About the state of economic science, and advice from a famous economist

Summary:  an economist explains the current state of the science of economics, and then Bruce Bartlett most-famous modern economist’s advice to us.

Excerpt from a post by Prof Brad DeLong (Economics, Berekeley) at his blog Grasping Reality with Both Hands.  It is so perfect that it needs no elaboration:

The problem is that economic theory is not rocket science. It is not like theoretical physics — conducting a relatively few crucial experiments to decide on basic theories and then working out the consequences of those theories from first principles. Economic theory is, instead, crystalized history. We take a bunch of historical episodes that seem relevant to the problems of interest of today. We boil down what seem to be their salient features. And then from the resulting soup and bones we construct simple stylized models that we think help us understand present and future episodes that fall into the same class.

The problem is that right now we have a financial crisis big enough and strange enough that there is only one past historical episode in the same class: the early stages of the Great Depression. And when there is only one, the value of skill at deriving theoretical lessons from the class is at a steep discount and the value of knowing the history is at a premium: better to take the history raw.

What would Keynes advise us to do?

His post discusses an article I recommend reading:  “What Would Keynes Do?“, Bruce Bartlett, Forbes, 5 December 2008 — “The government should spend on stuff, not on bad assets.”   Excerpt:

Every day that goes by makes clearer the parallels between the current financial crisis and the one that led to the Great Depression. Then, as now, the core problem was one of deflation, or falling prices. But fixing it will require more than just low interest rates. This was the key insight of British economist John Maynard Keynes, whose theories finally explained how to end the Great Depression. They may be the key to solving today’s crisis as well.

The Great Depression was so deep and prolonged for many reasons. Herbert Hoover stupidly signed the Smoot-Hawley Tariff, which crippled international trade and finance, and imposed one of the largest tax increases in American history in 1932, which was exactly the wrong medicine at the wrong time. Franklin D. Roosevelt at least understood that deflation was at the root of the problem, but he thought artificially raising the price of gold and preventing businesses from cutting prices and wages by law was the solution. In fact, it prevented the economy from adjusting, which made the situation worse.

{I will skip over his analysis, which is succient and excellent, and jump directly to the conclusion}

Keynes argued that the only thing that will really work is if the federal government uses its resources to purchase goods and services. It must buy “stuff”–concrete, computers, paper, glass, steel–anything as long as it is tangible. In other words, the government must spend the way households do, by buying things.

It must also employ labor, because much of what people spend money on today is in the form of services. This doesn’t necessarily mean putting workers on the federal payroll, it just means that, to the extent that the government purchases services, this will also help raise spending in the economy.

We will know that the government is spending enough to matter when interest rates start to rise. Although we think of saving as coming in financial form, in reality, saving represents things–labor and raw materials that are used to produce products and services people want.  Once the federal government increases its purchases of goods and services, it preempts resources that private businesses would otherwise use in production. As they compete with each other for those resources, their prices will rise and interest rates will rise.

At this point, Federal Reserve policy will become effective again. As prices and interest rates rise, the liquidity trap disappears and money begins circulating more rapidly; i.e., velocity increases. This is what ends an economic crisis. Unfortunately, it was not until World War II that the federal government spent enough on real resources–because they were needed for the war effort–to make Keynes’ theory work in practice.

The challenge for Congress and the Obama administration will be to devise a spending program that draws a significant amount of real resources out of the economy fast enough.

More analysis follows of various solutions —  also valuable to read.

Bruce Bartlett is a former Treasury Department economist and the author of Reaganomics: Supply-Side Economics in Action and Impostor: How George W. Bush Bankrupted America and Betrayed the Reagan Legacy.  Here is his Wikipedia bio.

FM comments on this

While sensible, this article sparks the following train of thought.

  1. Economics has been one of the most common undergraduate majors for several generations.
  2. This is Econ 101, the primary lesson from the major economic events in 20th century American and global history.
  3. One of the top experts on the depression era has been Fed Chairman throughout the entire crisis.
  4. Why should this article need to be written?   This message should be as necessary to say as “don’t pee upriver of your water source.”

Any answers?

Afterword

If you are new to this site, please glance at the archives below.  You may find answers to your questions in these.

Please share your comments by posting below.  Per the FM site’s Comment Policy, please make them brief (250 words max), civil, and relevant to this post.  Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For more information from the FM site

To read other articles about these things, see the FM reference page on the right side menu bar.  Of esp relevance to this topic:

Forecasts on the FM site about solutions to the crisis:

  1. A happy ending to the current economic recession, 12 February 2008 – The political actions which might end this downturn, and their long-term implications.
  2. Slow steps to nationalizing the US financial sector, 7 April 2008 — How this will change our society.
  3. Slowly a few voices are raised about the pending theft of taxpayer money, 21 September 2008
  4. How should we respond to the crisis?, 24 September 2008
  5. A solution to our financial crisis, 25 September 2008
  6. A quick guide to the “Emergency Economic Stabilization Act of 2008″, 29 September 2008
  7. The Paulson Plan will buy assets cheap, just as all good cons offer easy money to the marks, 30 September 2008
  8. The last opportunity for effective action before disaster strikes, 3 October 2008
  9. Prof Roubini prescribes first aid for America’s economy, 4 October 2008
  10. Effective treatment for this crisis will come with “The Master Settlement of 2009″, 5 October 2008
  11. Dr. Bush, stabilize the economy – stat!, 7 October 2008
  12. The new President will need new solutions for the economic crisis, 9 October 2008
  13. Results from the IMF meeting – just thin gruel, 12 October 2008
  14. The G-7 meeting was the last chance for action before the global recession, 12 October 2008
  15. A brief note about our financial system: Intermediation, disintermediation, and soon re-intermediation, 16 October 2008
  16. New recommendations to solve our financial crisis (and I admit that I was wrong), 23 October 2008
  17. A look ahead to the end of this financial crisis, 30 October 2008
  18. Expect little or nothing from meetings like the G20 – or the Obama Administration, 18 November 2008

Originally published at Fabius Maximus and reproduced here with the author’s permission.

3 Responses to "About the state of economic science, and advice from a famous economist"

  1. Guest   December 9, 2008 at 2:22 pm

    Isn’t it Keyensian economics that has failed here? After all, the government has done everything Keynes recomended: raised domestic spending, raised military spending, raised the minimum wage, cut taxes and expanded the money supply.Yet all we get is fail, macrofail.

  2. Payam   December 9, 2008 at 2:33 pm

    Actually the government hasn’t done any spending yet, as in spending on tangible stuff. What the FED has been doing is separate from that. The FED has only been trying to keep the financial system intact.

  3. Econophile   December 12, 2008 at 1:14 pm

    FM, why do you keep repeating the fairy tale that Keynesian economics got us out of the Great Depression? It is well known that it didn’t. It was the policies of Hoover and FDR that caused the depression. Why did a common market crash and recession turn into a 15 year depression? Massive deficit spending was just one of the errors FDR made that caused poverty and mass unemployment.Brad DeLong has it wrong too — and backwards. He’s the Keynesian poster boy for the ills of economic theory. You first come up with a good theory founded in logic and reason and then you look at data. How can you look at data without a theory? How do you know which threads of history to look at?