Economic Theory For The Real World

I have been highly critical of the government for its economic policies.  Well, here is one initiative that I think does have potential.

The Subcommittee on Investigations and Oversight of the Committee on Science and Technology of the House of Representatives is holding hearings on “the promise and limits of modern macroeconomic theory in light of the current economic crisis.”

As the Subcommittee explains in its hearing call:

The Subcommittee has previously looked at how the global financial meltdown of 2008 may have been caused or abetted by financial risk models, many of which are rooted in the same assumptions upon which today’s mainstream macroeconomic models are based. But the insights of economics, a field that aspires to be a science and for which the National Science Foundation (NSF) is the major funding resource in the Federal government, shape far more than what takes place on Wall Street. Economic analysis is used to inform virtually every aspect of domestic policy. If the generally accepted economic models inclined the Nation’s policy makers to dismiss the notion that a crisis was possible, and then led them toward measures that may have been less than optimal in addressing it, it seems appropriate to ask why the economics profession cannot provide better policy guidance. Further, in an effort to improve the quality of economic science, should the Federal government consider supporting new avenues of research through the NSF?

The hearing call then describes the essence of the mainstream macro model:

The dominant macro model has for some time been the Dynamic Stochastic General Equilibrium model, or DSGE, whose name points to some of its outstanding characteristics. “General” indicates that the model includes all markets in the economy. “Equilibrium” points to the assumptions that supply and demand balance out rapidly and unfailingly, and that competition reigns in markets that are undisturbed by shortages, surpluses, or involuntary unemployment. “Dynamic” means that the model looks at the economy over time rather than at an isolated moment. “Stochastic” corresponds to a specific type of manageable randomness built into the model that allows for unexpected events, such as oil shocks or technological changes, but assumes that the model’s agents can assign a correct mathematical probability to such events, thereby making them insurable. Events to which one cannot assign a probability, and that are thus truly uncertain, are ruled out.

The agents populating DSGE models, functioning as individuals or firms, are endowed with a kind of clairvoyance. Immortal, they see to the end of time and are aware of anything that might possibly ever occur, as well as the likelihood of its occurring; their decisions are always instantaneous yet never in error, and no decision depends on a previous decision or influences a subsequent decision. Also assumed in the core DSGE model is that all agents of the same type – that is, individuals or firms – have identical needs and identical tastes, which, as “optimizers,” they pursue with unbounded self-interest and full knowledge of what their wants are. By employing what is called the “representative agent” and assigning it these standardized features, the DSGE model excludes from the model economy almost all consequential diversity and uncertainty – characteristics that in many ways make the actual economy what it is. The DSGE universe makes no distinction between system equilibrium, in which balancing agent-level disequilibrium forces maintains the macroeconomy in equilibrium, and full agent equilibrium, in which every individual in the economy is in equilibrium. In so doing, it assumes away phenomena that are commonplace in the economy: involuntary unemployment and the failure of prices or wages to adjust instantaneously to changes in the relation of supply and demand. These phenomena are seen as exceptional and call for special explanation.

The Subcommittee goes on to ask whether this model is really sufficient for our needs, given that it appears to rule out the kind of crisis we are now struggling to overcome.  It concludes by raising the following challenging questions in an effort to determine whether “the reigning macroeconomic model [is] trustworthy for policy-making purposes? If not, should the government consider funding different kinds of research that may provide more useful insights to real economic outcomes?”

• Last month’s G20 summit in Toronto produced a broad policy consensus behind “austerity” plans designed to reduce public debt. Practically speaking, that means governments made commitments to slash their public spending. The recovery is still shaky, and the possibility of a double-dip recession looms on the horizon. What might be the consequences of cutting government spending now? How can we determine when austerity policies make economic sense?

• The basic unemployment rate in the United States has been hovering at just below 10 percent. Adding in the long-term unemployed who have become too discouraged to continue looking for work, as well as those who are working part time but would like to work full time, pushes the percentage of unemployed above 16 percent.  Yet not so long ago the consensus figure among economists for the U.S. “natural rate of unemployment” was stable at between 4 and 5 percent. How do economists explain this high and lingering unemployment rate? What can and should be done about it?

• It has been suggested that one reason so many are staying unemployed is that they are lazy and enjoy receiving unemployment benefits. What can economics tell us about whether unemployment benefits have a large perverse effect of increasing the unemployment rate? If that is so, why was the “natural rate” of unemployment thought to be closer to 4 percent just a few years ago?

• Japan has been stuck in a deflationary spiral for almost 20 years. Relatively high unemployment, weak productivity gains and slack demand appear to have become permanent features of its economy. Some observers point to signs that a similar condition could await the United States. How do macroeconomists explain Japan’s lingering deflationary situation? Is the U.S. in danger of falling into a similar trap, and what might be done to avoid it?

• The mortgage housing bubble that expanded throughout the first years of this century was anything but inconspicuous. Why weren’t more economists able to identify it and to recognize its potential for doing broad damage to the U.S. and world economies? If economics cannot currently identify emerging conditions that could threaten the Nation’s economic well-being, what kind of work do we need to fund to receive such insights.

This is a far more acceptable stance than that taken by Kartik Athreya, a senior economist in the Research Department of the Federal Reserve Bank of Richmond.  Athreya recently posted a four page statement (which no longer seems to be on the internet) arguing that too many people are unfairly challenging the work of mainstream economists.  In particular, “neither non-economist bloggers, nor economists who portray economics—especially macroeconomic policy—as a simple enterprise with clear conclusions, are likely to contribute any insight to discussion of economics and, as a result, should be ignored by an open-minded lay public.”

He goes on to say:

Many of those I am telling you not to listen to will more than successfully be able to match wits, in any generalized sense, with me. This is irrelevant. The question is: can they provide you, the reader, with an internally consistent analysis of a dynamic system subject to random shocks populated by thoughtful actors whose collective actions must be rendered feasible? For many questions, I and my colleagues can, and for those that the profession cannot, the blogging crowd probably can’t either.

To sum up his point: economics is a complex science, best left to well trained economists who are skilled in working the appropriate models.  Public debate over policy, or even the assumptions underlying the models, is inappropriate.  In short, our models are sound and we are making them better all the time; know your place people.

Finally, for a more critical and entertaining discussion of how mainstream economics has failed us, why leading economists continue to refuse to acknowledge its failure, and the lessons we should learn from this disastrous situation, read “The Great Mortification: Economists’ Responses to the Crisis of 2007–(and counting)” by Philip Mirowski.

A few highlights:

Mirowski notes that beginning in the 1980s leading economists took steps to marginalize methodologists and historians of economics from the discipline.  Their cover story was that students needed “more mathematics preparation, more statistics, and more tutelage in ‘theory,’ which meant in practice a boot camp regimen consisting of endless working of problem sets, problem sets, and more problem sets, until the poor tyros were so dizzy they didn’t have the spunk left to interrogate the masses of journal articles they had struggled to absorb.”

This, of course, did little to help either the students or their professors actually develop an understanding of real economic processes.  “Consequently, when the Great Mortification followed in the wake of the demise of the Great Moderation, those occupying the commanding heights of the profession were bereft of any sophisticated resources to understand their predicament.”

With economists unable to explain what was happening, the media turned to other sources for explanations.  What resulted were popular explanations of the crisis that had little to do with actual economic theory.

For example, most explanations of the crisis soon focused on the problem of toxic assets.  “People liked [this focus] because it embodied both a notion of the problem and the cure—if you ‘ingest/invest’ too many ‘toxic assets’ you die, but the way to get rid of poison is to flush it out of your system. Hence the entire crisis was not so different from an outbreak of E. coli in your spinach: dangerous, to be sure, but not a system pathology. All we had to do was detox, and everything would return to health. . . . The assets were toxic; we didn’t need to know how or why. We didn’t stop to think that the financial system intentionally produced them and therefore the entire metaphor was wonky at base. . . .
But more to the point, the metaphor had no basis whatsoever in the orthodox theory of finance.   In that theory, efficient markets are arbitrage-free, and any contingent claim can be reduced to any other contingent claim through some stochastic wizardry. Hence risk itself can always be commodified and traded away—that is the service the financial sector supposedly performs for the rest of the economy. The system as a whole simply cannot fail to price and allocate risks; hence there are no such things as virulently ‘toxic’ assets. Crappy assets, junk bonds, dogs with fleas, yes, but inherently ‘toxic,’ never.”

Economists have tended to ward off criticism by pointing to the scientific underpinnings of their work.  However, “although they trafficked in mathematical models, statistics, and even ‘experimentation,’ their practices and standards barely resembled those found in physics or biology or astronomy. Fundamental constants or structural invariants were notable by their absence. Indeed, one would be hard pressed to find an experimental refutation of any orthodox neoclassical proposition in the last four decades . . . . In the heat of battle, economists purported to be defending ‘science,’ when in fact, they were only defending themselves and their minions.”

Economists, who rely on models populated by agents acting on the basis of self-interest, rarely, if ever, examine their own work from the same lens.  “In any case, most conventional outlets for economic ideas have become willfully uninterested in the tangled conflicts of interest of the modern economics profession. Does anyone care that Martin Feldstein was on the board of AIG in the runup to its disastrous failure? Or that Paul Krugman once consulted for Enron (and got radicalized after the New York Times made him foreswear such perks)? Is anyone curious about the tangled history of the funding and organization of the Chicago School of economics? Does anyone care that Larry Summers worked for numerous hedge funds and investment firms before they had to be rescued by an administration that included…Larry Summers?”

Well, there is lots more interesting stuff there.

A Class Perspective On Economic Policy

Slate magazine has a very attention grabbing animation showing the growth in monthly unemployment, county by county, from January 2007 to October 2009, with each monthly picture reflecting changes from the previous year.  You can view it here.

It really helps to drive home the reality faced by millions of working people and the absolutely critical importance of passing an extension of unemployment benefits and implementing a meaningful national jobs program tied to a restructuring of our economy.

The Congress finally approved an extension of unemployment benefits, which is good.  But we should be clear that this is a stop-gap measure.  The average weekly unemployment payment is only $309; no one is getting rich here.

More importantly, many unemployed are not covered by unemployment insurance.  As the Economic Policy Institute points out:

Millions of the nation’s unemployed are not collecting unemployment benefits and are not eligible to do so under the laws in their state. Despite historically high unemployment, and record levels of long-term unemployment, only 67% of the unemployed workers in the U.S. were collecting unemployment insurance in the fourth quarter of 2009, the most recent quarter for which data are available from the Department of Labor. That “recipiency rate” includes workers receiving benefits under all of the extensions of emergency unemployment insurance that have been passed during the recession. When the recipiency rate is calculated based solely on the standard 26 weeks of unemployment, it drops to 35%: In other words, without the emergency extensions that have been passed, fewer than half of the country’s unemployed would be collecting unemployment.

Many who look at the sorry state of our economy are puzzled by the lack of meaningful national efforts to address it.   Let me offer a visual aid that might help to explain the lack of action.

As the chart below highlights, “although corporate profits suffered in the early part of the recession, they have been steadily growing for more than a year and are now 5.7% greater than they were at the start of the recession. . . .  Over that same period, the country lost 8.2 million jobs, or 5.9% of the job base. In other words, about one out of 20 jobs has simply disappeared. While job growth has resumed in recent months, the pace of job creation remains glacial, and as the chart shows, not nearly sufficient to recoup the losses suffered any time soon.”

In short, not everyone finds the crisis so terrible.   Still surprised by the lack of action?

Another Look At AmericaSpeaks and Deficit Politics

In a past post I discussed AmericaSpeaks, a political intervention by right-wing forces designed to promote fear of the national deficit as the greatest threat to our economic future and solutions weighted toward sharp cuts in social programs.

It appears that the organizers were not as successful as they no doubt had hoped they would be.  Despite being bombarded with material designed to scare and options designed to limit choices, majorities rightly held their ground and refused to be stampeded into endorsing socially destructive austerity policies.

For example, rather than supporting significant cuts in Social Security (which is self-financed and should not even have been part of the discussion), Medicare, and Medicaid, the overwhelming consensus of participants was that the deficit should be handled by:

•    Raising tax rates on corporate income and those earning more than $1 million.
•    Reducing military spending by 10 to 15 percent,
•    Creating a carbon tax and a securities-transaction tax.

Not a bad starting point.  On the other hand it remains to be seen how the organizers of AmericaSpeaks will report the results to the national deficit commission.

Some people have defended AmericaSpeaks on the grounds that the process was at least educational for participants.  On the face of it, a sustained discussion of government policies and their connection to the economy should be beneficial.

However, a poll of participants from four sites (Pasadena, CA; Augusta, ME; Chicago, IL; and Portland, OR) taken by the Center for Economic and Policy Research “revealed a surprising lack of knowledge among people who had just sat through a 6.5 hour-long discussion of the budget.”

The gaps are clearly in line with the biases of the organizers, or at least the major funders.  For example, the poll revealed that few people had any sense of the origins or timing of our current large deficits.  This lack of knowledge tends to reinforce popular perceptions, encouraged by the media, that out-of-control government spending is the main culprit rather than structural problems in our economic system.

In reality, as James Galbraith pointed out:

Overwhelmingly, the present deficits are caused by the financial crisis. The financial crisis, the fall in asset (especially housing) values, and withdrawal of bank lending to business and households has meant a sharp decline in economic activity, and therefore a sharp decrease in tax revenues and an increase in automatic payments for unemployment insurance and the like. According to a new IMF staff analysis, fully half of the large increase in budget deficits in major economies around the world is due to collapsing tax revenues, and a further large share to low (often negative) growth in relation to interest payments on existing debt. Less than ten percent is due to increased discretionary public expenditure, as in stimulus packages.

The poll also revealed that a minority of people were aware of the stability of our social security system.  According to the CEPR:

Only 31.1 percent correctly answered that the program could pay benefits for more than 25 years even if no changes are made. 23 percent thought that the program would first run short of money in less than 15 years. (The Social Security trustees project that the program will be able to pay all scheduled benefits for the next 27 years while CBO projects it can pay all benefits for the next 33 years.)

In addition, few people understood the basic assumptions underlying the Congressional Budget Office forecasts that are used to generate the estimates that are taken as proof of our debt crisis.  For example, these forecasts assume that our economy will rapidly recover over the next five years, generating sustained growth in production and employment.  And, without any structural changes.  Hmmm.

They also assume that we will have low inflation and high short term interest rates.  This combination is critical in creating the debt crisis (defined by a high debt-to-GDP ratio) because it ensures that current dollar GDP will grow relatively slowly (because prices will remain low) while interest payments on the national debt will soar (because interest rates will remain high).  However, if we make assume that low inflation is associated with low interest rates or high interest rates are associated with high rates of inflation—more likely associations–the, the debt/GDP ratio will fall significantly and the national debt crisis will disappear.  As it is, the CBO is forecasting interest payments on the debt rising to over 20 percent of GDP by mid-century. This would be equivalent to “new federal spending similar in scale to the mobilization for World War II”—something that is just not on the horizon.

As the CEPR concludes:

This lack of knowledge on key issues raises questions about the usefulness of the exercise. It is striking that people would have such a long period of time to devote to learning about and discussing the country’s budget and economic problems and yet were still seriously misinformed on several key issues. It appears that this effort was not very successful in educating the participants.

All that said, if you are dying to roll up your sleeves and take part in the deficit cutting process, let me recommend the CEPR debt calculator.  It provides excellent information about our current programs and how various policies would affect the debt burden in 2020 (which was the target year for AmericaSpeaks).

To access the calculator (illustrated below) click here.

The Ruins Of Detroit

Detroit appears to be a harbinger of our future.

That future is captured beautifully and painfully in a new book called The Ruins of Detroit by Yves Marchand and Romain Meffre.

Over the past generation Detroit has suffered economically worse than any other of the major American cities and its rampant urban decay is now glaringly apparent during this current recession. Yves Marchand and Romain Meffre documented this disintegration, showcasing structures that were formerly a source of civic pride, and which now stand as monuments to the city’s fall from grace.

“Ruins are the visible symbols and landmarks of our societies and their changes, small pieces of history in suspension. The state of ruin is temporary by nature, the volatile result of the end of an era and the fall of empires. This fragility, the time elapsed but even so running fast, lead us to watch them one very last time: being dismayed, or admiring, wondering about the permanence of things. Photography appeared to us as a modest way to keep a little bit of this ephemeral state.”

The picture below is of the United Artist Theater in Detroit.  You can see more of their pictures here.

Environmental writer Rebecca Solnit, recently in Detroit, commented that “the continent has not seen a transformation like Detroit’s since the last days of the Maya.” Detroit’s population has fallen from 2 million in the mid-1950s to 800,000 now.  “Poverty, joblessness, depopulation and decay have created an almost post-apocalyptic scene here.”

Mayor Dave Bing has announced his “revitalization” plan—shrink the city.  He is planning to cut city services to targeted neighborhoods, forcing their residents to move, and then tearing down their houses.

His plan is for a new, smaller, upscale, redesigned urban core.  And his plans are based, in large part, on recommendations from the organization, Living Cities. “Members of that national organization include the Bank of America, Deutsche Bank, J.P. Morgan Chase, Morgan Stanley, and Prudential Financial, along with ‘philanthropic’ groups like the Ford, Kresge, Kellogg and Skillman Foundations.”

Hmm, if you are suspicious that this plan has more to do with high-profit real estate deals then rebuilding the city for its inhabitants, you are probably right.   Sounds like what many of the same business elites have in mind for our national restructuring, doesnt it?

Already, Detroit is moving to close seventy-seven city parks—“the parking lots will be barricaded, trash bins will be removed, the grass will not be cut, equipment will not be maintained. No events will be permitted in the parks.”

Not surprisingly, there are other, more grass-roots visions for the city.  As Democracy Now reports:

Demolition crews here are planning to tear down 10,000 residential buildings over the next four years that the city has deemed dangerous. But as old structures are coming down, the city is redefining itself in other ways. An estimated 20 to 30 percent of the city’s lots are vacant. There’s a growing urban agriculture movement that community groups are using to reclaim Detroit. Several farms currently exist within the city, and there are hundreds more community, school and family gardens.

You can learn more about that movement here.

On June 23, 1963, Martin Luther King Jr. gave his “I have a dream speech” while leading a March in downtown Detroit.  That was two months before he used the same phrase in his more famous Washington D.C. address.

The struggle continues.

The Battle Over The Deficit

As discussed in previous posts, President Obama has established a so-called bipartisan deficit reduction commission.

This 18 person commission is bipartisan in that it includes both Republicans and Democrats.  However, far from representing different position on key social issues, these Republicans and Democrats are generally united in the belief that the budget needs to be balanced and that cutting social programs is the best way to achieve this goal.  Social Security and Medicare appear to be their primary targets.

The Commission, which meets in secret and is supported by staff previously employed by foundations funded by Peter Peterson who has long campaigned for cuts in social security, is to make its recommendations to Congress after the upcoming mid-term elections.  This is a dangerous situation.  As the Nieman Watchdog, a Harvard University journalism publication notes:

If [the commission reaches] agreement, their proposal will be voted on in December by a lame duck Congress, without the benefit of open hearings and deliberations in the pertinent committees and without the opportunity for open debate and amendment on the floors of the House and Senate.

On June 30, the economist James K. Galbraith made a presentation to the commission.  His remarks, although long, are well-worth reading.  They can be found here.

Quite frankly, we are in real danger of having our key social programs gutted.  For more on the political dynamics pushing this outcome, read this Talking Points Memo post, which describes how both republicans and democrats are lining up to endorse the attack on social security.

Even more seriously, the success of this push for austerity (which frames the attack on social security) also means that we are in real danger of losing the battle to rebuild our economy in ways responsive to the needs of the great majority of working people.  For example, read this In These Times article, “Labor Losing to DC Elites Over Job Creation.”

It is strange, isnt it–our collective work over the last decades has produced tremendous wealth–and yet, living and working conditions for the great majority keep getting worse.   I think we need to form our own commission, one that is prepared to examine the structural roots of class power and the social consequences of its operation.

The Insanity of Austerity

There is a world-wide push for cuts in government spending.  As the New York Times explains:

The world’s rich countries are now conducting a dangerous experiment. They are repeating an economic policy out of the 1930s — starting to cut spending and raise taxes before a recovery is assured — and hoping today’s situation is different enough to assure a different outcome. In effect, policy makers are betting that the private sector can make up for the withdrawal of stimulus over the next couple of years.

In particular, the leaders of the group of 20 agreed at their recent meeting in Toronto to cut their respective national budget deficits in half by 2013 and stabilize or reduce their government debt to GDP ratios by 2016.  Recognizing that this was not going to be an easy task, the leaders acknowledged that the timetable was to be thought of as a goal not a mandate.

Wow, here we are, in danger of a global double dip recession having never really recovered from the effects of the Great Recession, and governments have joined together to press for massive cuts in social spending.  No wonder people like Paul Krugman are starting to talk of a new (third) Depression.

At the time of the G20 meetings, our papers were filled with reports describing how President Obama argued vainly against this policy (which was strongly supported by the leaders of Canada, Germany and Britain).  But Obama’s own domestic policy record is not quite so pure.  For example, he recently established a National Commission on Fiscal Responsibility and Reform and appointed two men to lead it that have a long history of advocating sharp cuts in social programs, especially social security.  They are scheduled to give their report in December.

So, how do we explain what seems like insanity?  The media tells us that this is what the American people want—that their biggest fear is of runaway national debt and no politician can stand against this popular demand for cuts in spending regardless of the short term consequences.

In reality, if people do believe that we are best served by slashing government spending on social programs, it is largely because the media and our politicians have done all they can to convince them that this is what needs to be done.  However, there are strong reasons to doubt that people really buy the argument.   For example, at the June 26 national Town Hall meetings (organized by AmericaSpeaks) that were designed to encourage support for cuts in government social programs, organizers found that a significant majority of participants were not buying the argument.

Regardless, the real question is why a large majority of government and business leaders have embraced this strategy of slashing government spending.

Arguments for austerity are generally based on the following reasoning: capitalism is a well functioning system.  Right now we have problems because of excesses in the form of too much debt.  Previously it was private debt and now it is public debt.  We have to purge those excesses.  The Great Recession helped purge the private debt—now austerity is needed to purge the public debt.  Once that is accomplished, government borrowing will fall, interest rates will decline, and private business investment and production will soar, laying the groundwork for a long term expansion.

Of course, reality shows that this prediction is based on flawed reasoning.  In broad brush, beginning in the late 1960s, profits took a hit as intense global competition limited price increases at the same time as relatively full employment pushed up wages.  Government deficit spending kept the economy afloat during the 1970s but at the cost of growing inflation and stagnation (as business refused to invest because of the low profits).  Finally, in the 1980s, government and business elites joined together to reverse course.  They attacked unions, slashed regulations, and cut social programs.  Wages fell and price stability was achieved, but growth and profits remained weak.

That changed in the 1990s.  First a stock market bubble and then a housing bubble helped to generate growth and record profits.  Eventually the bubbles burst, leaving us in crisis.  We have again regained stability (but not growth) but at the cost of massive public debt.  In short, as a consequence of past government and corporate policies, our growth has become dependent on debt; without it, we face stagnation or worse.

So, returning to the question—why are our political and business leaders arguing for a policy that is likely to produce an economic disaster?  No doubt, some believe conservative fantasies about self-regulating capitalist economies.  But I would guess a majority do not.

This majority is worried—our economic system did not serve majority needs even when our economy was growing.  Now things are far worse.  Elites fear that unless something is done, popular movements for real structural change could get traction, leaving them the big losers.  This call for austerity has the virtue of shifting popular attention away from structural issues to government spending.  The more people view the government and in particular government spending on social programs as our main problem, the better it is for elites.

Moreover, if elites actually succeed in getting cuts in social programs, their own structural position will be strengthened.  For example, the weaker social security, the greater the demand for private pension programs; the weaker public education, the greater the demand for private education; and so on.  Dismantling public programs ensures a future going forward in which private activity will become more, not less, essential.

Now, there is a very good chance that their strategy will create a long depression.  Even that outcome doesn’t make their strategy self-destructive.  No doubt small and medium businesses will be hurt, and there will be a global shakedown, but the end result is likely to be a further concentration and centralization of power in the hands of large corporations.  And if social unrest does develop, they can always reverse course and support new stimulus programs and federal bail-outs, just like the financial sector did after the housing bubble burst.

So, where does that leave us—we know how austerity works—it punishes us in the short run while undermining the basis for healthy long-term growth.  Unfortunately, our political and business elites seem content to pursue policies that will produce this outcome.  If we don’t mount serious resistance, we face a very depressing future.

OK-lots of words here—if you want a fun way to understand the structural nature of our problems and why we need action, check out this wonderful animated video of David Harvey talking about the crisis, and how it is explained to us.