6 Unanswered Economics Questions: Answered



I recently stumbled on an interesting article by Edward Hadas. The headline is “Admit economic ignorance”, and that’s what he urges us to do: Recognize that there are questions that we, economists, can’t answer yet and maybe never will.

While I’m all for recognizing when we don’t know the answer to a question, and while I’m definitely in the camp that opposes the “natural science style” economics where every answer has to be super-precise and mathematical (rather than relying on psychology etc), his examples are not very good. In fact, I hereby accept the challenge to answer every single one of these “unanswerable” questions.

So, let’s get going:

1) What causes retail inflation?

What Mr Hadas doesn’t seem to realize is that there is a lag between an increase in the money supply and actual retail inflation. How long this lag is depends on several factors, but most of all on the propensity to consume, and indirectly on the banks’ willingness to lend out money. That is; if you print up trillions of dollars but have no way of making these trillions of dollars reach the economy, then they won’t cause any inflation. It is because of this “problem” that QE3 was announced; the Federal Reserve is now buying mortgage-backed securities directly, thinking the money will then reach the economy faster than if we just sit around and wait for banks to lend it out. The jury is still out on whether this will work, but personally, I don’t think so.

Also, the author appears to be clueless on the consensus among economists, as he claims

“If, as other professionals believe, prices fall when there is excess supply of goods and labour, then inflation rates are inexplicably high”.

To my knowledge, no economist believes that prices will fall when there is an excess supply of labour. This is a well-known phenomena that we recognized about 80 years ago: Wages are sticky. They don’t fall as easily as the stock market index does – people’s wage demands tend to stay pretty much the same during recessions, which of course is a problem as this means unemployment remains higher for much longer than necessary. If wages had adjusted instantaneously, unemployment would not be standing at 7.8 % right now. It takes a long time for workers, even those that are unemployed, to accept that they have to work the same hours for less pay than they used to get. It takes even longer of course in countries which have unemployment benefits, where an unemployed person doesn’t have to be in a great hurry to get a job.

So can we explain retail inflation? Pretty much, yes. The problem is not that economists can’t explain inflation, it’s that we ignore what we deep inside know when we give policy advise. We know that the stimulus, QE1-2-3 etc will come back and bite us in the form of higher inflation later, but many of us support it anyway due to shortsightedness.

2) How do financial asset prices affect the real economy?

First I need to quote the author again:

“Before the credit bubble burst, most economists believed high prices in financial markets were a sign and a cause of a strong economy.”

Before? We still do. High prices in the financial markets are a sign of a strong economy – it just isn’t necessarily a sign of an economy with strong fundamentals. That’s what economists got mixed up during the boom: Just because an economy is booming, doesn’t mean it’s good or sustainable. That depends on the cause of the boom. The economy was strong in 2006, but it wasn’t good: It was a house built on the beach. There’s a difference.

So how do financial asset prices affect the real economy? Short answer: It depends. In general, high asset prices is a good thing – a higher stock market index will lead to more savings for regular people with money invested in the stock market (and most people do have money in the stock market), when the stock market is booming it is easier for entrepreneurs to raise capital which means they can hire more, which leads to lower unemployment which as we all know is a good thing.

However, we keep coming back to the term fundamentals. In economics, we know that the only thing that causes long-term per-capita growth of GDP is technological improvements – new innovations, in short. An increase in the savings rate can also cause growth for a long time (though not forever – the explanation is too long and complicated for this post). Hence, it would make sense for the stock market to grow when the growth rate of technology is high, and fall when it is low. Obviously other factors would be involved as well; but here’s my point: Today, the stock market grows and falls mainly based on the actions of the Federal Reserve, and the federal government. The Federal Reserve (together with a few other central banks, most notably the ECB) caused the previous boom by oversupplying the economy with cheap credit which was lent out in the form of subprime loans, which caused prices of financial assets to soar temporarily (as quite a bit of that newly-printed money ended up in the stock market) and the extra demand forced unemployment down. Of course, the party wasn’t going to last forever.

It’s not that there is no connection between financial asset prices and the real economy, as the author seems to imply – rather; it’s all about the fundamentals. Why is the stock market growing? Why is the economy booming? “Why” is the great question you need to ask yourself before you can tell whether a stock market/economic boom is a good or a bad thing, and in the case of a boom in financial asset prices, you need to know why they are booming to understand what impact the boom will have on the real economy, long-term.

3) Do big fiscal deficits damage the economy?

This one is the easiest one to answer: Of course they do! In fact, deficits don’t even have to be big to damage the economy.

Let’s look at the counterevidence against this claim, starting with Japan: Before anyone wonders why Japan is surviving despite a government debt of above 200 % of GDP, remember this is the country that gave us the term “lost decade”, as in “Japan had a lost decade due to incompetent government policies which among other things brought government debt above 200 %”. Is this really a country who’s example we’d like to follow? That’s like looking at a lung cancer survivor and saying “Man, I really should start smoking, look at that guy – he survived with only a dozen rounds of chemotherapy and five surgeries!”. Just because Japan hasn’t officially gone bankrupt (yet!), doesn’t mean that their enormous government debt isn’t a problem. Japan survives mostly due to loyal domestic investors who keep buying government bonds, but the government debt still casts a huge shadow on the economy. Japan’s economy never fully recovered after their “lost decade”, and I can bet you any amount you want that government debt is a factor in why that is so.

Next, we have the claim that government debt used to be higher right after the WWII, and sure that worked out alright – we got the postwar boom at the same time our government debt was above 100 % of GDP! Of course, as any serious economist will tell you, the postwar boom was caused by an extreme increase in demand – as factories, houses etc had to be rebuilt, there was a lot of demand which spurred the economy. And luckily, there was also a lot of savings just waiting to be invested somewhere: This was due to the rationing in WWII which meant in most cases that you couldn’t spend your entire salary (you wouldn’t have had enough ration cards to do that). So WWII meant “mandatory saving” – and of course, these savings where consumed right after the war, creating an enormous boom. We could get into a more technical discussion about how the economies in Europe were below their steady states and so were bound to grow fast, but I think I’ll leave it at that.

There is another problem with deficits that I’ve pointed out before: Once you’ve ran a deficit for a few years, it becomes a habit. This is what I meant when I said (above) that a deficit doesn’t have to be big to be dangerous. Even a small deficit can increase the tolerance for deficits among policymakers, and the general population, which then leads to bigger deficits down the line.

It should be obvious that deficits are bad down the line, as sooner or later you won’t be able to afford the repayments. Keynesian critics will now claim that a country can run a deficit, invest in infrastructure or similar, and grow its way out of the deficit. However, Reinhart and Rogoff (This time is different, 2009) proved conclusively that this is pretty much impossible and that government debt is reduced through austerity, not stimulus.

4) What does quantitative easing actually do?

Here, I will admit the author has a point: Quantitative easing is kind of confusing. Does it lower interest rates, or raise them? The answer, of course, is both: In the short term, quantitative easing tends to lower interest rates as you’ll have more money, but the same demand for money as you used to have (more supply, same demand = lower price – and the price for money is the interest rate). However, if this keeps going for any significant amount of time, it is bound to also raise inflation expectations, which drives up interest rates again. This is one of the reasons why quantitative easing is only a temporary measure that cannot be used to grow the economy in the long-term. This isn’t really a question economists can’t answer; the answer just can’t be summed up in one line. You need to understand the difference between the short-, medium- and long-term. The author obviously doesn’t.

5) How much leverage is too much?

This is one of the trickier questions. Like I said, I’m not really a believer in “natural science” economics, so I won’t pretend like there is a specific answer to this that will always be correct. However, economics does give us a clue on how to handle the issue of leverage. You see, banks and other companies really don’t have anything to win from leveraging too much. They’re naturally quite risk-averse, even though it’s hard to believe with the past few years in mind. There is no incentive, and so in a free market, overleveraging should be quite rare.

The real cause behind over-leveraging is, again, government intervention – mainly in the form of the Federal Reserve. When credit is cheap, it’s very easy for a private corporation (bank or otherwise) to fall for the temptation of taking on more debt (leverage). This is especially so when all the others are doing it; a company that is watching all its competitors expand with the help of cheap credit may feel pressured to follow suit (this pressure may come from stockholders, or it may be internal). And of course, the source of the cheap credit is the Federal Reserve, distorting interest rates and incentives.

Again, the problem is not that we don’t know the solution to the problem; it’s that we pretend we don’t know it. Economists who are fully aware that incentives create actions and that lower interest rates create an incentive to take on more debt will still support quantitative easing of the kind we saw in the early 2000’s, which led to the current crisis.

6) How to deleverage without damaging the economy?

Mr Hadas makes one correct observation: So far we’ve only moved debt around, from the private balance sheets to government balance sheets. The best example of this might be Ireland, where the government stepped in during the financial crisis in september 2008 and issued a bank guarantee, effectively turning all bank debt into government debt. However, his claim that economists don’t know how to deleverage an economy without damaging it is totally wrong.

It’s about expectations: If deleveraging is a good idea in the medium- and/or long-term, then even if it doesn’t have positive effects today, it won’t necessarily cause a recession. Investors – most of them – think about the long term more than the short term. If you do something that won’t be good in the short-term but will be good in the long-term, you can very often reap the rewards in the short-term as well as investors invest more in anticipation of higher returns tomorrow. If deleveraging is good in the long term, then it shouldn’t cause any significant problems in the short term either. Whether you manage to pull it off depends on how good you are at expectations management, which in turn mostly depends on how credible you are (credibility is a problem for a lot of government). It’s not easy to do pull off a smooth deleveraging of the economy, but the reason is not because economists lack answers.

Summary

In summary, I conclude that Mr Hadas should pick up an economics journal before he writes another article. I don’t know anything about his credentials in the area, but whatever they may be, it doesn’t change the fact that this article clearly misses the mark. There are questions economists are still struggling with, but none of the above present any serious challenges. The real challenge is to convince policymakers to apply the knowledge that we economists possess.

Luckily, tuesday next week America will have a chance to elect an economist (Paul Ryan) and a businessman (Mitt Romney) to vice-president and president respectively. I know there is a debate on this site whether or not we conservatives ought to support Mitt Romney or not. Personally, I’m not an American citizen, but I would like to urge you who are lucky enough to hold American passports to vote for Romney/Ryan, if only to give economic science a greater influence in economic policymaking. The past four years, economic policies have been guided by class warfare and left-winged populism. I hope I’m not alone in thinking that it’s time we let actual, scientific economics solve our economic issues.

Thank you for reading.

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