Deficit Dilemma: Why Economists Can't Agree

Deficit Dilemma: Why Economists Can't Agree

The Fiscal Times

The partisan gulf over economic policy seems to be wider than ever. Some of the differences among politicians are ideological, and hence unavoidable, but the partisan bickering can also be attributed to the inability of economists to answer policy questions with anything resembling certainty and a unified voice.

Why can’t economists tell us what happens when government spending goes up or down, taxes change, or the Fed changes monetary policy? The stumbling block is that economics is fundamentally a non-experimental science, particularly in the realm of macroeconomics. Unlike disciplines such as physics, we can't go into the laboratory and rerun the economy again and again under different conditions to measure, say, the average effect of monetary and fiscal policy. We only have one realization of the macroeconomy to use to answer important policy questions, and that limits the precision of the answers we can give. In addition, because the data are historical rather than experimental, we cannot look at the relationships among a set of variables in isolation while holding all the other variables constant as you might do in a lab and this also reduces the precision of our estimates.

Because we only have a single realization of history rather than laboratory data to investigate economic issues, macroeconomic theorists have full knowledge of past data as they build their models. It would be a waste of time to build a model that doesn't fit this one realization of the macroeconomy, and fit it well, and that is precisely what has been done. Unfortunately, there are two models that fit the data, and the two models have vastly different implications for monetary and fiscal policy.

The Paul Ryan Plan:  Patient--Heal Thyself! 
In one class of models derived from classical foundations, e.g. New Classical and Real Business Cycle models, monetary and fiscal policy have no role to play in stabilizing the economy. Policy can make things worse, but there is no way to use policy to make things better. Thus, the best approach is a hands-off policy that allows the economy to take care of itself, a result that appeals to people with the ideological view that minimal government involvement in the economy is desirable. Some adherents of these models allow for intervention during major breakdowns, but even in this case government should get out of the way as soon as possible once the worst is past.

Paul Ryan's "Path to Prosperity" fits this model.  Lower taxes for corporations and individuals to get government out of the way, and the resulting growth will lift all boats.    Maybe.  But we tried that once before and the results were not exactly successful.  During his first term, George W. Bush enacted tax cuts in an attempt to get government out of the way and increase economic growth. However, there is no evidence that the personal, dividend, and capital gains tax cuts Bush enacted increased economic growth as promised, and the tax cuts did not pay for themselves. By  the end of Bush’s second term, with unexpected spending on war and security after 9/11 on top of the tax cuts, the national debt had grown significantly. Budgeted spending averaged 19.9% of GDP, similar to his predecessor President Bill Clinton, although tax receipts were lower at 17.9% versus 19.1%.

Obama and the Fed: The Doctor Will See You Now
The other class of models is in the Keynesian tradition. In these models, both monetary and fiscal policy can be helpful, though the effectiveness of each can vary over the business cycle. The best policy in this case is active rather than passive, so instead of staying out of the way as much as possible as in the models with a classical foundation, policymakers try to stabilize fluctuations in the economy on an ongoing basis.

The recent crisis provides examples of stabilization policy in action. The policies enacted by the Fed, and the various tax and government spending stimulus packages – most notably the $787 billion dollar stimulus package under Obama – were intended to offset the negative effects of the recession and spur a recovery. There is little doubt that the Fed’s actions during the crisis made things better. We didn’t have a repeat of the Great Depression. But the tax cuts and government spending in the Obama stimulus package – the policies that Paul Ryan and others have reacted so strongly to – are harder to evaluate. I believe that unemployment would have been at least 2% higher, perhaps even more, without these actions, and that we are recovering faster than we would have otherwise. But this is one of those policy questions that economists have difficulty answering with precision.

The contrast I’ve drawn between the two classes of models is a bit too stark, particularly where monetary policy is concerned. In addition, the ability to choose one model over the other is not quite as hopeless as I’ve implied. New data and recent events like the Great Recession push these models into unchartered territory and provide a way to assess which model provides better predictions. However, because of our reliance on historical data this is a slow process – we have to wait for data to accumulate – and there’s no guarantee that once we are finally able to pit one model against the other we will be able to crown a winner. Both models could fail as happened during the Great Recession.

But even if we had perfect models and perfect data, there would still be uncertainties and disagreements over the proper course of policy. Economists are hindered by the fact that people and institutions change over time in a way that the laws of physics do not. Thus, even if we had the ability to do controlled and careful experiments, there is no guarantee that what we learn would remain valid in the future.

Suppose that we somehow overcome every one of these problems. Even then, disagreements about economic policy would persist in the political arena. Even with full knowledge about how, say, a change in government spending financed by a tax increase will affect the economy now and in the future, ideological differences across individuals will lead to different views on the net social value of these policies. Those on the left tend to value the benefits higher, and place less weight on the costs than those on the right and this leads to fundamental, insoluble differences over the course of economic policy. Paul Ryan will never see eye to eye with Obama.

Progress in economics may someday narrow the partisan divide over economic policy, but even perfect knowledge about the economy won’t eliminate the ideological differences that are the source of so much passion in our political discourse.