Do Economists know what they are talking about?

June 29, 2010

Do Economists know what they are talking about, asks Robert Samuelson of Newsweek (June 28, 2010)

“..the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.
—John Maynard Keynes (1883-1946), The General Theory of Employment, Interest and Money (New York: Harcourt, Brace & World, 1936)

Almost everyone wants the world’s governments to do more to revive ailing economies. No one wants a “double dip” recession. The Group of 20 Summit in Toronto was determined to avoid one. In major advanced countries—the 31 members of the Organization for Economic Cooperation and Development—unemployment stands at 46.5 million people, up about 50 percent since 2007. It’s not just that people lack work. Lengthy unemployment may erode skills, leading to downward mobility or permanent joblessness. But what more can governments do? It’s unclear.

We may be reaching the limits of economics. As Keynes noted, political leaders are hostage to the ideas of economists—living and dead—and economists increasingly disagree about what to do.

Granted, the initial response to the crisis (sharp cuts in interest rates, bank bailouts, stimulus spending) probably averted a depression. But the crisis has also battered the logic of all major theories: Keynesianism, monetarism and “rational expectations.” Economics has become the shaky science; its intellectual chaos provides context for today’s policy disputes at home and abroad.

Consider the matter of budgets. Would bigger deficits stimulate the economy and create jobs, as standard Keynesianism suggests? Or do exploding government debts threaten another financial crisis?

The Keynesian logic seems airtight. If consumer and business spending is weak, government raises demand through tax cuts or spending increases. But in practice, governments’ high debts impose financial and psychological limits. The ratio of government debt to the economy (gross domestic product) is 92 percent for France, 82 percent for Germany and 83 percent for Britain, reports the Bank for International Settlements in Switzerland.

This means that the benefits of higher deficits can be lost in many ways: through higher interest rates if greater debt frightens investors; through declines in private spending if consumers and businesses lose confidence in governments’ ability to control budgets; and through a banking crisis if bank capital—which consists heavily of government bonds—declines in value. There’s a tug of war between the stimulus of bigger deficits and the fears inspired by bigger deficits.

Based on favorable assumptions, the Obama Administration says its $787 billion “stimulus” program created or saved up to 2.8 million jobs. This might be. Lenders haven’t lost confidence in U.S. Treasury bonds. Interest rates on 10-year Treasurys are just over 3 percent. But in Europe, financial limits have bitten. Greece’s huge debt (debt-to-GDP ratio: 123 percent) resulted in a steep rise of interest rates. Germany and Britain are debating plans to cut their deficits to avoid Greece’s fate.

That’s lunacy, writes Martin Wolf, chief economic commentator for the Financial Times. Concerted austerity may destroy the recovery. Exactly, echoes Nobel Prize-winning economist and New York Times columnist Paul Krugman, who argues that the U.S. economy needs more stimulus and bigger deficits. “Penny-pinching at a time like this . . .,” he writes, “endangers the nation’s future.”

Not so, counters Harvard economist Ken Rogoff. President Obama’s stimulus package may have “helped calm the panic” in 2009, but boosting spending now—with federal deficits exceeding $1 trillion—raises “the risk of having a debt crisis down the road.” Deficits should be gradually trimmed, he argues.

Indeed, some economists believe that budget cutbacks can stimulate economic growth under some circumstances. A study by economists Alberto Alesina and Silvia Ardagna found that budget cutbacks in wealthy countries often had an expansionary effect when spending reductions, not tax increases, were emphasized. Presumably, these budget plans favorably influenced interest rates and confidence without weakening the incentives to work and invest.

Like textbook Keynesianism, “monetarism” has also suffered in its explanatory power. This theory holds that big injections of money (“reserves”) into the banking system by the Federal Reserve should lead to higher lending, higher spending and—if large enough—inflation. Well, since the summer of 2008, the Fed has provided about $1 trillion of reserves to banks, and none of these things has happened. Inflation remains tame, and outstanding bank loans have dropped more than $200 billion in the past year. Banks are sitting on massive excess reserves.

There’s a great deal economists don’t understand. Not surprisingly, the adherents of “rational expectations”—a theory that people generally figure out how best to respond to economic events—didn’t anticipate financial panic and economic collapse. The disconnect between theory and reality seems ominous. The response to the initial crisis was to throw money at it—to lower interest rates and expand budget deficits. But with interest rates now low and deficits high, what happens if there’s another crisis?

Robert Samuelson is also the author of The Great Inflation and Its Aftermath: The Past and Future of American Affluence and Untruth: Why the Conventional Wisdom Is (Almost Always) Wrong.

22 thoughts on “Do Economists know what they are talking about?

  1. Good housekeeping is good economics. If we live within our means and deploy our resources to achieve economic and social returns (efficiency with equity), perhaps we can avoid getting into a global mess. Economic sophistication to what end? Go back to commonsense and self discipline.–Din Merican

  2. If only economists and weathermen could swap jobs…..then lawyers will be willing to swap places with their clients, I suppose!!

  3. Another economist, rambling along, trying to make sense of the dismal science.

    These guys are good at telling you tomorrow why what they forecast yesterday didn’t happen today.

    And good housekeeping isn’t always the solution in times when government seems bent on squeezing every ounce out of the people without commensurate increases in productivity or cutting back on deleterious practices such as corruption, profligacy, and plain wastage.

    Today alone I heard there will be a grand farewell for one top honcho in the civil service that will take the greater part of the day and the time, energies, and expenses of hordes of civil servants to witness the grand punching-out ceremony, followed by a gala dinner at Putridjaya.

    Like some blogger said somewhere, the Jurassic park should be the next destination of retiring folks like this.

    But that exacyly is my point. Instead of leading the way in austerity and commonsense measures, the government seems to be experiencing some kind of disconnect with the reality on the ground. Such an attitude helps if the money you are wasting is not yours.

    Cheers, I think.

  4. Din,

    It is interesting that during the G20 summit in Canada, there were 2 opposing views about world economy. US and obviously China were favouring spending to revive the economy while Europe was more on cutting spending through their austerity drive.

    We will know who is right and who is wrong about the economy maybe 3-5 years down the road. Or maybe both are right or wrong at the same time. Back home, I am still trying to figure out our government stands about the economy though we have been presented by with NEM to be high income country.

    With US & China encourage spending and Europe not spending, our smart economist must have figured out how to maneuver our economy between two opposing views by world economy power.

    Or perhaps, we tend to look at complex economy and in the process overlook the more fundamental that have been the bedrock of our economy in the 70s and 80s i.e. agriculture plantation.

    With the price of cocoa reaching the all time high this year, cocoa production could help our country economy at this time of uncertainty.

    See this

    and Malaysia cocoa cultivated area year to year is going south. See this

    You don’t have to be economist genius to say that was opportunity lost for Malaysia.

  5. Prof. Krugman’s opinion column is somewhat honest about how sharply this “science” is divided. Examples of the pundits slugging it out include (a) the U-turn by IMF after ruining so many countries (b) the continued depradations of floating captital, and the fundamental problem of capital and growth (c) whether the Renminbi should be floated (d) whether Western goverments should continue pumping “new” money into their economies or it is time to start squeezing.

  6. I am surprised to note that there is little interest in economci issues posted on this blog. There are only three comments on an interesting aspect of macroeconomics.

    You can’t spend your way out of a recession. The after effects of economic stimulation are dire– inflation and high interest rates and more uncertainty. The US and Europe must be prudent in the management of their economies.

  7. Err.., sorry Dr Kam.
    Economic theory/ies to me sounds something like what Mdm. Masi in Kenya, is trying to say. Only the fact that i speak and understand Manglish, prevents me from breaking out into a rash:

  8. drkam,

    economics is a study of the science of lying with numbers and statistics.

    The sacred word in economics is “ceterus parabus”, when everybody knows, everything else cannot be equal in real life. So predictions are made based on manufactured numbers.

    Economists and lawyers are cousins.

  9. Advent of Sovereign Funding and Central Banks playing along with derivatives has distorted capital markets. Very soon all important businesses will be owned by Sovereign Funds. Look at how International Sporting Events are marketed with governments standing in line to host them and you will get the picture. All this has thrown whatever economic theory that you and I learnt in school out of the window and rendered it meaningless. Every business has become too big to fail instead of too good to fail. This trend will continue for another 50 years or more because it is too good to give up and money has become like any another agricultural commodity that keeps growing with very little effort with the aid of digital technology.

    As regards economist who argue on the one hand and balance with the other are all in danger of becoming one-handed economist.

  10. Economics? Ask any sole proprietor of an old-world hardware store (yes there are still more than a few around). He will tell you all there is to know… And after listening to him, forget the modern economists.

  11. For economists it is “ceteris paribus”. For lawyers, say mutatis mutandis.
    There you go. Cousins, or just bad in-laws?

  12. Don’t think so. ‘Ceteris paribus’ means assuming all things remaining equal and ‘mutatis mutandis’ means allowing other things to change accordingly.

  13. I studied economics but with political science as major. And here’s what I learned.

    SOCIALISM: You have two cows. State takes one and give it to someone else.

    COMMUNISM: You have two cows. State takes both of them and gives you milk.

    FASCISM: You have two cows. State takes both of them and sell you milk.

    NAZISM: You have two cows. State takes both of them and shoot you.

    BUREAUCRACY: You have two cows. State takes both of them, kill one and spill the milk in system of sewage.

    CAPITALISM: You have two cows. You sell one and buy a bull.

  14. Economists: You have two cows. The state cow and the free enterprise cow are produce same quantity of milk, ceterus parabus.

    Lawyers: You have two cows. One could be proven to be a bull.

  15. correction

    Economists: You have two cows. The state cow and the free enterprise cow produce same quantity of milk, ceterus parabus.

  16. So we can now say economics is a lot of bull –Mr Bean

    Yes, when lawyers discuss about the economics of having two cows.

  17. MACC: You have two cows…you’re damned…you will be under investigation!

    UMNOISM: You have two cows. Both cows will be taken from you; one for cow-head demonstration and the other for demonstrating to their bigwigs what is the front of a WomaN and the back of a CoW.

    OZAWAISM: You have two cows…oh what a pair of udderly yours!

  18. Aiyaaah …! Wa happened to Malthusian Law of Diminishing Marginal Returns and Din’s humorous response?? Don’t tell me Din is afraid of his own shadow??
    What shadow, Bean. There is such a thing as increasing returns.—Din Merican

  19. Din, you are spot on. Spending within our means is good economics and financial management. If we need to borrow, we need to know whether that project will generate enough income, direct and indirect, to repay that borrowings. Meantime, we need to know whether we have the cash to service the loans otherwise we will default.
    I like what Lee Kuan Yew’s model of economic development. It’s predicated on social engineering and development, as aptly stated by the current DPM, Tharma. It’s about providing a home, education and a healthy clean environment for it’s citizens through enabling, facilatating and providing equal opportunities for all, irrespective of colour, religious beliefs or background. Singapore achieved this through it’s relentless effort at good governance, non-tolerance of corruption, sloppiness in civil service and mediocracy, high encouragement of and appreciation of meritocracy and an inclusive policy of equal opportunities for all. That they are able to build 10,000 housing units in a year in 1962 without the current technology of cranes speaks of their determination and advocacy of meritocracy.

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