10/24/10 1:19 PMJohn Stuart Mill vs. the European Central Bank - Grasping Reality with Both Hands

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Grasping Reality with Both HandsThe Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, Reality-Based, and Even-HandedDepartment of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 7080467; delong@econ.berkeley.edu.

Economics 210aWeblog ArchivesDeLong Hot on GoogleDeLong Hot on Google BlogsearchJuly 30, 2010

John Stuart Mill vs. the European Central Bank

We are live at Project Syndicate: John Stuart Mill vs. the European Central Bank:

One of the dirty secrets of economics is that there is no such thing as “economictheory.” There is simply no set of bedrock principles on which one can basecalculations that illuminate real-world economic outcomes. We should bear in mindthis constraint on economic knowledge as the global drive for fiscal austerity shifts intotop gear.

Unlike economists, biologists, for example, know that every cell functions according toinstructions for protein synthesis encoded in its DNA. Chemists begin with what theHeisenberg and Pauli principles, plus the three-dimensionality of space, tell us aboutstable electron configurations. Physicists start with the four fundamental forces ofnature.

Economists have none of that. The “economic principles” underpinning their theoriesare a fraud – not fundamental truths but mere knobs that are twiddled and tuned sothat the “right” conclusions come out of the analysis.

The “right” conclusions depend on which of two types of economist you are. One typechooses, for non-economic and non-scientific reasons, a political stance and a set ofpolitical allies, and twiddles and tunes his or her assumptions until they yieldconclusions that fit their stance and please their allies. The other type takes the carcassof history, throws it into the pot, turns up the heat, and boils it down, hoping that thebones will yield lessons and suggest principles to guide our civilization’s voters,bureaucrats, and politicians as they slouch toward utopia.

Not surprisingly, I believe that only the second kind of economist has anything usefulto say. So what lessons does history have to teach us about our current globaleconomic predicament?

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In 1829, John Stuart Mill made the key intellectual leap in figuring out how to fightwhat he called “general gluts.” Mill saw that excess demand for some particular set ofassets in financial markets was mirrored by excess supply of goods and services inproduct markets, which in turn generated excess supply of workers in labor markets.

The implication of this was clear. If you relieved the excess demand for financial assets,you also cured the excess supply of goods and services (the shortfall of aggregatedemand) and the excess supply of labor (mass unemployment).

Now, there are many ways to relieve excess demand for financial assets. When theexcess demand is for liquid assets used as means of payment – for “money” – thenatural response is to have the central bank buy government bonds for cash, thusincreasing the money stock and bringing supply back into balance with demand. Wecall this "monetary policy."

When the excess demand is for longer-term assets – bonds to serve as vehicles forsavings that move purchasing power from the present into the future – the naturalresponse is twofold: induce businesses to borrow more and build more capacity, andencourage the government to borrow and spend, thus bringing the supply of bondsback into balance with demand. We call the first of these “restoring confidence,” andthe second “fiscal policy.”

When excess demand is for high-quality assets – places where you can park yourwealth and be assured that it will still be there when you come back – the naturalresponse is to have credit-worthy governments guarantee some private assets and buyup others, swapping them out for their own liabilities and thus diminishing the supplyof risky assets and increasing the supply of safe assets. We call this “banking policy.”

Of course, no real-world policy falls cleanly into any one of these ideal types. Rightnow, the European Central Bank worries that continued expansionary fiscal policy willbackfire. Yes, it argues, having governments spend more money and continue to runlarge deficits will increase the supply of bonds, and thus relieve excess demand forlonger-term assets. But if a government’s debt emissions exceed its debt capacity, all ofthat government’s debt will become risky. It will have relieved a shortage of longer-term assets by creating a shortage of high-quality assets, and so be in a worse positionthan it was before.

The ECB contends that the core economies of the global North – Germany, France,Britain, the United States, and Japan – are now at the point where they need rapidfiscal retrenchment and austerity, because financial markets’ confidence in the qualityof their debt is shaken, and may collapse at any moment. And policymakers are fallinginto line: in late July, Peter Orszag, Director of the US Office of Management andBudget said that the coming fiscal consolidation in the US over the next three yearswill be the country’s deepest retrenchment in 60 years.

Yet, as I look at the world economy, I see a very different picture – one in whichmarkets’ trust in the quality of government liabilities of the global North’s coreeconomies most certainly is not on the brink of collapse. I see production 10% belowcapacity, and I see unemployment rates approaching 10%. More importantly for near-term economic policy, I see a world in which investors have enormous confidence incore economies’ government debt – for many, the only safe port in this storm.

Brad DeLong on July 30, 2010 at 02:23 AM in Economics, Economics: History,Economics: Macro | Permalink

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vtcodger said...***Chemists begin with what the Heisenberg and Pauli principles, plus the three-dimensionality of space, tell us about stable electron configurations.***

No, I'm pretty sure they don't. Moreover, they developed the Periodic Table ofElements around 1870 -- roughly 30 years before Pauli and Heisenberg were evenborn. Understanding of why the Periodic Table works took another 80-100 years. Theydid not even mention Pauli and Heisenberg in 1961 when I got my BS in Chemistry atUCLA.

That's important, because it is one of many demonstrations that you can do usefulscience and successful prediction without understanding exactly why things work.Darwin and Wallace didn't know about genetics but still managed to work outevolution. They didn't do a half bad job. Gregor Mendel did know quite a lot aboutgenetics by the time he died in 1884, but he did not know anything about DNA.(Neither would the knowledge have helped him much if it were somehow revealed tohim).

If anything this supports your argument. You don't have to know how economics worksto know that fiscal austerity during downturns and fiscal profligacy during booms areboth bad ideas.

Reply July 30, 2010 at 03:30 AMHopefully Anonymous said...I have a tricky (for me) question.I get generally that your point is that right now the financial product for which there isexcess demand is longer term assets (core north countries govt. debt), and that thedanger some claim to fear (although you and some other experts don't) is lack ofconfidence in core north countrry government debt, and for that reason they advocatethe govt. focus on paying down debt rather than selling more debt to finance spendingby core north countries.

My question is, how much should we be spending, and what should we be spending

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on? I also get as a follow-up point that some argue that the focus now should be onheavy spending without the inefficiency of determining best projects. I'm skeptical ofthat line, but I'm not sure it's wrong -it just seems convenient to me for factions thatwant to manage resources for the status (and maybe some other things I can'tarticulate now) it conveys, but aren't great resource managers.

Perhaps I'm analogizing poorly from my own micropsychology to macroeconomicrealities, but "let's spend a lot now, quickly" stylistically feels like bad management tome, and the technocratic arguments for spending a lot don't seem to match well to meyet with technocratic proposals of how to manage the money (it really does feel to melike the quick rush into Iraq, and the narratives of resource waste that ensued -lootedmuseums, ethnic civil wars instead of technocratic maintenance, etc.)

Reply July 30, 2010 at 03:50 AMHopefully Anonymous said...vtcodger,I think you terribly (although apparently with no ill will) misread Professor DeLong'svery clear prose.I think his point is that there are sciences with theoretical 1st principles andsubsequently layered principles (not in sequential historical time -your error- but inlevels of complexity or at least that match human intuitions of levels of phenomenon)that have run a gauntlet of empirical verification by some of the best minds on theplanet for generations, and that touted macroeconomic principles have not yet run thatgauntlet.

The good news for the prospect of a better macroeconomic is we're probably (quiteliterally on either side of this parenthetical comment) in a simulation -and thusmacroeconomic experiments should be possible to run, although the bad news for you,me, and our host is that if it's simulating anything economic, it's probably Prof.Krugman's theory of interstellar trade or some such thing, rather than how to create afantastic utopia for the people living at the time of this blog comment.

Reply July 30, 2010 at 03:59 AMSomeCallMeTim said in reply to Hopefully Anonymous...Hear, hear.

Isn't one of the criticisms of Japan's response to it's collapse that it spent a hugeamount on infrastructure projects, but did so incoherently, or at least without astrategy that looked much beyond the amount spent?

{apologies for any oversimplification of J's response...}

Reply July 30, 2010 at 10:05 AMConfabulator said...Or to use an analogy, filling a big hole that you have been digging yourself into foreight years or so can be accomplished quickly if your satisfied with simply back fillingit with a bunch of dirt. But to use that hole to construct a foundation capable ofsupporting an edifice that is enduring takes much more time and thought. Do we havethe time? Do we have the correct thinking?

Reply July 30, 2010 at 04:10 PMvtcodger said in reply to Hopefully Anonymous...***I think his point is that there are sciences with theoretical 1st principles andsubsequently layered principles (not in sequential historical time -your error- but inlevels of complexity or at least that match human intuitions of levels of phenomenon)

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that have run a gauntlet of empirical verification by some of the best minds on theplanet for generations, and that touted macroeconomic principles have not yet run thatgauntlet.***

I didn't misread it. I'm pointing out that those sciences generally didn't develop fromfirst principles. They developed by observation. The principles -- which aren't actuallyall that relevant to most day to day work -- came decades (or centuries) after thesciences in question knew pretty much how things worked ... if not why they worked.

Reply July 30, 2010 at 05:25 PMSam Costanzo said...The latest GDP report clearly shows that US demand is powering the growth of theworld economy. Since the US accounts for 24% of global GDP, the 5.1% growth in USdemand provides a powerful stimulus to the global economy.

Final sales of all products to US residents (including imports and excluding inventorychange) lag behind but are accelerating.

Final sales of US products to everyone (including exports and excluding inventorychange) are only inching ahead.

.............................................Q3......Q4......Q1.......Q2US purchases from all sources............. +3.0% +3.0% +3.9% +5.1%Final sales to US residents incl imports.. +1.8% +0.2% +1.3% +4.1%Final sales of US products incl exports... +0.4% +2.1% +1.1% +1.3%

It seems from the table above that our biggest problem is not so much lack of stimulusbut that too much of the growth of demand is leaking out to pay for imports... i.e., theproblem of global imbalances, energy policy and the atrophied US manufacturing base.

We need an industrial policy, energy policy and capital exports to creditworthydeveloping countries like India that have enormous needs for infrastructure. A $200billion 30 yr credit to India tied to the supply of US designed turnkey projects forroads, power plants, airports, water treatment, broadband, etc, etc, with the bulk of theequipment and materials tied to US exports would be a good start.

Reply July 30, 2010 at 05:43 PMMin said in reply to Confabulator..."Or to use an analogy, filling a big hole that you have been digging yourself into foreight years or so can be accomplished quickly if your satisfied with simply back fillingit with a bunch of dirt."

Filling in a big hole that you have dug for yourself is a nice analogy. :) So now we havefilled in about half the hole, and a lot of people are saying, we better stop piling up dirt,it was piling up dirt that got us into this hole. :(

Reply July 30, 2010 at 06:25 PMCranky Observer said...> Moreover, they developed the Periodic Table of Elements around 1870 -- roughly > 30 years before Pauli and Heisenberg were even born. Understanding of why the > Periodic Table works took another 80-100 years. They did not even mention Pauli > and Heisenberg in 1961 when I got my BS in Chemistry at UCLA.> > That's important, because it is one of many demonstrations that you can do useful > science and successful prediction without understanding exactly why things work. > Darwin and Wallace didn't know about genetics but still managed to work outevolution.

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The chemists of the 1700s and 1800s were doing useful work, and their theories werefor the most part getting closer and closer to reality over time. Heck, even thealchemists of the 1600s were doing useful work. The vast majority of economists arenot doing anything useful (except to the ruling class), do much damagingcounteproductive stuff, and their work is often at crashing variance with reality andseems to have gotten much _worse_ in many respects since 1980. That seems to me tobe a bit of a difference.

Cranky

Reply July 30, 2010 at 06:28 PMJohn Emerson said...I've been saying this all along, but apparently economists have always known this andjust refused to tell their clients.

Reply July 30, 2010 at 07:51 PMhartal said...Correction on the title--it should be William Blake vs. the ECB

“The classical doctrine that government spending was only a transfer of spending,rather than net increment, was challenged by William Blake in 1823. He argued thatsometimes liquid funds which were unavailable for private investment at the going rateof return were nevertheless available for the purchase of government bonds at thesame rate of return, since the lenders ‘prefer the security of government to that ofprivate borrowers,’ so that deficit spending represented a net increment of moneydemand, rather than a simple transfer…Later the younger Mill appropriated withoutcredit Blake’s assumption of idle capital and idle liquid hoards…” Thomas SowellClassical Economics Reconsidered, p. 71; he is quoting from William BlakeObservations on the Effects Produced by Expenditure of Government During theRestriction of Cash Payments,(1823) p. 62Blake’s text is on line http://socserv.mcmaster.ca/econ/ugcm/3ll3/blake/ExpenditureGovernment.pdf

Blake is quite circumspect about such a policy but he underlines that it would havestimulative effects at certain periods, and he reads better than the short quote fromSowell would indicate. Marx took over the same assumption from Blake in regards to aperiod juxtapositionof idle liquid hoards and idle capital and cited neither Mill norBlake (I believe) in the third volume of Capital. This is obviously not the Blake offearful symmetry.

Reply July 30, 2010 at 10:16 PMd4winds said in reply to vtcodger...I whole-heartedly agree. Copernicus & Kepler preceded Newton, who admitted that he"stood on the shoulders of giants." Coulomb preceded Gauss, etc., who precededMaxwell. Michelson-Morley preceded Einstein's special theory, etc, etc. Typically theunderlying principles were established only after the basic facts were well known. Evenseemingly purely conjectural theories validated by subsequent experiments (Einstein'sGeneral Theory is probably the most famously spectacular instance)were firstdeveloped under rigid requirements of conformity to known facts & of demonstratedlogical non-inconsistency at the observational level with the implications of othertheories accepted for their observational utility.

Reply July 31, 2010 at 03:17 AMSam Costanzo said in reply to Hopefully Anonymous...

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Sure, Brazil and Mexico, Columbia, Peru, Chile, Indonesia, South Africa, Turkey justfor starters. Countries that are on the path to development but need huge injections ofcapital and project knowhow to build the supporting infrastructure.

Reply July 31, 2010 at 06:35 AMhartal said...Sowell's quick discussion of William Blake--along with the criticism of him forsuggesting that fiscal policy could become a lever for permanent growth--can be foundhere

http://books.google.com/books?id=eYrEeWQWBFcC&printsec=frontcover&dq=thomas+sowell+classical+economics+reconsidered&source=bl&ots=9FlI4-hSyh&sig=Q7oY28hej0zklLTOkzN9CtnZ0gM&hl=en&ei=LTFUTKqPFYfGsAOIuJTbAg&sa=X&oi=book_result&ct=result&resnum=3&ved=0CCAQ6AEwAg#v=onepage&q=william%20blake&f=false

Reply July 31, 2010 at 07:25 AMOld Ari said...My favorite alchemist was "Mary the Jewess"?4C. One of her ideas still being used!

Reply July 31, 2010 at 08:40 AMBob Powell said in reply to Sam Costanzo..." our biggest problem is not so much lack of stimulus but that too much of the growthof demand is leaking out to pay for imports... i.e., the problem of global imbalances,energy policy and the atrophied US manufacturing base."

Exactly.

A major drag on GDP and employment is the continuing offshoring of jobs asevidenced by the again increasing trade deficit. From 2000 through May 2010 thecumulative trade deficit (trade debt) has been $5.8 trillion; that's how much GDP hasbeen reduced by insane "free trade" policy. Since 1980 it's $7.7 trillion of debt to othernations. There's no possible amount of stimulus that can make up for this drain onGDP.

Here's a hint based on the advanced mathematical tool called arithmetic: When moremoney is going out of an economy than is coming in ... it FAILS.

Reply July 31, 2010 at 10:48 AMBob Athay said in reply to vtcodger...You're right, but Brad's reference was quite consistent with my 1st year chemistrycourse (1969-70), which introduced concepts from quantum mechanics to provide anintuitively appealing framework for understanding the periodic table and why differentelements behave the way they do (and also how insightful those early chemists were).The fact that this foundation exists has an implication: a chemist from U. Chicago anda chemist from Princeton shouldn't have fundamental disagreements about whyhydrogen burns and helium does not. Economists, on the other hand, *do* seem todisagree on some basic definitions and axioms. Which means that two competenteconomists can take the same set of historical data and derive diametrically oppositeconclusions.

Reply July 31, 2010 at 02:08 PMJeffrey Davis said...Macro-Economics is politics with charts.Micro-Economics is bookkeeping.

Reply July 31, 2010 at 04:52 PMLee A. Arnold said...Brad, you really should get many of your posts collected in a book. Include all the

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Malthus-Say-Mill stuff, for example. You are providing, among other things,permanent economic education of a very high quality for the general reading public.

Reply July 31, 2010 at 07:22 PMTax Lawyer said...I North America, and Northern European debt is now somehow suspect, then where isan investor to turn? Japan? With a debt-to-GDP ratio and extremely low yields, I don'tsee how this could be profitable. Argentina anyone? The history doesn't lookpromising.

What we are seeing is a bunch of really rich people whining that they can't find a safeinvestment anywhere. So? Welcome to the real world. Mattresses still work, if you havea really secure lock on the room.

I have asked Professor DeLong for help on one matter before, but he has been tooswamped to deal with my question which is: "What happens to a net public and privatesector debtor in a trade war? We have seen the effect of this during Smoot-Hawley fora net private/public sector creditor, but is it a zero sum game where net importers winand exporters lose.

The invisible bond vigilantes just want to find the safest place to park their money andhope to generate some return on it. Bottom line: there is no safe place to park moneyexcept for in the red-headed, professionally discredited, dismissed step-child calledprecious metals or other commodities.

Reply August 01, 2010 at 11:47 AMJohn Emerson said...**The “right” conclusions depend on which of two types of economist you are. Onetype chooses, for non-economic and non-scientific reasons, a political stance and a setof political allies, and twiddles and tunes his or her assumptions until they yieldconclusions that fit their stance and please their allies. The other type takes the carcassof history, throws it into the pot, turns up the heat, and boils it down, hoping that thebones will yield lessons and suggest principles to guide our civilization’s voters,bureaucrats, and politicians as they slouch toward utopia.**

All economists should and must have a political stance. Economics is an applied policyscience like medicine, except that medicine is generally united on its goals -- long lifeand health. Economists differ, for example, on whether the welfare of the propertylessclass is an important consideration, and on the degree to which it's permissible todeliberately make the propertyless miserable in order to increase economic growth.

Beyond the weakness of economic theory, you have to doubt the possibility of a purelyscientific economics not influenced by political goals.

Reply August 01, 2010 at 11:49 AMpjcamp said...Economists should also bear that in mind when they tread into noneconomic realms.Your techniques aren't well suited for disciplines in which there are fundamental laws.

Also, I think you're referring to physicists, not chemists. Chemists are the economistsof physics.

Reply August 01, 2010 at 12:07 PMRickD said in reply to Hopefully Anonymous...Well, I'm a day late, but I share your frustration. vrcodger reads like somebody whofeels the need to inject "historical context" into every argument. DeLong's talking about

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how there exist fundamental concepts underlying the physical sciences that are agreedupon by all working scientists, but there is no similar set of core knowledge ineconomics.vrcodger simply ignores the core idea and sails off into an orgy of contextualism. My personal background is in mathematics. Yes, I know that math has been studied formillenia. And still, modern mathematics has organized itself around the basic conceptsof set theory. Yes, Newton, Gauss, Euler, Cauchy, etc., all did incredible work without20th century set theory. That's not the point. Modern mathematics is organized aroundset theory.

And modern economics appears to be organized around...whatever rich people want tohear. We have a generation of economists driving the world's economy off a cliff and allthey can do is collectively mock Keynes and praise Ayn Rand.

It's quite frustrating.

Reply August 01, 2010 at 10:00 PMmarkbenson143 said...The latest GDP report clearly shows that US demand is powering the growth of theworld economy. Since the US accounts for 24% of the global GDP, the 5.1% growth inUS demand provides a powerful stimulus to the global economy. Best life insurance provider

Reply August 02, 2010 at 12:06 AMNylund said...As pointed out, this is not true.

"Unlike economists, biologists, for example, know that every cell functions according toinstructions for protein synthesis encoded in its DNA. Chemists begin with what theHeisenberg and Pauli principles, plus the three-dimensionality of space, tell us aboutstable electron configurations. Physicists start with the four fundamental forces ofnature."

In each of those fields, it took them a very long time to get to these starting points.Sometimes centuries. Economics is hard to date. Where do you want to start? 18thcentury? Adam Smith? Then after him? A litle Say, Ricardo, Malthus, etc., but thingsdon't really take off until roughtly a century ago, and some may argue that true"macro" is only about 70+ years old. And heck, DSGE models are very recent. Thebenchmark international model (two countries instead of one!) is from the early 1990'sand it had problems and "puzzles" from day one.

As one professor put it, "yes, we're not nearly as good as physicists, biologists, orchemists, but they got got a few hundred years head start." He went on to say thatconsidered doctors bled people for centuries, we're really not doing that badconsidering how young we are at it. Everyone else has the distinct advantage of beingable to conduct experiments. If only the Fed could split the US in two and use half thecountry as a control group!

Reply August 02, 2010 at 06:49 AMJohn Emerson said...Nylund, what's your point? Actually existing economics is not as successful as biology,chemistry, or physics, in part because it hasn't been successfully theorized. Maybesomeday it will be, but right now it just plain isn't. And as a result, it can't give unique,reliable answers to a many important questions.

Some economists will tell you this, but most won't, some are willing to deceive you,

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Me: Economists:

PaulKrugmanMark ThomaCowen andTabarrokChinn andHamiltonBrad Setser

Juicebox

Mafia:

Ezra KleinMatthewYglesiasSpencerAckermanDanaGoldsteinDanFroomkin

Moral

Philosophers:

Hilzoy andFriendsCrookedTimber ofHumanityMarkKleiman andFriendsEricRauchwayand FriendsJohn Holboand Friends

and some of them probably don't even know.

Mathematical economics is difficult by lay standards, and that makes them seem likescientists, but people who understand the math are less impressed than laymen are.

Economics isn't worthless. Brad says its a historical science rather than a formalscience. I agree, but it's also so wired into major, controversial policy questions that itshould be regarded as a kind of skilled advocacy, like law. No one says that lawyersdon't know anything, bu they're not scientists. There plenty of times that you need aneconomist or a lawyer, and if you can afford one, you should get one.

An odd fact about the last 10 years or so is that both Presidents have seemed ignorantof economics, while at the same time the Federal Reserve has been under the controlof a now-discredited economic orthodoxy (compounded of course with Ayn Rand'spulp-fiction ideology).

Reply August 02, 2010 at 07:04 AMComments on this post are closed.

Procrustean Economics (Wonkish)New York Times (blog) - Sep 30, 2010Brad DeLong manfully takes on the efforts of various commentators to define awaythe paradox of thrift and redefine our current problems as somehow wholly ...Related Articles » « Previous Next »

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