[Pen-l] What good are economists?

[Louis Proyect <lnp3@xxxxxxxxx>]

http://www.businessweek.com/magazine/content/09_17/b4128026997269.htm
What Good Are Economists Anyway?
Why they failed to predict the global economic crisis—and why their help 
is still crucial to a recovery

By Peter Coy

Economists mostly failed to predict the worst economic crisis since the 
1930s. Now they can't agree how to solve it. People are starting to 
wonder: What good are economists anyway? A commenter on a housing blog 
wrote recently that economists did a worse job of forecasting the 
housing market than either his father, who has no formal education, or 
his mother, who got up to second grade. "If you are an economist and did 
not see this coming, you should seriously reconsider the value of your 
education and maybe do something with a tangible value to society, like 
picking vegetables," he wrote on patrick.net.

Take that, you pointy-headed failures! Go jump off a supply curve!

To be fair, economists can't be expected to predict the future with any 
kind of exactitude. The world is simply too complicated for that. But 
collectively, they should be able to warn of dangers ahead. And when 
disaster strikes, they ought to know what to do. Indeed, people pay 
attention to economists at times like this precisely because of their 
bold claim that they know how to prevent the economy from sliding into a 
repeat of the Great Depression. But seven decades after the Depression, 
economists still haven't reached consensus on its lessons. The debate 
has only intensified in recent weeks.

To fight the downturn, Federal Reserve Chairman Ben Bernanke, Treasury 
Secretary Timothy F. Geithner, and National Economic Council Director 
Lawrence Summers are attempting an unprecedented combination of massive 
fiscal stimulus and extreme monetary policy. If it produces a sustained 
recovery—and there are some early signs of hope—they will look like 
heroes. For now, though, it's disturbing that they've had to resort to 
policy measures that in scale and scope are way outside what the 
economics profession had studied or even contemplated in recent years.

The rap on economists, only somewhat exaggerated, is that they are 
overconfident, unrealistic, and political. They claim a precision that 
neither their raw material nor their skill warrants. Too many assume 
that people behave like the mythical homo economicus, who is 
hyperrational and omniscient. And they take sides in quarrels that 
freeze the progress of research. Those few who defy the conventional 
wisdom are ignored.

Critics are scathing. Nassim Nicholas Taleb, the scholar of rare events 
who wrote Fooled by Randomness and The Black Swan, says: "We have to 
build a society that doesn't depend on forecasts by idiotic economists." 
Says Paul Wilmott, a quantitative finance expert: "Economists' models 
are just awful. They completely forget how important the human element is."

In the face of such withering criticism, it's tempting to ignore the 
whole profession. But that won't do. For one thing, getting out of this 
mess and making sure it doesn't happen again will require the very best 
thinking of a generation. Macroeconomists—that is, those who specialize 
in business cycles and growth—have made important contributions. For 
example, research in the 1970s helped many countries eliminate chronic 
high inflation by highlighting the importance of having a strong, 
independent central bank.

Even now, progress is being made. Scholars of all stripes are belatedly 
getting up to speed in modern finance. Because they are trained to think 
of financial markets as efficient, most economists weren't primed to 
spot the dangers posed by lax mortgage lending, overleveraged financial 
institutions, and impenetrably complex derivatives. "The time is 
absolutely right for

new ideas to come in, much as they did in the 1930s and the 1970s," says 
Roger E.A. Farmer of the University of California at Los Angeles.

Besides, even if you're suspicious of economists' value, they are 
impossible to ignore. Here's why: Every idea you can think of for coping 
with this crisis is based on some supposition about the way the world 
works. Whether you realize it or not, all of those suppositions come out 
of one school of economics or another. As the British economist John 
Maynard Keynes wrote: "Practical men, who believe themselves to be quite 
exempt from any intellectual influence, are usually the slaves of some 
defunct economist."

So we had all better hope that the profession can get its act together. 
It won't be easy, because this crisis is rubbing salt in old wounds. It 
is reopening debates about one of the most contentious questions in 
macro, namely, the ability of government deficit spending (i.e., fiscal 
policy) to stimulate demand and get people back to work.

In January the fight over fiscal policy broke out in public after 
then-President-elect Barack Obama made what probably seemed to him a 
safe claim, saying: "There is no disagreement that we need action by our 
government, a recovery plan that will help to jump-start the economy." 
Not long after, some 250 conservative economists, in an open letter 
published in major newspapers, wrote: "With all due respect Mr. 
President, that is not true." Middlebury College economist David C. 
Colander, who himself is suspicious of the stimulus package, says: "The 
debate is reasonable. What's unreasonable is that we're undertaking it 
at this time" rather than decades ago.

Economists' worst sin is hubris. In the 1960s, free-market economist 
Milton Friedman persuaded virtually the entire profession that the Great 
Depression was caused by the Federal Reserve. That seemed to imply that 
better policy by the Fed, guided by economists, would prevent a 
recurrence. Bernanke, then a governor of the Federal Reserve, said as 
much in a 2002 speech for Friedman's 90th birthday that acknowledged the 
Fed's role in the Depression. He told Friedman: "You're right, we did 
it. We're very sorry. But thanks to you, we won't do it again." Famous 
last words.

Believing in the power of the Fed, economists mostly stopped researching 
the use of fiscal policy to fight recessions or depressions. What's 
more, recessions had become rarer and milder—the so-called Great 
Moderation. So who needed stimulus? Says New York University economist 
Xavier Gabaix: "Up until a year ago, you would look very old-fashioned 
if you were talking about optimal fiscal policy."

Mainstream economists' adherence to orthodoxy was also apparent in their 
casual dismissal of worries about bubbles in housing and stocks. Former 
Fed Chairman Alan Greenspan denied that a national housing bubble was 
even possible, since housing was not a single national market. He also 
brushed off the dangers of Wall Street concoctions such as derivatives. 
Only last year did he concede he was wrong. In Senate testimony, he said 
he was shocked to have found a "flaw" in his ideology, adding: "I have 
been going for 40 years or more with very considerable evidence that it 
was working exceptionally well."

Politics compounded the trouble. As a rough first cut, you can divide 
macroeconomists based on how concerned they are about economic 
instability. One group, in the tradition of Keynes, worries about 
self-perpetuating economic declines that leave the economy in a deep 
trough it can't escape. Members of this group say government needs to 
break downward spirals with the kinds of aggressive policies the U.S. is 
following now—cutting interest rates and raising government spending. 
The group includes Paul R. Krugman, the Princeton University economist 
and Nobel laureate; NYU's Nouriel Roubini, who was early in predicting a 
severe recession; and Yale University's Robert J. Shiller, who predicted 
the housing bust and the tech-stock bust.

Other economists have more confidence that the economy is 
self-equilibrating. They believe low interest rates and heavy deficit 
spending will be ineffective while leaving the U.S. with a mountain of 
debt. Count Harvard's Robert Barro in this camp, along with Chicago's 
Robert E. Lucas Jr., Arizona State University's Edward C. Prescott, and 
the University of Minnesota's Patrick J. Kehoe and V. V. Chari. No 
surprise, the equilibrium school mainly leans Republican, and the 
interventionist school seems to be crawling with Democrats.

Before this crisis, it seemed that economists might resolve their 
differences. The oft-combative Krugman, in the first edition of his 
textbook Macroeconomics in 2006, wrote that "the clean little secret of 
modern macroeconomics is how much consensus economists have reached over 
the past 70 years."

The mood now is uglier. On the left, Krugman says: "This is really 
fairly shameful, that we should be wasting precious months as a 
profession retracing debates that were settled 70 years ago." On the 
right, John H. Cochrane of the University of Chicago dismisses those who 
advocate Keynesian stimulus, saying: "Professional economists, the guys 
I hang out with, are not reverting to ancient Keynesianism any more than 
physicists are going back to Aristotle when they can't understand how 
fast the universe is expanding." There are some middle-of-the-roaders, 
such as Columbia University's Michael Woodford, who argue that 
macroeconomists are converging on a methodology for asking questions. 
But even Woodford agrees that "recent debates don't particularly make 
the field look unified."

The easiest criticism of macroeconomists is that nearly all failed to 
foresee the recession despite plenty of warning signs. In early 
September 2008, the median growth forecast for the fourth quarter was 
0.2%, according to a survey by Blue Chip Economic Indicators. The actual 
outcome was a 6.3% annualized decline. The Fed didn't do any better. In 
July 2008, Fed officials projected unemployment in the fourth quarter of 
2008 would end up between 5.5% and 5.8%. The actual number was 6.9%. 
Their projection for the fourth quarter of 2009, done at the same time, 
was for a range of 5.2% to 6.1%. Today, with unemployment at 8.5%, most 
forecasters expect the rate to be nearing double digits by the end of 2009.

Now that fiscal policy is back on the table, economists are fighting 
over the size of the ripple effect—or "multiplier"—of increased 
government spending. Interventionist economists think multipliers are 
large when the economy is operating below capacity—and it certainly is 
now. According to a Fed report on Apr. 15, one-third of manufacturing's 
productive capacity is going unused, the biggest share on record back to 
1948.

Obama Administration officials believe that their fiscal policy is on 
the right track. The stimulus program "is putting a little more energy 
into the consumer," National Economic Council Director Summers told 
Maria Bartiromo. "Two months ago you couldn't find anything positive." 
Christina D. Romer, Obama's chief economic adviser and a historian of 
the Depression, said in March that "at some point, recovery will take on 
a life of its own." Until then, she said, government should watch 
closely "to make sure the private sector is back in the saddle" before 
easing off.

Other economists say increased government spending may actually depress 
private employment. At a Council on Foreign Relations event on Mar. 30, 
Chicago's Lucas called the Administration's multiplier math "kind of 
schlock economics."

The truth is, even backers of stimulus can't be sure it will work. As 
World War II ended, many economists worried that growth would lapse as 
military spending fell. Sewell Avery, the CEO of Montgomery Ward, was so 
anxious about a postwar depression that he refused to open new stores. 
Economists still aren't sure why he was wrong, so they can't say 
reliably whether fiscal stimulus will end this recession or just 
interrupt it. "Is it possible to engineer a durable recovery with fiscal 
expansion, or are you just buying time?" asks Krugman, who favors 
coupling stimulus with drastic action to fix the banks.

What, then, is the way forward? Once this crisis is past, the next 
agenda for macroeconomists will be to help make the economy far more 
robust—enough to survive the blunders of politicians, bankers, and 
economists of the future. Taleb, the scholar of unpredictability, notes 
that nature achieves robustness through a redundancy that economists 
would consider wasteful: two hands, two eyes, etc. Blake LeBaron of 
Brandeis University suggests preventing huge crises by tolerating small 
disturbances, the way foresters use controlled burns to eliminate 
flammable underbrush. Perhaps out of the ashes of failure will emerge a 
better macroeconomics profession.

With Jane Sasseen and Theo Francis
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