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Friday, January 16, 2009

"Can Economists Be Trusted?" "Are There Ever Any Wrong Answers in Economics?"

Uwe Reinhardt:

Can Economists Be Trusted?, by Uwe E. Reinhardt, Economix: ...[W]ittingly or unwittingly, economists infuse their analysis with their own (or a political client’s) preferred ideology.

Consider, for example, President Bill Clinton’s 1993-94 health-reform plan. In this plan, President Clinton proposed a mandate on employers to provide their employees with health insurance.

Politically conservative economists predicted that the mandate ... would lead to vast unemployment. Economists supporting the Clinton health plan predicted that the ... mandate ... might even ... increase employment.

It can be shown with a simple mathematical model that an economist’s prediction in this regard is powerfully driven by two assumptions about the behavioral responses to mandated employer-paid health insurance. ... Unfortunately, the empirical literature on this responsiveness offers economists a wide range of estimates from which they can choose...

This example starkly illustrates how easy it is for economists to infuse their own ideology – or that of their clients – into what may appear to outsiders as objective, scientific analysis.

We are now seeing a replay of this tendency in the debate on the relative merits of added government spending versus added tax cuts as measures to stimulate the economy.

Writing in The New York Times, for example, the Harvard professor N. Gregory Mankiw, former chief of President George W. Bush’s Council of Economic Advisers, makes a case for stimulating the economy through tax cuts rather than added government spending. ...

To buttress his case..., he then cites an empirical study by Valerie A. Ramey, according to which the $1 of added government spending will ultimately increase gross domestic product (G.D.P.) by only $1.40, while according to another recent study by Christina and David Romer, $1 of tax cuts over time increases G.D.P. by $3.

Non-economists may ask, of course, exactly how a $1 cut in taxes would translate itself into a $3 increase in G.D.P. at a time when traumatized households, whose wealth has been eroded, might use any new tax savings merely to pay down debt or rebuild their wealth through added savings, rather than spend it, and when business firms unable to sell their output even from existing capacity might hesitate to invest such tax savings in more capacity.

But never mind this fine point.

More interesting is the fact that Christina Romer is to be the head of President-elect Barack Obama’s Council of Economic Advisers. In that capacity, last Saturday she released an analysis of fiscal stimulus alternatives, with a co-author, Jared Bernstein. Curiously — or perhaps not — for that analysis, the two authors assume a much larger four-year multiplier effect for added government spending (1.55) than for tax cuts (0.98), although they do confess to a high degree of uncertainty on the actual sizes of these multipliers.

So there you have the flexibility, shall we say, that economists enjoy when they apply their professional skills to affairs of state in what may seem, to outsiders, like purely scientific analyses.

In the first lecture of my freshman economics course at Princeton entitled “The Art of Siffing Among Seasoned Adults,” I demonstrate how seasoned adults routinely structure information felicitously (i.e., “sif”) to further their own agenda, and I point out that economists can be among the most skillful practitioners of this art. ... When economists advise on public policy, the operative mantra is Caveat Emptor!” ...

The answer to this, of course, is that economists should acknowledge the range of estimates, and, if they are committed to one set of estimates over another, if they want to get past the "on the one hand, on the other hand" construction, why they think one set is better or worse than another (let me admit to being less than perfect at this myself).

Brad DeLong:

Fama's Fallacy V: Are There Ever Any Wrong Answers in Economics?: Montagu Norman here, back from my grave once again. This time it is Greg Mankiw whose words have summoned me...

One thing that used to give me nightmares--and that provoked several of my nervous breakdowns--was how you could never get any economist (except for John Maynard Keynes) to take a definite position. They were always "on the one hand--on the other hand." This was what led Harry Truman in later days to wish for a one-handed economist, a wish that has never been fulfilled...

The "on the one hand--on the other hand" nature of discourse raises the question of whether in economics--a "science" where there is enormous intellectual and ideological and political disagreement about how the world works--there can ever be any wrong answers?. I believe that there can be wrong answers in economics, because examinations in economics tend to take a particular form: instead of asking (i) "do expansionary fiscal policies increase output and employment?" we ask (ii) "in models where there are idle resources and high unemployment, do expansionary fiscal policies increase output and employment?" (ii) is a question about a particular class of models of the economy, and so has a definite right answer--"yes, in that class of models they do"--and a definite wrong answer--"no, in that class of models they don't."

Eugene Fama claimed that "when there are idle resources--unemployment" expansionary fiscal policies had no effect in models in which the NIPA savings-investment identity:

investment = (private savings) - (government deficit)

held.

Now the NIPA savings-investment identity holds in all models--it is, after all, an identity, true by definition and construction. And every single model that has been built in which there is a possibility of high unemployment and idle resources is a model in which fiscal policy works because increases in government spending lead to unexpected declines in inventories and unexpected declines in inventories lead to firms to expand production, which leads to increases in income and saving.

I would, therefore, say that Fama's claim is "wrong". Not only does it not hold in all models in the class, it does not hold in any models in the class.

Greg Mankiw disagrees:

Greg Mankiw's Blog: Fama's arguments make sense in the context of the classical model... presented in Chapter 3 of my intermediate macro textbook.... I would go on to the Keynesian model.... But whether one leaves the classical model behind to embrace the Keynesian model is a judgment call...

Mankiw thinks that Fama is not wrong but is, rather, making a "judgment call."

But Mankiw writes in his chapter 3 that the classical model "assume[s] that the labor force is fully employed." And so Greg gets himself into Cretan Liars' Paradox territory here: Fama says that there is high unemployment and idle resources, while Mankiw says that Fama is not wrong because he makes sense as long as the labor force is fully employed and there are no idle resources.

Is Mankiw's answer here a "wrong" answer, or is he too making a "judgment call"? I seek an empirical test. I seek a Harvard undergraduate to take Greg Mankiw's course this spring, to write the following in an appropriate place:

the classical model of chapter 3 shows us that expansionary fiscal policies have no effect on output even where there are idle resources--unemployment.

and to report back on the reaction of the course instructors.

Let's ask another question. Does Greg Mankiw believe in the classical model he is using to defend Fama (in the classical model, the LM curve is vertical, and a vertical LM curve leads to a vertical supply curve, and to the result that demand side policies such as a change in government spending or taxes cannot change real output)?:

I disagree ... that the LM curve is vertical... Introspection is not a particularly reliable way to measure elasticities. There is a substantial empirical literature on money demand that demonstrates that it is interest-elastic. ... According to Ball, the interest semi-elasticity of money demand is -0.05: This means that an increase in the interest rate of one percentage point, or 100 basis points, reduces the quantity of money demanded by 5 percent.

How far off is the vertical LM case as a practical matter? One way to answer this question is to look at the fiscal-policy multiplier. In chapter 11 of my intermediate macro text, I give the government-purchases multiplier from one mainstream econometric model. If the nominal interest rate is held constant, the multiplier is 1.93. If the money supply is held constant, the multiplier is 0.60. If the LM curve were completely vertical, the second number would be zero. ...

Greg has been pretty good at saying there is a lot of uncertainty about the fiscal policy multipliers, and about explaining why estimates differ across studies, and why he favors one set of estimates over another, so I don't want to come down too hard on his disagreement with the 1.93 figure in his "favorite textbook", but it does seem like he is defending Fama with a model that he does not believe in.

    Posted by on Friday, January 16, 2009 at 02:07 PM in Economics, Methodology, Science | Permalink  TrackBack (0)  Comments (36)

          

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