Monday, June 13, 2011

The Limits of Economics

Today's Washington Post has a column on the economy by Larry Summers, a former member of President Obama's economic team. In it he talks about how the President's policies saved the country from economic collapse and what is needed to continue the recovery.

The big question is why anyone would listen to a word that Summers or any of the President's other advisors says? A bit over two years ago they projected how bad the recession would be with and without a stimulus and what the recovery would look like. They got everything wrong. The measures they took to stimulate the economy also failed. The economy stalled after the so-called QE2 instead of picking up.

The problem is that no one really understands economics. It is one of those chaos systems where there are too many inputs to even be identified to say nothing of tracked.

Economists think that they understand the economy but, unlike the hard sciences, they cannot test their assumptions in a lab. They can only observe the economy and come up with a theory that attempts to explain what happened. Even there, economists often come to different conclusions.

In addition, social policy has become heavily intertwined with economics. Take the year 1937. Paul Krugman wants to see more government spending. When he looks at 1937 he sees that FDR became worried about the deficit and took measures to reduce it, causing a recession. According to Krugman, the Great Depression would have ended if FDR had just kept spending.

But, a recent column by Amity Shales points out that other things also happened in 1937. The Social Security tax started and the Wagner Act was implemented which caused the number of strikes nationwide to more than double. This caused millions of lost hours of work. Could these have been a stronger factor in the recession than FDR's deficit reduction?

Several years ago, Christina Romer, another of Obama's former advisers, wrote a paper saying that government stimulus programs never worked. They either arrive too late or they are targeted at the wrong parts of the economy. After joining Team Obama, she reversed herself, justifying Obama's stimulus program. Would she have reversed herself if she had not joined the government?

Everyone agrees that government spending has an effect on the economy but there is a lot of disagreement on what that effect is. Obama's advisers believe that the effect is around 160%. Every dollar spent causes $1.60 in increased spending in the economy. Other economists believe that the effect is 60%. Every dollar spent caused $0.60 in economic activity. This is an important issue. Does government spending cause the economy to grow by 60% or to shrink by 40%? No one can say for certain.

I have been seeing a drumbeat of columnists insisting the the stimulus worked and that we need a new one, bigger if possible. Again, none of these people can really say if a new stimulus will work. I'm sure that they really think so but that is not the same thing as proving it.

The one thing that we know for certain - we will have to pay interest on every dollar borrowed to pay for new stimulus spending.

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