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To Find the Answers, Look Beyond Economics . . .
Posted By Barry Ritholtz On May 8, 2011 @ 11:00 am In Economy,Inflation,Psychology,Taxes and Policy | Comments Disabled
“AFTER more than a quarter-century as a professional economist, I have a confession to make: There is a lot I don’t know about the economy. Indeed, the area of economics where I have devoted most of my energy and attention — the ups and downs of the business cycle — is where I find myself most often confronting important questions without obvious answers…”
This week’s Sunday NYT Business section has an interesting column from Greg Mankiw: If You Have The Answers, Tell Me .
Well, Professor Mankiw, you asked. Rather than just give you the answers, I want to start by suggesting you are looking in the wrong places. That wrong place, is the field of economics.
Let’s put aside the fundamental error of classical economics — that Humans are rational, self-interested, profit maximizing creatures. They are clearly not; Humans are actually irrational social animals with flawed cognitive apparatus. Frequently emotional, occasionally self-destructive, often times erratic, humans only rarely exhibit the traits that economics ascribe to them. If the study of economics begins with such a shaky foundation, is it any wonder they get so much wrong?
Back to the questions Prof Mankiw asked about: Let’s see if we can’t give you a shove in the right direction (I have to warn you, I doubt you are going to like the answers):
1) How long will it take for the economy’s wounds to heal?
Most economists seem to focus on the post WWII economic cycles. This is the wrong approach. The most recent contraction was quantitatively different than the typical recession/recovery cycles. To get a better grasp as to what to expect, turn to history and statistical analysis instead of economics.
That is essentially what Reinhart & Rogoff did. In their December 19, 2008  paper, they showed historically, “the aftermath of banking crises is associated with profound declines in output and employment.” They had identified this phenomena 3 years ago, while the collapse was still unfolding. Their book, This Time Is Different: Eight Centuries of Financial Folly , expanded their prior paper on credit-crisis recessions.
2) How long will inflation expectations remain anchored?
Like the premature New York Journal obituary for Mark Twain, reports of inflation expectations have been greatly exaggerated. Human beings cannot forecast their own behaviors, let alone act on their expectations for inflation. Indeed, the only time most people even notice inflation is AFTER prices have skyrocketed — not before. The Recency Effect , the tendency to over-emphasize a single data point of what has just occurred rather than focus on long term series or trends –THAT is what drives behavior.
Friedman’s belief that people were engaging in immediate behavior based upon their momentary consideration of long term inflation reveal he hadn’t a clue as to how actual human beings operated in the real world. No wonder he foolishly believed we could get rid of the FDA — who needed Food inspections anyway? And the marketplace will help determine what Drugs will and should sell.
As Prof Mankiw writes, this “theory is now textbook economics, and is at the heart of Federal Reserve policy.” Which perhaps goes a long way in explaining why the Fed gets so much wrong in terms of recognizing inflation on a timely basis.
3) How long will the bond market trust the United States?
This is the most revealing question, because it reveals some biases that Professor Mankiw labors under.
He writes: “A remarkable feature of current financial markets is their willingness to lend to the federal government on favorable terms.” This must be a change of heart for the professor, given his role as Chairman of the Council of Economic Advisors from 2003-05. He never said much — at least publicly — about this “unsustainable fiscal trajectory” when his boss was busy turning a surplus into a “huge budget deficit.”
From the CBO to the GAO, every honest broker who has analyzed the situation has observed that the Bush tax cuts, the war of choice in Iraq, the prescription drug entitlement were the biggest factors pre-2008 in the runaway budget. Add to that the collapse of revenues brought about by the financial crisis, and you have the makings of a awful balance sheet.
Ironically, this is the one question Prof Mankiw asked that COULD be solved by economics. I do not know why he chose to ignore the answer. Perhaps it might be because he did not care for the answer economics gave.
One last comment: Prof Mankiw noted that “It is easier to attract with certainties than with equivocation.” Do not overlook a key underlying issue: The causal factor here is that the public wants certitude, regardless of how erroneous. Study after study has revealed that a “Frequently wrong, never in doubt” commentator is much preferred by the majority of viewers/readers over an intelligent commentator honestly discussing the unknowable future in terms of what is unknown and unknowable.
Probabilistic nuance versus strongly confident (but wrong)? The public chooses the latter almost every time.
You can see this not only in the ratings for various shows, but in the public’s investing performance. Its about as good as their favorite pundits are.
Which is to say, not very . . .
If You Have the Answers, Tell Me 
N. GREGORY MANKIW
NYT, May 7, 2011
Article printed from The Big Picture: http://www.ritholtz.com/blog
URL to article: http://www.ritholtz.com/blog/2011/05/look-beyond-economics/
URLs in this post:
 If You Have The Answers, Tell Me: http://www.nytimes.com/2011/05/08/business/economy/08view.html
 December 19, 2008: http://www.economics.harvard.edu/files/faculty/51_Aftermath.pdf
 This Time Is Different: Eight Centuries of Financial Folly: http://www.amazon.com/exec/obidos/ASIN/0691142165/thebigpictu09-20
 The Recency Effect: http://www.ritholtz.com/blog/?domains=http%3A%2F%2Fwww.ritholtz.com%2F&sitesearch=http%3A%2F%2Fwww.ritholtz.com%2F&cx=015905226837203657063%3Ax1cwdcykvvw&ie=UTF-8&oe=UTF-8&cof=FORID%3A11&s=Search&q=Recency+Effect%2C&sa.x=0&sa.y=0#933
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