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How Much Faith Should We Put in Keynesian Economic Models?

Economics / Economic Theory Dec 21, 2010 - 11:59 AM GMT

By: Robert_Murphy

Economics

Best Financial Markets Analysis ArticleJim Manzi is a private-sector expert in statistical analysis. He is my favorite commentator on the economics of climate change, because he dove into the IPCC reports and found that the proposed legislative "cures" (cap-and-trade or carbon-tax laws) are arguably worse than the disease, even according to the "consensus" numbers.


Lately, Manzi has been challenging mainstream economists to defend their models, which tout the benefits of fiscal and monetary "stimulus." Manzi has repeatedly asked why he should put any faith in the predictions of these models.

In this article, I'll highlight the hilarious response of Manzi's debate opponent, Karl Smith. In a follow-up article, I'll document another example of misplaced confidence in Keynesian models, courtesy of (you guessed it) Paul Krugman.

Manzi vs. Mainstream Economists

There are several articles in Manzi's archives where he tackles economists on the empirical case for stimulus; this longer article is a good introduction to his perspective. Manzi is not himself an economist, let alone an Austrian economist, but nonetheless he brings a refreshing perspective to the surprisingly weak foundation upon which governments and central banks have based their policies.

Most recently, Manzi has been arguing with Karl Smith, a professional economist (see 1, 2, 3, and 4). When Smith claimed that his models — which prescribe budget deficits and loose money as the way to help an ailing economy — were reliable, Manzi said, "Prove it."

Smith responded by admitting that of course we can't prove anything in science. However, Smith said we have good reason to think that mainstream economic models gave good predictions about the effects of various policies, certainly better than random guessing would. Here is the first part of Smith's case:

There are two basic lines of reasoning I can offer.

One is evidence and logic. We can talk about why in this case stimulus makes sense, why the evidence looks like it points in the direction that it does and why it seems to be telling us something different than mere folk wisdom.

Throughout human history evidence and logic have shown themselves useful. They are by no means omnipotent. The smartest people make mistakes. The most carefully argued cases are sometimes wrong. Nonetheless, as a general guide evidence and logic are useful.

Thus you should "rely" on my [prediction] because you follow my evidence and logic. And, if you don't follow my evidence and logic then we should talk about it. I talk about this for a living and am more than willing to devote as much time to it as Jim or anyone else wants. I crave the opportunity to offer evidence and logic for these positions. This what I hope to do with this blog.

Of course, nobody is disputing the usefulness or reliability of evidence and logic per se. Manzi's whole point is that it's not clear — it's not logical — that we should have faith in what the Keynesian model builders have been telling us for the last two years.

But now we come to the laugh-out-loud part. Here is Smith's second line of reasoning to justify his models' predictions:

The second line I offer is that of experience. That when economists had the helm we really were able to produce results. In the 1980s Central Banks were largely turned over to their economists who produced low inflation and low unemployment by manipulating the overnight lending rate.

Indeed, the two major failures in that period, Japan and the current recession, coincided with the overnight lending rate hitting zero and thus no longer being under the economist's control. So our basic argument was that we can steady the economy so long as we have control over the overnight rate seems to be validated.

An argument that delicious cries out for a good analogy. When I posted Smith's remarks on my blog, reader Andrew DePompei quipped,

I kind of see what he is saying here. I mean, I'm a really good driver, and do an excellent job of managing different road conditions, avoiding pedestrians, other cars and such. There are, however, two examples in which my car went off a cliff while I was behind the wheel. But at that point, being airborne, I really had no control over the car, so I can't be held accountable for what happened at the bottom of the cliff.

On a more serious note, there are several flaws with Smith's argument. For one thing, it's not as if economists weren't involved with central bank policy before 1980. For example, Irving Fisher thought the Federal Reserve had done a wonderful job stabilizing (consumer) prices in the late 1920s, which led him to make his infamously bullish remarks just before the stock market crashed (see pages 8–9 in this downloadable paper). Decades later, the high price inflation and unemployment of the 1970s was arguably the result of orthodox, hydraulic Keynesianism of the sort touted by Paul Samuelson in his prime.

So even on their own terms, when current economists pat themselves on the back for ushering in the "Great Moderation" of low price inflation and steady economic growth, all they are really saying is this: "Starting in about 1983, we economists did a great job steering the economy, compared to the horrible job economists did before then, what with the Great Depression and the stagflation of the 1970s. But then we slipped up again in 2008, when the second worst economic crisis in world history happened on our watch. It's Miller time."

Remember, the whole point of establishing the Federal Reserve (in 1913) was ostensibly to prevent the wild financial panics of the free market, such as the crash in 1907. Using the latest work from mainstream economists (i.e., not even Austrians), one can make a compelling case that the Federal Reserve has been a source of instability throughout its history.

Finally, even smack dab in the alleged golden age — when Karl Smith thinks economists did a great job steering the economy — the US stock market experienced the worst one-day crash in its history, falling more in 1987 than it did even in late 1929.

Conclusion

Before closing, I should mention that Karl Smith seems like a perfectly nice guy, and his debate with Manzi is very cordial. Yet his self-described "defense of economics" (by which he means mainstream macroeconomics) doesn't recognize that the empirical record is entirely consistent with those models being horrible.

Let me put it in other words: The Austrian critique of artificially low interest rates is that they fuel an unsustainable boom, sowing the seeds for an eventual crash. Yes, after a particular collapse, it's possible for the central bank to do it all again. This might appear to give a "soft landing," and indeed people might laud the Maestro for his deft manipulation of the federal-funds rate.

But tinkering with electronic bank reserves doesn't expand the actual supply of capital goods. Eventually, the inflationary chickens will come home to roost. The ultimate bankruptcy of monetary pump priming — of flooding the credit markets with money printed out of thin air — occurs when short-term interest rates hit zero, and can go no further.

Now it's true, Smith and others can say, "Well, once we hit the zero bound, there are other tools the Fed can use — it's not out of ammunition!" In response, the Austrians humbly suggest that the central bank stop shooting the economy.

What would it take for the interventionists to admit that they're making things worse?

Robert Murphy, an adjunct scholar of the Mises Institute and a faculty member of the Mises University, runs the blog Free Advice and is the author of The Politically Incorrect Guide to Capitalism, the Study Guide to Man, Economy, and State with Power and Market, the Human Action Study Guide, and The Politically Incorrect Guide to the Great Depression and the New Deal. Send him mail. See Robert P. Murphy's article archives. Comment on the blog.

© 2010 Copyright Ludwig von Mises - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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