Thursday, December 27, 2012

An Analogy for Thinking about Economic Policy

              In an earlier post, I wrote about how, despite the fascination with short-term economic stabilization policy, we actually know little about how such policy works (or fails to work) and that getting incentives right in the long run is more important in any event.  Here is an analogy that I find insightful in that regard.  It guides my thinking about economic policy.

              Imagine throwing a tennis ball into turbulent river rapids in which the water is tumbling and boiling.  My colleagues at Caltech would be the first to admit that predicting the path of the ball over the short-term is nearly impossible.  The churning of the water is just too chaotic on a second to second basis.  Over the course of a week, however, the path of the ball is highly predictable – it moves downstream at the average rate of the current.  The short-term fluctuations largely cancel out.

              Economies can be thought of in a similar fashion.  The short-run fluctuations are still far from understood, but their effect on a country’s standard of living pales in comparison to the impact of the “current” which is the long-run growth rate.  Getting the incentives right is so important because it plays a critical role in determining that growth rate.  An example illustrates this point.

              In 1960, Kenya and Taiwan were both largely underdeveloped agricultural societies with similar GDP per capita.  Over the next 50 years, the growth rate in Taiwan was one of the highest in the world.  As a result, by 2010 the standard of living in Taiwan was approaching that of the United States.  In Kenya, on the other hand, the growth rate averaged approximately zero over the same 50-year span, so that the standard of living barely budged from 1960.  

              The example is a vivid illustration of the importance of an economy’s growth rate in the long run, but it begs the question: what does it mean to promote growth by “getting the incentives right?”  As I discussed in a previous post, one instance of getting the incentives wrong is governments around the world making promises regarding retirement and health benefits that cannot reasonably be fulfilled.  I’ll talk much more about proper incentives in later posts.  But here is a nice current example from Edward Glaeser that is referenced Greg Mankiw's blog today.

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