Economists Cannot Run an Economy

Tim Iacono The Mess That Greenspan Made February 17, 2012

More evidence that U.S. economists are particularly ill-suited to run the U.S. economy comes via the fascinating exchange in recent days between St. Louis Federal Reserve President James Bullard and a small army of bloggers with PhDs in economics, nearly all of the latter ganging up on Bullard after he suggested that the “output gap” theory for what ails the U.S. economy may be fundamentally flawed and that attempts to boost overall demand to close that gap through freakishly low interest rates and other super accommodative Federal Reserve policies might end up doing more harm than good.

Bullard threw a cat amongst the pigeons in this speech(.pdf) when he noted the following:

The recent recession has given rise to the idea that there is a very large "output gap" in the U.S. The story is that this large output gap is "keeping inflation at bay" and is fodder for keeping nominal interest rates near zero into an indefinite future. If we continue using this interpretation of events, it may be very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates. This could be a looming disaster for the United States. I want to now turn to argue that the large output gap view may be conceptually inappropriate in the current situation. We may do better to replace it with the notion of a permanent, one-time shock to wealth.

Recall that I’ve railed on this subject a number of occasions over the years, the last time being this offering from about six months ago when it was noted:

The theory posits that it is not important what level of overall demand an economy has reached or how it got there, but that, when all the wheels fall off the wagon as they did back in 2008, the imperative is for the government to somehow restore that level of demand. Otherwise, you get another Great Depression.

It makes no difference if, back in 2005, people making $40,000 a year were buying no money down $500,000 homes and then, after the home's value went up to $600,000 in 2006, pulling out their $100,000 in brand new home equity to put in a pool, buy a motor home, and install big screen TVs in every room of the house because, once you reach a certain level of demand and it begins to drop like a rock because everyone has become indebted up to their eyeballs, it must be restored.

At that point, it simply becomes a question of how much taxes must be cut or how much money must be borrowed or printed to accomplish that goal.

Of course, I don’t have any models to back up the contention that an unusually large portion of economic output we saw in the middle of the last decade was “artificial” due to the housing bubble, but economists do have models, and that’s the crux of the problem.

As Bullard noted, the models economists use to determine the “potential” of the U.S. economy, in essence, extrapolates from the pre-2007 period to the post housing bubble period and, as a result, you end up with a big gap between potential and actual output that policy makers are now seeking to close by borrowing and printing money on a scale never before witnessed by Mankind.

For those of you preferring pictures to words, the chart below by Neil Irwin from this neat little interactive graphic at the Washington Post might be helpful.

Being more detached from reality than the population at large, economists seem to prefer the idea of debating ways to close the gap that has developed in recent years rather than thinking about whether the output gap even makes sense as Bullard has suggested.

The failure to deal with the real world rather than how that reality is reflected in models and the reluctance to venture outside of their analytical comfort zone to embrace common sense (as Bullard clearly has) have clearly produced yet another example where models – whether they’re good, bad, or indifferent – rule.

Models tell economists one thing, but common sense tells the rest of us something very different about what is going on here.

I’d go so far as to argue that the output gap theory is about the absolute worst way to think about an economy because the means become unimportant relative to the end – and that’s a very dangerous policy for an economy such as ours, prone as it is to asset bubbles.

Though few economists would read it this way, non-economists might argue that the chart above shows how the small output gap created by the bursting of the internet bubble was addressed under the Greenspan Fed by creating a housing bubble that has now left behind an even bigger output gap.

And this explains why we didn’t see big excesses in the economic data five or six years ago – because all our bubble economy was doing at the time was pushing output back to its “potential” from the 1990s that was also artificial, that is, to the extent that companies like Pets.com aren’t around anymore.

To a growing number of observers like Bullard, it appears that policy makers could now be in the process of creating an even bigger and more destructive asset bubble to close the current output gap, not considering the possibility that what they’re really doing is trying to artificially boost demand yet again to have it meet up with a level of potential that is now even more artificial than when the internet bubble burst.

A list of links are included below for anyone wanting to pursue this further. One can be hopeful that there are individuals like Bullard who are asking tough questions about what passes for conventional wisdom amongst the dismal set, but his self characterization of being “an army of one” doesn’t bode well for the future.

What output gap? – MacroManiac Jim Bullard chucks the Solow growth model!- Noahpinion Bubbles and Economic Potential – Krugman A loss in wealth should boost economic growth – The Money Illusion The trend is your friend (until it ends) – MacroManiac It’s Worse Than You Think – Fed Watch Bullard On Duy On Bullard On Potential Output – Econospeak James Bullard Responds to Tim Duy – Economist’s View Again With Potential Output – Fed Watch

Great post!

Economists have largely lost their minds. They keep coming up with ways to completely ignore the basis of free market capitalism. The “output gap” is just another version of the idea that “supply creates demand.”

“If you build it, they will come” is a great movie idea but it’s just fantasy in the real world.

Supply does not always create demand. Krugman, AG, BB and their ilk think that anything that boosts production will work to increase demand and thereby ‘prime the pump’ to ‘jump start’ the economy. (You need all the quote marks because, frankly, all these metaphors are inapt and stupid.)

It doesn’t take a PhD in econ (in fact that just gets in the way) to see that you can’t force people to buy excess production no matter how cheap you make credit and no matter how much free money you give them. Even the people you put to work making EXCESS crap, cannot be forced to spend their take home pay on crap they don’t want/need. The normal cycles of expansion and contraction must be left alone or you will get wild distortions as we see now.

Every business person would love it if the only issue they faced were production. But, sadly, you also have to worry about SALES! Marketing became my number one job as the owner of a small business. I had no problem at all producing as much of my wares as I wanted. SELLING IT, however, is not nearly as easy. Overproduction leads to bankruptcy. It’s called inventory control for a reason…

These morons seem to have no real world experience to temper their so-called thinking and they do not understand the word “EXCESS.” It’s this kind of Bass-Ackwards thinking that is killing the economy and will be our ruin.

Simply put, no one will admit the party is over and it’s time to clean up the mess.

I’ve been following this.

I don’t remember where, but in one of the related posts someone said, “But where’s his model? He doesn’t have a model!”

As if, it can’t exist in the real world unless it can be modeled.

Yes, this is a great post. I’ve said it a thousand times myself — “output” was artificially inflated by the bubbles, particularly the Housing Bubble. As you say, this is just common sense.

And yet the piled-high-and-deeper economists have yet to incorporate the bubbles into their models. More debt will solve a debt problem. Humans are rational. And a thousand other mistakes. The models are so at odds with Reality at this point that we can only conclude that neo-Keynesian economics (Steve Keen’s term) is a secular religion and economists are its high priests, worshiping those models.

I don’t have a model either. But then again there are poor people living in my neighborhood, which is not something Paul Krugman ever sees in Princeton, New Jersey.

[...] judge of newly uncovered Countrywide fraud database (Reuters) "¢ When Models Trump Common Sense (Tim Iacono) "¢ Citigroup Whistle-Blower Says Bank's "?Brute Force' Hid Bad Loans From U.S. (Bloomberg) [...]

Yes, at the peak of the bubble demand was inflated.

But the economy was able to meet that “inflated” demand without significant inflationary or upward wage pressures. Consequently, the output level at the peak was not inflated. Rather it represented what the economy was capable of producing, so using it as the point to establish a trend in output is perfectly rational and there is no reason to discount the output at the peak of the bubble.

Remember, potential output measures what the economy is capable of producing, not what demand is.

You’re saying that the hundreds of billions of dollars in home equity money sucked out of houses and spent on cars, boats, and big screen TVs back in 2005 and 2006 didn’t make output go higher than it otherwise would have been?

You’ll have to explain that one.

[...] When Models Trump Common Sense. Economics is the “science” most ripe for revolution right now. [...]

I don’t think the output gap theory is wrong, per se. It assumes that the entire economy is running at full employment and production.

But I also agree that aggregate demand was artificially inflated in an attempt to close the output gap.

The problem is that we have too many people and not enough *useful* work for them to do. So we end up making fake jobs to close the output gap. This doesn’t work very well. In order to safely close the output gap we need real jobs for these people to do.

The problem may be that while at the aggregated level there does indeed exist a large output gap, but by achieving growth as the Fed as attempted to do, via the wealth effect, i.e.via inflating asset prices, investment and overcapacity gets built into the assets segments of the economy involved even whilst a very large output gap continues to exist in the rest of the economy. The aggregate data may suggest that the Fed should do more to close the gap where in reality for the assets segments involved, there already exists overcapacity and mal-investment. I believe we have very poorly balanced growth on hand, leading to popular observations that the “99%” who are not involved in the asset side of the economy see no benefits flowing from this round of growth and indeed, the Fed should not attempt to grow the US out of this slow mo recovery by repeatedly stimulating the asset side of the economy via ever lower interest rates.

[...] When Models Trump Common Sense Tim Iacono (hat tip reader May S). He’s not right here. The big problem with focusing on demand creation is that the quick and easy ways to create it leak unduly into asset speculation. This is what happens when you have no labor bargaining power (or high income inequality, which is what you get after a prolonged period of no labor bargaining power). You need to fix that first. [...]

Economists Cannot Run an Economy

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