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Belmont Club

Crystal Balls

June 30th, 2010 - 3:23 am

The oncoming Third Depression, according to Paul Krugman, will be the result of a failure of nerve. He fears that policymakers around the world have succumbed to their fears and pulled back just when economic safety was within reach; they haven’t borrowed enough; haven’t spent enough to avoid the catastrophe he believes is increasingly likely. Writing in the New York Times Krugman said:

We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense.

And this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.

Who’s fault will it be? And if it is still possible to avert the disaster, how do we do it? It’s a debate that divides even the “experts”. Do we “stop spending” or as some others argue, keep spending to “stimulate the economy”?  The trouble with the debate is that evidence of policy failure is regarded as a posteriori proof of timidity. Krugman meets the accusation that deficit spending might have brought on his Third Depression by arguing that we haven’t spent enough.  In this world, nobody is justified by subsequent events. If things will get worse after the deficit spenders have been evicted from office in November, the losers will arise in a chorus arguing that if only they had been left to spend a little more, a little longer then all would have been well.  And even those who argue for reduced spending will find themselves using arguments very similar to their foes. If the recession continues after spending is cut, maybe it was cut too late. Rick Santelli is so frustrated he resorts to shouting: ‘Just stop spending’. But he hasn’t lost his marbles completely, he’s just guessed the truth. No macroeconomic expert really knows what’s going to happen and maybe we ought to defer to economic judgment of the polls when they throw out the deficit spenders in November.

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But some people still think they can state the future as fact. Kevin Drum, writing in Mother Jones argues that anyone who believes Rick Santelli should look at Ireland, which lacking the ability of the US to run monster deficits is experiencing “horrific” economic pain. Like an anti-Lincoln Steffens he has seen the future and it doesn’t work. Drum writes, “any country that can avoid Ireland’s fate surely ought to. We certainly can, for example. So why do so many people want us to follow the Irish path instead?” Megan McCardle in the Atlantic isn’t completely convinced that Drum has constructed the arrow of causality correctly. “Saying that ‘the results have been horrific’ implies that we know the alternative, in the form of even higher debt, would not have been even worse. That is certainly the dominant macroeconomic theory, but that theory hardly rises to the second law of thermodynamics.”

McCardle’s comparison between macroeconomic theory and physics is more odious than one might think. The fact that experts cannot settle on the proper prediction suggests the model they use can give rise to multiple or even contradictory predictions, like a compass needle that spins with alacrity of the second hand of an analog watch. The physicist Frank Tipler says that with a compass like that you should start worrying. He argued that since Nobel Prize economists could manifestly rise only to the level of predictive competence of astrology, they should exhibit the same modesty as Madame La Zonga.

The most authoritative macroeconomic theories are those advanced by Nobel Prize Winners in Economic Science, to use the official title of the prize. The Economics Nobel Prize is awarded at the same time as the Nobel Prize in Physics, Chemistry, and Medicine, the three hard sciences. The implication is that macroeconomics has the same predictive power as the theories of physics, chemistry, and molecular biology. Indeed, we should judge the validity of macroeconomic theories in the same way we judge the theories of the hard sciences. If anything, we should demand even more rigor and reliability from macroeconomics, because it is far more important than any hard science. The failure of macroeconomic actions in the Great Depression led to World War II, in which many millions were killed, to say nothing of the vast misery caused by the Depression itself.

But who said Madame La Zonga should be modest? What Tipler failed to realize was that it was this very malleability that gave the macroeconomists their political enormous power. Unlike physicists, chemists and biologists — but like Madame La Zonga — macroeconomists are under no obligation to respect the limits of mathematics or even gravity. Every set of hard science calculations resemble each other, but every macroeconomic prediction is free to vary in any way you like. You can’t get two physicists to disagree by very much on the temperature of a light bulb. But you can get any number of interpretations on the temperature of an economy. This makes the economic forecasting useful in ways hard scientists could only dream of.

If economic experts are useless at telling us what will happen Rick Santelli may be right to let the ordinary voters deliver a judgment on deficit spending.  If a roomful of Nobel Prize winning economists can’t do better than Al down at the garage, listen to Al. Yet many people, perhaps against their better judgment, will continue to patronize the experts for the same reason they talk to the clairvoyants in the pointy hats: they feel better when they are told what will happen, even if they suspect they are listening to lies. Doubt and uncertainty are psychologically difficult to bear so we banish it, if not always very well.  People will pay money to hear that “there is a tall dark stranger in your future”, so why not give somebody money to pronounce that “the recession will be over in six months”? Maybe a tall dark stranger will in fact intersect our lives, just as the recession may actually end in six months but if it happens, we’ll be darned if we know why. But we won’t care because it will seem like it came true.

The lack of a good predictive economic model has an equalizing effect on the public discourse. Where nothing is known the average man may literally know as much about the economic future of the country as the President. Just as a blind man may be the equal of sighted person in pitch darkness, getting the voters rather than the gatekeepers to decide things is no loss. Leaving economic policy to common sense might actually be the safer course. Wikipedia described an experiment in the 1980s which suggested that because macroeconomic models performed so poorly, the best course was often to leave well enough alone and muddle through rather than relying on ‘activist’ or ‘visionary’ prescriptions.

In the late 1980s a research institute compared the twelve top macroeconomic models available at the time. They asked the designers of these models what would happen to the economy under a variety of quantitatively specified shocks, and compared the diversity in the answers (allowing the models to control for all the variability in the real world; this was a test of model vs. model, not a test against the actual outcome). Although the designers were allowed to simplify the world and start from a stable, known baseline (e.g. NAIRU unemployment) the various models gave dramatically different answers. For instance, in calculating the impact of a monetary loosening on output some models estimated a 3% change in GDP after one year, and one gave almost no change, with the rest spread between.

Partly as a result of such experiments, modern central bankers no longer have as much confidence that it is possible to ‘fine-tune’ the economy as they had in the 1960s and early 1970s. Modern policy makers tend to use a less activist approach, explicitly because they lack confidence that their models will actually predict where the economy is going, or the effect of any shock upon it. The new, more humble, approach sees danger in dramatic policy changes based on model predictions, because of several practical and theoretical limitations in current macroeconomic models; in addition to the theoretical pitfalls.

The biggest danger to those who relied on the voodoo models came from the “law of unintended consequences”. Relying essentially on glorified guesswork, the visionaries risked driving off a cliff because they assumed they knew where they were going. Had they tapped their way forward they might have been better off. Yet such humility is too hard on persons accustomed to deference. In the end macroeconomists may have their little experiments. If they fail then they don’t win the Nobel Prize that year. What of the ordinary Joe? Well, if he speeds over the edge he might repeat the words that could come from Krugman — or from La Zonga — words that explain it all. “Let go over a cliff, die completely, and then come back to life – after that you cannot be deceived.”


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