Robert Samuelson February 16, 2014

 

These are hard times for economists. Their reputations are tarnished; theirfavorite doctrines are damaged. Among their most prominent thinkers,there is no consensus as to how — or whether — governments in advancedcountries can improve lackluster recoveries. All in all, the situationrecalls a cruel joke:

How many economists does it take to change a light bulb? None. When the one they used in graduate school goes out,they sit in the dark.

Recently, economists at the Organizationfor Economic Cooperation and Development (OECD) published aretrospective study of its economic forecasts. This qualifies as an actof bureaucratic courage, because the record was predictably dismal. Notonly did the OECD miss the 2008-09 financial crisis, but it routinelyover-predicted the recovery’s strength. In May 2010, for example, theOECD forecast that the U.S. economy would grow 3.2 percent in 2011.Actual growth was 1.7 percent. This is a huge error, and there werelarger misses for some European economies as well.

The OECDwasn’t alone. As the study notes, “groupthink” is endemic amongforecasters. The International Monetary Fund, private economists andgovernment agencies — including the Federal Reserve and CongressionalBudget Office — all committed similar mistakes.

In explaining its poor performance, the OECD cites three under-appreciated forces.

First, globalization: The weaknesses of some economies, especially the UnitedStates’, depressed other economies through reduced trade and greaterfinancial strains.

Second, fragile banks: Countries with undercapitalized banks fared especially poorly, presumably because the banks lent less.

And finally, economic regulation: Highly regulated societies had a hardertime adjusting to adversity than more flexible societies.

Allthese underestimated factors made forecasts too upbeat, says the OECD.Interestingly, one item not on the list is “too much austerity.” TheOECD economists found that they generally hadn’t underestimated theeffects of spending cuts and tax increases intended to shrink budgetdeficits in Spain, Italy, Ireland, Portugal and elsewhere. Greece was aconspicuous exception.

This conclusion is surely controversialbecause many economists attribute the weak recovery to misguidedausterity, especially in Europe. Just follow the advice of John MaynardKeynes (1883-1946), they say. When the economy suffers a massive drop in private spending, government should offset the loss by increasing itsbudget deficits. Europe’s budget cuts were too aggressive, they say,while U.S. “stimulus” policies were not aggressive enough.

Perhaps history will vindicate this appeal to Keynesianism. Or perhaps not. The fact is that the United States did respond aggressively under bothGeorge W. Bush and Barack Obama. It certainly didn’t embrace austerity.Federal budgets ran massive deficits — $6.2 trillion worth from 2008 to2013, averaging 6.4 percent of the economy (gross domesticproduct).Nothing like this had occurred since World War II. Yet, theeconomy limped along. Why wasn’t this enough?

It’s not justKeynesianism that’s under a cloud. The same fate has befallen monetarism — the doctrine that stable growth in the money supply can promote amore stable economy. Since 2008, the Federal Reserve has poured morethan $3.2 trillion into the economy to keep interest rates low andaccelerate economic growth. By monetarist reasoning, so much moneypumped out so quickly should spawn higher inflation. Some economistspredicted as much; it hasn’t happened yet. Consumer prices today are up a mere 1.5 percent from a year earlier.

If you add the last sixyears of U.S. budget deficits and the Fed’s injection of cash into theeconomy, the total is approaching $10 trillion. It’s hard to believethat all this stimulus didn’t aid the recovery, but the fact that itresulted in only modest growth has created an identity crisis foreconomists. The promise they held out was that, through suitableeconomic policies, they could produce long periods of stable growth and — just as important — avoid prolonged slumps and lengthy periods ofsubstandard growth. Clearly, they aren’t delivering on this promise.

The Great Recession and financial crisis changed behavior in fundamentalways that economists have yet to incorporate fully into their models ortheories. The widespread faith that modern societies were sheltered from deep and sustained economic setbacks has been shattered, causingconsumers, business managers and bankers to be more cautious inborrowing and spending. Economic stimulus may offset this caution, butif it signals that the economy is weaker than expected, it may alsofurther depress private spending. There are countervailing tendencies.

The faith in economics was, in many ways, the underlying cause of both thefinancial crisis and Great Recession — it made people overconfident andcareless during the boom — and the basic explanation for the weakrecovery, as stubborn caution displaced stubborn complacency. To regainrelevancy, economists are searching for a new light bulb — or better use of the old one. Meanwhile, most are still sitting in the dark.