Is the Dismal Science Really a Science?
By Russ Roberts
This article originally appeared in the Wall Street Journal on February 26, 2010
For an economist, these are the best of times and the worst of times. We live in the best of times because everyone wants to understand what happened to the economy and what's going to happen next.
Is the mess we're in a market failure or a government failure? Is the stimulus plan working? Would tax cuts for small business spur employment? When will the job market improve? Is inflation coming? Do deficits matter?
So many questions and so little in the way of answers. And so it is the worst of times for economists. There is no consensus on the cause of the crisis or the best way forward.
There were Nobel Laureates who thought the original stimulus package should have been twice as big. And there are those who blame it for keeping unemployment high. Some economists warn of hyperinflation while others tell us not to worry.
It makes you wonder why people call it the Nobel Prize in Economic Science. After all, most sciences make progress. Nobody in medicine wants to bring back lead goblets. Sir Isaac Newton understood a lot about gravity. But Albert Einstein taught us more.
But in economics, theories that were once discredited surge back into favor. John Maynard Keynes and the view that government spending can create prosperity seem immortal. I thought stagflation had put a stake in the heart of this idea back in the 1970s. Suddenly, he's a genius once again. F.A. Hayek, Keynes's more laissez-faire sparring partner, is drawing interest. There are various monetarists to choose from, too. Which paradigm is the "right" way to think about the boom and the bust? Or are they all wrong?
I once thought econometrics—the application of statistics to economic questions—would settle these disputes and the truth would out. Econometrics is often used to measure the independent impact of one variable holding the rest of the relevant factors constant. But I've come to believe there are too many factors we don't have data on, too many connections between the variables we don't understand and can't model or identify.
I've started asking economists if they can name a study that applied sophisticated econometrics to a controversial policy issue where the study was so well done that one side's proponents had to admit they were wrong. I don't know of any. One economist told me that in general my point was well taken, but that his own work (of course!) had been decisive in settling a particular dispute.
Perhaps what we're really doing is confirming our biases. Ed Leamer, a professor of economics at UCLA, calls it "faith-based" econometrics. When the debate is over $2 trillion in additional government spending vs. zero, we've stopped being scientists and become philosophers. Do we want to be more like France with a bigger role for government, or less like France?
Facts and evidence still matter. And economists have learned some things that have stood the test of time and that we almost all agree on—the general connection between the money supply and inflation, for example. But the arsenal of the modern econometrician is vastly overrated as a diviner of truth. Nearly all economists accept the fundamental principles of microeconomics—that incentives matter, that trade creates prosperity—even if we disagree on the implications for public policy. But the business cycle and the ability to steer the economy out of recession may be beyond us.
The defenders of modern macroeconomics argue that if we just study the economy long enough, we'll soon be able to model it accurately and design better policy. Soon. That reminds me of the permanent sign in the bar: Free Beer Tomorrow.
We should face the evidence that we are no better today at predicting tomorrow than we were yesterday. Eighty years after the Great Depression we still argue about what caused it and why it ended.
If economics is a science, it is more like biology than physics. Biologists try to understand the relationships in a complex system. That's hard enough. But they can't tell you what will happen with any precision to the population of a particular species of frog if rainfall goes up this year in a particular rain forest. They might not even be able to count the number of frogs right now with any exactness.
We have the same problems in economics. The economy is a complex system, our data are imperfect and our models inevitably fail to account for all the interactions.
The bottom line is that we should expect less of economists. Economics is a powerful tool, a lens for organizing one's thinking about the complexity of the world around us. That should be enough. We should be honest about what we know, what we don't know and what we may never know. Admitting that publicly is the first step toward respectability.
« Close It
Congressional Testimony, October 28, 2009
By Russ Roberts
What follows is my testimony before the House Committee on Oversight and Government Reform, delivered October 28, 2009. The topic was executive compensation and the Special Master for TARP Compensation, Kenneth Feinberg, who was determining compensation at the firms who had not repaid their TARP funds.
Chairman Towns, Ranking Member Issa, and Distinguished Members of the Committee:
Americans are angry about executive compensation.
Rightfully so.
The executives at General Motors and Chrysler don’t deserve to make a lot of money. They made bad products that people didn’t want to buy.
The executives on Wall Street don’t deserve to make a lot of money. They were reckless. They borrowed huge sums to make bets that didn’t pay off. And they wasted trillions of dollars of precious capital, funneling it into housing instead of health innovation or high mileage cars or a thousand investments more productive than more and bigger houses.
Everyday folks who are out of work through no fault of their own want to know why people who made bad decisions not only have a job but a big salary to go with it.
No wonder they’re angry at Wall Street,
But if we keep getting angry at Wall Street, we’ll miss the real source of the problem. It’s right here. In Washington.
We are what we do. Not what we wish to be. Not what we say we are. But what we do. And what we do here in Washington is rescue big companies and rich people from the consequences of their mistakes. When mistakes don’t cost you anything, you do more of them.
When your teenager drives drunk and wrecks the car, and you keep give him a do-over—repairing the car and handing him back the keys—he’s going to keep driving drunk. Washington keeps giving bad banks and Wall Street firms a do-over. Here are the keys. Keep driving. The story always ends with a crash.
Capitalism is a profit and loss system. The profits encourage risk-taking. The losses encourage prudence. Is it a surprise that when the government takes the losses, instead of the investors, that investing gets less prudent? If you always bail out lenders, is it surprising that firms can borrow enormous amounts of money living on the edge of insolvency?
I’m mad at Wall Street. But I’m a lot madder at the people who gave them the keys to drive our economy off a cliff. I’m mad at the people who have taken hundreds of billions of taxpayer money and given it to some of the richest people in human history.
I’m mad at President Bush and President Obama and Secretary Paulson and Secretary Geithner and Chairman Bernanake. And I’m mad at Congress. You helped risk-takers continue to expect that the rules that apply to the rest of us don’t apply to people with the right connections.
You have saved the system, but it’s not a system worth saving. It’s not capitalism but crony capitalism.
Using a Special Master for Compensation to get our money back is too little, too late.
Many people argue that because the government handed out the money, the government has a right to dictate how it is spent. It’s a reasonable thought in personal relations. If I offer you money, I have a right to attach strings to my generosity. But in a constitutional democracy like ours, it is not the government that has rights. We, the people, have rights. The Constitution exists to restrain government, not to empower it.
Whether government has the right to limit pay isn’t the question. The question is whether it’s a good idea for the government to have the power to set compensation. Despite our anger, the answer is no.
F. A. Hayek, the Nobel Laureate economist, said: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”
The Special Master imagines he can design compensation packages that “align incentives” while “retaining key talent.”
But it is impossible for any one person—no matter how wise—to anticipate the consequences of such decisions. Certainly the Special Master does not possess that knowledge.
The Special Master doesn’t even know who is key and who is not. Some of that talent should leave and some of those firms need to disappear. But he does not know enough to decide correctly.
Nor does he have any incentive to acquire that knowledge. He has no skin in the game.
A single individual has been given enormous arbitrary power with insufficient accountability or transparency. This is not good for the rule of law, democracy or capitalism.
By focusing on those who owe the government TARP money, the Special Master distracts us from other firms that benefited from government rescue such as Goldman Sachs and JP Morgan Chase.
The comfort we receive from seeing compensation reduced distracts us from the policies that created the problem in the first place—the rescue of Wall Street from its own recklessness.
It is a charade of political window dressing to make crony capitalism look respectable.
I want my country back.
Let’s get the government out of the auto business, out of the banking business and out of the compensation design business. We need explicit timetables to disengage from government ownership including a plan for how the Federal Reserve will draw down its balance sheet. Most of all, we need to stop trying to imagine we can design housing markets and mortgage markets and financial markets and compensation.
I want my country back.
I want a country where responsibility still means something. Where rich and poor, Main Street and Wall Street live by the same rules. We don’t need a Special Master to level the playing field. We just need to take the crony out of crony capitalism so we can get back to the real thing.
Will Time Prove Ben Bernanke Wrong?
By Russ Roberts
(This piece appeared on NPR.org on 8/25/09)
President Obama has reappointed Federal Reserve Chairman Ben Bernanke, praising his creativity in preventing another Great Depression.
Talk about damning with faint praise.
It's true that we appear to have avoided the worst-case scenarios of the last year, but at what price?
Back in March of 2008, Bernanke and Treasury Secretary Henry Paulson engineered a rescue of Bear Stearns. A single suitor, JP Morgan Chase, was chosen to receive a sweetheart deal in the name of avoiding a credit freeze. The freeze came anyway. The Bear Stearns rescue was the beginning of an unprecedented expansion of power in the hands of the Fed and the Treasury with a level of opaque decision-making that is not appropriate for a democracy.
Even today we have heard little justification for the expansion of the Fed's power and the Fed's balance sheet.
Yes, we have avoided a depression. But let us count the costs.
Financial firms that made irresponsible and imprudent decisions have been rescued, propped up and bailed out.
AIG has received about $180 billion. That is almost $2,000 for every American household. That money has gone to sustain the bonuses of AIG and the financial health of its counterparties, such as Goldman Sachs. This is an obscene travesty.
The Fed currently holds $600 billion worth of Fannie, Freddie and Ginnie mortgage-backed securities. I am not optimistic about how that will turn out.
The Fed has injected hundreds of billions of reserves into member banks. This will fuel future inflation unless Bernanke is willing to raise interest rates when the recovery begins. There will be tremendous political pressure on him not to do so. So inflation is likely to come along with any recovery.
Worst of all, Bernanke, Paulson and Timothy Geithner have continued the disastrous policy of sustaining bondholders and creditors of reckless financial institutions. Capitalism is a profit-and-loss system. The profits encourage risk-taking. The losses encourage prudence. The bondholders and creditors are the single most important check on imprudence. They care only about one thing: solvency. By making them whole, their incentive to restrain recklessness has been greatly weakened. This sows the seeds of the next financial crisis.
I feel sorry for Bernanke. In one sense, as the world's greatest living authority on the Great Depression, he is the best man for the job. But because he is the world's greatest living authority on the Great Depression, another catastrophic economic debacle of a similar magnitude would be particularly embarrassing were it to occur on his watch. I believe he has gone too far in the other direction.
The Great Depression was caused, or at least greatly worsened, by too little liquidity. Bernanke has avoided that mistake. He has instead committed the opposite mistake of too much liquidity and too few failures. Obama has praised him. How history judges him will be the real test.
