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Evidence-based Economics
Edmund Phelps, Nobel laureate in economics for 2006, is Professor of Economics at Columbia University and Director of its Center on Capitalism and Society. His previous piece for Webdiary was Subsidies that Save.
by Edmund S Phelps
There is a movement in medicine to require that applications for licenses to sell a new drug be "evidence-based." By contrast, trained economists view their discipline as having already achieved this scientific standard. After all, they express their ideas with mathematics and arrive at quantitative estimates of implied relationships from empirical data.
But economics is not evidence-based in selecting its theoretical paradigms. Economic policy initiatives are often taken without all the empirical pre-testing that could have been done.
A notorious example is postwar macroeconomic policymaking under the radical Keynesians. The radicals relied on Keynes’s untested theory that unemployment depended on "effective demand" in relation to the "money wage," but their policy ignored the part about wages and sought to stabilize demand at a high enough level to ensure "full" employment.
Cecil Pigou and Franco Modigliani objected that if demand were successfully increased, the money wage level would rise, catch up to demand, and thus push employment back down to its previous level. Employment cannot be sustained above its equilibrium path by inflating effective demand.
Nevertheless, the radicals prevailed through what the economist Harry Johnson called "scorn and derision." Postwar macroeconomic policies were dedicated to "full" employment, without any evidence that money wages would not get in the way.
In the late 1950’s, neo-Keynesians finally conceded the point raised by Pigou and Modigliani. Will Phillips’s work on wages gave them no choice. But they still insisted that steady increases of demand at a fast enough rate would keep demand one step ahead of the money wage level, so that employment could be kept as high as desired, albeit at the cost of steady inflation.
In different ways, Milton Friedman and I objected, arguing that such a policy would require an ever-rising inflation rate. Money wages will lag behind demand, I argued, only as long as the representative firm is deterred from raising wages by the misperception that wages at other firms are already lower than its own – a disequilibrium that cannot last.
Like the radicals, the neo-Keynesians did not engage their challengers with empirical testing. The efficacy of high demand was a matter of faith. Yet events in the 1970’s put that faith to a cruel test. When supply shocks hit the US economy, the neo-Keynesians’ response was to pour on more demand, believing it would revive employment. There was little recovery – only faster inflation.
The current era offers a parallel. Although policy has since shifted to reflect supply-side economics and real business-cycle theory, the new reigning paradigm’s builders and promoters display the same antipathy to checking data for serious error.
An earlier classroom lesson was well-founded: temporarily below-normal tax rates on labor this year, when merged with the prospect of reversion to normal rates next year, will encourage households to squeeze more work into this year and to work less in future years. This proposition was recently tested anew on Icelandic data and performed well.
But the supply-siders jumped to the daring conclusion that a permanent cut in tax rates on labor would encourage more work permanently – with no diminution of effectiveness. Larry Summers and I both doubted that this could be generally true. If every increase in the after-tax wage rate gave a permanent boost to the amount of labor supplied, we reasoned, steeply rising after-tax wages since the mid-nineteenth century would have brought an extraordinary increase in the length of the workweek and in retirement ages. But both have fallen, and in continental Europe unemployment is higher.
In my view, this core tenet of supply-side economics rests on a simple blunder. What matters for the amount of labor supplied is the after-tax wage rate relative to income from wealth. While after-tax wage rates soared for more than a century, wealth and the income it brought grew just as fast.
To be sure, if tax rates were decreased permanently this year, there would initially be a strongly positive effect on labor supplied. But there would also be a positive effect on saving and thus on wealth next year and beyond. In the long run, wealth could tend to increase in the same proportion as after-tax wages. The effect on work would vanish.
We must proceed cautiously, however. In standard analyses, the tax cut brings a reduction in government purchases of goods and services, like defense. But a tax cut could instead contract the welfare state – social assistance and social insurance, which constitute social wealth. In that case, the tax cut, while gradually increasing private wealth, would decrease social wealth. The issue is an empirical one.
Research I did with Gylfi Zoega a decade ago confirmed that cuts in taxes on labor boost employment in the short run. But what about the long run? Do large long-run effects of tax rates show up in international differences in employment?
In 1998 we examined OECD data for a correlation between national unemployment rates in the mid-1990’s and current tax rates on labor. We found none. In 2004, we looked at labor-force participation rates and again at unemployment. Still no correlation. High-unemployment countries include high-tax Germany, France, and Italy, but also low-tax Japan and Spain. Low-unemployment nations include low-tax Britain and the US, but also very high-tax Denmark and Sweden.
Neoliberals are now telling continental Europe that tax cuts on labor can dissolve high unemployment. But the effectiveness of such tax cuts would be largely, if not wholly, transitory – especially if the welfare state was spared. In two decades’ time, high unemployment would creep back. The false hopes raised by cutting taxes would have diverted policy makers away from fundamental reforms that are necessary if the Continent is to achieve the dynamism on which high rates of innovation, abundant job creation, and world-class productivity depend.
Copyright: Project Syndicate 2005.
www.project-syndicate.org
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What is the ideal age of a financial advisor?
Jenny Hume: “I would not want to base my financial decisions on the advice of a thirty year old.”
Isn’t this just another form of discrimination Jenny? Warren Buffet founded his first investment partnership when he was 26, if you’d followed his advice then, you’d be enormously wealthy now. Being 28 myself, I’m interested to know at what age I’ll acquire the necessary knowledge and experience for providing reliable financial advice.
Age and experience
Gareth: No, not discriminiation in my book, just caution. You ask me "at what age would you have the necessary knowledge and experience to provide financial advice?" Well, as I don't know much about you, I would not hazard a guess, but if you are only 28, thenmy instincts would be, not yet. And I always trust my instincts. If you have the required skills, tertiary education in relevant fields, and more importantly a proven track record of at least ten years of sound investment of your own money, then at whatever age that makes you. Most cannot get to that by 30 in my experience. Some do of course, but there are not too many Warren Buffets around. As a general rule, I think young people need to make their own mistakes with their own money before they go risking others, or advising them. And that takes time. Maturity comes with age and education and especially life experience. Yes, I think age still counts for something in this world, and life experience too. My current adviser would be around 45.
I am staggered that such young people are today able to take a major bank down with them.
Mr Smith goes to Sydney
Malcolm B Duncan, once a upon a time knowing that your words along with your insults would, “IF” you are elected, be coming back in the not to distant future, with interest, would have given me quiet satisfaction.
Because I know that as surely as night follows day I will be reading some small article in the mid pages somewhere about some politician and his annual half arsed schemes and proposals. This is just the way it has always been for those before you and always will be for those following. The ridgy didge figures of course, for the “terrific new schemes” will be costed and based on projections that are “absolute crap”, “voodoo - who killed the chicken” and of naturally “Astronomy”
The truth is apart from the basic courtesy of reply because you used my name. Your views on “things” move my emotions or care factor, not a jot.
Of course you will be “different”. They all say that as well. At least at the start.
mmmmmmmm, yeah, well, whatever.Incomprehensible or just incomprehension?
The "C" team must be on the shift today, Jay White. Try 1898 - Sir Stephen Stevens did a rather good job codifying common law. I'll be satisfied if I can just re-common the codes.
You all must be busting yourselves at the thought of a Debnam Government - it certainly scares the shit out of me.
An interesting posting in ZNET
ZNet |Economy | AN ECONOMY OF BUCCANEERS AND FANTASISTS
What I find most scary
Jay, thanks for an interesting link. What I find most scary is to see people who to me look like they are not long out of nappies, wheeling and dealing on the domestic and the global financial and stock markets. Look at those they interview to bring us all the good and bad news. Kids most of them. Do any of them really know what they are talking about? Time the older generation took back the reins in my opinion. Frankly I would not want to base my financial decisions on the advice of a thirty year old. Cheers.
Michael Coleman
Michael Coleman "Gareth, I guess one of the defining differences between our views on this subject is that I don't believe the government is telling the truth".
"Sorry, but I'm not buying the official budget figures. At the very least, they are misleading".
Nothing you say on economics should be taken seriously again after these statements.
These figures are put together not by politicans but professionals in the financial field. They have a requirement to ethical and professional honesty and standards. This figures are open and accountable by LAW.
Good day to you sir.
David R: mighty b*ll*cks you're talking there, Jay - budget papers are always a good test to set economics students to see if they can work out all the weasels, omissions and various spurious claims to have caused things to happen that the Govt has no control over ...
The receding Universe
Glad to see the collective back in full, frenzied flight.
What a load of absolute crap. At worst, economics is like voodoo - who killed the chicken; at best, it is like Astronomy - all it does is look into the past.
No figures are "accurate". They involve rounding, assumptions, exclusion of certain material but, for all that, they can only ever tell us what happened. They are not predictive.
It is one of the reasons I am constantly bemused by the stock market figures trotted out every night on the ABC news. All they tell us is what happened today. Beyond that it is pure speculation.
Rather like quacks in the middle ages diagnosing from real speculation.
That does not necessarily MEAN that the Government is lying (experience has taught me to take the f***-up over the conspiracy theory every time); just that it hasn't got a clue what's going to happen next.
Maybe you should roster the "A" shift on Jay White.
Now I don't feel so guilty
Malcolm B Duncan: "No figures are 'accurate'".
Thank you. Now I won't feel so guilty when Census and Stats sends round those forms wanting all sorts of figures that would test any farmer's patience, and as you say, they only tell us what has happened, they are not predictive. So all they get from me is best guess. Once the crop has failed, who cares how many acres were involved. Time to move on.
BTW did you see the other night that Cubby has run dry? A bit of a turnup for the books, given the amount of water the thing held. There's no money in cotton at the moment, so it would seem to me to be a good time for the Government to do something about Cubby, and some of those other big turkey nest dams in the M/D Basin. I have a nasty feeling about this drought. I have never seen spring rains fail so totally over such a wide area, on top of a dry winter. Depressing.
But cheers anyway.
Lies, Damned Lies And Government Figures
Gareth, I guess one of the defining differences between our views on this subject is that I don't believe the government is telling the truth.
For example, in the year ended 30/09/2005, the government reported a budget deficit of USD 319 billion. Yet total federal debt increased by 553.7 billion over the same period.
This year (ended 30/09/2006), they report a budget deficit of 248 billion. Once again total federal debt has increased by 574.3 billion over the period.
Sorry, but I'm not buying the official budget figures. At the very least, they are misleading.
It will never happen
The missing factor in all economic theories is the manipulation of man, and politicians who do not give a fig for some theory that may well do what it supposedly might if ever left unchecked to carry it's course. But that will never happen given the nature of man to meddle for many reasons.
Many of us wouldn't buy into the great globalization scam but were re-buffed but now evidence comes forward that we were correct. it was meant to raise the living standards of workers worldwide but we see in this instance in China that US corporations having fled off-shore for cheap labor intend to keep it that way as China attempts to raise the standards of their own workers. This doesn't augur well for the rest of US workers. The evidence is that all economic theory is basically just an unproven theory worshiped by normally sane politicians who are manipulated by businessman.
The one man who got something right about all this was the philosopher Bertrand Russel who said over 60 years ago that the east and west would eventually become the mirror of each other.
US Economic Outlook
Michael Coleman, re “I am disappointed that your reply to me does not make any attempt to deal with the implications of the GAO Comptroller General's projections and the consequences of required fiscal reform. He has made it very clear that the US economy cannot simply grow its way out of current and projected debt.” I was answering your question about why the US won’t suffer a similar slump as Japan. The GAO is essentially advocating cuts in discretionary spending and various benefits (including health). I don’t recall reading any subsequent GAO prediction of economic collapse as a potential consequence of these fiscal reforms.
The Congressional Budget Office (which provides the economic and budget data used in the GAO projections) is reasonably positive in its 10 year budget and economic outlook for the US economy. It predicts GDP growth of 3.4 % in 2007 averaging around 3% p.a. out to 2016. It predicts an annual fiscal surplus by 2012 under current US fiscal policy.
The CBO outlook addresses a number of your concerns too Michael.
Real estate values: “Despite an anticipated weakening in the housing market, economic growth will be driven by forces already in motion” goes on to discuss expansions in productive capacity and business investment.
Weaker USD: “The lower value of the dollar combined with somewhat stronger economic growth abroad will cause exports to increase faster than exports.”
Spending: “The increases in employment and wages seen last year are also expected to continue, with the unemployment rate remaining near 5%, underpinning consumer spending.”
Inflation: “Core inflation will increase slightly in the near term, from 2.2% in 2005 & 2006 to 2.3% in 2007.”
Re “Where do you think the money will come from to fund the consumption growth that forms the backbone of the US economy?” From numerous sources including population increase, productivity growth, wage growth, export growth etc.
Michael, Japan is not a good place to base your argument. Japan’s fiscal deficit is far worse that the US and it imports virtually all of its energy requirements. Yet Japan’s economy and standard of living retain their rich first world status and a positive future outlook.
No Way Out
Gareth Eastwood I am disappointed that your reply to me does not make any attempt to deal with the implications of the GAO Comptroller General's projections and the consequences of required fiscal reform. He has made it very clear that the US economy cannot simply grow its way out of current and projected debt.
Even if we assume business-as-usual over the next thirty years (and I believe that will be impossible), the increase in taxation and reduction in government spending required to balance the books will have a significant, depressing effect on the standard of living in the USA.
Three million relatively well paid manufacturing jobs have already been lost in the USA since 2000. Jobs in the services sector pay considerably less. This, in itself, is evidence of a contraction in standard of living.
Growth in the services sector has been driven by health care, real estate sales and financial services. As we know, the real estate boom is now over and jobs in this sector will naturally contract. Unfunded liabilities in the health care sector may well see government reduce benefits and contract the health sector to try to balance the budget.
The influx of poor immigrants to the US has been one of the factors suppressing wages growth there. Median household income in 2004 was 4% less in real terms than in 1999. While this is good for corporate profits, it is a significant factor in the growth of household debt which is up by 70% since 2000. The biggest run of corporate profits in US history have occurred at the same time as the biggest run of consumer borrowing in US history. This is another sign of a system out of balance. It cannot bode well for future consumption.
US economic growth is now extremely credit and debt intensive. In the absence of real income growth, it has relied on heavy borrowing to drive up house prices and more heavy borrowing to turn capital gains into cash. It is trivially obvious that this is unsustainable growth. Indeed, it is growth today at the expense of growth tomorrow.
Adjustable Rate Mortgages have seen significant growth in debt as unpaid interest is capitalised. Many properties were bought with no intention (or capacity) to pay off the loan by installment. Risk taking speculators intended to "flip" these properties to the next, greater fool willing to pay even higher prices.
The IMF published a paper in 2003 called "When Bubbles Burst". It clearly states that the bursting of housing bubbles present much greater threats to the economy than equity bubble busts. I believe a drop of 20% to 30% in house prices should be enough to bankrupt huge numbers of borrowers in the US and take more than a few financial institutions down with them.
A depreciating US dollar will produce higher prices for US consumers. These inflationary forces will require higher interest rates. Combine this with no income growth, no savings, higher taxes and reduced government spending and the poor old US consumer is screwed. Where do you think the money will come from to fund the consumption growth that forms the backbone of the US economy?
The biggest threat to the US standard of living in the longer term is the huge US energy deficit. The US economy imports more than 70% of its needs. The real prospect of energy shortages and consequent price pressures and demand destruction over the next three decades will make it exceedingly difficult, if not impossible, to grow the US economy. I think the US experience will make them look back at the long Japanese recession with envy.
...
Timothy Wong, Congressman Ron Paul is one of the few US politicians I have read who tells the truth as he sees it. The End Of Dollar Hegemony is a must read, IMO.
Dr. Kurt Richebächer and Dr. Marc Faber are two economists whose logic I find compelling and whose writings have significantly influenced my thinking.
Thanks Gareth
I do appreciate it when you make the effort to explain your opinions as you have done with this reply to my question.
I will think about what you have written and give you my considered response as soon as I can. Thanks again.
The USA is not Japan
Gareth Eastwood: Japan of the 80's and 90's also had VERY heavy building restrictions. There were heavy clauses on height limits and such, causing availability problems and grossly inflating property prices in a rampaging market. Thus the evil spiral begins.
Everything you have said thus far I agree with.
Michael, an answer to the Japan question
Michael Coleman, re “So, Jay, CP, anyone, would you care to explain why you think a similar slump cannot befall the USA?” (from the other thread) Don’t mind if I do…
Firstly we have to define what we consider a “slump”. I could define it as a recession (2 consecutive quarters of negative real GDP) or maybe a “deep and nasty” recession (real GDP sustains a fall of more than 5% over a period exceeding 12 months) as per our previous discussion on the thread “Can the IMF avert a global meltdown?” Maybe rising unemployment as well, perhaps +2% like what occurred in Japan?
Factors of the US economy that compare favourably to Japan:
- Larger and more competitive services sector. Globally the services share of GDP and trade is growing. The Japanese economy is reliant on the export of manufactured items.
- The US land mass contains significantly greater supplies of virtually every key energy and natural resource. The US has more oil, coal, uranium, grains, timber, water etc than Japan, which is dependent on imports.
- Neither the US equity nor real estate markets are as grossly inflated as they were in Japan in 1989. From Forbes:
Based on an equal-weighed basket of all S&P 500 stocks, the average stock’s trailing P/E ratio is in line with ten-year norms. For broader indexes that include small and mid-cap stocks, average P/Es are modestly above ten-year norms.
- The US labour market is far more flexible and responsive to change than Japan’s in 1989. The US will not suffer a similar rise in unemployment.
- Japan does not enjoy a continual influx of diverse new immigrants adding more ambitious entrepreneurs and productive workers to the economy.
- The US population is growing and younger than Japan’s flat and aging population.
- The US economy is generally subject to far less regulatory hurdles than Japan’s was in 1989 and still is now.
Concerns about the US foreign debt, held by both govt and households can be balanced against other factors. Primarily, if foreign debt is causing economic problems, the USD would normally depreciate. A weaker USD has benefits for the US economy including more competitive exports.
Re “This happened to a nation with a strongly positive trade balance and high personal savings rates.” Michael I don’t believe that anyone has proven there is a correlation between a nation’s trade balance or savings rate and their economic performance. Japan’s “slump” occurred while it had a large positive balance of trade and a very high savings rate. The US and Australian economies have performed significantly better in the corresponding period, whilst having a negative balance of trade and low savings rates.
I believe that like Japan in the 90’s, the present concerns about the US economy will ultimately not harm the American standard of living.