So far so good but this is only Year One

Here’s the question: Do economists understand what’s happening to the American economy? And here’s the answer: no, they don’t. So when I see the American economy picking up, I am excited to see how accurately classical economic theory explains what to do with the result right there before your eyes. I also don’t know if this is true – Economy to grow at 5.4% rate in first quarter, Atlanta Fed tracker shows – but no one will be surprised if things turn out that way. The question for the future, however, is different – whether our present growth rates can be sustained, and on whether you can depend on our current economic establishment not to muck things up.

Alas, economists learn not from experience, not from observing the world and what happens, but only via the theories they have been taught and passed examinations to demonstrate their knowledge of. I suppose there’s no other way, but it should make you cautious. Leaving economies in the hands of economists drenched in modern economic theory is not the best long-term strategy. A couple of examples of economic thinking from the very highest reaches of economic theory to help put things into perspective. First this via The Institute of International Monetary Research:

The accompanying video looks at a different topic. In an article in the current issue of The Oxford Review of Economic Policy, Professor Paul Krugman claims that economic theory and analysis have worked well over the last decade. He is a champion of the well-known Keynesian prescription, that an increase in the structural (i.e., cyclically-adjusted) budget deficit boosts aggregate demand and makes above-trend growth (with falling unemployment) more likely. According to Krugman, cheered on by Keynes’ biographer, Lord Skidelsky, in the Project Syndicate blog, these textbook ideas were translated into policy in the USA and went far to check the Great Recession. Krugman and Skidelsky believe that, in this sense, economics worked.

That is, it worked in the sense that the ridiculously exaggerated forecasts of doom never eventuated. But the recovery never occurred either, a recovery that is occurring now based on principles absolutely and completely antithetical to the policies adopted by those who applied a Keynesian stimulus.

So let me also mention this, Should We Reject the Natural Rate Hypothesis?, from the latest issue of the Journal of Economic Perspectives. This is the interim conclusion:

To summarize: I read the macroeconomic evidence as suggestive of persistent effects of monetary policy on the natural unemployment rate and potential output. But the evidence is not overwhelming. Moreover, looking just at recessions has its limits: It cannot answer whether there are symmetrical effects of booms and recessions, which is a crucial issue for the design of policy. In this context, a closer look at potential channels of persistence and more microeconomic evidence may help to assess potential nonlinearities or asymmetries between recessions and booms.

And this is the conclusion at the end:

Where does this leave us? . . . The general advice must be that central banks should keep the natural rate hypothesis as their baseline, but keep an open mind and put some weight on the alternatives. For example, given the evidence on labor force participation and on the stickiness of inflation expectations presented earlier, I believe that there is a strong case, although not an overwhelming case, to allow US output to exceed potential for some time, so as to reintegrate some of the workers who left the labor force during the last ten years.

That is, we should keep the theory intact but ignore the theory when it suits us because something else would be preferable even if the theory doesn’t tell you what that is. Indeed, if we are looking at the US economy and trying to explain its astonishing reversal over the past year, there is not a theory found in any modern text [except possibly mine] that will help you understand what is going on or why. These and their students are the people who run the show and make macro and monetary policy decisions while also regulating business. So far so good, but this is now before the economic establishment again gets their claws on the levers of power.

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