Economists And Public Policy

Summary:

• Economists often refer to results they don’t have explanations for as “puzzles.” From my perspective, those “puzzles” touch on nearly every important economic change over the last 150 years.
• In fact, economists (and other social scientists) have recently begun questioning the reliability of their research. In other words, do they have a sound basis for knowing what they think they know? To further complicate things, humans adapt to policy and change behavior. Not only does that make extrapolation dangerous, it burdens policy makers with the need to guess about new behavioral consequences arising from the policies they propose.
• Such incomplete knowledge begs the question of why anyone has faith in economic policy. But humans have a strong bias toward the illusion of control -- a belief that their actions control outcomes. For example, few people question whether the Federal Reserve “controls” interest rates. A credible argument can be made that the Federal Reserve really only adjusts to long term changes that would have occurred with or without them.
• Society is unlikely to resist the urge to impose new policies -- it is simply too attractive to think one can “solve problems.” Perhaps economists greatest contribution can be to ask critical questions and recall for us the results of past hubris.

Economic Puzzles

If you spend much time reading current economic research, you will soon pick up on the recurring use of the word “puzzle” to describe something that economists don’t fully understand or that hasn’t turned out the way they expect. A short list includes:

1. Why didn’t monetary policy and quantitative easing work as well as expected post 2008?
2. Why has income inequality grown even as higher education became more prevalent?
3. Why hasn’t the supply of PhDs kept up with the increased wage premium for advanced education?
4. Why has productivity declined?
5. Why did the economy slump after WW I, and then surprise economists after WW II when it boomed?
6. Why has the relationship between inflation and unemployment (the “Phillips Curve”) broken down?

This is by no means an exhaustive list and there is no shortage of proposed (and often competing) explanations for these questions.

The following abstract from the World Bank Group publication Puzzles In Economic Growth is also illustrative of developments that have surprised economists (before the fact):

“Looking at the economic growth of seemingly similar countries one can find striking differences. Why has Australia gotten so much ahead of New Zealand, in spite of the latter being held up as a paragon of free market reform? How is it possible that Austria, with its persistently oversized state enterprise sector, has managed to (nearly) catch up with Switzerland? How can we account for the differences in economic growth between Estonia and Slovenia, and which of these two countries has been more successful at systemic transformation? Why is Mexico so much poorer than Spain, despite having been wealthier all the way into the 1960s? Why has Venezuela, which in 1950 had a per capita income higher than that of Norway and remains a major exporter of oil, slipped behind Chile? Why is Costa Rica lagging behind Puerto Rico, even though in the 1970s the U.S. territory's fast development slowed to a crawl and is now far below other comparable island economies? Why has 'communist' China outstripped 'capitalist' India? Why has Pakistan's growth lagged behind that of Indonesia, even though the latter suffered one of the deepest crises in world economic history in the years 1997-98? Why, even before the 2010 earthquake, the Dominican Republic has been visited by several dozen times more tourists than Haiti, despite being situated on the same island? ”

The authors provide answers to the questions they raise, but it seems clear 1) the answers are all available with hindsight, and 2) their explanations often feature relatively unpredictable and uncontrollable economic shocks and initial conditions.

Do We Know What We Think We Know?

There has been a “reproducibility crisis” in all sciences, however it has been particularly acute in social sciences. Andrew Gelman, among others, has been a vocal critic of “p-hacking” and other errors in research design. In the area of capital markets efficiency, a recent paper by Hou, Zhue, and Zhang found that most “documented” stock market anomalies (286 of them!) fail to replicate. Even if one finds a replicable excess return anomaly and publishes it, it is likely the anomaly will be arbitraged away unless it turns out to be merely return for additional risk. This highlights a general problem in social sciences: that new knowledge can lead to behavioral changes that make the original observation (or policy) obsolete.

A Bias For “Action”

These uncertainties have resulted in long-standing philosophical near theological debates over the merits of governmental policy. Hayek, for example, is famously known for his belief that all governmental attempts to control the economy are sub-optimal from an information theory perspective. Nevertheless, empirically one observes that government plays a large role in nearly every developed country. Of 28 countries in an OECD data set, the median federal and state expenditure as a percent of GDP is 45%, ranging from a low of 29% in Ireland to a high of 57% in France (the US value is 38%).

Figure 1: Government Expenditure And Wealth

Figure 1 shows the relationship between government expenditure and GDP/capita. There is no obvious causal relationship indicating government expenditures cause wealth, suggesting perhaps the government’s primary role is to redistribute wealth in order to ensure social stability.

The Federal Reserve

The effectiveness of monetary policy is an economic arena which seems to enjoy nearly universal faith. Specifically, faith in the ability of the Federal Reserve to moderate economic cycles by setting interest rates and/or the growth in money supply. But it is worth asking whether the Fed controls the interest rate or simply adjusts ex post facto to the rate dictated by long-term changes in the economy. If aging, declining fertility, productivity declines, global trade, and excess regulation are all influencing inflation and the demand for credit, how does the Federal Reserve oppose those forces in any meaningful and sustainable way?   

Figure 2: Did The Federal Reserve “Control” This Interest Rate?

 

If the Fed sets artificially low short term rates, unsustainable asset bubbles result. If it sets artificially high short term rates, long term capital investment would disappear because investors would prefer riskless artificially high return short maturity investments. Thus on a sustained basis, the Federal Reserve can only “set” rate levels which are consistent with the level of demand in the economy. Over the long term demand sets the rate, not the Federal Reserve.

Economists’ Role In Shaping “Good” Policy

I have no expectation that people will stop trying to formulate new policies. We are geared to continue seeking social progress, just as we are programmed to continue seeking other forms of progress like cures for cancer or improving technology.

In fact even existing popular policies like Social Security and Medicare, are likely to require changes. I have pointed out that Social Security has been extremely effective in nearly eliminating poverty among Seniors. Nevertheless Social Security faces issues like its financial “insolvency”, whether it is equitable to younger generations, and whether it is efficient.

Defenders of free market solutions should also want new policies which address corporations’ (and organized labor’s) ability to coerce public resources and restrain competition through preferential regulation.[1]

 

Thus this essay is not meant to bash the economics profession. Economists are quite capable of self criticism and it is not particularly comforting to me that “...half the number of [Stanford] students graduate with degrees in economics today as did in 2000.”[2] I believe economists should play a critical role in setting policy. But my belief is their chief contributions are to understand prior mistakes, question the sustainability of policy costs, examine efficiency leakage, and ask whether policy changes might have adverse behavioral consequences. My view is that this kind of humility leads to more effective policies and less wasteful outcomes.

[1] Examples are the sugar and ethanol lobbies; government employee pensions exceeding those in the private sector etc.

[2] “Ensuring Academic Breadth”; Stanford Alumni Journal, January/February 2017.

Transparent and reproducible: Figure 1can be generated by using the free, publicly-available R program, OECD data linked in this article, and the R code available in “policyLimits.r" on github.