extent fiscal policy is the right tool to
deal with country-​specific shocks and to what extent it can (should)
substitute for the lack of an independent monetary policy. Finally,
you need to figure out how much policy space is left to governments
after they have fought the new Great Recession and rescued
their banks.
• You need to think about how to define the rules in practice. How
should debt be defined? How should implicit liabilities, coming
from Social Security and other promises to future generations, be
treated? If rules are defined in terms of deficits and debt, what are
the most appropriate definitions of the two concepts for the ques-
tion at hand? How should rules deal with privatization revenues?
Should rules apply to gross debt or to net debt? Should the budget
be separated between a current account and a capital account?
Should the deficit rules apply only to the government current ac-
count? Can rules be enforced by politicians, or do we need to set up
independent committees?
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Foreword ix

• You need to think about political-​economy issues. Why are

rules needed in the first place—​to protect people from their
governments, or to protect the governments from themselves?
How can a particular set of rules be manipulated or distorted by a
national government? How will sanctions against a misbehaving
government be imposed? Will these sanctions be credible ex ante?
Is international coordination, such as in the G20 framework, an ad-
vantage or a diversion from every government’s duties?
To answer these questions, you need many conceptual tools. Among them are
a dynamic general equilibrium model with overlapping generations, a model
of short-​run fluctuations with careful treatment of expectations, political-​
economy models to think about the case for rules, and agency models to help
you think about the design of specific rules. In each case, with guidance from
theory, you need to look at the evidence to get a sense of which theoretical
arguments are more relevant. This is not easy to do. Courses will typically give
you the theoretical tools without much incentive to apply them and leave you
to use them on your own without much practical training. This is not what
this book does. It motivates you to use tools, gives you the tools, and shows
you how they can be employed.
Last, but not least, this book is among the very first that offer students
a rigorous and comprehensive treatment of the global financial crisis and
the Great Recession that followed. The authors do not try to cast a veil over
the conceptual difficulties economists face when they reflect on the causes
of the crisis, on the limitations of traditional approaches that the crisis has
uncovered, maybe on the excessive faith in theory, and on the need for more
theoretical work to better understand the crisis and make sure it does not
happen again. But they do not throw the baby out with the bath water and
claim that economists have “mistaken beauty for truth,” as was suggested by
Paul Krugman. On the contrary, they show how existing theories can be used,
cross-​fertilized, and replaced in a historical context to understand the crisis
better. This is the way forward.
In short, this book trains you to be a good macroeconomist—​a good
economist. It instills the right attitude and gives you the right methodology: to
build solidly on theory, to use the theory to look at the data, and then to
go back and forth between the two until a coherent picture forms. As I was
reading the book, I felt again the excitement that comes with doing research
on macroeconomics. I hope this excitement is contagious, and I wish you a
very good read.

Olivier Blanchard, C. Fred Bergsten Senior Fellow,

Peterson Institute for International Economics
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Preface

This is a book for those who are eager to find out what shapes, or should
shape, economic policy: the major stylized facts that capture the messages
from history; the theories that help make sense of these facts and analyze the
impact of policy decisions; the controversies that surround policy choices; the
rules and institutions that contribute to determining them; and, last but not
least, the way experience, theories, and institutions interact.
The first edition of this book—​in French—​dates back to 2004. This is
the second English edition. Meanwhile, Italian and Chinese translations were
published, and the fourth French edition (prepared in parallel to the English
one) was released in late 2017. Each vintage has been noticeably different from
the previous one. The original book arose from a seminar designed to build
a bridge between the students’ theoretical baggage and economic policy-​
making, which many of them planned to embrace as a profession, and this
second English edition follows the same approach. Not only is this new edi-
tion more insightful, more precise, and more comprehensive than the previous
one, but it also incorporates the new analytical insights and new practical
responses developed in response to the major economic policy challenges
that arose in the past 15 years and that have revisited the way many issues are
looked at and many problems are approached.
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xii Preface

Over the past decade, the world has been hit by the global financial crisis
and the Great Recession (uppercase letters reflect the trauma it has caused),
prompting a rediscovery of finance by an economic profession that had long
assumed that the financial plumbing was flawless; Europe’s currency area has
come through a near-​death experience; inflation has almost disappeared,
while forgotten deflation concerns have reemerged; public debt has soared,
and the threat of sovereign insolvency that was regarded as the sad privilege
of developing countries has reached the advanced world; emerging countries
have come of age; income inequality has risen to the forefront, first of political
controversies and, gradually, of policy discussions; and the nature of labor has
structurally changed. New questions have prompted new research and called
for new responses rooted in theory and informed by practical experience.
This new edition fully takes this major renewal into account. It provides
the reader with an up-​to-​date overview of economic policy as it is discussed,
designed, and implemented. All chapters have been thoroughly reviewed,
some have been entirely rewritten. A new chapter on financial stability has
been introduced. The result, we believe, is a book like no other.

The Interaction Between Research and Practice

This book stands at the crossroads between theory and practice. Our premise
is that the all-​too-​frequent disconnect between them is detrimental to both
good policy and good research. We posit that going back and forth between
practice and theory enlightens practice and helps construct better theories.
All four of us are teachers; all of us combine, or have combined, research
and policy advice: we have been advisors, experts, members or chairs of con-
sultative bodies, senior officials, central bankers, researchers in think tanks,
and commentators at a national, European, or international level. We have
been confronted with the reality of economic policy-​making in different
places—​and this has changed the way we understand, teach, and use eco-
nomic theory.
We have learned from experience that research can be the victim of its
own internal logic and ignore important, sometimes even vital, economic
insights. We have also learned that ignorance of the lessons of History and
neglect of theoretical advances can make policy ineffective, even toxic.
The global financial crisis will have a long-​lasting effect on policy-​making
and economic theory. Some of the mechanisms at play before and during the
crisis had been identified and studied in the aftermath of previous crises,
while others have been updated or altogether uncovered. In a first step, in
order to fight financial disruption, to revitalize the economy, and to design
new crisis-​prevention schemes, economists tapped knowledge which had
been buried deep in economic textbooks, drawing lessons from economic his-
tory; they attempted to avoid repeating past mistakes; and they rehabilitated
models which had been considered mere theoretical curiosities. In a second
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Preface xiii

step, new research was initiated. Some of it was very theoretical and aimed to
identify sources and contagion channels of financial fragility and to renew our
approach to risk management; some of it was empirical and aimed to sharpen
our understanding of the impact of economic policy or to explore previously
overlooked dimensions, such as income inequality or systemic risk. In this
book, we survey this research and discuss its contribution to economic policy,
in particular in Chapters 4–​6 devoted to fiscal policy, monetary policy, and
financial stability.
In Europe, the crisis has uncovered specific deficiencies in the way eco-
nomic thinking and policy-​making interact. The creation of a supranational
currency was an undertaking (one may say, an experiment) of unprece-
dented ambition. Many of the pitfalls that were encountered could have been
foreseen, at least in part. Heterogeneity within the currency area, inadequate
adjustment mechanisms to asymmetric shocks, self-​reinforcing price diver-
gence, and weak incentives to fiscal responsibility, to mention but a few, were
well-​known issues. They had been identified from the outset by academics,
and their significance could be inferred from historical experience. Other
challenges related to the non-​pooling of bank risk or the lack of a lender of
last resort to governments had been identified by some but had not been
subject to a complete diagnosis. A deeper, more genuine dialogue between
researchers and policymakers could have helped anticipate and prevent the
euro area crisis. Unfortunately, however, policy complacency set in after the
launch of the euro, and, for long, policymakers seemed more interested in
the analyses that justified their choices than in those that questioned them.
A genuine dialogue intensified only when it appeared that the euro was under
mortal threat.

The Responsibility of Economists

The more theory and policy interact, the greater the responsibility of
economists. This raises several issues related to their integrity, their intellec-
tual openness, and their ability to debate.
Let’s face it: The crisis has cast suspicion on the economic profession.
Economists have been blamed for being blind, complacent, or even captured.
They have been charged with intellectual conformism, excessive trust in
market mechanisms, being too close to the world of finance, and being
weak with the powerful. After the euro area crisis, they have been accused of
drawing biased conclusions on the costs and benefits of monetary integration
(that is, underestimating the former and overestimating the latter). They have
been diagnosed with an acute myopia which leads them to take interest only
in social interactions with a pecuniary nature, to focus on the accumulation
of wealth more than on its distribution, and to ignore the damage caused by
growth and the political forces that shape economic institutions. And they
have sometimes been blamed for focusing on specialized, “elegant” models
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xiv Preface

at the expense of understanding a complex reality—​for mistaking beauty for

truth, as cogently expressed by Paul Krugman.
As for integrity, it is fair to acknowledge that professional economists,
while lecturing others about the importance of incentives, have for too long
turned a blind eye to their own conflicts of interests. Beyond the pecuniary
dimension, which should not be overlooked, economists must be aware that
being too close to any professional constituency—​including politicians and
government technocrats—​risks blunting their critical sense. After the crisis,
their professional ethics have been questioned. This has already prompted
greater disclosure, for example in professional journals, an effort which needs
to be further advanced. Full transparency on potential conflicts of interest
must be ensured.
As for the criticism of being intellectually blind, it is often based on a mis-
taken preconception. Economic theory is not the Trojan horse of free-​market,
small government, minimal redistribution mindset some believe it is in liberal
circles. Several recent recipients of the Nobel Memorial Prize in Economics
have devoted their research to inequalities, poverty, and government inter-
vention, or to the limited rationality of economic agents. Economists do re-
gard the market as an efficient tool to allocate resources, but they are equally
concerned with its failures and unequal distributional effects, and they have
designed instruments to identify and correct them.
Democracy would benefit if participants in the public debate made a
better (and more informed) use of economic analysis. Economists are not
ideologues: they devote an increasing part of their time to empirical work and
experiments, tapping a rapidly expanding trove of data. Nowadays, unlike a
few decades ago, the bulk of research published in top economic journals is
empirical. And theory remains essential to identify the key parameters which
will make a policy successful and to guide empirical analysis beyond the sur-
face of pure statistical regularities.
Some economists may see themselves more as advocates—​of market ef-
ficiency, of economic openness, of price stability or of (de)growth—​than as
scientists or engineers. And when confronted by politicians, civil society ac-
tors, or experts of other disciplines, some cautious and balanced researchers
may also tend to simplify their points excessively and overplay their so-
cial role. Policymakers often make a biased use of the outcome of research,
placing an excessive weight on work that merely confirms their priors. In the
mid-​2000s, scholars of finance or of the euro too often struck a Panglossian
tone, while those who struck a note of caution were largely ignored. In such
cases, admittedly, the culprit is less research than the relationship between
research and policy, and economists share the blame. And methodological ar-
rogance is unwarranted. When it comes to the myopia and apparent irration-
ality of individuals, economists often hide behind Elinor Ostrom or Richard
Thaler (both Nobel-​Prize winners) who have endeavored to understand non-​
monetary interactions, non-​pecuniary incentives, and collective action. And
they emphasize that concepts such as utility, intertemporal maximization, or
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Preface xv

social welfare give them all the necessary instruments to build a multifaceted
approach to public action, far from the simple religion of growth. This is all
true but easily misleading. Economists should be more open to the finding of
other social sciences. The strength of their discipline does not come from any
inherent superiority of what George Stigler once celebrated as the “imperial
science,” but from the blend of analytical rigor and empirical relevance that
their profession has been able to develop. They should heed Keynes’s invita-
tion to model themselves on the humility and competence of dentists.

A Unique Structure

Economic textbooks typically cover economic theory in a given field—​

macroeconomics, microeconomics, finance, international trade, etc.—​and
use real-​life stories to illustrate theoretical results. Their representation of ec-
onomic policy instruments and of the decision-​making process often remains
rudimentary and abstract: the decision-​maker is supposed to choose without
constraints the interest rate or the level of public spending, whereas in real life
such decisions involve complex processes.
Conversely, many excellent essays on economic policy are more con-
cerned with describing the ebb and flow of new ideas and institutions than
with discussing their theoretical underpinnings. They are informative but
frustrating. Our book aims to fill that gap. We present the main analytical
tools—​theoretical and empirical instruments, or old and new—​that are rel-
evant to addressing real-​life policy issues; we explain how these instruments
can be used to identify policy trade-​offs and guide the policymakers’ choices;
and we discuss the theoretical uncertainties, blind spots, and controversies
that justify cultivating humility and caution when formulating policy advice
and that make the job of economists so challenging and rewarding. We hope
that this book will provide the reader with the necessary tools to understand
and participate in the debates which will develop in the years to come.
There are nine chapters. The first three set out the general frame-
work of economic policy-​making. Chapter 1 describes the methodolog-
ical foundations and toolbox essentials that will be used in the rest of the
book. Chapter 2 adds a note of caution: it outlines the limits of government
intervention and the political-​economy reasons that may render it sub-
optimal. Chapter 3 introduces the plurality of policy-​making within and
between sovereign nations. Chapters 4–​9 cover six domains of economic
policy: fiscal policy (Chapter 4), monetary policy (Chapter 5), financial sta-
bility (Chapter 6), international capital integration and foreign exchange
policy (Chapter 7), tax policy (Chapter 8), and long-​term growth policies
(Chapter 9). Chapter 6 is entirely new and benefited from comments by
Laurence Boone, Lorenzo Cappiello, Anne Le Lorier, and Peter Praet,
whom we would like to thank here. Each of these six chapters is struc-
tured in a similar way: the first section outlines stylized facts derived from
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xvi Preface

recent economic history, the second section introduces the theoretical

models policymakers should have command (or at least a knowledge) of,
and the third section presents the main policy options. There are many
cross-​references between the six chapters, but they are written in such a
way that each of them can be read on its own.
This book is by no means comprehensive. We cover macroeconomics in
a broad sense, focusing successively on money, the budget, finance, exchange
rate, taxation, and growth. We have chosen not to address, or address only at
the margin, a number of otherwise important areas of economic policy, such
as competition policy, social protection, labor policies, international trade, or
climate change. We have also decided not to write specific chapters on inter-
national economic policy, regional (and especially European) integration, or
the management of local governments. Chapter 3 summarizes what economic
theory has to say on the assignment of policy instruments to different levels
of government and on the difficulties of global governance; however, in any
policy domain, some levers are global, some are regional, some are national,
and some are local, and we have therefore addressed them in conjunction in
each of the six thematic chapters.
Economists are often blamed for resorting to technical vocabulary as a
way of protecting themselves from inconvenient questions. To help the reader
overcome semantic barriers, we have been careful to define all key concepts at
least once in the book and to signal these terms with italics. The index at the
end of the book provides a complete list of keywords with the corresponding
pages where they are defined and illustrated.
Additionally, we have parked most mathematical developments in tech-
nical boxes. We see mathematics neither as the purpose of economic science
nor as the instrument that would allow us to draw a line between truth and ide-
ology. As Paul Romer once noted, mathematics can be used in support of ide-
ology, and, conversely, some seminal theoretical articles mentioned in this book
do not show any equations. Mathematics is nevertheless unique in mapping in
a coherent and rigorous way a set of assumptions into conclusions. It is also the
basis for statistical tools allowing us to confront assumptions with real-​world
data. As a language, it is, however, fitter to expose a flow of rigorous reasoning
than to explain it and present its conclusions. We give examples of how it can be
used, but we also make the reasoning explicit in more literary ways.
As “reading assistance,” each chapter includes many charts and tables be-
cause our approach fundamentally relies on facts. It also includes theoret-
ical and descriptive boxes. Additionally, there are extensive bibliographical
references so that the reader can dig further into any of the issues covered.

Conclusion

We express our gratitude to all those who have encouraged us and who have
helped make this joint endeavor a reality. We owe a lot to our students, whose
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Preface xvii

questions and criticisms have greatly improved the relevance, accuracy, and
legibility of this book. We also thank our colleagues and friends who have
commented on previous versions. Writing on economic policy requires us to
update data and facts tirelessly. For this last edition, we have benefited from
particularly effective assistance by Paul Berenberg-​Gossler, Pranav Garg, and
Amélie Schurich-​Rey. Without them, this book would be less caught up with
today’s debates.
​Paris, Florence, Frankfurt, New Delhi, March 2018
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Economic Policy
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1
Concepts

1.1 A Primer on Economic Policy

1.1.1 The economist and the Prince: Three alternative approaches
1.1.2 What do policymakers do?
1.2 The Whys and Hows of Public Intervention
1.2.1 The three functions of economic policy
1.2.2 Why intervene?
1.3 Economic Policy Evaluation
1.3.1 Decision criteria
1.3.2 Experiments and ex post evaluation
1.3.3 Collateral effects
Conclusion
Notes
References

Practical men, who believe themselves to be quite exempt

from any intellectual influences, are usually the slaves of some
defunct economist. Madmen in authority, who hear voices in
the air, are distilling their frenzy from some academic scribbler
of a few years back. I am sure that the power of vested interests
is vastly exaggerated compared with the gradual encroachment
of ideas. Not, indeed, immediately, but after a certain interval;
for in the field of economic and political philosophy there are
not many who are influenced by new theories after they are
twenty-​five or thirty years of age, so that the ideas which civil
servants and politicians and even agitators apply to current
events are not likely to be the newest. But, soon or late, it is
ideas, not vested interests, which are dangerous for good or evil.
​John Maynard Keynes (1936; chapt. 24, part 5)

The last sentences of The General Theory of Employment, Interest and Price by
the famous British economist are a fetish quotation for economists who take

1
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2    
Economic Policy

them as an acknowledgment of their social role. Yet they also express the com-
plexity of the links between theory and economic policy. They suggest that
economic expertise can neither be regarded as the servant nor as the master of
political decision. It does influence it, but in an indirect way and with delay.1
However, Keynes (1931, part V, chapt. 2, last sentence) also expressed de-
tached irony about the economists’ pretense to determine the policymakers’
choice:

If economists could manage to get themselves thought of as humble, compe-

tent people on a level with dentists, that would be splendid.

The interaction between economic ideas and political motivations was aptly
characterized in the classics as political economy.2 This type of interaction be-
tween power and knowledge is certainly not specific to the economic disci-
pline. It arises in all fields where public decision relies at least partially on
scientific or technical expertise. For reasons we develop later in this chapter
and throughout the book, however, it is more pronounced in economics and
more general in the social sciences than, say, in geology or biology.
This chapter introduces the main themes of economic policy analysis. We
start in Section 1.1 with a discussion of the various approaches to economic
policy an economist can adopt. In Section 1.2, we discuss the arguments for
and against public intervention, both from a micro-​and a macroeconomic
standpoint. Finally, Section 1.3 is devoted to the evaluation of economic policy
choices and deals with both criteria and instruments.

1.1 A Primer on Economic Policy

1.1.1 The economist and the Prince: Three alternative approaches

An economist can adopt diverse attitudes vis-​à-​vis policy decisions: she or he

can limit herself to studying their effects on the economy (positive economics),
she can seek to influence them through recommendations that draw on her
expertise (normative economics), or, finally, she can take them as a topic for re-
search and study their determinants (political economy or political economics).
All three approaches coexist in today’s economics.

a) Positive economics

In positive economics, the economist takes the point of view of an outside

observer and aims to determine the channels through which public decisions
affect private behavior and outcomes. For example, she analyzes the effects of
a tightening of monetary policy, an increase in public expenditure, a tax re-
form, or a new labor market regulation. Economic policy choices are regarded
as entirely exogenous, meaning that they are not determined within the model
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Concepts     3

that explains the economy and whose variables—​such as prices, incomes,

output, and the like—​they influence.
Positive economics therefore approaches economic policy with the same
concepts and methods as those used to study other economic phenomena: for
example, there is hardly a difference between studying the effects of a rise in
the central bank money lending rate on nonfinancial agents and analyzing
the effects of an exogenous rise in the risk premium which banks require for
lending to private agents; similarly, the effects of a rise in the minimum wage
can be analyzed within the same framework and with the same tools as those
of a strengthening of the bargaining power of trade unions.

b) Normative economics

The second approach is called normative economics. The economist here

adopts the posture of an adviser to a supposedly benevolent Prince—​or polit-
ical master—​and examines which set of decisions can best serve explicit public
policy purposes, such as reducing unemployment, improving the standard
of living, or safeguarding the environment. The public decision-​maker is
regarded as a social planner and the economist as an engineer who tells him
or her how to select adequate means for reaching certain ends, meaning how
to design policies and then how to implement them. Economists are certainly
not short of policy advice, and they generally do not need a request from the
Prince to express their views. In all cases, however, they make explicit or im-
plicit assumptions about social preferences that cannot be derived solely from
economic theory.
Normative economics relies on the knowledge base of positive economics
to assess the effects of different possible decisions. However, it also requires
a metric within which to compare alternative situations. Assume that a gov-
ernment wants to reduce unemployment and suppose that two competing
policies may lead to this result but at the price, for the first one, of a lowering
of the employees’ average wage income and, for the second one, of an increase
in wage inequality. Choosing between these two solutions requires assessing
the social cost of each of those policies against the social benefit of lowering
unemployment. This implies defining a preference order between situations,
each characterized by the unemployment rate, the average wage income level,
and a measure of inequality. Constructing such a ranking raises considerable
conceptual and practical difficulties.
Furthermore, normative economics frequently implies giving up the first-​
best solution that would be reached in the absence of informational, insti-
tutional, or political constraints for a second-​best solution, one that respects
those constraints.3
Let us take the example of carbon dioxide emissions, which governments
have committed to limit to curb global warming. A first-​ best solution
consists in creating a global carbon dioxide tax to incite companies to use less
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4    
Economic Policy

carbon-​intensive energy sources. The carbon tax, however, hurts powerful

special interests, such as those of car makers or oil-​producing companies;
requires international coordination and implementation; and is disputed on
equity grounds by developing countries. The climate agreement reached in
Paris in December 2015 therefore leaves participating countries free to choose
the means they intend to rely on to reduce emissions.
Some governments consider making existing government policies
“greener,” say by restricting public tenders to companies which meet carbon
dioxide emission standards. Such a second-​best solution, however, bears sig-
nificant unintended consequences. It distorts economic choices by making
the implicit price of carbon dioxide differ across the economy, and, moreover,
due to limited competition among providers, taxpayers may ultimately bear
the cost of the policy in place of the owners of the companies—​who would be
better placed to steer their behavior.
Economists involved in public decisions face many such constraints.
The question they face is typically not “how can unemployment be
reduced?” but “in view of the stance and prejudices of the main players—​
government departments, majority and opposition in Parliament, and var-
ious stakeholders—​what is the most cost-​effective proposal consistent with
the government’s overall policy philosophy and commitments already pub-
licly undertaken?” This second question obviously is a very weak version of
the first one, but major economic decisions are very often taken this way.
Economists may understandably be tempted to abstain from participating in
such decisions. But, as Herbert Stein, a chairman of the Council of Economic
Advisors under US presidents Richard Nixon and Gerald Ford, used to say,
“Economists do not know very much [about economics. But] other people,
including the politicians who make economic policy, know even less” (Stein,
1986, p. xi). Returning to the ivory tower may thus be an undesirable option.
Second-​best recommendations nevertheless raise important difficulties.
The second-​best optimum can in fact be inferior to the initial situation in wel-
fare terms. An example of an inferior second-​best solution can be found in
trade policy: liberalization on a regional basis only can divert trade from an
efficient global producer to a less efficient regional partner, which worsens the
allocation of resources in comparison to a situation of uniform tariff protec-
tion.4 What is perceived as a small step in the right direction therefore does not
necessarily improve upon the status quo; on the contrary, it can reduce welfare.
Beyond this disturbing result, modern public economics emphasizes
the equally formidable difficulty associated with the existence of asym-
metric information between the public decision-​maker, the agents in charge
of implementing policies, and those who bear the consequences. Not un-
like Soviet central planning, the traditional approach of economic policy
postulated that the decision-​maker had perfect information (in fact, he or she
was frequently assumed to know better than private agents) and perfect con-
trol over the implementation of his decisions. The reality, of course, is that the
5

Concepts     5

decision-​maker has both an incomplete knowledge of reality and an imperfect

command of policy implementation. Take the regulator in charge of a specific
sector (e.g., telecommunications). He gets information on costs, returns on
investment, or demand elasticity largely from the companies that he is re-
sponsible for controlling. For the latter, this information has strategic value.
They have every reason not to be fully transparent or to provide biased in-
formation. When dealing with them, the regulator therefore suffers an infor-
mational disadvantage even when he supplements the information provided
by the regulated companies with indirect indications derived from observing
market prices and quantities.
Likewise, government bodies responsible for policy implementation are
not flawless transmitters: they often do not pass on adequate information
from below or instructions from above. For example, even if teachers from
the education ministry have first-​hand knowledge of the situation in their
classes, the minister in charge may not have accurate overall information,
which obviously affects the quality of his or her decisions. Reciprocally, the
minister’s policy may not be considered adequate by the teachers who have
their own views on education policy, and this affects its implementation and
effectiveness.
The importance of information asymmetries for private markets was first
highlighted in research by 2001 Nobel laureates George Akerlof, Michael
Spence, and Joseph Stiglitz, but it was Jean-​Jacques Laffont5 and Jean Tirole
who worked out their consequences for public economics. They initiated re-
search on the design of contracts that encourage agents to reveal the infor-
mation which they would otherwise keep for themselves (thereby allowing
regulators to take more appropriate decisions). Such contracts are examples of
mechanism design, meaning the design of optimal institutions or procedures
to deliver social outcomes. Mechanism design covers issues ranging from
auctions of public assets, voting procedures for public decisions, regulations
to curb private behaviors, or contracts between the government and private
contractors. All such mechanisms should be designed in a way that delivers
the expected outcome while overcoming the government’s lack of informa-
tion.6 Key to this outcome, as explained by Nobel Prize laureate Eric Maskin,
is incentive compatibility:

Because mechanism designers do not generally know which outcomes are op-
timal in advance, they have to proceed more indirectly than simply prescribing
outcomes by fiat; in particular, the mechanisms designed must generate the
information needed as they are executed. The problem is exacerbated by the
fact that the individuals who do have this critical information—​the citizens
in the public good case or the buyers in the asset-​selling example—​have their
own objectives and so may not have the incentive to behave in a way that
reveals what they know. Thus, the mechanisms must be incentive compatible.
(Eric Maskin, 2007, p. 3)
6

6    
Economic Policy

c) Political economics

Like positive economics, of which it can be regarded as an extension, the po-

litical economy approach refrains from making prescriptions and takes the
viewpoint of an external observer. However, instead of considering the po-
litical decision-​makers’ behavior as exogenous, it treats it in the same way it
treats private agents’ behavior; that is, as endogenous (determined by the state
of the economy itself). The government is therefore no longer regarded as a
Deus ex machina that monitors and steers the private economy in the name of
the general interest but, instead, as a machine directed by politicians (i.e., by
rational players whose behavior follows specific objectives and faces specific
constraints). The simplest models of politically motivated behavior often draw
on the simplistic assumption that the politicians’ only objective is to hang
on to power and therefore to maximize their reelection chances. However,
more elaborate models also recognize the need to fulfill electoral campaign
pledges (which become a constraint after election); partisan preferences; the
role of special interest groups, which may dwell on the need to maintain long-​
term relationships within a social group; and—​at the extreme—​corruption
and bribery. The political economy approach also endeavors to represent the
behavior of technocrats within government or of those in charge of public
agencies (central banks, independent authorities, international institutions)
and to determine how the external and internal governance and the mandate
of these institutions influence economic performance.
A political economy approach is evidently essential to the analysis of gun con-
trol policy in the United States. But it is also required in fields like trade policy,
to explain why protection varies across sectors, or labor market policy, to under-
stand why the employment performance varies considerably across countries.
Political economy does not exclude normative judgments, but it does have
implications regarding their scope. James Buchanan, one of the initiators of
modern political economics, claims that such judgments are valid only if
applied to the framework (often called policy regime) that determines eco-
nomic policy: the constitution and, more largely, all the rules, procedures, and
institutions surrounding economic policy decisions. To draw on a distinction
introduced by Robert Lucas (see, e.g., Lucas, 1976), the choice of an economic
policy regime involves normative considerations, but the actual economic
policy decisions are the result of political processes within the framework of
this regime. It would therefore be pointless to exercise normative judgment
on what must be regarded as endogenous variables. According to Buchanan,
“the object of economic research is ‘the economy,’ which is, by definition, a so-
cial organization, an interaction among separate choosing entities. . . . [T]‌here
exists no one person, no single chooser, who maximizes for the economy, for
the polity. . . . That which emerges [from the decision-​making process] is that
which emerges from results, and that is that” (Buchanan, 1975, pp. 225–​226).
The role of the economist is to study the functioning of these processes and
the incentives they create for public decision-​makers. It is to discuss whether
7

Concepts     7

these incentives create a political bias or help align the outcome of the deci-
sion process with the public interest. It is not to give advice to the Prince or
his marquis.
During the last decades of the twentieth century, the political economy
approach was strengthened by two concomitant developments. First,
the theory of rational expectations7 developed in the 1970s (in particular
by Robert Lucas) emphasized that private agents do not react to stimuli
as automatons, but rather use their reason to anticipate policy decisions.
A good example of such behavior is provided by exchange-​rate crises. As
developed in Chapter 7, such crises can only be understood by considering
the strategic interaction between private speculators and official authorities.
These crises often occur because private agents know the public decision-​
makers’ preferences and constraints (or at least guess what they are) and
therefore can assess the probability of a currency devaluation. While not
directly related to the political economy approach, the theory of rational
expectations thus challenged the idea that the State dominates and steers
the private economy. It resulted in integrating into economic models a rep-
resentation that makes public decision-​makers react endogenously to en-
dogenous events rather than behave exogenously.
The second development of research on political behavior was a reaction
to failures of government intervention in areas such as macroeconomic man-
agement, employment, or development. While some of these failures could
be ascribed to genuine policy mistakes, insufficient knowledge, or simply
bad luck, in other cases there was a need to provide explanations for a per-
sistent inability to learn from past mistakes and from international experi-
ence. Why are certain regulations maintained even though they obviously
lead to outcomes that contradict stated policy objectives? Why have some
developed countries returned to full employment more rapidly than others
after the 2009 global crisis? If this were simply a matter of identifying appro-
priate policies and institutions, some form of learning should be at work, and
less-​successful governments could be expected to learn, even slowly, from
successful ones. Since some do not, there is a need for political economy
explanations.
The choice of a regime regarding product, capital, and labor market
regulations involves preferences and trade-​offs between, say, efficiency and
equity; economic interests, which can differ between, say, incumbents and
newcomers; and representations of how the economy works, on which various
players may disagree.8 From a knowledge perspective, it is therefore impor-
tant to identify the source and understand the nature of these disagreements.
From a policy perspective, recognizing and explicitly considering the intel-
lectual and political environment of public decisions becomes as necessary as
determining what is the first-​best solution. Political economy then becomes
essential both from a positive point of view (to understand why economic
policy does not achieve its objectives) and from a normative one (to evaluate
the chances of success of various reform strategies).
8

8    
Economic Policy

Positive economics, normative economics, and political economics thus

coexist, and the modern approach of economic policy draws on all three
methods. Positive economics remains indispensable to the understanding of
the likely effects of public decisions. Normative economics brings intellec-
tual discipline to policy choices and helps address the trade-​offs they involve.
Both, however, face limits and are increasingly complemented by political
economics.
Avinash Dixit (1996) once observed that the traditional approach of ec-
onomic policy envisaged the ultimate policymaker—​the Prince—​as an om-
niscient, omnipotent, and benevolent dictator. The economics of imperfect
information taught us that he or she was not omniscient. Second-​best theory
was developed in recognition of the fact that he or she was not omnipotent.
Political economy tells us that he or she is not always benevolent. This should
not be a cause for policy nihilism—​only a motive against policy naïveté.
The remaining sections of this chapter will focus on the traditional
approach whose shortcomings are then discussed in Chapter 2.

1.1.2 What do policymakers do?

The main tasks of economic policymakers can be grouped into six categories:
1. Set and enforce the rules of the economic game. Market structures and
property rights are not preordained. They are social and historical
outcomes shaped by power relations between interest groups, and,
if left unchecked, they are fraught with abuse and fraud. Economic
legislation provides the framework for the decisions of private agents.
Enforcement covers the protection of property rights, competition
policy, labor law, and the supervision of regulated markets such
as banking and insurance. Economic legislation increasingly has
an international dimension (through international treaties and
agreements)—​especially, but not only, in the European Union.
2. Tax and spend. Government spending amounts to about one-​half of
gross domestic product (GDP) in continental European countries
and one-​third in the United States and Japan. Budgetary decisions
affect households’ and firms’ income and behavior through taxation
and social insurance; they affect productivity and long-​term growth
through infrastructure, research, and education spending; and they
affect aggregate demand through changes in spending or overall
taxation (including negative taxation such as subsidies).
3. Issue and manage the currency. The choice of a monetary and
exchange-​rate regime is one of the most important single decisions a
government can make. Defining and implementing monetary policy
is the function of the central bank, an often independent branch of
government that is responsible for setting interest rates, maintaining
9

Concepts     9

the value of the currency, and ensuring that the banking system does
not fall short of liquidity, even in the case of a crisis (Chapter 5).
4. Produce goods and services. This is much less a government
responsibility today than it used to be in the first decades after World
War II, but most governments are still responsible for providing
healthcare or education services, and some still own public enterprises,
notably in sectors like transport or energy.
5. Fix problems or pretend to. Ministers are frequently held responsible
for a vast array of issues, from financial market turmoil to wage
negotiations, company mergers, and plant closures and relocations.
Many problems are beyond their capacity to solve, but they can still try
to influence private decisions—​or at least pretend to.
6. Negotiate with other countries. Governments negotiate with other
countries on trade liberalization and the definition of global rules
and objectives (such as the Sustainable Development Goals). They
participate in the governance of global and regional institutions (such
as the United Nations, the International Monetary Fund (IMF), the
World Bank, the World Trade Organization, or the European Union).
They also participate in international fora (G7, G20, Organization
for Economic Cooperation and Development [OECD], and regional
summits) to hold discussions on global problems such as tax
compliance, financial stability, development, and global warming
and to set directions for future formal negotiations. International
coordination occupies a large part of the agenda of heads of state and
governments, central bank governors, and finance ministers.
In fact, economic policy debates vary widely across countries. In the United
States, the bulk of the policy discussion revolves around interest rate
decisions taken by the Federal Reserve Board and discussion in Congress on
the President’s tax and budget plans and on a limited set of specific issues
such as energy security, trade and investment agreements, social security, or
healthcare reform. In Western Europe, the so-​called structural reforms—​that
is, attempts at changing labor market institutions, competition in product
markets, welfare policy, and pensions—​have taken center stage. In recent
years, reforms of the euro area and assistance to countries in crisis have been
at the very top of the European agenda. Throughout the 2000s and 2010s, ec-
onomic policy in Eastern Europe, China, and other transition economies has
focused on the introduction of markets and the privatization of state-​owned
companies. In India, major policy issues have also included market liberal-
ization, inclusive finance and poverty reduction. Finally, Argentina, Brazil,
Turkey, and others have gone through long phases in which the sole obses-
sion of policymakers was to control inflation, allocate credit, and prevent—​or
cure—​financial crises.
Economic policy also means different things at different times. Before the
crisis that erupted in 2007–​2008, no policymaker thought she would have to
10

10    
Economic Policy

design and implement a wholesale bank rescue, a large-​scale budgetary stim-

ulus, or a massive expansion of the central banks’ balance sheet. Consequently,
financial sector reform has gained prominence in the aftermath of the crisis,
both locally and globally.
To speak of “economic policy” in general may thus be regarded as pre-
sumptuous. However, there are many common features of economic policy-​
making across various contexts, fields, institutional setups, and time horizons,
and they can be apprehended through a simple unified framework.

a) A simple representation of economic policy

We start by distinguishing objectives, instruments, and institutions:

•​ The objectives of economic policy are numerous (and some-
times contradictory): improving the population’s standard of
living, promoting sustainable growth, achieving full employment,
maintaining price stability, reaching a fair distribution of income,
alleviating poverty, and the like. They are sometimes explicitly
stated in official texts. For example, the US Full Employment and
Balanced Growth Act of 1978—​known as the Humphrey–​Hawkins
Act—​mandated the federal government to “promote full employ-
ment and production, increased real income, balanced growth, a
balanced Federal budget, adequate productivity growth, proper
attention to national priorities, achievement of an improved trade
balance . . . and reasonable price stability . . . ” (emphasis added).
In the European Union, Article 3 of the treaty on the European
Union9 states that the Union “shall work for the sustainable devel-
opment of Europe based on balanced economic growth and price
stability, a highly competitive social market economy, aiming at full
employment and social progress, and a high level of protection and
improvement of the quality of the environment.” What is immedi-
ately clear from such laundry lists of wishes is that economic policy
has more than one objective and is easily given ambitious targets,
irrespective of the difficulty or even impossibility of reaching all of
them simultaneously.
•​ As already discussed, instruments are also numerous. Traditional
ones relate to monetary policy (the setting of official interest rates)
and fiscal policy (the choice of the levels of public expenditures and
taxes). Economic policy is sometimes presented as a combination of
these two instruments only. However, beyond them, it can and must
rely on a variety of microeconomic instruments: structure of taxa-
tion, subsidies, social security transfers, privatizations, competition
policy, trade policy and more.
•​ Last, institutions directly affect market equilibriums and the effec-
tiveness of policy instruments. According to economic historian and
11

Concepts     11

Nobel Prize Winner Douglass North (1993), “Institutions are the hu-
manly devised constraints that structure human interaction. They are
made up of formal constraints (rules, laws, constitutions), informal
constraints (norms of behavior, conventions, and self-​imposed codes
of conduct), and their enforcement characteristics. Together they de-
fine the incentive structure of societies and specifically economies.”
Lasting features of the organization of products, labor, and capital
markets (i.e., the bankruptcy code, the rules governing employment
contracts, the legislation on takeovers) or of the framework for eco-
nomic policy decisions (i.e., budgetary procedures, the statute of the
central bank, the exchange-​rate regime, the rules governing com-
petition, etc.) are regarded as institutions. This definition includes
nonpublic institutions such as trade unions, which are private
associations but affect the functioning of labor markets.
Within this framework, institutions represent a kind of social capital. They
are not eternal, can evolve, be reformed, or disappear, but they have some
permanence and can be taken as given for the traditional analysis of most
policy choices—​until a deep economic crisis prompts a rethinking of their
performance.

b) Economic policy as a succession of trade-​offs

Consider a government that targets n different economic variables, such as

the unemployment rate, the inflation rate, and the current account balance
(in this case, n = 3), and has a specific objective for each of them. For instance,
the government wants an unemployment rate of around 5% of the labor force,
an inflation rate of around 2% per year, and a balanced current account. These
preferences can be summarized by a loss function that depends on the differ-
ence between each target variable and its desired value.
Assume now that the government has p independent policy instruments;
that is, p variables that it can handle directly (for instance, the fiscal bal-
ance and the short-​term interest rate, in which case p = 2). Economic policy
then consists in setting the p policy variables such that the loss function is
minimized.
If p = n, then the n policy objectives can all be achieved because there is
an equal number of instruments (when objectives and instruments are inde-
pendent and under certain assumptions; see box 1.1). In our example, how-
ever, we have p < n, and the n objectives cannot be achieved simultaneously,
which implies trading off one objective against another one. For instance, the
government needs to accept a current account deficit if it wants to lower un-
employment to a level close to 5% while keeping inflation close to 2%. More
generally, to reach n independent policy objectives, the government needs at
least an equal number of independent policy instruments. This is known as
the Tinbergen rule.10
12

12    
Economic Policy

Box 1.1 Trade-​Offs Versus Structural Reforms

Consider a government that has n target variables Y1, Y2, . . . Yn, represented
by a vector Y = (Y1, Y2, . . . Yn), and n corresponding objectives. Its preferences
can be summarized by a loss function L that measures the welfare
loss associated with a divergence between the value taken by the target
variables Yi and their objective values Yi :

(
L Y1 − Y1 ,Y2 − Y2 ,Yn − Yn ) (B1.1.1)
L is assumed to be a convex, continuously differentiable function with
L(0, 0, . . . 0) = 0. Suppose also that the government can use p policy
instruments represented by a p-​dimensional vector X = ( X1 , X 2 … X p ).
With I standing for institutional characteristics, one can postulate that
there exists a function H, conditional on institutions, that links the state of
the economy, Y, to the instrument vector X:
Y = HI (X) (B1.1.2)
Economic policy then consists in selecting X such that L is minimized,
under the constraint (B1.1.2).
If n = p, then it is usually possible (assuming independent targets and
instruments) to invert Equation (B1.1.2) and find the vector X which allows
Y to be exactly at its target level.
If n > p, this is no longer the case (provided the n target variables are
independent), and the government faces a trade-​off. In other words, the
program leads to choosing values for (X1, X2 . . . Xp) such that, at the
margin, it is not possible to improve on any of the targets without welfare
deteriorating due to a higher divergence on other targets. Analytically, this
corresponds to a situation where:
n
∂L
dL = ∑ dYi = 0 (B1.1.3)
i =1 ∂Yi

that is, for any pair (i, j) of objective variables,

dYi ∂L ∂Y j
=− (B1.1.4)
dYj ∂L ∂Yi

The marginal rate of substitution between any two objectives is therefore

equal to the inverse ratio of the partial derivatives of the loss function.
This formula, formally identical to what is obtained in a consumption
maximization program, means that, at the minimum of the loss function,
any improvement in an objective is offset by a deterioration in another
one in inverse proportion to the effects of these variations on the loss
function. In the simple case where there are two objective variables Y1 and
Y2 with only one instrument X to reach them, X can be substituted along
13

Concepts     13

(B1.1.2), giving an explicit formulation of the trade-​off between Y1 and Y2,

conditional on the institutions I:
g I (Y1 ,Y2 ) = 0 (B1.1.5)
This relationship is represented in figure B1.1.1. The government can
trade Y2 for Y1 (or vice versa), along the gI(Y1, Y2) schedule, or it can change
the set of institutions from I to J in order to improve the trade-​off (in which
case the schedule shifts to the north-​east of the figure).

Figure B1.1.1 From managing trade-​offs to reforming institutions: an illustration.

One direct implication of the Tinbergen rule is that an independent cen-

tral bank with a single objective of price stability will be technically able to
reach this objective since it can fully make use of one instrument (the official
interest rate, assuming that it effectively influences prices). This piece of arith-
metic was successfully applied in the 1990s when a large number of central
banks around the world became independent and inflation rates decreased
dramatically (see Chapter 5).
However, governments generally have many objectives but only a limited
number of instruments. Hence, trade-​offs are part of a government’s everyday
life. These trade-​offs are conditional on their preferences (for instance, how
much more wage inequality they stand ready to accept to reduce the unem-
ployment rate by one percentage point) and also on institutions (for instance,
on whether wages are negotiated with unions or set by firms).
In such a setting, divergences in policy prescriptions can be either of a
positive or of a normative nature: they can result from different views on the
functioning of the economy (the constraint) or from different preferences, as
represented by the loss function.
14

14    
Economic Policy

Such a representation was widely used in the 1960s. For instance, A. W.

Phillips (1958) evidenced a negative relationship between the unemployment
rate and the growth rate of nominal wages for the United Kingdom from 1861
to 1957. This downward-​sloping Phillips curve led to the idea of a trade-​off
between unemployment and inflation: according to Phillips’s findings, a one
percentage point fall in the unemployment rate had to be “paid back” by a
0.8 percentage point rise in the inflation rate. The simultaneous rise of infla-
tion and unemployment in the 1970s challenged this excessively simple rep-
resentation. The necessity to manage policy trade-​offs nonetheless obtains
whenever the number of independent instruments is smaller than that of in-
dependent policy objectives.

c) Changing the institutions: Structural reform

The trade-​offs just described are generally reversible: the central bank raises
or cuts the interest rate according to the economic situation, parliament
increases or reduces taxes, and the like. However, starting in the 1980s and
1990s, persistent problems in growth and employment in Europe highlighted
the limits of such economic management. A good example here is the ap-
parent trade-​off between employment and productivity. In some European
countries fewer people work, but those who work have a high level of produc-
tivity. Other countries achieve much better performances about employment
but at the price of weaker productivity. Collectively, the European countries
seem confronted with a trade-​off described by the negatively sloped AA curve
of figure 1.1. Attempts at modifying the position of a country along the AA
schedule through various levers such as tax rates and public spending can be
characterized as economic management.
However, trading off more jobs for less income per worker is unsatisfac-
tory. In a low-​employment situation, the true objective of economic policy
should be to reach at the same time higher employment and higher produc-
tivity levels. The right answer would therefore consist in moving the AA
schedule outward, thereby simultaneously raising employment and produc-
tivity. This requires reshaping institutions: for example, stronger incentives
to remain active and take up jobs, more investment in education, an environ-
ment that fosters innovation, and the like.
In a more general way, structural reforms aim to improve economic policy
trade-​offs by changing the institutions. The IMF (2004) defines them as
entailing “measures that, broadly speaking, change the institutional frame-
work and constraints governing market behavior and outcomes,” while
the OECD focuses on their ability “to improve long-​term material living
standards through higher productivity and labor utilization.” The mathemat-
ical interpretation of policy trade-​offs versus structural reforms is detailed
in box 1.1.
It is common, but inaccurate, to equate structural policies and supply-​side
policies. Making the central bank independent, choosing a new currency
15

Concepts     15

Figure 1.1 The employment–​productivity trade-​off, 2012.

Authors’ calculations with OECD data.

regime, or adopting a framework for fiscal policy are true structural reforms
because they aim to improve existing trade-​offs between various objectives
by moving the corresponding schedules outward (see Chapters 4 and 5).
Conversely, a change in tax rates, which is mostly a supply-​side measure, does
not have the character of a structural reform.
However, many of the structural reforms undertaken since the 1980s in
advanced economies were admittedly of a supply-​side nature. Widespread re-
form of capital markets through the elimination of credit controls, the scrap-
ping of many deposit regulations, and the liberalization of capital flows had
major consequences, both micro-​and macroeconomic, with positive as well
as negative implications (improved access to finance for firms and households,
but also excessive risk-​taking which led to the 2007 crisis). Deregulation in
product markets, following its initiation in the United States in the 1970s,
increased competition and fostered innovation, resulting in productivity
gains, especially in sectors such as transport, telecommunications, and en-
ergy. In the EU, the gradual introduction starting in the mid-​1980s of a single
market11 for goods and, to a lesser extent, for services had similar objectives.
In developing and emerging countries, and since 2010 in euro area coun-
tries hit by the financial crisis, the standard concept has been that of struc-
tural adjustment—​a package of reforms advocated by the IMF and the World
Bank (and in Europe by the Troika consisting in the European Commission,
European Central Bank, and IMF) and enforced on countries requiring fi-
nancial assistance that encompasses several features of what we call structural
reform.
16

16    
Economic Policy

Structural reforms are often viewed as having negative short-​term, but

positive long-​term effects. The most telling example of such effects was, at the
end of the twentieth century, the transition of the former planned economies
of Central and Eastern Europe and the former USSR to market economies.
Figure 1.2 highlights the GDP cost of this transformation: it generally took
several years for GDP to return to its pretransition level. Furthermore, some
of the most successful posttransition countries where those, like the Baltic
States, where the initial fall was the most pronounced.
There is no consensus on whether structural reforms have a negative or pos-
itive impact on output in the short run, and it depends much on their nature.
On the one hand, reforms aiming to increase productivity exert downward
pressure on costs and prices, pushing the real interest rate (the gap between
the nominal interest rate and the inflation rate) up and weighting on aggregate
demand. They may also create anxiety, which favors precautionary savings
and wait-​and-​see attitudes. On the other hand, if individuals and companies
spend out of their permanent income, an expected increase in productivity
lifts consumption and investment already today. The former, negative impact
can moreover be counteracted by a more expansionary monetary policy, ex-
cept when the country is part of a fixed-​exchange-​rate regime or a monetary
union and when interest rates are already at the lower bound and cannot be
lowered any further (Eggertsson, Ferrero, and Raffo, 2014). Some empirical
studies have found positive effects to dominate, even in the short run (Bouis
et al., 2012), but the issue remains controversial.

Figure 1.2 GDP impact of the transition to the market economy in the 1990s.
Real GDP, trough level = 100. Author’s calculations based on the Groningen
Growth and Development Center’s Global Economic database. The x-​axis
represents years before or after year 0 when the trough of real GDP was
reached.
17

Concepts     17

Such intertemporal effects necessarily raise political economy issues. For a

democratic government facing reelection, undertaking reforms that will an-
tagonize voters and only yield benefits after its term expires can be a recipe for
failure. How to surmount this political economy constraint (for example, by
finding ways to compensate incumbents for the rents they will lose because of
the reforms) is a major theme for research.

1.2 The Whys and Hows of Public Intervention

Having presented what policymakers do and how economic policy works, let
us move to an upstream question: Why is public intervention needed? What
are the objectives of public intervention? Economic theory provides useful
and precise answers.

1.2.1 The three functions of economic policy

Musgrave and Musgrave (1989) have distinguished three essential functions

of fiscal and, more largely, economic policy:
•​ Allocation policies that intend to optimize the assignment of re-
sources to alternative uses. Allocation policies cover public
interventions aiming to affect the quantity or the quality of the
factors (capital, unskilled and skilled labor, technology, land, etc.)
available for production and their sectoral or regional distribution.
Policies providing public goods such as infrastructure or environ-
mental preservation are also included in this category.
•​ Stabilization policies vis-​à-​vis macroeconomic shocks that move the
economy away from internal balance (defined as full employment
together with price stability). This calls for policies that aim to bring
the economy closer to balance—​a role assigned to monetary and
fiscal policies.
•​ Redistribution policies between agents or regions. This involves
policies designed to correct the primary distribution of income.
Progressive taxation policies and social transfers as well as access to
education and health are key instruments to this end.
Redistribution clearly has a different scope than either allocation or stabiliza-
tion since it addresses the distribution of income within society. Allocation
and stabilization may seem to pursue similar goals. The distinction between
them directly refers to the difference between long-​term output growth and
short-​term fluctuations around the trend: allocation policies aim to increase
the maximum level of output that can be reached without creating inflation—​
generally called potential output or potential GDP—​while stabilization policies
aim to minimize the divergence between actual and potential output, known
as the output gap (figure 1.3 and box 1.2).
18

18    
Economic Policy

Figure 1.3 Stabilization versus allocation policies.

Box 1.2 Aggregate Supply, Aggregate Demand, and

the Output Gap

In a simple model of the supply side of the economy, potential output is

determined by the factors of production (mainly labor supply and the
capital stock), as well as by the factors affecting productive efficiency.
A standard representation is:
Yt = Ft (K t , N t ) (B1.2.1)
where Y is production, K the capital stock, N employment, and F
the production function. K and N depend on time and so does F as
improvements in technology allow more to be produced with the same
quantity of factors (this simple representation does not consider the
quality of labor).
In the short run, K can be considered exogenous, so K t = K t . Let us
define N t as the employment level that is reached when unemployment rate
is at a level ut consistent with internal balance, called the equilibrium rate of
unemployment. ut cannot be zero because, at each point in time, a fraction
of the labor force is looking for a job. Its level depends on the efficiency of
the country’s labor market institutions. So, if Lt is the labor force,
N t = (1 − ut ) Lt (B1.2.2)
Potential output can thus be defined as:

(
Yt = Ft K t , N t ) (B1.2.3)
19

Concepts     19

It is exogenous in the short term but endogenous in the long term as the
capital stock adjusts.
The output gap can thus be defined as the difference ogt between the
demand-​determined output Yt and the supply-​ determined potential
output Yt . It is generally measured as a percentage of the potential output:
Yt
og t = −1 (B1.2.4)
Yt
A negative output gap means that production is below potential,
implying nonequilibrium (or involuntary) unemployment. A positive
output gap means that production is above potential. This may look strange
if one thinks of the capital stock and the available labor force as a physical
constraint. However, there are ways to adjust to a higher level of demand.
For example, a standard response to excess demand is to have recourse to
overtime; or older equipment that was regarded as obsolete but had not
been discarded can also be used again; or less-​efficient producers, who were
hardly able to compete in normal conditions, may increase their supply.
However, such responses tend to be costly, implying a rise in the marginal
cost of production and therefore a rise in the aggregate price level.
The output gap is a simple notion, but it is hard to measure in practice
because the capital stock K t , the equilibrium rate of unemployment u t , and
the production function F are all unobservable (this is less true for the
capital stock that could be measured through surveys, but in practice it
is generally evaluated on the basis of past investments and assumptions
regarding the annual rate of discard of existing equipments). The various
available measures, such as those provided by international institutions
(such as the IMF, the OECD, and the European Commission) differ
significantly and are frequently revised. In addition, Coibion et al. (2017)
show that estimates of potential output are sensitive to the cycle and
respond not only to supply shocks but also to demand shocks that only
affect output transitorily. Because of these difficulties, potential output is
sometimes derived from actual output through purely statistical techniques
(by applying a filter to the actual series to estimate its trend). However,
this ignores the fact that potential output is an economic notion and that
its level depends on prices: for example, a higher price of energy reduces
potential output because it makes certain energy-​intensive production
techniques unprofitable.
The difficulty in measuring potential GDP can be illustrated through
comparing the United States and the euro area after the global financial
crisis. In the United States, the crisis seems to have lowered the level of
potential GDP, but not its growth rate (Figure B1.2.1a). In the euro area,
both the level and the growth rate seem to have declined (Figure B1.2.1b).
Back in 2009, though, it was difficult to anticipate such divergence.
20

20    
Economic Policy

Figure B1.2.1 Potential and actual gross domestic product (GDP), United States
and euro area, 2000–​2016, 2009 = 100.
The pre-​crisis trend is fitted between 1992 and 2007.
IMF, World Economic Outlook Database, April 2017, and authors’ own
calculations.
21

Concepts     21

This distinction between the three main functions is widely used in policy
discussions; it brings some analytical discipline and clarifies the aims of policy
decisions. The distinction is followed in this book, of which Chapters 4–​7 deal
primarily with stabilization, Chapters 8-​9 with allocation, and Chapter 8 also
with redistribution. As we shall see, however, there are many reasons why
these three functions frequently interfere with each other, making economic
policy choices less clear-​cut than in this simple presentation.

1.2.2 Why intervene?

For economists, public intervention requires justification. This is because the

first theorem of welfare economics establishes that any competitive equilibrium
is a Pareto optimum. In other words, it is not possible to improve the welfare of
an economic agent without reducing that of another one. The second theorem
of welfare economics states, conversely, that any Pareto optimal equilibrium
can be sustained by a competitive equilibrium, provided that the government
can implement initial lump-​sum transfers (meaning transfers which do not
depend on the wealth or income of their recipients).
These are both very powerful and very limited results. They are powerful
because if public intervention can improve the fate of some agents only by
deteriorating that of others, this immediately raises the question of the moral
basis and acceptability of such an intervention. They are, however, limited for
three reasons. First, the Pareto criterion does not say anything on the distri-
bution of income and wealth between economic agents. Yet it may be socially
desirable, for example, to reduce a wealthy individual’s income to improve
that of a poor one. Second, Kenneth Arrow and Gérard Debreu (1954) have
shown that the first theorem of welfare economics relies on a very demanding
set of hypotheses. A true competitive equilibrium requires, inter alia, strictly
competitive markets, the existence of a complete set of markets that allows the
carrying out of transactions on all goods at all periods, and perfect informa-
tion. Third, implementing lump-​sum transfers is politically challenging, and
they hardly ever exist in the real world (see Chapter 8). Challenge any one of
these assumptions, and there is justification for public intervention (box 1.3).
In fact, these welfare theorems, which were often interpreted as providing
the doctrinal basis of laissez-​faire, can just as well provide arguments for
public intervention (see Stiglitz, 1991, for a discussion). These arguments will
tend to be specific to the three functions of economic policy: allocation, sta-
bilization, and redistribution.

a) Allocation

State intervention is justified when it is able to remedy market failures (i.e.,

to improve the efficiency of resource allocation in comparison to the market
outcome). The most frequent reasons for such failures are the presence of
monopolies, externalities,12 information asymmetries between agents, market
2

22    
Economic Policy

Box 1.3 Microeconomic Arguments for Public Intervention

Public intervention has microeconomic justification when one of the

assumptions of the first theorem of welfare economics is violated.

Competition Is Not Perfect

Rationale. Profit maximization by a company implies equalizing the mar-

ginal cost (of producing an additional unit) and the marginal income
(from selling an additional unit). Under perfect competition, the marginal
income is the market price of the product, and profit maximization leads to
a social optimum. If a firm holds a monopoly position or, more generally,
has some market power,24 it has to consider the (less than infinite) elasticity
of demand for its product and the fact that its marginal income is less than
the market price. This is because selling an additional unit when demand is
elastic implies lowering the price of all previous units. In comparison with
the perfect competition outcome, this leads the firm to reduce quantities
sold and to increase the price, to the detriment of the consumer.
Public intervention can aim to restore perfect competition conditions
(for example, by blocking mergers leading to, or threatening to lead to,
excessive market power). However, it is not always desirable to eliminate
monopolies: when production involves high fixed costs or, in general, when
there are increasing returns to scale,25 larger firms or even monopolies are
more efficient than smaller firms. This is what is meant by natural monopoly.
For example, it is more efficient to have the railway network managed by
a single entity than by several, but this implies regulating its behavior or
subjecting it to potential competition (via granting it a fixed-​duration
contract only) in order to prevent it from exploiting its monopoly power.
Consequences. This argument provides the prime justification of antitrust
policy, whose aim is to prevent firms from acquiring a dominant position
or from abusing it. In the name of consumer protection, institutions in
charge of it, such as the Federal Trade Commission and the Department of
Justice in the United States, the Bundeskartellamt in Germany, or the
European Commission in the EU, can block mergers and acquisitions if
they threaten to create monopolies or fine companies that abuse a dominant
position in their market. For example, the European Commission (which is
in charge of this policy for cases with a cross-​border dimension) regularly
blocked merger operations (Olympic Air–​Aegean Airlines in 2011, Deutsche
Börse–​Euronext in 2012, UPS–​TNT and Ryan Air–​Air Lingus in 2013) that
were regarded as a potential threat to competition. It also levied fines on
companies whose behavior was regarded as obstructing competition. In
2004, Microsoft was fined €497 million for abusing its market power in
the EU. However, the argument also has wider applications: for example,
23

Concepts     23

it provides a justification for setting a minimum wage if employers locally

hold near-​monopoly positions as purchasers of unskilled labor (this is
called a monopsony).

Economic Activities Have External Effects

Rationale. In the presence of externalities, the private cost of a resource or

the private profit from production do not coincide with the social cost or
the social benefit. For example, a firm that consumes a natural resource
such as clean water or whose production technique spoils the environ-
ment does not usually take the corresponding social costs into account in
its profit maximization. It then tends to overconsume natural resources
and to overproduce. The reverse occurs when the externality is positive
(i.e., if production has favorable nonmarketable effects). For example, a re-
search and development–​intensive firm that establishes a facility in an area
tends to exert positive effects on other firms through the development of
local suppliers and subcontractors, the creation of a more liquid market for
skilled labor, and links with university departments. However, those pos-
itive externalities are not considered in the decision by the firm to open a
new facility, which leads to a suboptimal number of such facilities. It is also
the high negative externalities from a default of large financial institutions
that justify rescuing banks in a financial crisis. The risk is that a bank de-
fault would make other financial institutions insolvent, thereby triggering
a chain reaction.
Consequences. Environmental economics largely rests on this type of
argument, both about local pollution (water and air spoilage, waste, etc.)
and global pollution (greenhouse effect). The first-​best economic response
(not necessarily the most frequent one) generally consists in letting agents
“internalize” externalities by taxing the negative ones (this is the so-​
called polluter–​payer principle) and by subsidizing the positive ones (local
governments routinely subsidize investment from nonresident companies
or grant them tax exemptions). However, here again, the argument
is broader: a company which lays off its employees exerts a negative
externality on the community, which bears the cost of unemployment
insurance, and the one that hires creates a positive externality. This
justifies making a company’s contributions to unemployment insurance a
function of its hiring and firing behavior, as is the case in the United States.
Olivier Blanchard and Jean Tirole (2008) have proposed extending such
experience rating (or bonus-​malus system) to Europe. As for the risks of
letting a major financial institution default on its liabilities, the dramatic
consequences of the Lehman Brothers bankruptcy in 2008 and the rescue
24

24    
Economic Policy

of a series of other US and European banks in the following months

illustrate the importance of state intervention.

Information Is Imperfect

Rationale. The optimality of the competitive equilibrium rests on the as-

sumption of perfect information. If information has a strategic character
and if agents use it to their profit, the market outcome is no longer nec-
essarily Pareto-​optimum. The potency of this argument was recognized
with the awarding of the 2001 Nobel Prize to George Akerlof and Joseph
Stiglitz who contributed to the development of the economics of imperfect
information. Stiglitz and Weiss (1981), for example, showed that when the
creditor (say, a bank) has less information than the debtor (say, a company)
on the risk incurred in lending, it cannot accurately price the risk in set-
ting the interest rate on the loan. It may then select a price that is too high
for good borrowers and will only attract the riskiest ones. To prevent this
phenomenon, known as adverse selection,26 it is optimum for the creditor
to ration credit, which is socially inefficient (see Chapter 5).
Consequences. Imperfect information is pervasive and it also affects
policymakers, who rarely enjoy an undisputed informational advantage.
The limits this creates for government intervention are discussed in
Chapter 2. Public policy can foster the dissemination of market-​relevant
information, either in the form of aggregate statistics or through
standardizing the disclosure of company-​specific information. Accounting
and financial reporting standards, for example, are intended to ensure
that financial markets benefit from comparable, undistorted information.
Governments can also provide public insurance (such as for labor or for
health) as a way to overcome adverse selection.

Markets Are Incomplete

Rationale. The optimality of the competitive market equilibrium hinges

on the existence of markets for all necessary transactions at all rele-
vant horizons. When such markets are missing, Pareto-​optimality is not
guaranteed. For example, borrowing to finance one’s education is made
difficult by the absence of collateral on which the loan can be guaranteed
and by the fact that the choice of a professional specialization is hardly
reversible. The near-​absence of a market for young people to borrow to
finance investment in their own human capital tends to limit access to
higher education. In the absence of public intervention, private investment
in human capital is therefore suboptimal, which harms growth.
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CHAPTER XXVII.

Confectionary.

Citron.
 TO CLARIFY SUGAR.

It is an economy to use at once the very best sugar for confectionary

in general, for when highly refined it needs little or no clarifying, even
for the most delicate purposes; and the coarser kinds lose
considerable weight in the process. Break it into large lumps, and put
it into a very clean preserving-pan; measure for each pound a pint of
spring water if it be intended for syrup, but less than half that quantity
for candying or making barley-sugar. Beat first apart (but not to a
strong froth), and afterwards with the water, about half the white of
an egg for six pounds of sugar, unless it should be very common,
when twice as much may be used. When they are well mixed pour
them over the sugar, and let it stand until it is nearly dissolved; then
stir the whole thoroughly, and place it over a gentle fire, but do not
disturb it after the scum begins to gather on the top; let it boil for five
minutes, then take the pan from the fire, and when it has stood a
couple of minutes clear off the scum entirely, with a skimmer; set the
pan again over the fire, and when the sugar begins to boil throw in a
little cold water, which has been reserved for the purpose from the
quantity first measured, and repeat the skimming until the syrup is
very clear; it may then be strained through a muslin, or a thin cloth,
and put into a clean pan for further boiling.
For syrup: sugar, 6 lbs.; water, 3 quarts; 1/2 white of 1 egg. For
candying, &c.: sugar, 6 lbs.; water, 2-1/2 pints: 5 to 10 minutes.
 TO BOIL SUGAR FROM SYRUP TO CANDY, OR TO CARAMEL.

The technicalities by which confectioners distinguish the different

degrees of sugar-boiling, seem to us calculated rather to puzzle than
to assist the reader; and we shall, therefore, confine ourselves to
such plain English terms as may suffice, we hope, to explain them.
After having boiled a certain time, the length of which will in a
measure depend upon the quality of the sugar as well as on the
quantity of water added, it becomes a thin syrup, and will scarcely
form a short thread if a drop be pressed between the thumb and
finger and they are then drawn apart; from five to ten minutes more
of rapid boiling will bring it to a thick syrup, and when this degree is
reached the thread may be drawn from one hand to the other at
some length without breaking; but its appearance in dropping from
the skimmer will perhaps best denote its being at this point, as it
hangs in a sort of string as it falls. After this the sugar will soon begin
to whiten, and to form large bubbles in the pan, when, if it be
intended for barley-sugar, or caramel, some lemon-juice or other
acid must be added to it, to prevent its graining or becoming sugar
again; but if wanted to candy, it must be stirred without ceasing until
it rises almost to the top of the pan, in one large white mass, when it
must be used immediately or laded out into paper cases or on to
dishes, with the utmost expedition, as it passes in an instant almost,
from this state to one in which it forms a sort of powder, which will
render it necessary to add water, to stir it until dissolved, and to
reboil it to the proper point. For barley-sugar likewise it must be
constantly stirred, and carefully watched after the lemon-juice is
added. A small quantity should be dropped from time to time into a
large basin of cold water by those who are inexperienced in the
process; when in falling into this it makes a bubbling noise, and if
taken out immediately after, it snaps clean between the teeth without
sticking to them, it must be poured out instantly: if wanted for sugar-
spinning, the pan must be plunged as quickly as possible into a
vessel of cold water.
 CARAMEL.

(The quickest way.)

Put into a brass skillet, or preserving-pan, some sifted sugar of the
finest quality, and stir it softly with a wooden spoon or spatula, over a
very gentle fire until it has become liquid; a pale or a deep tint may
then be given to it, according to the purpose for which it is required:
so soon as it is entirely melted, and looks clear, it is ready for use.
Pastry-cooks glaze small pastry by just dipping the surface into it;
and they use it also for nougat, and other confectionary, though it is
not in general quite so brilliant as that which is made by the
preceding receipt. When the sugar first begins to melt, it should be
stirred only just in that part, or it will not be equally coloured.
 BARLEY-SUGAR.

Add to three pounds of highly-refined sugar one pint and a quarter

of spring water, with sufficient white of egg to clarify it in the manner
directed in the last page but one; pour to it, when it begins to whiten,
and to be very thick, a dessertspoonful of the strained juice of a fresh
lemon; and boil it quickly until it is at the point which we have
indicated above. A few drops of essence of lemon may be added to
it, just as it is taken from the fire. Pour it on to a marble slab, or on to
a shallow dish which has been slightly oiled, or rubbed with a particle
of fresh butter; and when it begins to harden at the edges form it into
sticks, lozenges, balls, or any other shapes at pleasure. While it is
still liquid it may be used for various purposes, such as Chantilly
baskets, palace bonbons, croquantes,[176] cerises au caramel, &c.:
for these the vessel containing it must be set into a pan of water, and
it must again be liquefied with a very gentle degree of heat should it
cool too quickly. As it soon dissolves if exposed to damp, it should be
put into very dry canisters as soon as it is cold, and these should be
kept in a dry place.
176. These are formed of small cakes, roasted chestnuts, and various other
things, just dipped singly into the barley-sugar, and then arranged in good
form and joined in a mould, from which they are turned out for table.

Best sugar, 3 lbs.; water, 1-1/4 pint; white of egg, 1/4 of 1; lemon-
juice, 1 dessertspoonful.
 NOUGAT.

This is a preparation of barley-sugar, and almonds, filberts, or

pistachio-nuts, of which good confectioners, both foreign and
English, make a great variety of highly ornamental dishes. We must,
however, confine our directions to the most common and simple
mode of serving it. Blanch twelve ounces of fine Jordan almonds in
the usual way, wipe them very dry, split them in halves, and spread
them upon tins or dishes; dry them in a very gentle oven, without
allowing them to brown; or if the flavour be liked better so, let them
be equally coloured to a pale gold tint: they should then be often
turned while in the oven. Boil to barley sugar in a small preserving-
pan six ounces of highly-refined sugar, throw in the almonds, mix
them with it well without breaking them, turn the nougat on to a dish
slightly rubbed with oil, spread it out quickly, mark it into squares,
and cut it before it is cold; or pour it into a mould, and with an oiled
lemon spread it quickly, and very thin over it, and turn it out when
cool. It must at all times be carefully preserved from damp; and
should be put into a dry tin box as soon as it is cold.
Sugar, 6 oz.; almonds, 12 oz.
Another and more expeditious way of making it, is to boil the sugar
to caramel without any water, as directed at page 563: the proportion
of almonds can be diminished at pleasure, but the nougat should
always be well filled with them.
 GINGER CANDY.

Break a pound of highly-refined sugar into lumps, put it into a

preserving-pan, and pour over it about the third of a pint of spring
water; let it stand until the sugar is nearly dissolved, then set it over a
perfectly clear fire, and boil it until it becomes a thin syrup. Have
ready in a large cup a teaspoonful of the very best ginger in powder;
mix it smoothly and gradually with two or three spoonsful of the
syrup, and then stir it well into the whole. Watch the mixture carefully,
keep it stirred, and drop it often from a spoon to ascertain the exact
point of boiling it has reached. When it begins to fall in flakes, throw
in the freshly-grated rind of a very large lemon, or of two small ones,
and work the sugar round quickly as it is added. The candy must
now be stirred constantly until it is done: this will be when it falls in a
mass from the spoon, and does not sink when placed in a small
heap on a dish. It must be poured, or laded out, as expeditiously as
possible when ready, or it will fall quite into powder. If this should
happen, a little water must be added to it, and it must be reboiled to
the proper point. The candy, if dropped in cakes upon sheets of very
dry foolscap or other thick writing-paper laid upon cold dishes, may
be moved off without difficulty while it is still just warm, but it must not
be touched while quite hot, or it will break.
Sugar, highly refined, 1 lb.; water, 1/3 of a pint; ginger, 1
teaspoonful; rind of 1 large lemon.
 ORANGE-FLOWER CANDY.

Beat in three-quarters of a pint, or rather more, of water, about the

fourth part of the white of an egg, and pour it on two pounds of the
best sugar broken into lumps. When it has stood a little time, place it
over a very clear fire, and let it boil for a few minutes, then set it on
one side, until the scum has subsided; clear it off, and boil the sugar
until it is very thick, then strew in by degrees three ounces of the
petals of the orange-blossom, weighed after they are picked from
their stems. Continue to stir the candy until it rises in one white mass
in the pan, then lay it, as quickly as it can be done, in cakes with a
large spoon, upon thick and very dry sheets of writing paper placed
quite flat upon the backs of dishes, or upon trays.[177] Take it off
before it is entirely cold, and lay the candy reversed upon dishes, or
place the cakes on their edges round the rim of one until they are
perfectly cold; then secure them from the air without delay in close
shutting tin boxes or canisters. They will remain excellent for more
than a year. The orange-flowers will turn brown if thrown too soon
into the syrup: it should be more than three parts boiled when they
are added. They must be gathered on the day they are wanted for
use, as they will soon become discoloured from keeping.
177. As the heat of the boiling sugar would injure these, no good ones should be
used for the purpose.

Sugar, 2 lbs.; water, 3/4 pint; 1/4 white of egg; orange-blossoms, 3

oz.
Obs.—When sugar of the finest quality is used for this confection,
as it ought to be, it will not require the white of egg to clarify it.
 ORANGE-FLOWER CANDY.

(Another Receipt.)

The French, who are very fond of the delicious flavour of the
orange-blossom, leave the petals in the candy; but a more delicate
confection, to English taste, is made as follows:—Throw the orange-
flowers into the syrup when it has boiled about ten minutes, and after
they have simmered in it for five more, pour the whole out, and leave
them to infuse until the following day, or even longer, if more
convenient; then bring the syrup to the point of boiling, strain it from
the blossoms through a muslin, and finish it by the foregoing receipt.
 COCOA-NUT CANDY.

Rasp very fine a sound fresh cocoa-nut, spread it on a dish, and

let it dry naturally for two or three days, as it will not bear the heat of
an oven, and is too oily for use when freshly broken. Four ounces of
it will be sufficient for a pound of sugar for most tastes, but more can
be used at pleasure. Boil the sugar as for the orange-flower candy,
and when it begins to be very thick and white, strew in the nut, stir
and mix it well, and do not quit it for an instant until it is finished. The
pan should not be placed upon the fire but over it, as the nut is liable
to burn with too fierce a heat.
For almond-candy proceed in exactly the same way, but let the
almonds, either whole or split, be perfectly well dried in a gentle
oven, and do not throw them into the sugar until it approaches the
candying point.
 PALACE-BONBONS.

Take some fine fresh candied orange-rind, or citron, clear off the
sugar which adheres to it, cut it into inch-squares, stick these singly
on the prong of a silver fork or on osier-twigs, dip them into liquid
barley-sugar, and place them on a dish rubbed with the smallest
possible quantity of very pure salad oil. When cold, put them into tin
boxes or canisters well dried, with paper, which should also be very
dry, between each layer.
 EVERTON TOFFIE.

No. 1.—Put into a brass skillet or small preserving-pan three

ounces of very fresh butter, and as soon as it is just melted add a
pound of brown sugar of moderate quality; keep these stirred gently
over a very clear fire for about fifteen minutes, or until a little of the
mixture, dropped into a basin of cold water, breaks clean between
the teeth without sticking to them: when it is boiled to this point, it
must be poured out immediately, or it will burn. The grated rind of a
lemon, added when the toffie is half done, improves it much; or a
small teaspoonful of powdered ginger moistened with a little of the
other ingredients as soon as the sugar is dissolved and then stirred
to the whole, will vary it pleasantly to many tastes. The real Everton
toffie is made with a much larger proportion of butter, but it is the less
wholesome on that very account. If dropped upon dishes first rubbed
with a buttered paper, the toffie when cold can be raised from them
easily.
Butter, 3 oz.; sugar, 1 lb.: 15 to 18 minutes. Or, sugar, 1 lb.; butter,
5 oz.; almonds, 2 oz.: 20 to 30 minutes.
No. 2.—Boil together a pound of sugar and five ounces of butter
for twenty minutes; then stir in two ounces of almonds blanched,
divided, and thoroughly dried in a slow oven, or before the fire. Let
the toffie boil after they are added, till it crackles when dropped into
cold water, and snaps between the teeth without sticking.
Sugar, 1 lb.; butter, 5 oz.; almonds, 2 oz.: 20 to 30 minutes.
 CHOCOLATE DROPS.

Throw into a well heated metal mortar from two to four ounces of
the best quality of cake-chocolate broken small, and pound it with a
warm pestle until it resembles a smooth paste or very thick batter;
then add an equal weight of sugar in the finest powder, and beat
them until they are thoroughly blended. Roll the mixture into small
balls, lay them upon sheets of writing paper or upon clean dishes,
and take them off when they are nearly cold. The tops may be
covered with white nonpareil comfits, or the drops may be shaken in
a paper containing some of these, and entirely encrusted with them;
but it must be recollected that they will not adhere to them after they
become hard. More or less sugar can be worked into the chocolate
according to the taste; and a Wedgwood mortar may be used for it
when no other is at hand, but one of bell-metal will answer the
purpose better.
 CHOCOLATE ALMONDS.

When the chocolate has been softened, and mixed with an equal
proportion of sugar, as directed in the foregoing receipt, enclose
singly in small portions of it some almonds previously well dried, or
even slightly coloured in the oven, after having been blanched. Roll
them very smooth in the hand, and cover them with the comfits, or
form them like the almond shamrocks of page 574. Filberts and
pistachio-nuts may be substituted for the almonds with good effect;
but they also must be perfectly dry.
 SEVILLE ORANGE PASTE.

Wipe, and pare in the thinnest possible strips, some Seville

orange-rinds, and throw them into plenty of boiling water. When they
are extremely tender, lift them on to a large sieve reversed to drain;
press the water from them a little, and before they are quite cold,
pound them to the smoothest paste, and blend thoroughly with them
as much fine sifted sugar as can possibly be mixed with them. Roll
the mass out extremely thin, and with a very small tin-cutter form it
into cakes or leaves, or any other shapes, and then dry it in a VERY
gentle oven. Store it in close-shutting boxes as soon as it is cold. A
little choice prepared ginger may be added to it in the pounding
when it is liked.
Paste of lemon or citron-rind may be made in the same way.
CHAPTER XXVIII.

Dessert Dishes.
 DESSERT DISHES.

A well-selected and well-arranged rice-crust, however simple in its

character, may always be rendered agreeable to the eye and to the
taste: but in no department of the table can so much that is attractive
to both be more readily combined; and at the present day an unusual
degree of luxury is often displayed in it, the details of which,
however, would be out of place here. Forced strawberries of
magnificent size, and of the best varieties, brought by culture and
management all to perfection on the same day, and served on their
plants, in the pots in which they are grown, concealed in others of
porcelain or of chased silver, are amongst the expensive novelties
now commonly introduced at costly dinners of display, and may
serve as an illustration of it.[178]
178. To these may be added miniature fruit trees in full bearing placed down the
centre of the table, and intermingled with the choicest exotics.

For common occasions, a few dishes of really fresh fruit tastefully

disposed and embedded in large green leaves, will be all that is
required for a plain summer or autumn rice-crust; and at other parts
of the year such as are appropriate to the season; but from the
immense variety of cakes, biscuits, confections, ices, bonbons, and
other sucreries (some of them extremely brilliant in appearance), and
of fruit native and foreign, fresh, dried, and preserved in every
possible manner which are adapted to them, desserts may be
served in any kind of style.
 PEARLED FRUIT, OR FRUIT EN CHEMISE.

Select for this dish very fine bunches of red and white currants,
large ripe cherries, and gooseberries of different colours, and
strawberries or raspberries very freshly gathered. Beat up the white
of an egg with about half as much cold water, dip the fruit into this
mixture, drain it on a sieve for an instant, and then roll it in fine sifted
sugar until it is covered in every part; give it a gentle shake, and lay it
on sheets of white paper to dry. In England, thin gum-water is
sometimes used, we believe, for this dish, instead of the white of
egg; we give, however, the French method of preparing it. It will dry
gradually in a warm room, or a sunny window, in the course of three
or four hours.
Obs.—This is an inexpensive dish, which if well prepared has the
appearance of fine confectionary. The incrustation of sugar much
increases too the apparent size of the fruit. That which is used for it
should be of the best quality, and fine and dry. When it becomes
moist from the fruit being rolled in it, it will no longer adhere to it as it
ought.