What Is The Mechanism? Or Is It Just A Miracle?

by Mario Rizzo  

In Sunday’s New York Times, Paul Krugman says:  

“From the beginning, I argued that the American Recovery and Reinvestment Act, a k a the Obama stimulus plan, was too small. Nonetheless, reasonable estimates suggest that around a million more Americans are working now than would have been employed without that plan — a number that will grow over time — and that the stimulus has played a significant role in pulling the economy out of its free fall.”  

He admits a mistake of a sort. However, he does say that fiscal stimulus is the “[l]ast and probably least, but by no means trivial…[of] the deliberate efforts of the government to pump up the economy.”  

The over-all theme of the article is that big government is our salvation.”[U]tter catastrophe no longer seems likely…Big Government, run by people who understand its virtues, is the reason why.”   

Post hoc ergo propter hoc?  

How do we know that fiscal stimulus played a non-trivial or any helpful role in the apparent easing of the rate of decline in economic activity?  I think we need a theory and evidence.  

Now, of course, there is no dearth of Keynesian theories – all leading to same policy conclusion. If  recession, then more (government) spending. But what is the mechanism by which about $70 billion in extra spending (this is the amount of the total stimulus package now spent) reduces the rate of increase in unemployment and reduces the rate of decrease in output in a $14 trillion economy? If my advanced arithmetic is correct this is ½ of 1 percent of the GDP. What kind of Super Multiplier is that? 

However, things are more disturbing than that. Just a couple (or so) weeks ago President Obama said that not enough of the stimulus had been spent yet and so it was too early to expect results. But mirabile visu! The Almost Recovery has appeared. (It seems more like political opportunism instead.)  

Climbing higher on the disturbance ladder, we see that the early (Jan.) simulations of the economy with stimulus versus the economy without stimulus were quite off the mark. We are already worse off (in unemployment) than we were supposed to be with the stimulus. We are about where it was said we would be without the stimulus. Did the stimulus have no effect?  Quite impossible, of course!  

Climbing even higher on the ladder. People may react to these failed predictions as simply failed forecasts because things were even worse than we had first thought (Larry Summers’s argument). The future is hard to predict. 

But the past and present are also hard to predict. What do I mean? The statement that the stimulus has already saved or created a certain number of jobs is not a brute fact – like the presence of the table upon which I am writing. (This is not literally a brute fact, but let that pass.) It is the implication of a theory or a model about how the economy is supposed to work. Suppose the economy is hypothesized to function as a more or less Keynesian mechanism. Let us say that looking backward, the model fit the actual economy’s behavior over the relatively normal past. We shock or “stimulate” it with various amounts of spending. Then, if previous relationships hold, we get results.  

Since forecasting is usually a terribly inaccurate business, using a model – no better than any – to tell us what would have happened if we did not have the stimulus is not likely to produce reliable results – even  under normal conditions. Is it reasonable then to think that such a model or models based on past data will fit these abnormal times? Recall economists of many stripes have been telling us that we are in unprecedented times. 

When such models are used for forecasting, the future comes into actuality and we see how far wrong we were. But contrary-to-fact worlds don’t occur to test the “prediction” of how well off we would have been. (How well do these models predict where we are? We’ll have to see.)  

How fun.

Let me go back to Krugman’s article. I italicized an interesting phrase. Big government can work when it is run by people who understand its virtues. He should have said big government can work when it is run by people who themselves determine how well it works.  

The pop-Keynesian intellectual trap tightens.

17 thoughts on “What Is The Mechanism? Or Is It Just A Miracle?

  1. Keynesianism is a disease. In the future I see AA meetings tailored to getting Keynesians some help. Austrians’ll lead interventions (yes, interventions) against their Keynesians comrades the same way friends corner their alcoholic associates.

    “Paul, enough’s enough. You’re hurting us. You’re hurting your friends. You’re hurting your family. You’re hurting the country. Get better Paul – get better!”

  2. Cui bono?

    A crisis provides an opportunity for the rulers to expand their power. The question is why economists are willing to provide rationales for the expansion of power.

  3. Jerry raises a great point. We have these external rents in economics. If you’re really good and so on, then you can work for the Fed, the FTC, the World Bank, and so on. If you’re really, really good and a bit lucky and so on, you may become chairman of the Fed, or president of the World Bank, and so on. Larry White had a nice piece in Economic Journal Watch on the influence of the Fed on monetary economics. In his closing paragraph he says:

    “When (say) the insurance industry sponsors a report on the advisability of federal subsidies for terrorism insurance, the sponsorship alerts cautious readers to scrutinize the research methods and findings for pro-industry bias. Raising the question of the Fed’s status quo bias alerts us that the same sort of scrutiny is appropriate to monetary policy research, to avoid employing a double standard.”

    You can download Larry’s paper from this page:

  4. Jerry writes,

    “The question is why economists are willing to provide rationales for the expansion of power.”

    Jorg Guido Hulsmann discusses this briefly within his book “The Ethics of Money Production.” The answer easily understood: the economics profession is inextricably linked with the monetary authorities of the government. Academic support of central banking and central planning can ensure reciprocal support, in the form of grants and others special privileges. I can’t recall who said this but a Mises Daily author once wrote that academia is one of the most heavily subsidized sectors within the economy. Its current existence requires government sponsorship so its no surprise that you can find its leaders and spokesman groveling before the State.

  5. Michael,

    I think it’s more of a institutional selection bias. The politics of economics promotes bad economists into positions of authority and power.

    Those who disagree end up at fringe organisations or drop out to pursue other goals; those who are willing to say whatever is expected of them or just lie get found out. But those who actually believe their own bullshit, talk nonsense with conviction, are consistent in their absurdity, but mimic intelligence and gather followes, it is they who succeed in the business of economics.

    Okay, perhaps I am over-stating this a little, but, disturbingly, there is rather more than a grain of truth to it, in my opinion.

  6. Roger is right. Larry’s article on the Fed’s 800-pound gorilla role in the science of macroeconomics is a must read.

  7. And of course,what never gets discussed by the High Priest is the role that Big Government and its too-cheap fiat money played in creating the crisis. In other words, the cure to Big Government is Bigger Government.

  8. Prof. Rizzo, you mention that only .5% of GDP has been spent in stimulus which you suggest is too small to have any effect. What about the role of expectations as a possible explanation for the economists in favour of this policy? Could a line of reasoning be: if you know in the future some industry X will be receiving ‘stimulus’ funding would that not stimulate private investment now?

    FYI, I’m not in favour of the stimulus but trying to think of any future rationales that a proponent may throw up.

  9. I agree with Lee Kelly who seems to be saying we shouldn’t question peoples motives unless it’s quite clear they are lying only to get power. Lenin may have wanted power but, like Marx, there is no doubt he believed in Marxism (or his version). Sure, Keynesians like power but it is also true they need power to accomplish their goals. Their vision reinforces their career aspirations.

  10. Let’s say that the stimulus of $70 billion created/saved 1 million jobs. That means a price-tag of $70,000 per job, which probably more than covers the salaries for these people (since most of these jobs weren’t “created/saved” more than a few months ago).

    So as long as the government is willing to pay peoples salaries – everyone has jobs!

  11. Mario,
    i agree with you entirely. Krugman is comparing the real world in its current state to some contrarian history tale that he plays out in his own head, and, hoping that a similar alternate storyline will be mirrored in the minds of his readers, announces to the world “told you so!”.

    The problem for Krugman is, it is not scientifically valid to use contrarian history scenarios as evidence.

    However, i think the more general problem relates to something Krugman mentions in the quote – “pulling the economy out of its free fall”.

    Implicitly, Krugman is announcing to the world that he cannot see the bottom, that is, he cannot say why, once the capitalist system suffers an aggregate demand shock, what stops the decline in output from feeding on itself until nothing is left.

    This is a very important point in understanding the Keynesians’ thinking. Regarding the bailout saga, i recently heard Krugman say that without the AIG bailout we would have been “staring into the abiss” – meaning, in affect, “we do not have a model”.

    Since we are no longer headed into a self-reinforcing downward spiral, as the Keynesians thought we might be, they cannot comprehend that it could have been anything other than some ‘by design’ countervailing force that rescued the economy from oblivion.

    This is pure ‘falling dominos’ thinking to be sure, but it highlights a problem with the mainstream understanding of how economies work – one that ommits any grasp of the importance and commonplace occurance of business failure (exits, shutdowns) to the normal functioning of the capitalist order.

    To believe that in an economy that loses 10% of all firms every year and still manages (usually) healthy growth, that the loss of a single (albiet large) insurance company might end human civilization as we know it, is to be in a state of almost total ignorance as to the forces that maintain the overall stability of the capitalist system, and indicates that the Keynesians are still very much at the ‘drawing board’ stage at best.

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