By Terry Burnham
Economists are divided on both fiscal and monetary policy, the most important economic issues of the day. The divide is on the direction of policy, not on some detail. A field cannot be more lost than to be clueless on its most important issues. This is the equivalent of Lewis and Clark disagreeing on whether they are going to the Mississippi or the Pacific. When you don’t know east from west, you are lost.
The fiscal policy question is the impact of government deficits and debt on the size of the economy. A concrete fiscal question is to determine the impact of an additional dollar, or trillion dollars, of spending and debt by the US federal government. In economic parlance if the government spends an additional $1, and borrows the $1, what is the impact on the economy?
The answer depends on whom you ask. Keynesian economists believe the $1 of extra spending is ‘stimulus’ that gets multiplied to become something more than $1. On the other extreme, some economists believe that the $1 has to come from somewhere. If the government uses the $1 to create, for example, an IRS Star Trek video (click here), then the additional spending makes the society poorer, because the $1 would have been used better by the private sector.
This intellectual disagreement over the impact of fiscal decisions has spilled into the public domain with the fight between Nobel Prize winner Paul Krugman and the Harvard Duo of Carmen Reinhart and Kenneth Rogoff. Here is the letter written by Reinhart and Rogoff labeling Krugman‘s comments on their work as “spectacularly uncivil behavior.” The spat is over the impact of debt on economic growth.
So what is the impact of an extra $1 of government spending? The answer, according to leading is economists, is somewhere between +$5 and -$5.
I want to repeat this to make the point clear. Economists do not know if government “stimulus” makes the economy bigger or smaller.
The battle over monetary policy is perhaps even more vicious than the battle of fiscal policy.
Federal Reserve Chairman Ben Bernanke stands at one extreme of this debate. According to “Helicopter Ben”, The Federal Reserve can make us richer by loose monetary policy. The first step in this approach was to cut interest rates to zero, the second step was to undertake “quantitative easing,” under which the Federal Reserve has purchased trillions of dollars of bonds, and is continuing to purchase more bonds at the rate of an additional $1 trillion a year.
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What is the impact of monetary looseness? Chairman Bernanke states that economic growth is “being supported” by quantitative easing and low interest rates; Federal Reserve Vice Chair Janet Yellen is more specific in stating that loose monetary policy has “raised private payroll employment by about 3 million jobs.”
In sharp contrast to Chairman Bernanke and Vice Chair Yellen, many economists believe that the Federal Reserve’s actions have hurt the economy. One of the most prominent critics is Stanford Professor John Taylor, inventor of the “Taylor Rule” of monetary policy. Testifying to Congress in April 2013, Professor Taylor argues that “these (Federal Reserve) policies have been a drag on the recovery.”
What is the impact of Federal Reserve policy? It ranges from having created 3 million jobs to have decreased the number of jobs.
Again, let me repeat the current state of economics. Economists do not know if monetary “stimulus” makes the economy bigger or smaller.
During the Manhattan project there was some debate about whether an atomic explosion would burn the atmosphere and end all life on earth. The scientists convinced themselves that life would not end, and continued with the program. The physicists of the Manhattan project were intellectually honest in admitting that the outcome of novel actions cannot be known.
Even without consensus on direction of impact, economists have taken historic actions. Recent US fiscal deficits are the largest in history outside of World War II. Similarly, monetary policy is in uncharted territory. Prior to 2008, the Federal Reserve had never undertaken quantitative easing.
If economists were honest, they would acknowledge that no one can know the impact, of the first-time-in-the-history-of-the-world policies. Reasonable people can debate these issues. What is not debatable is the field does not have a unified view on the most central economic issues.
Economics is a lost field.
Let me end this section with three less serious symptoms of the sorry state of economics.
1. The best-selling economic book explains Sumo, but not economics.
Freakonomics has sold more than 4 million copies making it one of the best-selling economic books in history. It tells us, for example, that Sumo wrestlers are likely to throw matches when their opponent is in danger of losing status with a loss. Freakonomics is, however, silent on monetary or fiscal policy. This is not negative statement about the book or the authors, but it is a negative statement on the field. Where is the best-selling book that correctly explains how to grow the economy?
2. Nobel Prize winner Professor Harry Markowitz does not use his own theory.
Professor Harry Markowitz won his Nobel Prize for a theory on how to make investments. When investors decide to buy stocks or bonds, for example, Professor Markowitz’s theory argues the optimal mix requires examination not only of historic risk and return, but also the correlation (or co-variance) between returns.
Does Professor Markowitz use his theory when he buys stocks and bonds? No. He splits his money 50-50. He is quoted as saying, “I should have computed the historical co-variances” but through psychological introspection he instead just split his money equally into stocks and bonds.
3. Nobel Prize winners Professor Myron Scholes and Robert C. Merton did use their own theory and almost blew up the world.
Q: What is worse than an economist who doesn’t use his Nobel prize winning theory?
A: Economists who do use their theory (and almost collapse the world economy).
Professor Myron S. Scholes and Robert C. Merton won the Nobel Prize in 1997. Both men were principals in the hedge fund Long-Term Capital Management (LTCM). Soon after their Nobel Prizes, LTCM went bust. The NY Times says the LTCM went bankrupt because of it “made a number of unsound, esoteric bets.” The bets were so large that the US government had to rescue LTCM. Then Federal Reserve Chairman, Alan Greenspan defended the action by stating to congress, “failure of LTCM … could have potentially impaired the economies of many nations, including our own”.
Economics is a lost field. More than 200 years after Adam Smith wrote the Wealth of Nations, economics has no answer to the most important economic questions. Fields go through periods of growth and periods of stasis; I believe we are in a period of prolonged stasis in that we do not know more than we did 10 or 100 years ago.
Furthermore, I fear that this is a dangerous time to be ignorant of economic realities. The financial crisis is not over, and, consequently, it would be good to know what policies to pursue.
Is there any good news on the state of economics? Yes. There are two meanings of lost. One is a permanent outcome such as the Soviet Union lost the cold war. The second is a temporary state of being confused about location and direction. I am optimistic that economics is lost in the second, temporary sense. Economics has great elements, and many great people. It has the ability to find its way, and that will be the subject of a separate essay.
28 November 2015