Sunday, November 07, 2010

The Most Expensive Research Project Ever

As in observer of, but not a participant in, the macro wars of the past fifty years, I was struck by the way in which 1960's Keynesianism, largely abandoned by academic economists due to its inability to explain real world events, was suddenly revived in response to recent economic difficulties. Not only revived, but presented by its supporters, including President Obama, as what all economists believed in—a claim that provoked a newspaper ad signed by a large number who didn't.

The truth is that, as Gary Becker puts it in a recent blog post, "The unpleasant fact we economists have to face is that there is not strong evidence on the actual effects of governmental spending on employment and GDP. The usual claimed effects are generally based on predictions from highly imperfect theoretical models of the economy rather than from strong direct and clear evidence on the employment consequences of different fiscal stimuli."

Which is one reason why, as Becker goes on to point out, the contrast between the current policies of the U.S. and the U.K. should be of considerable interest to economists. The U.S. policy, confidently predicated on the theory that deficit spending reduces unemployment, has been to greatly expand both spending and deficit relative to their long term levels, with spending up from about 20 percent of GNP to about 25 percent. The U.K., in contrast, is proposing to reduce its deficit, mainly by reductions in spending, by about 1.5% of GNP for each of the next four years; if they carry through, they will have cut spending, relative to GNP, by about as much as Obama and Bush have increased it. At the same time, Obama's fiscal policies are combined with a substantial increase in government involvement in economic affairs, most notably in health care, while Cameron is at least proposing a decrease.

There are, of course, lots of other differences between the U.S. and the U.K. But such a drastic difference in policy ought to produce results large enough to outweigh them. If the current position of the U.S. administration and its economists is correct, their policy should decrease unemployment by a substantial amount while the U.K. policy increases it by a comparable amount. If on the other hand, as I suspect, the U.S. recession has been so severe not despite Obama's policies but because of them, and similarly for the Great Depression and FDR, the prediction reverses. It will be interesting to see.

Economists should be grateful to President Obama and Prime Minister Cameron for arranging something reasonably close to a scientific experiment on the effects of government policy. Other people might look at the matter somewhat differently. Whichever of the two turns out to be wrong will have imposed a very large cost, quite possibly in the trillions of dollars, on the population he is experimenting on.

Which is the justification for the title of this post.

To be fair, there is a competing claimant to the title. One could view the communist states of the 20th century as a similar research project, this time on the effect of central economic planning. Seen from that point of view, measured in human cost and perhaps also measured in dollars, it was a still more expensive experiment.


Anonymous said...

I think you might underestimate the problem of endogeneity. Potentially both countries follow the same policy algorithm, but what makes them different is exactly what makes the policy implementation different.

James Wilson said...

Several weeks ago Reason Magazine noted the experiences of budget-cutting in New Zealand in the 80's, Canada in the 90's, and - yes - the United States after WWII (where the budget was cut by over half and 10 million government "employees" (servicemen) were let go.

lowly said...

"The usual claimed effects are generally based on predictions from highly imperfect theoretical models ..."

Thought we'd switched topics to climate change there. How to reconcile the English and American actions? When I think Brits, I think total loss, but then they pull a fiscal prudence stunt? Whereas, here in the US, it's only the crust that's daft, but we get the Godzilla of all spending sprees?!

Anonymous said...

"Whichever of the two turns out to be wrong will have imposed a very large cost, quite possibly in the trillions of dollars, on the population he is experimenting on."

You are assuming the policies will have large, obvious effects. It seems more likely to me that the differences will be lost in the noise, too small to measure with any confidence.

dWj said...

The Republicans' recent success might throw a monkey wrench in the experiment. They don't have the power to change tax law, but they have a significant say over spending, and I think they'll go along with an Obama-proposed spending hike to a much lesser extent than they were willing to do with Bush-proposed spending hikes.

Anonymous said...

We already have a natural experiment with austerity budgeting.


It is right there. Look what is happening.

Liutgard said...

An interesting observation. However, something I think we seem to be overlooking here (and which was not an issue during the Roosevelt Administration), is the vast increase in outsourcing. How does that affect (or not) the GDP? Also, the outsourcing and automation of many jobs that formerly supported a significant portion of the working population has changed not just the employment rate, but the nature of consumption. Why pay an American a decent wage when you can buy cheap crap from China? Something that I have noticed in the past decade is that we all want jobs that will support an upper middle income (or higher) lifestyle, but we don't want to pay the costs of goods and services that support the jobs that support that lifestyle. It becomes a downward spiral- the more we demand low prices, the more goods are imported and jobs are sent overseas. No jobs or lower-wage jobs increase the demand for lower prices of goods... I think it's the economic version of the saying "Everyone wants to get to heaven, but nobody wants to die".

Ricardo Cruz said...

Liutgard of Luxeuil said:
Something that I have noticed in the past decade is that we all want jobs that will support an upper middle income (or higher) lifestyle, but we don't want to pay the costs of goods and services that support the jobs that support that lifestyle.

Sure, people always and everywhere want to buy from others cheap, and sell to others dear. More international trade will change the pay composition of jobs, but in the aggregate it should be beneficial. If you want to understand why, you can read in any econ website a summarization of David Ricardo's accessible illustration of trade: comparative advantage.

jeremy h. said...

Re: Ireland. This is a different case, since they do not have control over monetary policy:

Both the UK and US do have control over monetary policy, so the comparison is better, but still imperfect.

Anonymous said...

The best time for a state to reduce the deficit is in a slump (employment and interest rates are low). This way we can lower employment and reduce return on the capital even further. Because, you know, Keynes had been disproved by academic economists. And its not like we want economy working and people employed anyways.

Anonymous said...

Wow. Just wow. 'Luminaries' like Fama and Cochrane from the Chicago school want to claim that 2008 was an exogneous shock to the economy, or brought about by a reevaluation of capital's marginal efficiency and David Freidman claims that Keynesianism was unable to explain real world events. The mind well and truly boggles.

The problem professor is that you've been reading the wrong Keynesians. Minskian dynamics not only accounted for the investment bubbles of the 60s and stagflation of the 70s but the inevitability of the serial investment busts that have led us to our current predicament. And they've been available at your local library for going on 40 years.

Regarding Keynesian stimulus, you obviously don't know what people far from the ivory towers of pointless pontificating in the actual business of managing money are doing. TO A FORECASTER, these are keenly aware of the existence of a direct relationship between government stimulus and growth, and of just how important that is ESPECIALLY in a debt deflation deleveraging cycle like that we've just been through and are to a lesser extent still mired in. The result is that these policies, fiscal and monetary, are baked into both the forecasts you read and market prices.

This of course doesn't mean practitioners universally believe such policy to be a good idea- far from it- but the idea that it doesn't impact short-term growth or negatively impacts short-term growth is just preposterous to the point of lunacy. It is utterly ususpported by practice of experts with skin in the game and utterly unsupported by the data (likewise is it utterly unsupported by the Great Depression, whose end was brought about by removing the private sector from investment decisions full stop courtesy of WWII).

Meanwhile, as world governments like Canada talk about the supposed uncertainty shrouding climate science, all gear up for a land rush in a summer ice free arctic in a way that makes it clear it's not a back-up plan.

Point being, money talks and bs walks. We know which side of the ledger this blog deals from.

Terramar GM said...

I respect Neo-Keynesianism, and similar equilibrium theories such as RBC.

But whether we need a stimulus or not, when the stimulus is mostly pork it will actually make things worse -- the equivalent of hiring people to dig holes and then fill them in, or even worse the equivalent of hiring workers to demolish buildings and replace them with an inferior ones.

TGGP said...

Charles Kenny says communism wasn't so bad for economic growth.