Monday, May 13, 2013

Coup d'etat and economists

If I found myself in charge of a new country after a coup d'etat, and was limited to a single economist to help me build the new country, I wouldn't want some Nobel Prize winner—not even someone like Paul Krugman. The reason is that those who win such a prize are brilliant in certain ways, but that doesn't necessarily mean much when it comes to practical economics. After all, one only needs a single great idea (and often not even that) to get a Nobel. As we've seen with any number of brilliant Chicago School economists: when it comes to the actual economy that all of us struggle with each day, they are usually driven much more by their ideological preferences rather than what the profession generally has to teach about the economy.

Take for example the idea of Ricardian equivalence. This is an idea from David Ricardo, an economist 
who followed closely on the heels of Adam Smith. The idea is that there is a limit to government stimulus.[1] If the government decides to spend beyond its income, the taxpayers will assume that this means that future taxes will have to be raised to pay off the spending. As a result of this, the taxpayers will reduce their spending to provide for the taxes that they know are coming. There is one obvious problem with this theory: people aren't nearly as rational as economists always assume. And there are other problems. But if we assume that the model is completely accurate, it still doesn't prove that stimulus doesn't work.

An example will help. Let's assume the government provides stimulus over 2 years that they will pay off by issuing 30 year bonds. The taxpayers will not set aside all the money to pay their taxes in that 2 years. They put aside a much smaller amount for the 30 years over which the bonds will mature. Thus, a big government stimulus will not be offset by a huge reduction in spending by the private sector. And this is the case even if Ricardian equivalence is right, which is far from certain.

I bring this up, because lots of distinguished economists argued that the 2009 stimulus bill (ARRA) couldn't help the economy because of Ricardian equivalence. They weren't talking long term, here. Instead, they just didn't understand a basic economic fact. They were lost in the mythical fairy land were theory is reality. Economics as a whole is prone to this mistake, but conservatives are especially prone to it. I've been thinking about this since Dean Baker wrote yesterday, "As a general rule economists are not very good at economics."

A lot of people wonder why Baker has never been given a Nobel Prize. After all, he is consistently right about pretty much everything. Check out this Birthday Boasts article last year about a lot (but certainly not all) of the things he's been right about that most of his fellow economists have been wrong about. But really: they don't give out Nobel Prizes for that kind of thing. Instead, they give out such prizes to focused work on something (usually) very small. Although I may find people like Paul Krugman and Joseph Stiglitz very useful in understanding economic policy, it isn't because of their Nobel Prize winning work.[2]

Baker's article is about how the world should never have taken Reinhart-Rogoff 90% debit cliff seriously in the first place. As I noted last month:

The second reason I didn't accept this paper comes from an idea that Dean Baker has been drilling into my brain the last few years: debt-to-GDP ratios are meaningless. What matters is the interest burden of the debt. A government will have no more difficulty managing a 50% debt-to-GDP ratio at 4% than it will a 100% dbt-to-GDP ratio at 2%. Or let me personalize it: would owing $2,000 on a credit card really matter if the bank only charged you $5 per year in interest?

When put this way, economics starts to sound like a very simple science that requires little more than common sense. Indeed, that's how Baker noticed the housing bubble years before it exploded: house prices had always stayed pretty much flat when adjusted for inflation. Then, in 1995, they started going way up. There was no reason to believe that there was a real reason for houses to be worth more. So Baker's conclusion: it was a bubble.

When I have my Augusto Pinochet moment of being able to rebuild a country after a coup, I will not reach out to a brilliant, but ideologically blinded Nobel Prize winning economist like Milton Friedman. Nor will I consult with much more clear-sighted Nobel laureates like Krugman and Stiglitz (although they would both make excellent seconds). Instead, I would pick Dean Baker because I think he sees the world as it is rather than as it ought to be. Of course, it matters that he is a liberal and thus cares about the effects policies have on people. But in an economic adviser, the first thing you want is someone who can see the world clearly. And on the right especially, we get ideology before reality or people. Now all I have to do is find a good coup d'etat opportunity.

[1] Actually, this is more how it seems to be used today by conservatives, especially following Robert J. Barro's work. The original idea is more general: taxes and debt are the same because the people know they will have to pay for it one way or another. Apparently, Ricardo himself didn't believe that such an equivalence existed. This gets to the heart of something that is wrong with science generally: ideas are often celebrated more because they are interesting than that they are right.

[2] I am not, however, saying that their research is irrelevant. Krugman's work on liquidity traps and Japan have been really helpful in analyzing what we are currently going through. But that isn't the work he got the Nobel for. Stiglitz's work was on asymmetric information in economic models. That does not have a direct relationship to our economy. It does, however, show how screwed up economics as a science has been. The idea that information asymmetries would not be fundamental to the science demonstrates how lost in theory land it has always been.

(Cross-posted at Frankly Curious.)


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