December 4, 2022

Economic View: If You Have the Answers, Tell Me

Now, if you follow economic commentary in the newspapers or the blogosphere, you have probably not run into many humble economists. By its nature, punditry craves attention, which is easier to attract with certainties than with equivocation.

But that certitude reflects bravado more often than true knowledge. So let me come clean and highlight three questions that perplex me. The answers to them may well shape the economy in the years to come.

How long will it take for the economy’s wounds to heal?

When President Obama took office in 2009, his economic team projected a quick recovery from the recession the nation was experiencing. The administration’s first official forecast said economic growth, computed from fourth quarter to fourth quarter, would average 3.5 percent in 2010 and 4.4 percent in 2011. Unemployment was supposed to fall to 7.7 percent by the end of 2010 and to 6.8 percent by the end of 2011.

The reality has turned out not nearly as rosy. Growth was only 2.8 percent last year, and the first quarter of this year came in at a meager rate of 1.8 percent. Unemployment, meanwhile, lingers well above 8 percent, and according to Ben S. Bernanke, the Federal Reserve chairman, is expected to keep doing so throughout this year.

Economists will long debate whether President Obama’s policies are to blame or the patient was just sicker than his economists realized. But there is no doubt that the pace of this recovery will come nowhere close to matching the one achieved after the last deep recession, when President Ronald Reagan presided over a fall in the unemployment rate from 10.8 percent in December 1982 to 7.3 percent two years later.

Looking ahead, an open issue is whether the recession will leave scars that prevent a return to jobless rates that were considered normal just a few years ago. A striking feature of today’s labor market is the rise of long-term joblessness. The average duration of unemployment is now almost 40 weeks, about twice what it reached in previous recessions. The long-term unemployed may well lose job skills and find their future prospects permanently impaired. But because we are in uncharted waters, it is hard for anyone to be sure.

How long will inflation expectations remain anchored?

In 1967, Milton Friedman gave an address to the American Economic Association with this simple but profound message: The inflation rate that the economy gets is, in large measure, based on the inflation rate that people expect. When everyone expects high inflation, workers bargain hard for wage increases, and companies push prices higher to keep up with the projected cost increases. When everyone expects inflation to be benign, workers and companies are less aggressive. In short, the perception of inflation — or of the lack of it — creates the reality.

Although novel when Professor Friedman proposed it, his theory is now textbook economics, and is at the heart of Federal Reserve policy. Fed policy makers are keeping interest rates low, despite soaring commodity prices. Why? Inflation expectations are “well anchored,” we are told, so there is no continuing problem with inflation. Rising gasoline prices are just a transitory blip.

They are probably right, but there is still reason to wonder. Even if expectations are as important as the conventional canon presumes, it isn’t obvious what determines those expectations. Are people merely backward-looking, extrapolating recent experience into the future? Or are the expectations based on the credibility of policy makers? And if credibility matters, how is it established? Are people making rational judgments, or are they easily overcome by fear and influenced by extraneous events?

Mr. Bernanke and his team may learn that, in turbulent times, expectations can become unmoored more easily than they think.

How long will the bond market trust the United States?

A remarkable feature of current financial markets is their willingness to lend to the federal government on favorable terms, despite a huge budget deficit, a fiscal trajectory that everyone knows is unsustainable and the failure of our political leaders to reach a consensus on how to change course. This can’t go on forever — that much is clear.

Less obvious, however, is how far we are from the day of reckoning.

Winston Churchill famously remarked that “Americans can always be counted on to do the right thing, after they have exhausted all other possibilities.” That seems to capture the attitude of the bond market today. It trusts our leaders to get the government’s fiscal house in order, eventually, and is waiting patiently while they exhaust the alternatives.

But such confidence in American rectitude will not last forever. The more we delay, the bigger the risk that we follow the path of Greece, Ireland and Portugal. I don’t know how long we have before the bond market turns on the United States, but I would prefer not to run the experiment to find out.


So those are the three questions that puzzle me most as I read the daily news. If you find an economist who says he knows the answers, listen carefully, but be skeptical of everything you hear.

N. Gregory Mankiw is a professor of economics at Harvard.

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Economic View: Needed: A Clearer Crystal Ball

In fact, some people view the recent crisis as just another “black swan event,” one of those outliers, as popularized by Nassim Taleb, that come out of the blue. And it’s clear that a lot of smart people simply didn’t see the housing bubble, the instability of our financial sector or the shock that came in 2007 and 2008.

But the theory of outlier events doesn’t actually say that they cannot eventually be predicted. Many of them can be, if the right questions are asked and we use new and better data. Hurricanes, for example, were once black-swan events. Now we can forecast their likely formation and path pretty well, enough to significantly reduce the loss of life.

Such predictions are a crucial challenge in economics, too, and they are why data collection need not be a dull or a routine field. If done correctly, it can be very revealing. The Dodd-Frank Act of 2010 created a Financial Stability Oversight Council with a research arm, the Office of Financial Research, to help confront systemic risks. Perhaps these new organizations will improve our knowledge, mirroring the progress we have seen with hurricanes.

Of course, there was already an organization that looked a bit like a leaner version of the oversight council, yet it did nothing effective to prevent the recent crisis. That is the President’s Working Group on Financial Markets, created by President Ronald Reagan after the stock market crash of 1987. The real hope for the new organization is its research office — but only if it is given enough resources. The law charges the new office with collecting data, standardizing it and “developing tools for risk measurement and monitoring.” Those tasks aren’t as minor and as technical as they may sound.

Armchair scientists will never get far; observation makes all the difference. Think of the advances that came with the microscope and telescope. So it is with measurements in economics, too.

When I wrote the second edition of my book “Irrational Exuberance” in 2005, I produced a century-long series of home prices, which revealed how unusual the housing-price boom was at the time. General talk about the nature of bubbles didn’t convince many people that a bubble was forming, but the data I collected did convince at least some that we were in a very risky and historically unparalleled situation.

Donald L. Kohn, the former vice chairman of the Federal Reserve Board, along with the board economists Matthew J. Eichner and Michael G. Palumbo, argued in a 2010 paper that a significant reason the financial crisis was not anticipated was that the board had no reliable information on two important variables. One, it said, was “the underlying credit risk associated with the rapid growth of home mortgages and a consequent increase in the vulnerability of borrowers to a downturn in home prices or incomes.” The other was the growth of financial vulnerability outside the traditional banking sector because of “a greater reliance on short-term funding for longer-term financial instruments.”

Such acknowledgments of information black spots are familiar. The Depression of the 1930s was blamed on a lack of knowledge, too, but one result was an improvement in our measurement systems.

The government’s National Income and Product Accounts data began as a reaction to the Depression. And the term “gross national product” first appeared in an article by Clark Warburton in 1934, amid the Depression’s darkest days.

It took years, however, to develop this concept. The new Keynesian economic theory provided the intellectual framework for integrating disparate sources of information. That was no easy task. The Commerce Department didn’t start publishing G.N.P. data until 1942 — backdating it to the beginning of the Depression in 1929. (In 1974, it restated it as gross domestic product, or G.D.P.)

The Federal Reserve started work on its Flow of Funds Accounts in the Depression as well. These accounts, which go beyond G.N.P. and show the flow of funds from each kind of financial institution to another, offer a much better picture of the kinds of instabilities that led to the Depression. This innovation took a long time, too. The Fed didn’t begin publishing these accounts until 1955, backdating them to late in the Depression, in 1939.

Eventually, these advances led to quantitative macroeconomic models with substantial predictive power — and to a better understanding of the economy’s instabilities. It is likely that the “great moderation,” the relative stability of the economy in the years before the recent crisis, owes something to better public policy informed by that data.

Since then, however, there hasn’t been a major revolution in data collection. Notably, the Flow of Funds Accounts have become less valuable. Over the last few decades, financial institutions have taken on systemic risks, using leverage and derivative instruments that don’t show up in these reports.

Some financial economists have begun to suggest the kinds of measurements of leverage and liquidity that should be collected. We need another measurement revolution like that of G.D.P. or flow-of-funds accounting. For example, Markus Brunnermeier of Princeton, Gary Gorton of Yale and Arvind Krishnamurthy of Northwestern are developing what they call “risk topography.” They explain how modern financial theory can guide the collection of new data to provide revealing views of potentially big economic problems.

TODAY, our prosperity depends on finance, and on its associated disciplines of accounting and macroeconomics. The financial crisis didn’t demonstrate their bankruptcy, as some would say. We should respond just as we did to the Depression, by starting the long process of redefining our measurements so we can better understand the risk of another financial shock.

The past suggests that this project will take many years to complete. But it will be worth the effort. 

Robert J. Shiller is professor of economics and finance at Yale and co-founder and chief economist of MacroMarkets LLC.

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