It is most difficult, if not impossible, to describe our or others' ongoing naive experience without in the process destroying the experience itself.  Indeed, we are always three levels removed from the ongoing experience itself when we study it.  That is, when we describe this experience to ourselves we are already once removed from it; when we subsequently try to analyze this experience into its components we are twice removed.  And finally, when we begin to conceptualize and generalize meaningfully from the particular experience we are thrice removed from it.

BERKELEY – One of the dirty secrets of economics is that there is no such thing as “economic theory.” There is simply no set of bedrock principles on which one can base calculations that illuminate real-world economic outcomes. We should bear in mind this constraint on economic knowledge as the global drive for fiscal austerity shifts into top gear.

Unlike economists, biologists, for example, know that every cell functions according to instructions for protein synthesis encoded in its DNA. Chemists begin with what the Heisenberg and Pauli principles, plus the three-dimensionality of space, tell us about stable electron configurations. Physicists start with the four fundamental forces of nature.

Economists have none of that. The “economic principles” underpinning their theories are a fraud – not fundamental truths but mere knobs that are twiddled and tuned so that the “right” conclusions come out of the analysis.

The “right” conclusions depend on which of two types of economist you are. One type chooses, for non-economic and non-scientific reasons, a political stance and a set of political allies, and twiddles and tunes his or her assumptions until they yield conclusions that fit their stance and please their allies. The other type takes the carcass of history, throws it into the pot, turns up the heat, and boils it down, hoping that the bones will yield lessons and suggest principles to guide our civilization’s voters, bureaucrats, and politicians as they slouch toward utopia.

Not surprisingly, I believe that only the second kind of economist has anything useful to say. So what lessons does history have to teach us about our current global economic predicament?

In 1829, John Stuart Mill made the key intellectual leap in figuring out how to fight what he called “general gluts.” Mill saw that excess demand for some particular set of assets in financial markets was mirrored by excess supply of goods and services in product markets, which in turn generated excess supply of workers in labor markets.

The implication of this was clear. If you relieved the excess demand for financial assets, you also cured the excess supply of goods and services (the shortfall of aggregate demand) and the excess supply of labor (mass unemployment).

Now, there are many ways to relieve excess demand for financial assets. When the excess demand is for liquid assets used as means of payment – for “money” – the natural response is to have the central bank buy government bonds for cash, thus increasing the money stock and bringing supply back into balance with demand. We call this "monetary policy."

When the excess demand is for longer-term assets – bonds to serve as vehicles for savings that move purchasing power from the present into the future – the natural response is twofold: induce businesses to borrow more and build more capacity, and encourage the government to borrow and spend, thus bringing the supply of bonds back into balance with demand. We call the first of these “restoring confidence,” and the second “fiscal policy.”

Austerity drives can unleash confidence By Guy Monson and Subitha Subramaniam

Published: July 27 2010 11:23 | Last updated: July 27 2010 11:23

Britain’s politicians appear to thrive on habitual experimentation. In the early days of the financial crisis, the UK was the first to offer the banking system unconditional support. It then went on to become the first country to embrace “zero” interest rates and quantitative easing. Now, just two years on, the new coalition government looks set to do another first by abandoning the spirit of Keynesian interventionism that prevailed during the dark days of the crisis.

The Con-Lib volte-face on state spending is to be lauded; as the facts changed, the coalition changed its mind. The ever-expanding state was no longer the solution to economic lethargy, but the cause for endemic underperformance, and unless the state itself was “right-sized”, the economy would struggle to achieve its potential. Such flexibility of thinking or opportunistic policymaking is remarkable; Keynesian interventionism worked to resuscitate animal spirits in the dark days of financial panic, but with markets now more rational and the costs of interventionism rising to 40 per cent of gross domestic product, does it not then make sense for policymakers to throw out the Keynesian rule book?

To begin with, Keynesians argue that government spending has a positive multiplier effect on the economy, with every pound of government spending increasing GDP by roughly £1.70 (the “multiplier”). Keynesians therefore believe that periods of weakness in private demand should be offset by increases in government spending.

But perhaps this is too simple – there are limits to Keynesian interventionism. As the state gets larger and larger, the multiplier benefits of government spending become smaller and smaller, and taxing the working many to support the non-working few eventually leads to a system of the working few supporting the non-working many.

There is also the question of affordability; when debt loads are light, it is easy to be guided by Keynesian interventionism. However, with the Treasury’s purse exhausted, and the debt-to-GDP ratio set to climb to 70 per cent by 2012, further intervention needs funding. At the extreme, debt monetisation, or the explicit purchase of the Treasury’s deficit bonds by the central bank, could resolve funding needs. But there is no free lunch for the government – debt monetisation will eventually lead to a loss of investor confidence, with bond vigilantes demanding higher interest payments which would gobble up scarce government resources.

Perhaps the biggest fallacy of today’s interventionists is to ignore the role of private sector expectations. Government spending does not exist in isolation, pumping up demand in bad times and pumping down demand in good times. Government policies usually trigger a strong feedback loop from the private sector, as households, investors and corporations all start to adjust their spending and investing decisions.

There has been no better champion for the importance of the private sector’s reaction to government policy than David Ricardo, a classical economist from the 18th century. In Ricardo’s world, there is an “equivalence” of public and private spending that essentially renders the fiscal pump irrelevant. The private sector understands that there is no free lunch for the government and anticipates that government splurges will be followed by tax increases. Periods of government expansion are therefore offset by increased private savings, and periods of fiscal frugality offset by private spending. For Ricardo, the fiscal multiplier is essentially zero and government spending has no impact on economic growth.

In recent years, classical economists have taken Ricardo’s “equivalence” a step further by arguing that the fiscal multiplier on government spending is actually negative. In other words, spending splurges reduce growth and austerity drives raise growth. This is because government behaviour not only impacts the private sector’s expectations but also confidence. A smaller government improves confidence as the private sector expects lower future taxes and lower interest rates. Both these work to lower savings and boost asset values, which become the engine for a sustainable expansion. In sharp contrast to the Keynesians’, these classical economists believe that austerity drives can unleash “expansionary fiscal contractions”.

Though seemingly a paradox, expansionary fiscal contractions are not a figment of economists’ imagination. They have occurred in recent history, with Denmark and Ireland in the 1980s being the most successful examples. In both cases, there were three key ingredients for success.

First, the public sector made a clear commitment to embark upon large-scale restructuring aimed at improving the flexibility of the market and the economy. Fiscal consolidation targeted structural reforms that aimed to improve the competitiveness of the labour market. Second, the fiscal consolidation plans were credible, permanent and broad-based. Only when the public believed that the government would not backtrack, did they change their savings and consumption behaviour positively. Third, fiscal consolidation triggered a powerful decline in interest rates and interest rate expectations, which boosted asset values and consumption.

The economic reality is that the role of the government can be either a Keynesian positive or a classical negative, depending upon how fiscal plans are executed. If consolidation plans tackle structural reform and are permanent and credible, then there is every chance that growth can resume even as the government makes cuts. However, if fiscal consolidation measures are temporary and not targeted at reform, then there is every chance that growth suffers as the government recedes.

The new government has little choice but to play the hand it has been dealt, and this is a hand of grim fiscal realities. Its decision to execute a large, permanent and credible fiscal consolidation programme is an active choice to shift the government “multiplier” in its favour. It is seeking to improve confidence and growth even as austerity reigns – and its foresight should be lauded. Better to create a smaller and more nimble government that steers the economy through tomorrow’s world of austerity, than passively to stay the course and hope for a better tomorrow.

Guy Monson is chief investment officer and managing partner at fund manager Sarasin & Partners. Subitha Subramaniam is Sarasin’s chief economist

JULY 28, 2010 --> How the Blinder-Zandi Study Was Done Arnold Kling Alan Blinder and Mark Zandi used Zandi's econometric model as the basis for a claim that the stimulus and the TARP worked. Thirty-five years ago, I was Blinder's research assistant, doing these sorts of simulations on the Fed-MIT-Penn model for the Congressional Budget Office. I think they are still done the same way. See lecture 13. Here are some of the things that Blinder had to tell his new research assistant to do.

1. Make sure that there were channels in the model for credit market conditions to affect consumption and investment.

2. Correct the model's past forecast errors, so that it would track the actual behavior of the economy over the past two years exactly. With the appropriate "add factors" or correction factors, the model then produces a "baseline scenario" that matches history and then projects out to the future. For the future, a judgment call has to be made as to how rapidly the add factors should decay. That is mostly a matter of aesthetics.

3. Simulate the model without the fiscal stimulus. This will result in the model's standard multiplier analysis.

4. Make up an alternative path for what you think would have happened in credit markets without TARP and other extraordinary measures. For example, you might assume that mortgage interest rates would have been one percentage point higher than they actually were.

5. Simulate the model with this alternative scenario for credit market conditions.

6. (4) and (5) together create a fictional scenario of how the economy would have performed had the government not taken steps to fight the crisis. According to the model, this fictional scenario would have been horrid, with unemployment around 15 percent.

Some comments:

i) Blinder and Zandi do not spell out the details of step 1 or step 4. Thus, I have no idea how to evaluate their approach to estimating the impact of financial measures.

ii) Other than the add factors, and any ad hoc adjustments that were made in step 1, every result in the paper would have been found by simulating the model three years ago. There is no new evidence being brought to bear. What Blinder and Zandi are reporting is the Keynesian theory that was built into the model.

iii) They report model multipliers to two decimal places, e.g. 1.61 for extending unemployment insurance benefits. They do not provide confidence intervals or any other estimate of reliability.

iv) the paper has not been published in a peer-reviewed journal. The theoretical and statistical properties of the model probably would not be considered acceptable in modern practice. Even if those issues were overlooked, the intensity of the political rhetoric combined with the opacity of the exercise would cause difficulties for most editors of academic journals.

I do not think we will ever know what would have happened to the economy without the fiscal stimulus and the large monetary interventions. My guess is that the overwhelming majority of economists would agree that we will never know the answers to those questions. However, in the competition for public attention, Blinder and Zandi have two advantages. First, they support a narrative in which government experts did the right thing, which is comforting to government experts and all who believe in them. Second, at a tactical level, their use of an esoteric computer model along with those two decimals of precision, they intimidate journalists and other laymen.

I know that they think this is for a good cause. They really believe that the stimulus and TARP were good policies that got a bad rap. But in my view that does not justify this unseemly exercise in propaganda dressed up as research.

July 3, 2009, 7:24 am ‘Rationing’ Health Care: What Does It Mean?

By UWE E. REINHARDT

Uwe E. Reinhardt is an economics professor at Princeton.

As the dreaded R-word — rationing — once again worms its way into our debate on health care reform, it may be helpful to relearn what is taught about rationing in freshman economics.

In their well-known textbook Microeconomics, the Harvard professor Michael L. Katz and the Princeton professor Harvey S. Rosen, for example, put it thusly:

Prices ration scarce resources. If bread were free, a huge quantity of it would be demanded. Because the resources used to produce bread are scarce, the actual amount of bread has to be rationed among its potential users. Not everyone can have all the bread that they could possibly want. The bread must be rationed somehow; the price system accomplishes this in the following way: Everyone who is willing to pay the equilibrium price gets the good, and everyone who does not, does not. [Italics added.]

In short, free markets are not an alternative to rationing. They are just one particular form of rationing. Ever since the Fall from Grace, human beings have had to ration everything not available in unlimited quantities, and market forces do most of the rationing.

Many critics of the current health reform efforts would have us believe that only governments ration things.

When a government insurance program refuses to pay for procedures that the managers of those insurance pools do not consider worth the taxpayer’s money, these critics immediately trot out the R-word. It is the core of their argument against cost-effectiveness analysis and a public health plan for the nonelderly.

On the other hand, these same people believe that when, for similar reasons, a private health insurer refuses to pay for a particular procedure or has a price-tiered formulary for drugs – e.g., asking the insured to pay a 35 percent coinsurance rate on highly expensive biologic specialty drugs that effectively put that drug out of the patient’s reach — the insurer is not rationing health care. Instead, the insurer is merely allowing “consumers” (formerly “patients”) to use their discretion on how to use their own money. The insurers are said to be managing prudently and efficiently, forcing patients to trade off the benefits of health care against their other budget priorities.

These thoughts popped into my head as I sat as a guest in the White House East Room during last week’s ABC News town hall meeting. There a neurologist suggested in his question that the president and his policy-making team seek to impose rationing of health care so that more lower-income Americans can receive it, all the while refusing to countenance that rationing for their own families.

One must wonder where people worried about “rationing” health care have been in the last 20 years. Could they possibly be unaware that the United States health system has rationed health care in spades for many years, on the economist’s definition of rationing, and that President Obama and Congress are now desperately seeking to reduce or eliminate that form of rationing?

Let me remind rationing-phobes what they would find in the huge body of research literature and media reports on our health system, should they ever trouble themselves to read it:

• Many Americans without health insurance or very high deductibles routinely forgo prescribed medicine or follow-up visits with a doctor because they cannot afford it, risking more serious illness later on.
• A 2008 peer-reviewed study by researchers at the Urban Institute found that health spending for uninsured nonelderly Americans is only about 43 percent of health spending for similar, privately insured Americans. Unless one argues that the extra 57 percent received by insured Americans is all waste, these data imply rationing by price and ability to pay.
• A few years ago, The Wall Street Journal featured a series of articles reporting how often uninsured middle-class Americans are charged the highest prices at pharmacies and in hospitals, and how sometimes they are hounded over medical bills to the point of being jailed for failed court appearances.
• Studies have shown that solid middle-class American families — even ostensibly insured families — can lose all of their savings and sometimes their homes over mounting medical bills in the case of severe illness.
• In its report Hidden Cost, Value Lost: The Uninsured in America, the prestigious Institute of Medicine a few years ago estimated that some 18,000 Americans yearly die prematurely for want of the timely health care that health insurance makes possible and that can prevent catastrophic illness.
• A recent study by an M.I.T. professor found that uninsured victims of severe traffic accidents receive 20 percent less health care than equivalent, insured victims and are 37 percent more likely to die from their injuries.

Need I go on?

As I read it, the main thrust of the health care reforms espoused by President Obama and his allies in Congress is first of all to reduce rationing on the basis of price and ability to pay in our health system.

An important allied goal is to seek greater value for the dollar in health care, through comparative effectiveness analysis and payment reform. As I reported in an earlier post on this blog, even the Business Roundtable, once a staunch defender of the American health system, now laments that relative to citizens in other developed countries, Americans receive an estimated 23 percent less value than they should, given our high health care spending.

To suggest that the main goal of the health reform efforts is to cram rationing down the throat of hapless, nonelite Americans reflects either woeful ignorance or of utter cynicism. Take your pick.