Monday, June 13, 2011

Economists Need to Be Better Economists; The Social Science of Economics is Failing

Economics is Driven by Policy Research and Issues to Fight the Great Depression of 1929-1941, not the Great Recession of 2008- ?.

[Disclosure Alert:  Serious, possibly boring subject matter follows]

If early 2008 counts as the beginning of the severe downturn in the U.S. economy, then the U.S. is now entering its fourth consecutive year of subpar economic performance, with the expectation that slower rather than faster economic activity lies ahead.

The economics profession is now in its 8th decade since the foundation of modern macro-economic theory and policy was developed by John Maynard Keynes.  Given those nearly 8 decades and the immense amount of resources that have gone into the economics profession and the immense amount of research and study that has taken place and that we have no better economy than what we have in June 2011, The Dismal Political Economist can only conclude that as a driver of appropriate economic policy, the economics profession has failed.

The reason for this is that Economics has failed to break out of a rigid structure for proposing and analyzing policy that would have been appropriate in 1933 but useless for 2011.  Here are the specifics of how the study of economics that has failed America and is continuing to fail.

  1. The Definition of Recession is Too Narrow.  Although they deny it, the NBER (for some reason given the status as the arbiter of defining a recession) is credited with defining a recession as two consecutive quarters of negative economic growth.  Consequently, in the economics profession the recession ended in June, 2009.  This is patently ridiculous.

A recession should be defined in terms of unemployment, the most critical variable on any economic structure.  A recession should be defined as lasting as long as the unemployment rate is above the full employment rate plus a modest cushion (for statistical error)  for a six month period.  We would propose a cushion of 25%. So if the full employment unemployment rate were 4.8%, a recession would be described as any six month period in which the unemployment rate exceeded 4.8% + 25% of 4.8% or 6.0%. 

This is not just playing with words.  Defining a recession in this manner would cause government and politicians to focus much more closely on the economy in general and the unemployment rate in particular.  Policy is driven by perception.  If the economy is perceived to be in a recession policy will be driven to end that recession.  In the 2012 election Democrats will try to convince voters that the economy has largely recovered.  Republicans will try to convince them that it has not.  Neither side will argue for what policy is needed to go forward.  If both sides were forced to acknowledge that the U. S. was still in recession the debate would shift more towards policy, where the debate should be.

  1. Monetary Policy is Asymmetric.  Economists, like everyone else, like a nice neat world.  It is accepted that restrictive monetary policy is a highly effectively tool in slowing down an economy.  Reducing the supply of money, the availability of credit and raising interest rates will cause a reduction in economic activity.  Therefore Economists desperately want the opposite to be true, that increasing the supply of money, increasing the availability of credit and lowering interest rates will stimulate an economy.

Unfortunately social structure does not always conform to the neat picture that economists want. Economics and economists need to recognize that monetary policy is very limited in stimulating an economy.  Actually Economists learned this in the 1930’s, so they only need to re-learn what they once knew.  This will stop once and for all expectations that Quantitative Easing will bring the economy out of the recession (as it would now be defined).

  1. All Government Spending is Not Equal in Stimulating the Economy.  Macro economic theory preaches that increasing government spending expands the economy, and stops there.  It needs to recognize that certain types of spending are more stimulating than other types, and to direct government policy makers to the type of spending that is most stimulating.   

For example, building jet engines that the Defense Department neither wants nor needs will create jobs and boost income. Investing the same amount of money in infrastructure, or research into carbon alternative forms of energy will create jobs and boost income.  But it will do much more.  It will increase the productivity and efficiency of the economy, and thus create more growth and employment than the expenditures on jet engines.  Economists need to communicate this concept of “maximum stimulating spending” to policy makers, after, hopefully, they themselves grasp the concept.

  1. The current goals of economic policy are in direct conflict with one another.  The Economist Magazine in its lead story says this.

the two big problems facing America’s economy: how to get more people back to work, and how to fix the deficit

Everyone agrees with that statement.  But the ugly truth is that these two policy goals are in direct opposition to each other.  Policy to reduce unemployment will increase the deficit.  Policy to reduce the deficit will cause unemployment to be higher than it otherwise would be.  The economics profession must confront Americans with that fact and America must choose which goal it wants to achieve.  The economics profession must also tell Americans two other substantial but painful truths.

A.     Attempts to obtain both goals at the same time will lead to obtaining neither goal.

B.     The idea that reducing the deficit will cause some type of ”confidence fairy” to descend upon the business community, which will then commence massive hiring is pure fiction.  Those economists who want to reduce spending, like the 150 who signed a letter in support of massive reductions in spending in return for raising the debt ceiling need to say they support that position on personal political grounds, not on the basis that such policy will increase employment.

  1. The cost of medical care is going to rise, and both seniors and taxpayers will be paying more for senior health care in the future.  It is a simple fact.  When you consume more of a good or service, the total amount of spending on that good or service increases.  This, not the proposal to raise the enrollment age in Medicare, was the major substantive contribution by Sen. Lieberman in his proposal for fiscal changes relating to Medicare.  Going forward a major role for Economics is to find a way to make the cost increases as small as possible, because it has not done so in the past.

  1. A modern economy can only function when there is a government providing various goods and services in an efficient manner, and when there is effective regulation.  Economic theory that tries to conclude otherwise is invalid and will harm the economy.  Economics has failed to develop the policy structure and framework in which government can operate in an efficient and effective manner, and so the anti-government forces are winning the battle. 

  1. Increased Risk damages an economy.  Risk is produced by uncertainty.  Economics has failed to show the country that the uncertainty regarding tax policy has been damaging to the economy, maybe as much as the lower taxes and the deficit they created.  Successful tax policy can involve high taxes or low taxes, but tax policy must be set and fixed in order for business to assess the business environment and make good investment decisions.  Economics has failed to develop a concept of optimal tax policy or to convey the message that policy where taxes have to be renewed or allowed to expire creates uncertainty which leads to lower investment.

  1. High Taxes Do Not Per Se Prevent Strong Economic Activity.  The anti-tax, anti-government Conservatives have thrust this concept on an America that in inherently given to be opposed to government.  Economics needs to say that this position, while comfortable, is wrong.  If it were correct,  high tax Germany would not be the strongest economy in Europe.

  1. The U. S. can learn from successes in other countries.  Other national post offices are succeeding while the U. S. Postal Service is failing.  Germany is demonstrating the co-operative efforts between Government, Business and Labor can produce highly efficient industries that compete in world markets despite high wages and benefits and high national taxes.  Political philosophy which says that this is not so is wrong, and the Economics profession has failed to develop the methods to show how it can work in the U. S.

  1. An Aging Population Means Lower Growth.  The ability of the economy and its participants to grow and prosper depends upon employment and productivity of labor and capital. As the U. S. economy ages, a larger percentage of its population will be consuming without producing.  This means lower growth.  The Economics profession needs to address this issue, develop policy to minimize the negative impact of aging and prepare the population for this unfortunate fact.

Economists are highly educated very intelligent men and women.  Someone needs to tell them it is no longer 1933.  Hopefully, The Dismal Political Economist just did.


  1. Nice blog, I'm glad I found it. I'm not an economist. I am an American game developer living in India. I've studied and followed economics since the late 80s and I've noticed some troubling aspects of economics and I think you've done a good job pointing out many of them. But, I would add a few items to your list.

    Regarding Monetary policy I agree to a point. Monetary policy can work, but it's aimed at a group that neither wants nor needs to borrow. Dr. Krugman constantly says we are at the zero lower bound. Homeowners are nowhere close and that's the group holding up demand. Macro economics seems to think the economy is a black box with gross inputs rather than a white box with multiple inputs that do very different things. Yes, eventually all the money settles down. It settles right into the pockets of the wealthy and the big banks. How much velocity will you get if you put the ball at the bottom of the hill?

    Economists make no effort to explain how the world works, and that cuts both ways. Many authors write books and columns waxing poetic about what could be done or should be done or what the models say, but only the hard line Heyak is a leftist pinko economists write about the nuts and bolts of how everything works and this distorts economic understanding. Margret Thatcher read the road to serfdom. What if Keynes was that easy to read? What would the 80s have looked like? What if there was a counter to Atlas Shrugged?

    But it's not just for our benefit. Economists need to get out in the real world, intellectually. If consumers are rational then advertising is a waste and no company would pay for it, but reallity says different. All commodities have the same price. Not true. Here in Lucknow food is vastly cheaper than in the US. So why don't they sell the rice in the US? Because the infrastructure is so bad it would cost too much to ship it to the US. So recognizing reality gives economic backing to improved infrastructure.

    Economics has no vision for the future. What will be the new means of exchange? On the internet there are bitcoins and there are reputation points. Both are doing very well. How does that impact economics. The marginal analysis of electronic media says the price should be near zero. Piracy is the market taking matters into its own hands. How does economics explain $20 for something that should be near free? The answer is always, “but the cost to make the movie.” But we never say but the cost to make the socks. We ship to China to get costs down.

    Thanks for the interesting blog.

  2. "But it will do much more. It will increase the productivity and efficiency of the economy, and thus create more growth and employment"

    Wrong, wrong wrong! Increasing productivity and efficiency decrease employment when no new products are introduced.

    11. The Ability for Society to Produce Has Outstripped its Ability to Consume. Economics has failed to explain why people earn more money than they are willing to spend. Markets are distorted by oversupply of labour and underconsumption of goods, which has lead to banks and companies collecting trillions of dollars in cash because shareholders gain more utility from possessing money than they do from spending it. Economics has failed to recognize valid solutions to the unemployment problem:

    "If consumers are rational then advertising is a waste and no company would pay for it"
    Consumers are rational, they just have access to limited information, both about products and about other people in society. In the current economy, the inefficiency that results from advertising is just one more way of keeping people employed, for those who view that as the goal of an economy.

    If rice was cheaper, would the wealthy spend more of their income than they do now? And FYI, rice in the US is currently about four times the price of rice on the international market, the same being true in other countries such as Japan as a way to keep local producers somewhat profitable and avoid foreign dependence in food. See for example, less than 1% of the expenditures of the bottom quintile of the US go toward "Cereals and cereal products", $93 out of $20,410 compared to $212 out of $94,150 for the highest quintile for households.