James Galbraith Describes Major Forecast Failure in Model Used by Romers to Attack Friedman on Sanders Plan

Yves here. Now the big artillery is coming out. The Gang of Four, as Bill Black called them, that attacked Gerald Friedman for publishing a model that showed that Bernie Sanders’ economic plan could work, delivered what they though was a roundhouse punch on Thursday, in the form of a short paper by Christine Romer and David Romer. Their conclusions, which were taken up quickly by the mainstream media, such as the New York Times, would seem to be fatal:

The demand impacts forecasted are too large

The Friedman model assumes the output gap is larger than it is

The plan is likely to do little to increase productive capacity

The latter claim is bizarre since quite a few economists around the world are now pushing for infrastructure spending, precisely because it has spillover effects on productivity. For instance, Larry Summers pointed out in the Wasshington Post in 2014 that the IMF estimated that every dollar of infrastructure spending increased GDP by nearly $3 and the Sanders plan calls for significant infrastructure expenditures. By contrast, Friedman used very conventional fiscal multiplies of 1.2 in the early years falling to .8

So why do the Romers say so confidently that Friedman is off base? They are using a different model. And as Galbraith explains long-form, it’s one with a pretty crappy track record in post-crisis America. And Galbraith gives an important warning:

In the real world, forecasts are a very weak guide to policy; when attempting to make major changes the right strategy is to proceed and to take up the challenge of obstacles or changing circumstances as they arise. That is, after all, what Roosevelt did in the New Deal and what Lyndon Johnson did in the 1960s. Neither one could have proceeded if today’s economists had been around at that time.

By James Galbraith, professor of Government/Business Relations at the Lyndon B. Johnson School of Public Affairs, the University of Texas at Austin. His most recent book, Inequality and Instability was published in March, 2012 by Oxford University Press. The next will be The End of Normal, from Free Press in 2014. Originally published at the Institute for New Economic Thinking website

The Romer/Romer letter to Professor Gerald Friedman marks a turning point. It concedes that there are indeed important issues at stake when evaluating the proposed economic policies of Presidential Candidate Bernie Sanders. These issues go beyond the political debate and should be discussed seriously between and among professional economists.

All forecasting models embody theoretical views. All involve making assumptions about the shape of the world, and about those features, which can, and cannot, safely be neglected. This is true of the models the Romers favor, as well as of Professor Friedman’s, as it would be true of mine. So each model deserves to be scrutinized.

In the case of the models favored by the Romers, we have the experience of forecasting from the outset of the Great Financial Crisis, which was marked by a famous exercise in early 2009 known as the Romer-Bernstein forecast. According to this forecast (a) the economy would have recovered on its own, in full and with no assistance from government, by 2014, (b) the only effect of the entire stimulus package would be to accelerate the date of full recovery by about six months, and (c) by 2016, the economy would actually be performing worse than if there had been no stimulus at all, since the greater “burden” of the government debt would push up interest rates and depress business investment relative to the full employment level.

It’s fair to say that this forecast was not borne out: the economy did not fully recover even with the ARRA, and there is no sign of “crowding out,” even now. The idea that the economy is now worse off than it would have been without any Obama program is, to most people, I imagine, quite strange. These facts should prompt a careful look at the modeling strategy that the Romers espouse.

I attach here the manuscript version of Chapter 10 from my 2014 book, The End of Normal, “Broken Baselines and Failed Forecasts,” which discusses these issues in (I hope) accessible detail.

It should be noted that these issues, while important, do not bear on whether economists should try to discourage American voters from supporting the Sanders program. In the real world, forecasts are a very weak guide to policy; when attempting to make major changes the right strategy is to proceed and to take up the challenge of obstacles or changing circumstances as they arise. That is, after all, what Roosevelt did in the New Deal and what Lyndon Johnson did in the 1960s. Neither one could have proceeded if today’s economists had been around at that time.


Excerpt From:

The End of Normal By James K. Galbraith (Free Press, 2014)

Chapter Ten: Broken Baselines and Failed Forecasts

The Great Financial Crisis broke into public view in August, 2007, when the interbank lending markets suddenly froze. It built through that fall and winter, to the failure and fire sale of Bear Stearns in March, 2008. By then the US economy was slowing down, and Congress enacted the first “stimulus” package at the request of President George W. Bush. But this was all prologue. Through the spring, summer and early fall, the official line continued to be that problems were manageable, that the slowdown would be modest, that growth would soon resume. The presidential campaign played itself out that year on topics of greater interest to the voting public: a prolonged debate among the Democrats over the details of health care reform and between the eventual nominees over the war in Iraq. True panic would await the bankruptcy of Lehman Brothers, the sale of Merrill Lynch, the failure of AIG, and the seizure of Fannie Mae and Freddie Mac in September, 2008.

Then panic came. Money-market-mutual funds fled from the investment banks whose debts they had unfortunately held. Their depositors then began to flee, seeking safety in insured deposits in the banks. The funds had to be rescued by a guarantee from the President, who duly committed the Treasury’s Exchange Stabilization Fund to their support. As depositors then fled the smaller banks to the larger ones, deposit insurance limits had to be raised. Globally, access to dollars dried up, threatening banks, especially in Europe, that needed dollars to service debts they had incurred at low rates of interest in New York. This threatened the collapse, ironically, of foreign currencies against the dollar. Meanwhile Treasury Secretary Henry Paulson and his team struggled to come up a program that could keep the big banks from sinking under the vast weight of corrupt and illiquid mortgage-backed-securities, made against over-priced and over-appraised properties, that they held.

Once the immediate panic was quelled, the public’s reaction to these events was conditioned by three major and closely-related forces. First, new loans were no longer available, on any terms let alone the preposterously easy ones of the pre-crisis years. Second, home values declined and so even if lenders had wanted to resume lending the collateral to support new loans had disappeared. And third, there was fear. The consequence was a very sharp decline in household spending (and so also in business investment), in production and employment, and a sharp increase in private savings. Households, mired in debt, began the long, slow process of digging themselves out.

In the face of such events, one might think that economists responsible for official forecasting would be moved to review their models. Yet as the financial world crumbled, there is no sign that any such review took place. Indeed there were practically no modelers working on the effects of financial crisis, and so the foundations for such a review had not been laid. Though many observers saw that the disaster was of a type and severity not captured by the available models, they could not change the structure of the models on the fly. So the models absorbed the shock, and went on to predict – as they always had done in the past – a return to the pre-crisis path of equilibrium growth.

Consider the baseline economic forecast of the Congressional Budget Office, the officially nonpartisan agency lawmakers rely on to evaluate the economy and their budget plans. In its early January forecast in 2009, CBO measured and projected the departure of actual from “normal” economic performance – the “GDP gap.” The forecast had two astonishing features. First, the CBO did not expect the recession to be any worse than that of 1981-1982, our then-deepest postwar recession. Second, CBO expected a strong turnaround beginning late in 2009, with the economy returning fully to the pre-crisis growth track by around 2015, even if Congress had taken no action at all.

Why did Congress’s budget experts reach this conclusion? On the depth and duration of the slump, CBO’s model was based on the postwar experience, which is also the run of continuous statistical history available to those who program computer models. But a computer model based on experience cannot predict outcomes more serious than anything already seen. CBO – and every other modeler using this approach – was stuck in the gilded cage of statistical history. Two quarters of GDP loss at annual rates of 8.9 and 5.3 percent were beyond the pale of that history. A long, slow recovery thereafter – a failure to recover in any full sense of that word – was even more so.

Further – and partly for the same reason that past recessions had been followed by quick expansions – there was baked into the CBO model a “natural rate of unemployment” of 4.8 percent. This meant that the model moved the forecast economy back toward that value over a planning horizon of five or six years, no matter what. And the presence of this feature meant that the model would become more optimistic when the news got worse. That is, if the news brought word of a ten percent unemployment rate, instead of eight percent, then the model would project a more rapid rebound, so as to bring the economy back to the natural rate. A twelve percent unemployment rate would bring a prediction of even faster recovery. In other words, whatever the current conditions, the natural rate of unemployment would reassert itself over the forecast horizon. The worse, the better.

Then there was another problem, which has to do with the way economists inside the government interact with those outside. When the government has a scientific question – say on the relation of tobacco to cancer or the danger of chlorofluorocarbons to the ozone layer – there is a protocol for getting an answer, which typically consists of setting up a commission of experts who, within a relatively narrow range, are able to deliver a view. That view may be controversial, but there is at least a fairly clear notion of what the scientific consensus view is, as distinct from (say) the business view. The Intergovernmental Panel on Climate Change does not feel obliged to include, among its experts, the designated representative of the coal companies.

With economic forecasting there is no such independent perspective. A large share of working economic forecasters are employed by industry – especially by banks. And those in academic life who forecast often make some outside living by consulting with private business. The CBO and the Office of Management and Budget – which do the economic forecasting for the government, are not independent centers but derivative from the dominant business/academic view. Typically the business forecasters aggregate their views into an average or community viewpoint; this is published as the “Blue Chip” consensus. And here is the result: a vigorous dissent – say by Nouriel Roubini – in early 2009, making the case that conditions were far worse than they seemed, and that the long-term recovery forecast was wholly unrealistic, would have been immediately classified as an eccentric or unusual point of view. As such, it would be either dropped from the consensus (as an “outlier”) or simply averaged in. Either way, it would carry little weight.

And meanwhile, the financial economists – those employed directly by banks being perhaps anxious to avoid having their institutions seized – became a chorus of optimists. In April 2009, for example, in New York City at the annual Levy Institute Conference on economics and finance, James W. Paulsen of Wells Capital Management projected a “V-shaped” economic recovery and scrawled “Wow!!” over a slide depicting the scale of the stimulus to that point.* CEA Chair Christina Romer polled a bipartisan group of academic and business economists, including those of this type, and senior White House economic adviser Lawrence Summers told “Meet the Press” that the final package reflected a “balance” of their views. This procedure guaranteed a result near the middle of the professional mind-set.

The method is useful if the errors are unsystematic. But they are not. Even apart from institutional bias, economists are by nature cautious and in any extreme situation the mid-point of professional opinion is bound to be wrong. Professional caution even dampened the ardor even of those who may have been ideologically disposed to favor strong action. In November, 2008, 348 left-leaning economists signed a letter to the President-elect, demanding a stimulus of just $350 billion.* Within a few weeks, a much larger package was on the table, but the tentativity of the left position helped to tie the hands of those within the administration who might have pushed for more.

The CBO and the OMB took the measure of these views as though they were an unbiased sample, which they were not, and as though the situation were within the normal post-war range, which it was not. It’s hard to imagine a set of forecasting principles and consultation practices less well-suited to recognizing a systemic breakdown. Short of a decision to override the forecasting exercise – a decision that could only have come from the President, for which he was not qualified, and that would have been open to criticism as “political” interference in a technical process – there was no way for an unvarnished analysis of the grim situation to make it to the center of policy-making.

The principles underpinning the models, as they were built, reinforced the notion that recovery would be automatic and inevitable. A key such principle is that of a “potential rate of total output” or potential GDP. This is usually calculated in a simple way, by extending the trend of past growth of total production (gross domestic product) into the future. It is therefore assumed that the capacity to produce continues to grow, even if actual growth and production fall short for a time. The presumption is that the economy can, if properly managed (or not-managed, according to ideas about policy) always return to the rate of production predicted by the long-run trend of past output growth.

The concept of a natural rate of unemployment – also known as the “non-accelerating inflation rate of unemployment” (NAIRU) – provide a notional mechanism for the return to potential. The NAIRU idea is that the unemployment rate is determined in a market for labor, governed by the forces of supply and demand, which impinge on the level of wages – the price of labor. If there is unemployment, then market pressures will drive real wages (wages measured in terms of their purchasing power) down. This will improve the attractiveness of workers to employers, and gradually bring the unemployment rate back to its normal or natural level. The return of employment to normal then implies a return of production to its potential.
*

The NAIRU had been a staple of textbook economics for decades, with the mainstream view holding that any effort to push unemployment below six or seven percent would generate runaway inflation. Over the 1980s these estimates came under challenge, and in the 1990s, as unemployment fell without rising inflation, the custodians of natural-rate estimates progressively lowered their numbers. For those who had argued against the high NAIRU, the relatively low NAIRU estimates, on the order of five percent, of the post-crisis forecasts produced a bitterly ironic outcome. Previously a high NAIRU had been an excuse for policy complacency in the face of high unemployment. Now the low NAIRU became a reason for considering the high actual unemployment rate to be anomalous – and thus for expecting a rapid “natural” rebound of economic growth – and once again for doing little.

The infamous Christina Romer/ Jared Bernstein forecast of early 2009 illustrates this property. Romer and Bernstein, senior economists with the incoming Obama team and in Bernstein’s case the progressive economists’ lone representative on the team, predicted that with no stimulus package unemployment would peak at about 9 percent in early 2010.
With stimulus, they held that the peak would be around 8 percent in early 2009, a mis-forecast for which they were criticized somewhat unfairly*. The more important point is that with or without stimulus, Romer-Bernstein projected that unemployment would return to near five percent by 2014. And they projected that a return to unemployment below 6 percent, expected in 2012, would be delayed only by six months if there were no stimulus. Romer and Bernstein were trapped not so much by the unexpected depth of the slump, as by the entirely formulaic expectation, dictated by the NAIRU, of what would happen afterward.

Among other consequences, the official theory of events was forced to concede that the benefits of any fiscal expansion, or stimulus program, would be felt only in the very short term. From the standpoint of the new administration, as expressed by its own economists – perhaps unwittingly, but still – the entire American Recovery and Reinvestment Act – the signature response to the crisis – was only a stopgap. It was conceived and designed, at least in macroeconomic terms, as nothing more than a bit of a boost on the way to an otherwise-inevitable outcome. In practical terms it was much better than this, but that fact was downplayed, even concealed – rather than being trumpeted as it might have been.

The grip of teleology on the half-hidden mechanics of the forecasting process is actually even stronger than this. Looking out over ten years or so, official economic forecasts tend to show minor losses from stimulus programs. This is thanks to what they project to be the financial consequences – higher interest rates – of increasing the government’s debt. This effect is supposed to “crowd out” private capital formation that would otherwise have occurred. Once the shortfall in total production is made up, the extra interest burden associated with recovering the lost ground more quickly than otherwise is projected to weigh as a burden on private economic activity going forward. With less private investment, there will be (it is projected) a smaller capital stock, slightly less output, and eventually the gains associated with stimulus will be outweighed by these offsetting losses.

And so the Obama Team found itself working from predictions that foresaw a top jobless rate of around nine percent, with no stimulus, and a fast recovery beginning in the summer of 2009 with stimulus or without it. Those forecasts helped to place an effective ceiling on what could be proposed or enacted, as a practical matter, in the form of new public spending. When CEA Chair Romer proposed an expansion program well above one trillion dollars, Lawrence Summers advised her that the number was “extraplanetary.” Summers did not necessarily disagree with Romer’s estimates; in retrospect he has said he did not. Rather, his
political judgment was that to propose such a large plan would undermine the credibility of the analyst – given the weight of the forecasts with the President and Congress. So eight hundred billion dollars over two years became the number around which expectations coalesced.

Given the pressure for quick results, the American Recovery and Reinvestment Act tilted toward “shovel-ready” projects like refurbishing schools and fixing roads, and away from projects requiring planning, design and long-term project execution, like urban mass transit or high-speed rail, even though a large number of such long-term investments, including in energy and the environment, were tucked inconspicuously into the bill, as Michael Grunwald tells in his 2012 book, The New New Deal, on the expansion program. There was an effort to emphasize programs with high estimated multipliers – “more bang for the buck” – though this was also compromised by accepting tax cuts for political reasons, for about a third of the dollar value. Tax cuts have low multipliers, and especially so when the household sector feels strong pressure to pay down its debts rather than embark on new spending. The bill also provided considerable funds to state and local governments to hold off the sacking of teachers, police and fire, and other local public servants. Such expenditures are stabilizing, but they add nothing to the economy that wasn’t already there.

The push for speed also influenced the recovery program in another way. Drafting new legislative authority takes time. In an emergency, it was sensible for Chairman David Obey of the House Appropriations Committee to mine the legislative docket for ideas already commanding broad support (especially among Democrats). In this way he produced a bill that was a triumph of fast drafting, practical politics and progressive principle. But the scale of action possible by such means was unrelated to the scale of the disaster. And in addition to that, there was, to begin with, the desire for political consensus. The President chose to start his administration with a bill that might win bipartisan support and pass in Congress by wide margins. He was of course spurned by the Republicans; in spite of making tax cuts a major feature of the bill, no House Republican voted for it.

The only way to have avoided being trapped by this logic, would have been to throw out the forecasters and their forecasts. The President might have declared the situation to be so serious, and so uncertain, as to require measures that were open-ended; that were driven by the demand for them; measures that would not be subject to appropriations limits and that would therefore break, as necessary, all budgetary rules and all the constraints. A program enacted under that stipulation could then have been scaled back, once in place, should it prove to provide more support than the economy required*. In early 2009, that would have been a remote risk.

Of course forecasting failures became apparent quite quickly when the economy did not remain on the growth track anticipated in early 2009. 2010 was a disappointment, as were 2011 and 2012; from the trough of the slump economic growth never exceeded 2.5 percent. The ratio of employment to population never improved, and unemployment declined largely because in increasing numbers people ceased looking for work. Residential investment in 2012 was half its 2005 levels; total investment remained more than ten percent below its previous peak.

And what happened when the economy did not cooperate with the forecasts? Did this bring on a review of the models? Again, one might hope so. Again, one would be disappointed. The simple response of the forecasters to the failures was to run the models again, with a new starting point. Thus the five-year window for the start of a full recovery kept receding into the future, year by year, like a desert mirage. In 2009, full recovery was expected by 2014; in 2010, the date became 2015, and so forth.* Each year, the forecasters told us, the world would be “back to normal” – with full employment, recovered output, and high investment – five years hence.

It’s plainly unsatisfactory, to forecast in this way. But what’s the alternative? To develop a different point of view, one needs a model capable of generating a picture of the future that does not necessarily yield a mirror of the past. To do that, one needs a structured grip on the underlying mechanics. One needs a vision of how the economy works, and one needs to have the courage to assert that vision – ironically – in spite of the fact that it cannot be derived from the past statistical record. This is the hard part. But only in this way can one see that the baseline is baseless, that equilibrium is vacuous, that the past growth path is not the single best forecast. There is no way to build such a model for use by functionaries, and hence no easy escape from the mental traps of statistical prediction.

In an emergency, therefore, forecasts are not only useless; they are counterproductive. Franklin Roosevelt was blessed by history, in that he came to power in an age bereft of national income accounts and economic forecasting models. He was working in the dark, with nothing to guide him but a sense of urgency, the advice of trusted observers, and the observed results of action. So he tried everything, the plausible and the implausible alike, and both received and accepted full credit for the results. If Roosevelt had had the benefit of today’s economic experts, Keynesians and anti-Keynesians alike, he would have never gotten the New Deal off the drawing boards.

It is no surprise, then, that in 2008 and early 2009 the policy responses to crisis were in roughly inverse scale to the influence of forecasting on the decision makers. In the financial sphere, and especially at the beginning, the panic was pervasive and the policy reaction boundless. Forecasts did not matter. The Federal Reserve dropped interest rates to zero, provided unlimited liquidity to banks, and essentially unlimited access to dollars to the world financial sector. Only the element presented to Congress, the monstrous cash-for-trash operation called the Troubled Asset Relief Program (TARP) was limited in scale, to an arbitrary number ($700 billion) chosen for political reasons [because it was “more than $500 billion and less than a trillion,” as one senior Senate staffer put it to me.] But TARP was window dressing. Initially, it was designed to have been a scheme of reverse auctions, intended to “discover prices” for the bad assets and so simulate the behavior of the financial markets that suddenly no longer existed. As the notorious three-page, $700 billion proposal made its way through Congress, it became clear that the idea would not work. The auctions could not be got up-and-running in the few days’ time available, and could not be protected from manipulation even if they had been.

Quite quickly, schemes based on mimicking or supporting markets were replaced by improvised quasi-nationalization. Deposit insurance was increased from one hundred thousand to $250,000 on all accounts, and extended to cover business payroll accounts that often exceed that limits for brief periods. The Treasury deployed TARP funds to take an equity position in the major banks, providing them with capital that they needed for regulatory reasons. Further funds flowed to Goldman Sachs, Morgan Stanley and foreign counterparts like Deutsche Bank from a decision to pay off the insurance giant AIG’s credit default swaps at face value. Meanwhile the Federal Reserve took over the commercial paper market, assuring a flow of funds to major companies who had been relying on money market mutual funds. The Fed also made dollars available on a large scale, at near-zero cost, and created its own (non-auction) support for toxic assets (via TALF, PPIP and other facilities), while Treasury addressed foreclosures with a program, called HAMP, to “foam the runway” for the banking system * by stringing out the process of foreclosure on millions of defaulted or troubled home loans. The Federal Reserve also swapped currencies, to the tune of $600 billion, with foreign central banks whose national banks otherwise would have had to sell off non-US assets in order to meet their dollar liabilities.* Such actions would have driven up the dollar against the Swiss franc, Euro, pound and yen.

The next piece of the policy was to restore confidence, at least in the future of the big banks. To this end, in early 2009 Secretary Geithner launched a program of “stress tests,” whose stated purpose was to establish the extent to which banks required more capital – a larger cushion of equity – to protect themselves against even worse economic and financial conditions. Whether they gauged this accurately is doubtful, since they did not require banks to mark their failing mortgage portfolios to market prices, and since – contrary to all normal practice – the results of the tests were negotiated with the banks themselves before being released. But the fakery of the stress tests served a larger purpose: it demonstrated to the world that the United States government was not going to assume control over the banks, or otherwise let them fail. Bank shares rallied – spectacularly.

The great financial rescue of 2008 permitted the banks to continue operations, soon enough free of constraint on activities and on compensation. None of the big banks were seized, no bankers jailed. With bank earnings but nothing else in full recovery by mid-2009, there was a savage political reaction. The Federal Reserve’s programs were, moreover, as opaque as they were Pharaonic, and ultimately an audit ordered by Congress along with disclosures incident to a suit by Bloomberg revealed embarrassing abuses, including the participation of at least two top bankers’ wives in the TALF program. And so voters punished the bailouts in the 2010 congressional mid-terms, while a terrified Congress enacted, as part of the Dodd-Frank financial reform act, numerous limits on repetition of the bailout policy.

Nevertheless, the banking system survived. The big banks especially were saved. Their market share increased. Their profits soared and their stock prices recovered. They could meet their need for revenue by lending abroad, by speculation in assets, and simply by pocketing the interest on their free reserves. Limits on their freedom of maneuver remained minor, as even the weak restrictions imposed in the Dodd-Frank Act came only very slowly into effect. As time went on, the Federal Reserve pursued its programs of “quantitative easing,” which were ongoing purchases of assets from the banking system, including large volumes of mortgage-backed securities. While this program was touted as support for the economy, its obvious first-order effect was to help the banks clean up their books, and to bury potentially-damaging home loans deep in the vaults of the Fed itself, where they might – or might not – eventually be paid.

As for the supposed economic policy goal of all this largesse, the President stated it many times. The purpose of saving the banks was to “get credit flowing again.” The Treasury Secretary, Timothy F. Geithner, stated his view that, as an affirmative policy, the government sought a world financial sector dominated by American big banks, and an American economy in which private banks played a leading role. But it is one thing to have the banks and something else entirely for them to make loans. And loans to support commercial and industrial lending, still less new residential construction, were not on the agenda. New loans to businesses or households? To whom would they have made loans? For what? Against what collateral, with a third or so of American mortgages already underwater? Against what expectation of future profits? Five years later the banks had still not returned to this business. Nor would they.

In banking policy, as expressed by the President, the dominant metaphor was of plumbing. There was a blockage to be cleared. Take a plunger to the toxic assets, it was said, and credit conditions will return to normal. Credit will flow again. But the very metaphor was misleading. Credit is not a flow. It is not something that can be forced downstream by clearing a pipe. Credit is a contract. It requires a borrower as well as a lender, a customer as well as a bank. And the borrower must meet two conditions. One is creditworthiness, meaning a secure income and, usually, a house with equity in it. Asset prices therefore matter. With the chronic oversupply of houses, prices fell, collateral disappeared, and even if borrowers were willing they couldn’t qualify for loans. The other requirement is a willingness to borrow, motivated by the “animal spirits” of business enthusiasm. In a slump such optimism is scarce. Even if people have collateral, they want the security of cash. And it is precisely because they want cash that they will not deplete their reserves by plunking down a payment on a new car.

With few borrowers knocking on the door, for banks the safe alternative was to sit quietly and rebuild capital over time, by borrowing cheaply from the central bank and lending back to the government, at a longer-term, at a higher rate. For this there are two tools: the cost of funds from the Federal Reserve, and the interest rate on longer-term bonds, paid by the Treasury. So long as the two agencies are able to maintain the spread – the positive yield curve – between these two numbers, profitable banking is easy. This is what the large money center banks did in the 1980s, after the Latin American debt crisis, it is what the supervisors instructed regional and smaller banks to do in this crisis (by tightening up on underwriting guidance) and it is the preferred solution for all, among bankers and those who supervise them, who like a quiet life. But it does not lead to new loans.

After a certain amount of time, most detached observers would conclude that the purpose of unlimited (and forecast-free) intervention in banking was to save the banks and the bankers. A beneficial effect on the rest of the economy was not impossible, and not to be despised. But it was not the objective of policy in the financial sphere.

In the event, the American Recovery and Reinvestment Act poured about two percent of GDP in new spending and tax cuts per year, for two years, into a GDP gap estimated to average six percent for three years. In other words, as a matter of arithmetic, it might have worked to restore full production at levels prevailing before the crisis, if the fiscal multipliers had been close to two. But under the conditions, and the mix of spending types and tax reductions in the bill, they were not close to that value.

Given the political and economic constraints on the “stimulus package,” there remains a puzzle. Why, in the wake of financial calamity, did the US economy fall as little as it actually did? Employment and market incomes fell by some ten percent. Yet the fall in real GDP – in total output – from 2007 to 2009 was just three and a half percent; that in personal consumption expenditures was only two and a half percent. How come so little? Some are tempted to credit the unlimited actions of the central bank – but we have seen, without loans there is no stimulus, however low the interest rate.

The answer is that total federal government spending (purchases of goods and services) rose by over six percentage points in the same period, health security payments rose twenty-five percent, Medicare nearly fifteen percent, Social Security by over sixteen percent, and other income security programs (notably, unemployment insurance) by over forty-five percent. Meanwhile total tax receipts fell over eight percent. In sum, and notwithstanding the small scale of the ARRA, the federal budget deficit rose to above ten percent of GDP.

Some of these changes were enacted after the stimulus package, in further measures including extended unemployment insurance, a federal add-on to state plans, and (later on) a two percentage-point reduction in payroll tax collections. But most of these changes were automatic – which is to say, they too were forecast-free. They reflected increased demands on federal programs that already existed, and that had existed for decades, as well as the lucky special circumstance that very high oil prices in 2008 helped produce a substantial cost-of-living adjustment in Social Security in 2009. And they reflected the effect of declining private incomes on tax revenues. Overall, some ten percent of private incomes were lost in the crisis, but about four-fifths of these losses were made good, in the aggregate, by the stabilizing force of a changed federal fiscal posture – and the resulting large deficits in the public accounts.

What saved the United States from a new Great Depression in 2009 was not the underlying resilience of the private economy, nor the recovery of the banking sector. And it was not the stimulus program, though that clearly did help. It was, mainly, the legacy of big government that had been created to deal with the Great Depression, and to complete the work of the New Deal. Big government programs – Social Security, Medicare, Medicaid, unemployment insurance, disability insurance, food stamps, and the progressive structure of the income tax – worked to transfer the loss of private income from households, which could not handle it, to the government, which could.

In short, the very scale of government created over the previous century meant that the public sector could step up to meet the needs of the population when the private sector no longer did so. And in the spirit of the age, according to which no achievement goes unpunished, this success, modest and qualified, relative to expectations, though it was, led to a rapid change in the public debate.

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61 comments

  1. fresno dan

    “…. we have the experience of forecasting from the outset of the Great Financial Crisis, which was marked by a famous exercise in early 2009 known as the Romer-Bernstein forecast. According to this forecast (a) the economy would have recovered on its own, in full and with no assistance from government, by 2014, (b) the only effect of the entire stimulus package would be to accelerate the date of full recovery by about six months, and (c) by 2016, the economy would actually be performing worse than if there had been no stimulus at all, since the greater “burden” of the government debt would push up interest rates and depress business investment relative to the full employment level.

    It’s fair to say that this forecast was not borne out: the economy did not fully recover even with the ARRA, and there is no sign of “crowding out,” even now.”

    ……………………….
    The method is useful if the errors are unsystematic. But they are not. Even apart from institutional bias, economists are by nature cautious and in any extreme situation the mid-point of professional opinion is bound to be wrong. Professional caution even dampened the ardor even of those who may have been ideologically disposed to favor strong action. In November, 2008, 348 left-leaning economists signed a letter to the President-elect, demanding a stimulus of just $350 billion.* Within a few weeks, a much larger package was on the table, but the tentativity of the left position helped to tie the hands of those within the administration who might have pushed for more.

    ==========================================
    I’m not gonna say I told ya so…..well, that’s a lie. I told ya that the gang of four would come up with an analysis and say that Friedman made an error. I didn’t think they would have the Chutzpah to just use a different model – that is provably wrong.
    Will the gang of four answer the obvious question – how did they decide their model is the better model???
    LOL

    But to use a model that is sooooooooooooo empirically wrong I think proves to those amenable to evidence that the books are cooked. But its like giraffes – their necks don’t get long by changing, there are giraffes with long necks and short necks, but the only ones who survive are the long neck ones. Likewise, their are economists who believe the bull, and they get jobs – those who don’t believe the bull, don’t…
    The only question is: who benefits?
    Well, maybe the 50 years of increasing inequality is a coincidence…..and maybe all the think tanks and research centers that employ these economists are funded by squillionaires,

    OR

    “After a certain amount of time, most detached observers would conclude that the purpose of unlimited (and forecast-free) intervention in banking was to save the banks and the bankers. A beneficial effect on the rest of the economy was not impossible, and not to be despised. But it was not the objective of policy in the financial sphere.”

    So we saved the banks….kinda like if they had thrown all the people off the Titanic to save the boat…

  2. Rodger Malcolm Mitchell

    Only an economist would debate “Medicare for All” on the basis of economic growth formulas.

    Economics is a social science, and “social” means “people.” I, for one, do not care whether spending on “Medicare for All” is economically stimulative by 1%, 10% or 113.54%. I care about only two things:

    1. Federal spending does not cost taxpayers a dime. (Federal spending is not funded by federal taxes.)
    2. “Medicare for All” would provide a full range of free medical services to people who currently cannot afford a full range of medical services.

    So, what the heck are you people arguing about? Is it worth your life to learn how many angels can dance on the head of a pin?

    1. diptherio

      You should add a #3, if I may be so bold: Health care is a public good, i.e. you benefit from the people around you not being sick and vice versa. It’s not just the poor getting the health care who benefit, but everyone else they interact with as well.

      1. MyWag

        @ diptheio:
        True.
        And that is also the reason cited for going after the problems that lead to Ebola and ZIKA…..poverty and unhealthy living.

        Medicare for all, would also free up the wasted time and energy of those who have to navigate the obscenity of the current ‘partial market based solution’.

        And imagine adding the ‘genius’ of those who would slice and dice our health insurance; into profits. All those people and the minions that carry out their policies, could be added to productive society.

        1. RMO

          Did I have really odd economics professors and textbooks? I only took the 100 level micro and macro courses as part of a BBA in accounting and it was at a “smaller” university (both teachers lectured at one of the big universities in my city too though) but both professors and most of the textbooks took pains to explain that economics cannot and should not be used to evaluate questions of ethical and moral right or wrong or to judge issues of social welfare. At best they can tell you something about how decisions and policies in those areas will affect a society and its constituent individuals in terms of money, labor hours etc. They were also quick to point out just how far from a notionally “perfect” market the supposedly free markets we operate under really are and that even a “free market” is an artificial construct of the society that uses it and not some primal force of the universe like electromagnetism or gravity.

    2. Uahsenaa

      But the political mentality we have to deal with nowadays is one in which everything becomes subject to a cost/benefit analysis largely devoid of any consideration like “will this make people’s lives less miserable?”

      I see this all the time in government hearings, where every leftish policy proposal has to genuflect to efficiency and reducing costs, even though the military, for instance is never subject to such rhetoric. If you even hint to John McCain’s armed services committee that you think we should spend a single dollar less on a missile or a bloated weapons platform, because perhaps its not cost effective, he will through a literal temper tantrum. He does it all the time.

    3. Banana Breakfast

      We should certainly go further: universal health care should be enacted even if it is not economically stimulative, because people’s lives are worth more than money. This is one way politicians attacked over the cost of such programs should respond to their attackers, e.g. Cruz’s attacks on Trump in the most recent Republican debate: while they shot back and forth about “letting people die in the street” and “who will pay for it”, the clear riposte was: How much does it have to cost before you’ll let a person die, Mr. Cruz? And given your outspoken Christian views, and insistence on incorporating Christian principles into government, how much would it have to cost before Christ would do so? In short, what would Jesus do?

    4. Benedict@Large

      I’ve long suggested that we need a new CBO-type agency, but staffed by actuaries instead of economists, that instead of forecasting the monetary effects of suggested policy changes would forecast the number of lives saved or lost or lengthened or shortened.

  3. Terez

    I am amused that Galbraith had what essentially amounts to a pre-written response to this paper. His author bio is confusing, though; it appears to be stuck somewhere around 2013.

  4. RDeschain

    The problem is that Friedman’s number is so high that, even if the modelling is correct, people won’t believe it. If Friedman supports the Sanders policy, he did a terrible job of managing expectations. He also put the Sanders campaign in the position of having to support his numbers, because if they don’t, it looks like they don’t believe in their own plan.

    On a Wall Street, shorts will sometimes float earnings expectations that they know are unreasonably high so that they can consequently claim actual results are disappointing. That feels like what is happening here, even though I don’t believe Friedman intended it that way. This is what happens when amateurs play at politics, however.

    Obviously the real question should be simply whether Sanders’ plan is better than the alternative status quo – not whether or not it can hit some arbitrary growth number. The Friedman paper managed to completely derail that debate, which is exactly the way the Hillary supporters want it. The plan critics have largely been able to avoid answering the more important question (and Yves correctly points out that R and Rs handwaving about that towards the end of their paper is a real WTF moment – if fiscal policy doesn’t have much effect on the economy then why the hell do we need economists in the first place).

    1. Terez

      In Galbraith’s original response to the Gang of Four, he noted that the growth numbers were hardly unprecedented in modern history, so what excuse do they have for not believing it? Weak growth is at present largely due to weak purchasing power; this is something the average voter can intuitively understand if anyone bothers to explain it to them. One can hardly expect robust growth when one is already squeezing the last drops of blood out of the turnip. The only real question is whether Bernie could successfully implement any of his plans.

    2. Donald

      I agree to some extent, though I don’t blame Friedman. The Friedman paper, right or wrong, should have been a minor issue. It’s just a model. What made it an issue was the Gang of Four plus Krugman plus the NYT telling the world that this proved Sanders was a flake. And Sanders’s campaign staff person ( what’s his name) fell into the trap. Faced with the gang ( one of them the Nafta defender who accurately informed the Canadian government Obama wasn’t serious about his Nafta critique in the 2008 campaign)’ the Sanders worker said it was political. Well, yes, obviously, but that gave Krugman the excuse to play the wonk who is only concerned about facts. This after weeks of attacking Sanders, including a post where he bashed single payer not only as politically impossible, but as a plan which would produce many losers.

        1. Knute Rife

          I’m sure they’ll do exactly what they did with Friedman: exactly what the Clinton campaign tells them to.

    3. Brizie

      RDeschain asks: “…if fiscal policy doesn’t have much effect on the economy, why…
      RD, you have that backwards. Fiscal policy can have huge (yuuuge) positive effects on economies. It’s monetary policy that doesn’t have much effect (other than creating bubbles) on economies.

    4. mcarson

      Friedman is a university professor. He did this for his own information and as a math nerd version of a fun evening.
      Krugman’s comments about his intelligence and motives are on the edge of legally slanderous.
      I don’t know why these people are going after this poor guy so hard, it’s very unethical.

  5. Steve H.

    – But a computer model based on experience cannot predict outcomes more serious than anything already seen.

    Not true. Extrapolation is a standard procedure. Interpolation is understood to be more accurate, to have less uncertainly, because there is less likelihood of unknown unknowns.

    Good science is hard to do. Supercomputers model weather, but tolerably good local forecasts are only good in a time-frame less than a week. What made the recent gravity-wave announcement possible was the exhaustive removal of confounding factors like servo vibration. We know that increased CO2 leads to increased energy in the global system, but continue to be surprised by short-term manifestation of the effects.

    These cases are all based on uncovering causal factors in the physical world. The parameters cannot be changed by a legislative act or a contractual obligation. Undoing the regulatory mechanisms that were put in place for the economy has been proceeding at a rate that changes conditions in a way that is very difficult to account for. Mechanics would be much harder if the value g for gravity kept changing.

    The financial environment further adds in obfuscation and deliberate complexity as a way to create short-term niches where rapid growth can occur before inhibitory mechanisms take hold. The inside information allows positional advantage for harvesting the fruit of the hybrid weeds. And that has been a political decision.

    1. Yves Smith Post author

      Repeat after me: economics is not a science, despite economists’ pretensions.

      Worse, as I discuss long-form in Chapter 2 of ECONNED, mainstream economists have adopted an assumption that economies will achieve full employment all on their own, that that is their equilibrium state. They’ve required an assumption called “ergodicity” which explicitly rules out positive feedback loops…like the sort that cause financial crises. Why did they do that? Because to use the sort of math that would include instability would render their models not tractable…..meaning they could not make forecasts.

      If you read the sorry history (it was Paul Samuelson who was behind this push; Keynes rejected it BTW), it was the result of the desire to make economics “scientific” when economics is firmly anti-empirical. Any modeling method that rejects a huge significant class of factors, the ones that are internal to the system that produce feedback loops, cannot be take seriously.

      Thus your basic premise about economic models is wrong.

      1. zapster

        ” mainstream economists have adopted an assumption that economies will achieve full employment all on their own, that that is their equilibrium state. They’ve required an assumption called “ergodicity” which explicitly rules out positive feedback loops”

        AKA “economic phlogiston”

      2. Steve H.

        Dammit. Now that Peters & Gell-Mann article is looking like an apologia for ergodicity. “We thank K. Arrow for discussions…”

      3. Knute Rife

        Economics is about as scientific as astrology. Economists love creating pretty graphs to show how elegant their models are, but the reason the graphs look so good is that the underlying grids look like they were drawn by Salvador Dali.

  6. GlobalMisanthrope

    Here’s a current Galbraith bio to replace the outdated one:

    Lloyd M. Bentsen Jr. Chair in Government and Business Relations at the Lyndon B. Johnson School of Public Affairs, the University of Texas at Austin. His most recent book (2014) is The End of Normal: The Great Crisis and the Future of Growth.

  7. Donald

    Is there a missing footnote? The piece says Romer was unfairly criticized at one point with an asterisk, but I didn’t find what I assume is a footnote somewhere.

  8. Jerry Hamrick

    I owned a ladies’ dress shop on the historic square of a Texas town that for many years had been a tourist attraction for people who lived in the DFW metroplex. From the beginning, my store earned good profits and flourished. Then the Bush crash came. Sales dropped quickly, but not from lack of traffic, but from lack of money. Higher cost merchandise, dresses, jewelry, etc. dropped off the cliff. We continued to see the same size crowds on the square as they attended our frequent events. We continued to see the same number of people coming into our store, but the number of sales tickets and amount of these tickets dropped. If I had not had enough personal capital to keep it going I would have closed immediately. But then we heard that the nearby power plant was going to add another reactor and 14,000 people would move into the area. And at about the same time the oil drilling, or fracking, was going full blast So, I rode on a little longer. But the power plant plan was dropped, the oil industry tanked, and I sold the business in 2012. Many other stores that had been on the square for many years closed and were replaced with newcomers with new money and with new dreams. Some of those stores have closed and a new cycle of dreamers has begun. Anyhow, the economic problem faced by the people in my area was a lack of demand. Plain and simple. People did not have money to spend. Ladies, longtime customers in many cases, browsed, but did not buy or they bought lower-priced goods. And the boom is not in sight.

  9. Charles Myers

    I have pasted the next 3 Paragraphs from the Article. Here is my question.

    What would stop Goldman Sachs from pitching a deal like this to Google?

    Goldman Sachs: We have a start up Uber we would like to invest in.

    Google: Seems risky. There is a massive Insurance problem.

    Goldman: Don’t worry we will loan you a billion at zero interest and if it goes bust we will just bury it in the Fed or we can bury in our reserves because there is no mark to market.

    The next piece of the policy was to restore confidence, at least in the future of the big banks. To this end, in early 2009 Secretary Geithner launched a program of “stress tests,” whose stated purpose was to establish the extent to which banks required more capital – a larger cushion of equity – to protect themselves against even worse economic and financial conditions. Whether they gauged this accurately is doubtful, since they did not require banks to mark their failing mortgage portfolios to market prices, and since – contrary to all normal practice – the results of the tests were negotiated with the banks themselves before being released. But the fakery of the stress tests served a larger purpose: it demonstrated to the world that the United States government was not going to assume control over the banks, or otherwise let them fail. Bank shares rallied – spectacularly.

    Nevertheless, the banking system survived. The big banks especially were saved. Their market share increased. Their profits soared and their stock prices recovered. They could meet their need for revenue by lending abroad, by speculation in assets, and simply by pocketing the interest on their free reserves. Limits on their freedom of maneuver remained minor, as even the weak restrictions imposed in the Dodd-Frank Act came only very slowly into effect. As time went on, the Federal Reserve pursued its programs of “quantitative easing,” which were ongoing purchases of assets from the banking system, including large volumes of mortgage-backed securities. While this program was touted as support for the economy, its obvious first-order effect was to help the banks clean up their books, and to bury potentially-damaging home loans deep in the vaults of the Fed itself, where they might – or might not – eventually be paid.

    With few borrowers knocking on the door, for banks the safe alternative was to sit quietly and rebuild capital over time, by borrowing cheaply from the central bank and lending back to the government, at a longer-term, at a higher rate. For this there are two tools: the cost of funds from the Federal Reserve, and the interest rate on longer-term bonds, paid by the Treasury. So long as the two agencies are able to maintain the spread – the positive yield curve – between these two numbers, profitable banking is easy. This is what the large money center banks did in the 1980s, after the Latin American debt crisis, it is what the supervisors instructed regional and smaller banks to do in this crisis (by tightening up on underwriting guidance) and it is the preferred solution for all, among bankers and those who supervise them, who like a quiet life. But it does not lead to new loans.

  10. RedDan

    Two critical elements that must go into a more condensed and pointed rebuttal to Romer and Romer (and Krugman) are as follows:

    1) http://krugman.blogs.nytimes.com/2009/01/10/romer-and-bernstein-on-stimulus/

    • the above is Krugman evaluating Romer-Bernstein: Take home message is that their forecast is a bit too optimistic about a stimulus that is too small.

    2) http://www.bradford-delong.com/2014/02/yes-christina-romer-and-jared-bernstein-were-far-on-the-pessimistic-and-correct-side-of-forecast-consensus-in-december-2008-w-1.html

    • the above is DeLong evaluating Romer-Bernstein against actual data, and stating that they were on the pessimistic and “correct side” of the forecasting done at the time.

    Please understand i am not an econometric modeler, rather I use models to understand dynamic systems in the earth sciences… different parameters, functions, and guiding assumptions… but I do know models in general, and do understand how to judge inputs, outputs, and tuning… and I know hindcasting.

    That said, take a closer look at DeLong’s post in particular.. the data part.

    The dark blue line is the Romer Bernstein U3 forecast assuming “stimulus applied.” The light blue line is the R-B U3 forecast assuming no stimulus. The red dots are the actual U3 data.

    There was a stimulus applied and maintained… both direct stimulus in the form of infrastructure investment spending, and multiple forms of enhanced “enticement” stimulus (homebuyer credits, mortgage relief, TARP, multiple rounds of QE, many different forms of inducements to banks to get them to lend, and businesses to get them to borrow).

    So if the stimulus was applied and R-B was a good model, why then were the actual numbers far in excess of the “no stimulus” projection? In short, their model run with no stimulus closer approaches the data than their model run with stimulus. Did they forget to multiply a negative number through or something?

    If R-B performed best of the other competing models, making it the “best forecast” and it performed so badly, then maybe their model is garbage?

    And maybe if hindcasting indicates a model is garbage, and another forecaster uses a model with similar empirical foundation but changes some key parameters… it should not be A) dismissed out of hand in insulting, demeaning, and libelous fashion, and B) should be applied to prior situations in a hindcasting exercise to evaluate its potential as a predictor.

    Take the 2007-2008 numbers, put them into the model as parameterized by Friedman, and compare the output to the Romer Bernstein model performance.

  11. grayslady

    I question whether any economic model is satisfactory when it doesn’t include the impact of political decisions designed to take away the financial wherewithal of individuals–specifically, government “trade” deals (whether WTO, NAFTA, TPP) that eliminate good-paying jobs, anti-union policies, and failure to enforce anti-trust laws. It doesn’t take a degree in economics to understand that the U.S. relies on its citizens to fuel the economy by behaving as “consumers.”

    IMO, Galbraith should have addressed the pathetic decline of real wages since the 1970s that, in turn, fueled massive borrowing by homeowners–primarily against their one major asset, their residence–to fund ordinary expenses. This is basic financial analysis from my banking days: without adequate cash flow, it doesn’t matter what the value is of your assets, unless you are planning to sell your assets. Even then, depending on the nature of your business, the true value of your assets may not be worth anywhere near their book value.

    Most citizens simply didn’t have the cash flow, and hadn’t for some time, to service their debts. With consumers having no money to spend, why would companies risk increasing their inventories for non-existent sales? Therefore, the goal of preserving the lending pipeline was either a spurious excuse, or worse, incredibly stupid. As Galbraith rightly points out, the only actions that saved the economy were those directed at individual consumers–the safety net programs.

  12. fresno dan

    hmmmmm….
    “With few borrowers knocking on the door, for banks the safe alternative was to sit quietly and rebuild capital over time, by borrowing cheaply from the central bank and lending back to the government, at a longer-term, at a higher rate.”

    Hmmmm – isn’t the FED all about MORE inflation? So either they don’t get more inflation and supposedly the economy stays in the crapper because inflation = prosperity (uh, I have already commented on how wages/income was rising more slowly than inflation, so …how is there suppose to be more demand???)
    Anywho – so if there is more inflation, the banks are screwed….unless they are paid VERY high interest by the government…which KEEPS loaning (uh, isn’t it more accurate to say in such a scenario, “giving”????) banks LOW interest money.

    Anyway, reminds me of a snake eating its tail – it will never starve because it will always have plenty of well fed snake tail to eat…

    1. HotFlash

      Odd you should say that. I was just thinking today about the financial Ouroboros and thinking it was just about up to its own ears.

  13. zapster

    I don’t think that projection is high. The elephant in the room is underemployment. The underemployed, and especially the long-term unemployed are stacked with both degrees and experience now. We’ve got kids working at starbucks now with JDs, and 50-60 year old engineers stalled waiting for employers to start looking beyond their preferred young, white male demographic. Moving them into jobs that they’re qualified for will be a huge boost in productivity all by itself. A published rate of 5.5% with most people under-employed doesn’t capture the true potential to be achieved by full employment.

  14. Eric Titus

    I don’t see how anyone can keep defending the Friedman paper. Why are Galbraith, Baker, etc so invested in it (economists I usually like after all)?

    Now even before getting to the concerns raised by Romer+Romer, what stuck out to me is that most of Friedman’s projected growth is coming from Sanders’ medicare-for-all plan. Even if we assume it passes congress, there is a common-sense reason to be skeptical: the plan is supposed to shrink healthcare expenditures, not grow them. Friedman’s model here is a bit unclear, he assumes much higher utilization of the healthcare system under Sanders’s plan (about 10-20% higher I think). He also does not appear to reduce private insurance spending even after medicare-for-all goes into effect.

    On the maths side, the Romer takedown is fairly blistering. But I would point to another problem, which is that Friedman’s model includes all sorts of accounting shifts, and I am not confident that he is accurately modeling the consequences of these shifts.
    Here is a quote for example: “In the Sanders program, an additional $3 trillion in revenue becomes available through the reduction in tax expenditures.”
    Doesn’t this seem like a bit of a red flag? The $3 trillion shouldn’t be counted as new public spending, they are just a shift from spending through tax cuts to direct spending.

    1. Donald

      Baker isn’t a defender of the Friedman paper– he says it is too optimistic and we should only expect 2 to 4 years of growth in the 4 to 5 percent range.

      As an outsider I’ve never understood the precision with which any economist makes claims– the whole enterprise seems like a bad case of physics envy. I’d almost prefer it if they converted everything into utils as their unit, just to make it clear how weird the process is.

    2. RedDan

      The underlying premise, probably explicitly incorporated into the model, is that tax cuts are not stimulative and direct gov’t spending is.

      I think it’s clear from historical data that this has been shown to be pretty accurate as a guiding assumption.

  15. Peter Dorman

    I probably shouldn’t write this, because it will be misunderstood — but here goes anyway. (1) I am skeptical of economic forecasting in general. No existing model has an acceptable track record. The world is too complex and contingent. (2) Friedman made an elementary mistake, confusing one-time and ongoing stimulus, not once but multiple times in his paper. In my opinion, it was due to not writing down his model, which would have made it clear. Romer and Romer pointed this out, and it was devastating. (3) According to Wolfers (and in this case, since he’s describing his conversation with Friedman and Friedman hasn’t disputed it, he’s credible), Friedman was surprised by the R&R criticism. He tried to cover by saying that he was following the approach of Joan Robinson, but there’s nothing in JR that justifies (or could justify) his error. I feel sorry for Friedman, but mistakes are mistakes and he should simply fess up. (And yes, so should Rogoff and all the others whose errors were much more consequential — and less accidental.) (4) Jamie Galbraith is right on the main points (and his book chapter is fine), but he should acknowledge that, in this specific case, Friedman’s work is indefensible. (5) This has nothing to do with the case for Sanders’ policies! They are fully justified. (6) Personally, I would go much further than Sanders — more socialist, as I understand it, than social democrat. There’s no reason why careful, accurate economics has to be in conflict with radical, ambitious politics.

    1. Banana Breakfast

      What’s to misunderstand? Your post is clear, and seems likely to be uncontroversial with most of the people who post here.

    2. Steve H.

      I think this is the article you’re talking about. The excerpt seems worth a rebuttal (by someone who knows more than I do).

      ” The multiplier he uses is on average 0.89. In the Congressional Budget Office models that he’s drawing from, this means that if the government spends $100 more today, output will rise by $89 this year, but when that stimulus is withdrawn next year, output will then fall back to its earlier level.

      From start to finish, that $100 extra government spending yields $89 worth of more stuff. By contrast, in Mr. Friedman’s figures, output stays $89 higher each year, forever. Over a 10-year period, this means that $100 of government spending yields a total of $890 worth of more stuff, implying a 10-year multiplier of 8.9.”

      nytimes.com/2016/02/27/upshot/uncovering-the-bad-math-or-logic-behind-bernie-sanderss-economic-plan.html?smid=tw-share

      1. Yves Smith Post author

        Galbraith is working up a longer form reply. His short version is that one time stimulus can indeed have long-term effects; that’s the clear lesson of World War II spending.

        This via e-mail:

        There could be a “math error” in the Friedman paper; I have not replicated the math or even seen the coding. But I don’t think Peter Dorman’s point, reiterating the Romers, about time-limited interventions having only time-limited effects is necessarily correct.

        One example comes to mind that may be helpful. Suppose a temporary jobs program establishes an income stream for a household, sufficient to make them “creditworthy” going forward, when they weren’t before and would not have been otherwise. In that case, the higher level of activity initiated by the public program can devolve upon and be sustained by the private sector afterward; you don’t return to the status quo ante.

        1. Darthbobber

          WWII was (among other things) a time-limited economic intervention. And that intervention provided the basis for the economy of the next quarter of a century.

      2. Darthbobber

        1) Only the infrastructure program out of the Sanders proposals is temporary spending, and it accounts, as I recall, for less than a tenth of the spending.

        2) To assume, as R&R do,(and as that school of thought holds) that you just have to subtract this back out from future GDP at a 1 to 1 rate when the spending stops, seems to me to require you to assume that NONE OF THAT INFRASTRUCTURE after being built has any ongoing positive effect on GDP.
        from the fact that its now available for use. (though we know that better transportation, for example, reduces the turnover time for each valorization cycle of capital.) This is to assume that good roads, bridges, trains, etc., have no net positive economic impact, so I just they just get built because people think they’re pretty?

        3) Purely economic modeling probably can’t mechanically “capture” the likely positive impact of the existence of that infrastructure in a rigorous way, because this would require you to examine the material world and the people in it, a contamination which the neoclassical school routinely avoids.
        (So it doesn’t count because they can’t figure out how to count it.)

  16. Benedict@Large

    I’d question the Romer&Romer assertion that the output gap is smaller than Friedman’s estimate. R&R use the dreaded NAIRU to calculate the size of the available but unused workforce, and many economists do not believe NAIRU even exists, but rather stands as an excuse used by supply-siders to distract from a demand deficient world. In any case, CofFEE (Center of Full Employment and Equity) has demonstrated that, with proper policies, unemployment can be driven effectively to zero, and thus it is R&R’s output gap that is too low. (A note, Kelton, economic advisor to Sanders in the Senate, is fully on board with CofFEE’s work.)

    It all boils down to this. R&R are essentially admitting that conventional (orthodox) macroeconomics has nothing to offer today’s economy, and claim that the use of heterodox macro, about which they know nothing, is wrong. This is the constant claim of orthodox macro, even after the entire discipline flopped on its face in 2008. Some people never learn.

  17. susan the other

    Build a big ugly yardarm on the whitehouse lawn and hang Obama by his heels where he can pontificate upside down.

  18. bas

    Greenspan admitted he had disregarded the “human element” in economics.

    http://www.theguardian.com/business/2008/oct/24/economics-creditcrunch-federal-reserve-greenspan

    “I have found a flaw,” said Greenspan, referring to his economic philosophy. “I don’t know how significant or permanent it is. But I have been very distressed by that fact.”…
    In prepared remarks before the House of Representatives, Greenspan, 82, who retired in 2006, called the financial crisis a “once-in-a-century credit tsunami” and said it had “turned out to be much broader than anything I could have imagined”.

    He suggested his trust in the responsibility of banks had been misplaced: “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity (myself especially) are in a state of shocked disbelief.”

    The congressional committee’s Democratic chairman, Henry Waxman, pressed him: “You found that your view of the world, your ideology, was not right, it was not working?” Greenspan agreed: “That’s precisely the reason I was shocked because I’d been going for 40 years or so with considerable evidence that it was working exceptionally well.”

    I am shocked Greenspan thought the financial industry was such a bunch of great people full of impeccable integrity. Economists don’t deal in the world of people.

  19. Russell Scott Day/Founder of Transcendia

    Nothing works if you don’t believe in it. If it had not been for the Viet Nam war, we would have liked it.
    Blockhead training of those who are destined to become bureaucrats was most characterized by Doystosesky in Notes from the Underground.
    When working on designing a better government we developed the idea of giving Bureaucrats a career path to Technocrat, with the goal then incentivizing people in these places are not such Blockheads. Paying AIG credit default swaps at face value out of the Treasury is criminal, and same as the incredible law that prohibits government negotiation for drug pricing.
    We may as well work at getting all of the people to work in the government together, since as it is modeled, only some few do.
    “World Citizen” sounds lofty until you see how the World Citizen with all that compound interest flowing to them makes their buying up islands just a billboard for all the deeds they have you don’t.
    The Nation, of people, in it together ceases to exist for them, but not you.
    You being all the working classes who do live honest lives of work. I was a Lineman to corporate jets, getting minimum wage fueling million dollar private planes.
    I discovered by accident of research that I was working for a CIA MI6 Front business. (Page AvJet) You read that all of Communications were spawned by CIA Mind Control Science.
    We didn’t set out to work for the CIA. Fortunes were made from heroin smuggling and I suspect that smuggling is just as alive and well today as it was when I was part of that scene, ignorant.
    It is like at the time of the coup when Kennedy was assassinated there was established the Foreign Nation, and the left over nation.
    Since then what is left over from whatever the spies and the spy directed armed forces do to enrich themselves, all Milo Minderbinders, is what the Nation we are in together? gets.
    So for me the thing is in what I read that Edward Hallet Kerr wrote about how Institutions can be led by Ideals when the Great Man makes the Mission of the Institution clear.
    I maintain now in the US that it is Meyer Lansky Financial Engineering we live with. The Petrodollar as the currency basis is done, buried in Yeman. Fiat currency of the US as represented by the petrodollar is undermined by the type of financial engineering employed to confuse the people with control of the Treasury money, which they regard not as that of the people of the United States, but as theirs.
    Blockheads taking the path of least resistance is hard to believe, much less believe in, but the blockheads do it because they are confused and don’t have a mission in front of them aimed at an outcome that keeps us together.
    Free Speech is the last greatest thing about the United States. Yves Smith, blog here isn’t the sort of thing same in China they who divvy up the wage slave labor want their people to be able to read in my judgement.
    When no one has above subsistence earnings they do not have the means to make things in their own “laboratories”.
    We need to see risen up more Co-ops so the general acceptance of the together actors and actions are better infused into the mental landscape.
    If it is lost, the reason for national togetherness, then it is all to the class to unite. Hence the love of race in the corporate media that engages in “Communications” which substitute for Mind Control.
    – a letter is like this, rambles around. Suggestions: One that Bureaucrats do have a career path towards Form writers, as opposed to Form Enforcers. And Two: The raising of the Minimum wage. And Three more Co-Ops. 4 return to the Treasury of CIA Front businesses profits that are not being properly used for the Mission of the CIA to inform the Executive, in ways that confirm or disprove common sources of information and misinformation.
    My Mission is preventing the Apocalyptic Riot which means physical presence as a neutral marketplace, not the militarized presence the US bases represent as elites smuggling opportunities.

  20. John

    Krugman, for one, has railed against the EU and the Us for years, saying the multipliers are far higher in the current anvironment where the majority have too little money to spend.
    Saying sanders plan can’t work goes against his past positions, presumably to support the dem elites’ pick… And the reason for this is that they are desperate to continue what has become massive and pervasive corruption in government.
    Reps are similarly worried, tho they are fondly hoping their loose cannon can be controlled if he wins.
    Both parties are totally corrupt… If fascism is rule by corporations and oligarchs, we are now fascist… current rulers, and the elites that serve them, all profit from the status quo and are naturally terrified of any change.
    Voting for Hillary is voting the corruption ticket.

  21. Darthbobber

    EP Thompson’s marvelous diatribe “The Poverty of Theory, or An Orrery of Errors”, had some caveats about the dangers of unexamined assumptions:
    “The appearances will not disclose this significance spontaneously and of themselves: does one need to say this yet again? It is not part of my intention to deny the seductive ‘self-evident’ mystification of appearance, or to deny our own self-imprisonment within unexamined categories. If we suppose that the sun moves around the earth, this will be confirmed to us by ‘experience’ every day. If we suppose that a ball rolls down a hill through its own innate energy and will, there is nothing in the appearance of the thing that will disabuse us. If we suppose that bad harvests and famine are caused by the visitation of God upon us for our sins, then we cannot escape from this concept by pointing to drought and late frosts and blight, for God could have visited us through these chosen instruments. We have to fracture old categories and to make new ones before we can ‘explain’ the evidence that has always been there.”

    “…if we suppose the Soviet Union to be a Workers’ State guided by an enlightened Marxist theory; or that market forces within capitalist society will always maximise the common good; then in either case we may stand in one spot all day, watching the blazing socialist sun move across blue heavens, or the ball of the
    Gross National Product roll down the affluent hill, gathering new blessings on its way. We need not recite this alphabet once again.”

  22. Darthbobber

    Nothing in this less-than-edifying series of of polemics really rises to the level of a rigorous analysis of macroeconomic impact of the Sanders plans (sketches for plans, really, which it what campaign material usually is.)

    Friedman’s paper is the most detailed of the lot, but hardly rises to the level that you’d be at if you were producing a full-blown analysis as guidance for policy. Its an interested observers’ take. More than casual, less than full.

    The Gang of Four +Krugman’s initial material isn’t even that. Its an impressionistic, broad-brush slam relying largely on unsubstantiated assumptions.

    R&Rs (11 page!) “forensic analysis” is not an analysis of the Sanders proposals, but a polemical nit-picking of Friedman’s paper, which assumes but does not demonstrate many of its central thrusts. (and indeed, since they were clearly under time pressure to get this hacked out in time to produce a political result, rather than a contribution to economics, they could scarcely have done more in that time frame.)

    Galbraith quickly moves far afield from discussion of details in the Friedman paper to use the controversy as grist for his (needed) assault on Orthodoxy.

    In the meantime, its worth remembering that:
    The main purpose of the Sanders healthcare plan is to solve the healthcare problem.

    The main purpose of the College plan is to solve the problem of affordable higher education.

    The main purpose of the infrastructure program is to provide needed infrastructure.

    And any positive effect on growth above baseline expectations is a big bonus.

    Roosevelt, of course, was unaware that he was engaged in some exercise in Keynesian pump-priming. He thought he was providing needed relief, putting people to work and getting useful things built in the process. And he was.

    1. Steve H.

      Galbraith says, “If Roosevelt had had the benefit of today’s economic experts, Keynesians and anti-Keynesians alike, he would have never gotten the New Deal off the drawing boards.”

      More ricebowls teetering toward the floor. Has the economics profession become an obstacle to a healthy economy? Necessity could demand a paradigm shift, and the professionals using the worseless models will, if they already haven’t, start to feel their livelihood being threatened.

      As Yves so gently pointed out, the models don’t allow positive feedback. Systems models require feedback. The Limits to Growth study was a systems model, and its predictions have been remarkably robust. A bank run is a positive feedback loop.

      So they can use Nobel-winning physicists to take the ergodic numbers and gussy them up with logarithms and non-linear equations, and it doesn’t matter because it’s still a fundamentally flawed method of analysis. “I’m not trashing your book; I’m trashing your philosophy of life.” What was supposed to be a method was actually a means, and those arguing within the framework become korinthenkackers tossing raisins at each other.

      The shift in the political realm is easy to see. Sanders is talking about shifting the method, similiar to Roosevelt. Trump broke the money-go-round when he didn’t buy ads for Super Tuesday. They are both genuine threats to the status quo, and both are expecting to be attacked. Many political professionals are correct in their assessment that they are under attack, and are responding aggressively. Economists challenging the status quo should expect no less.

      1. clinical wasteman

        ‘Worseless’ as in ‘could not possibly be worse’? If you just made that up, loud applause and please permit us all to use it in future.
        100% agreement with Yves, though, on the a priori, axiomatic etc status of the rule that economics is NOT science. Whenever it pretends otherwise it betrays what Perry Anderson (in turn quoting an un-named source) called the cocksureness of an ill-stocked mind.

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