Monday, December 24, 2012

Economic "Science" and Economic Policy



              The term “economic policy” immediately brings to mind government actions to combat economic fluctuations, particularly slowdowns.  Recent examples are the Fed’s experiments with quantitative easing and the Obama Administration’s stimulus program.  These policies are the subject of intense public scrutiny and debate.  But there are two big problems with this preoccupation with short-term economic stabilization efforts.

              The first problem is that we, and by we I mean the economics profession as a whole, do not know how, and even if, these government policies work.  In fact, we don’t even understand how the downturns they are meant to combat arise and endure in the first place.  This does not mean that we don’t have theories.  Decades of research and thousands of published papers have produced plenty of theories.  Indeed, that is another aspect of the problem.  There are dozens of incomplete theories, many passionately supported by their adherents, but none capable of adequately explaining how recessions develop and why they persist.  

              To make matters worse, competing theories generally produce different predictions and have different policy implications.  As a result, leading economists end up offering diametrically opposed policy prescriptions.  For example, Professor John Taylor, a leading expert on monetary policy, argues that the Federal Reserve should follow a largely mechanical monetary policy, but Professor Ben Bernanke, another leading expert and current Federal Reserve Chairman, rejects that advice.  With regard to fiscal policy, Nobel Prize winning economist and New York Times columnist Paul Krugman, is a vigorous advocate of Keynesian style government stimulus programs, but Robert Barro and John Cochrane, both of whom studied such programs in detail, argue that they have virtually no positive impact on economic activity.  The list of such disputes goes on and on and covers virtually every aspect of monetary and fiscal policy.

              The second problem is that despite the intense interest on the part of the public and the media, and the ongoing debates among economists, short-term fluctuations have only a second order effect on the long-run standard of living Americans experience.  One thing on which economists do agree is the simple arithmetic that says that per capita output, the accepted measure of the standard of living, is determined exclusively by the average hours worked per capita times the productivity of the people doing the work.  This means that there are only two ways to improve our standard of living: increase the number of hours worked or make our workers more productive.  In this respect, there is another broad area of agreement among economists.  Namely, that because economics is the science of incentives and how those incentives affect behavior, increasing hours worked and/or productivity requires getting the incentives right.  Unfortunately, when it comes to determining what the right incentives are the consensus evaporates.  More on that in future posts.

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