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Saturday, March 28, 2009

WHY THE EXPERTS IN POLITICAL AND ECONOMIC MATTERS ARE ALMOST ALWAYS WRONG

Today's Buggy Topic

The topic was inspired by a couple of posts by Professor Mark Thoma, a macroeconomics professor who runs the laudable web site Economist's View, both of which dealt with the troubles that plague mainstream economics . . . the troubles multiplying and underscored by the failures of virtually all big-name economists to anticipate the current global financial and economic meltdown.  Nor is that the end of the troubles.  They've been compounded by the noted backbiting feuds among different economic camps --- especially New Classicals (the dominant economic paradigm since 1980 or so) and New Keynesians, who have adopted many of the basic microeconomic and macroeconomic  concepts that New Classical economists have spun over the last few decades.

Click here for prof bug's own take on why better data, better mathematical modeling, or even better use of new general economic theories are not likely to be a serious guide to predicting future system-wide breakdowns of the sort that have plagued economic theorizing to data.  And quite simply because the experts in economics --- like their counterparts in finance, political science, psychology, sociology, and history --- have a terrible record when it comes to predictions.  To put it bluntly, they do little better than taking any child, blindfolding it, and having it throw a dart at a target full of alternative possibilities. 

In the Meantime,

to make sense of the debate about experts' failures in economics --- which means you need to read and understand Professor Thoma's post, the linked article he refers to, and the various comments in the thread that follows --- consider the postulates and differences between the two dominant economic theories about the overall behavior of the economy . . . especially when it comes to recessionary tendencies that are built into the business-cycle. 

   Oh wait.  It just dawned on buggy's mind.  Before you read the post by Professor Thoma linked to a few moments ago --- along with prof bug's stuff by way of reply --- you might find it very useful and possibly a pre-requisite to read the previous Thoma-post and exchanges that excited so much to-ing and fro-ing, along with some anger, among economists and other posters about the utility of mathematics in contemporary economic theorizing.  Click here for it.  Be sure to read the lengthy exchanges that follow, none of which involve prof bug: he preferred to post his sagacities in the subsequent Thoma-post, linked to earlier here. 

  And come to that, you might enjoy and find profitable a couple of follow-ups at the Thoma site: Click here, then here.  Always assuming that prof bug doesn't get kidnapped and go sky-rocketing with malevolent ET-like creatures to another galaxy, he is very likely --- when he gets the time --- to post a lengthy comment in that latter Thoma-linked thread.  As you can see, it deals with the need to consider the psychological aspects of economic and financial behavior that hardly square with rational-behavior assumptions . . . a matter to which we now turn.

The Key Theoretical Postulates of New Classical Economics 

 They amount to about eight in number. 

    1)  The representative economic and financial agent (person)  is fully rational and makes the best use of the information available to him or her in their behavior as workers, consumers, savers, investors, and business managers . . . including financial ones --- rational expectations.

    2) These economic agents have as much information available to them about the economy's workings and current state-of-affairs as any expert economist or economic or financial regulator --- no asymmetrical information to mark their behavior.

    3)  Financial markets have interest rates and prices of bonds and stocks  that reflect accurately all the information available to anyone --- the efficient market hypothesis.   

      4)  Financial managers and investment specialists will carefully adjust their risk-taking advice and behavior in order to look after the self-interests of their investing clients --- there are no principal/agent conflicts of interest.

      5)  And all markets --- labor, product, savings-and-investment --- are always in equilibrium, thanks to total price flexibility,  unless dislocated by external (exogenous) shocks such as big breakthroughs in new technologies or sudden shifts in consumer preferences (say, for Asian as opposed to American cars as occurred in the early 1980s and again more recently) or the availability of natural resources caused by wars or by unanticipated manipulations of supply and prices by a cartel like OPEC . . . though even OPEC's governments will eventually adjust their behavior in line with long-term enlightened self-interest that reflects the market-oriented interests of their consuming countries and representative economic agents.

Enter Business-Cycles and the  Long-Term View of Market Economies in New Classical Economics . . . Which Entail:

 . . . marked limits on counter-cyclical fiscal and monetary policies for fighting recessions . . . however severe.

    6)   Even exogenous dislocations and shocks to the economy will be temporary.  Market-oriented economies will , as a general thing, quickly adjust to these dislocations . . . witness the average US recession since 1945, at any rate until the current system-wide financial and economic meltdown.  The average length of recessions until the current one has been about 9 months, and unemployment has generally risen only three percentage points before an upturn in the business cycle occurs . . . though improved job-market conditions are a lagging indicator, business firms needing to be sure that sales and profits are going to rise before they start hiring again.  The same self-adjusting mechanisms characterize inflationary tendencies.  These noticeably moderated after the early 1980s . . . thanks to the growing sophistication of monetary policies.

    7)   The previous sixth condition can be restated in more general abstract terms: a market economy like the US's will reflect a built-in self-adjusting tendency toward general equilibrium . . . the latter measured best by long-term growth over the decades in GDP and per capita income.  The statistical term for such a long-term trend growth is ergodicity: whatever, in statistical language, the initial and subsequent conditions of the economy happen to be at any point, any changes will be random and eventually return the economy to general equilibrium as measured by long-term growth potential.  And such potential reflects uniquely supply-side inputs: the growth in cumulative capital stock, the growth in the labor supply, improved human capital (formal education and on-the-job training and experience), and technological breakthroughs . . . whether the latter are embodied in new machines and products or in better knowledge for running the economy.

    8)   And, finally, as a general thing, recessions can't be tamed by demand-side countercyclical changes in either fiscal or monetary policies.  Since the economy will sooner or later return to its full long-term potential and general equilibrium across all markets ---- labor, product, and savings-and-investments --- any efforts by fiscal or monetary policymakers to lessen the "real" technological and other shocks, which require the reallocation of capital and labor across various sectors of the economy, can only worsen things and delay the self-adjustments.  This theoretical view is known as "real business cycle theory" . . . for which the originators, Edward Prescott and Finn Kydland (the latter at prof bug's former university UCSB) have won a Nobel Prize

New Keynesianism

In an effort to respond to the failures of standard old-Keynesianism --- especially the steady rise in inflation after 1967, the need to take monetary policymaking more seriously as the major tool for dealing with it, and the collapse of any stable tradeoff between a little more inflation and a little less unemployment at the margin (the Phillips curve), with stagflation emerging in the late 1970s --- Keynesian scholars took seriously the need to examine the microeconomic basis of their macroeconomic assumptions.  And in effect what they did was adopt most of the above 8 postulates save for 3) total price flexibility ; and 5) all dislocations to the economy's functioning are exogenous rather than internal to its functioning; and 8) the inability of fiscal or monetary policymaking to reduce the length or depth of recessions.

Instead, New Keynesians postulate that:

  1. In the short-run, there are price rigidities in product markets because of what is called menu-costs.  It is disruptive to business-to-business purchases and sales for contracts to be constantly changed in response to lower or higher demand either by consumers for end-products or by businesses buying inputs from other businesses in response to changes in consumption behavior.
  2. In the short-run too, there are wage rigidities even in the presence of declining sales and profits for business firms.  Instead of reducing the wages of all their employees as profits fall off, business firms prefer to lay off the junior and less experience workers.  They do so because they put a larger value on their more senior and experienced (or better trained) workers and want to maintain their morale and loyalty to their firm.
  3. There are also some complex coordination problems that, in the short run, prevent prices and wages adjusting quickly to declining sales, profits, or wages in real terms (minus inflation).

As for policy matters, because of these rigidities, recessionary recurrences in market economies --- built into the business cycle --- need to be countered by effective policymaking.  Unlike in old-style Keynesianism, however, the preferred policy is monetary: reductions in interest rates and, if need be --- as Bernanke and the Federal Reserve are now doing --- quantitative easing . . . increases in the money supply that result from a Central Bank buying all sorts of long-term financial assets (including mortgages if need be) and, if need be, buying US Treasury securities directly rather than selling them to the public. 

As for fiscal stimulus, New Keynesians are themselves somewhat divided.  In the current large-scale financial and economic meltdown, most favor a strong fiscal stimulus of the sort that President Obama's administration is pursuing right now.   Others, including some prominent ones, are concerned that the fiscal multiplier effects of such stimuli are small --- maybe even less than 1.0 in some cases, but anyway bound to begin petering out in a year or two.

Enter An American-European Gap 

Note that in West Europe, virtually all the EU countries --- whether governed by a dominant Social Democratic party or by conservative parties --- are generally skeptical.  Whether it's because they fear running large fiscal deficits, or fear the inflationary tendencies in the long-run that such deficits might entail, or because for theoretical reasons they share New Classical (and some New Keynesian) skepticism about the multiplier effects, the fact remains: there is a gap here, and the meeting of the G-20 will at best achieve some promenade-lathering over the differences that cannot or will not be overcome.