Burying good ideas.
By John Quiggin
238 pages; Princeton University, 2010
In his book Zombie Economics, subtitled "How Dead Ideas Still Walk Among Us," Australian economist John Quiggin tries to bury five major economic ideas that many mainstream economists have accepted for the last two decades or more. Two of the ideas are in macroeconomics, the part of economics that studies Gross Domestic Product, inflation, and unemployment; one idea is in finance; and two ideas are in microeconomic policy.
Although Quiggin is obviously a smart economist who has thought a lot about these issues and often has good criticisms and insights, three of the five ideas hold up well despite his efforts to put them to rest. On one of the ideas, he delivers some heavy blows, and it is not clear whether the idea should be revived. But in only one of the five cases does Quiggin make a persuasive case for burying an idea.
DSGE | Quiggin is on his strongest ground in rejecting much of modern macroeconomics. One of the ideas that he effectively buries is dynamic stochastic general equilibrium (DSGE), the idea that the macroeconomy can be modeled in a manner that adequately takes account of shocks, technological change, preferences, and institutions. DSGE became all the rage in the 1990s and 2000s.
In my opinion, although possibly not in Quiggin's, the originators of DSGE started with good intentions. They wanted to build
a macroeconomic framework on top of microeconomic principles. But they did so by making extremely unrealistic assumptions.
One of the most extreme assumptions, notes Quiggin, is that of the "representative agent." In DSGE analysis, the millions of flesh-and-blood humans with different tastes and abilities are collapsed into one person, and the thousands of goods and services are collapsed into one good. Writes Quiggin: "The fact that people differ massively in their tastes, wealth, and good or bad economic fortune is assumed away on the basis that all these differences should cancel out in the aggregate." Quiggin quotes economist Charles Goodhart's lament that DSGE "excludes everything I'm interested in."
To say that Quiggin has good reason to reject DSGE is not to say that his preferred alternative is strong. Quiggin accepts a Keynesian view of macro, but he gives only scattered evidence for that view and some of his evidence is misleading. Comparing the economies of Australia and New Zealand, for example, Quiggin points out that the New Zealand government in the 1980s cut the size of its government sector, whereas the Australian government did not. By 2000, he writes, "when New Zealand finally abandoned radical reform, income per person was one-third less than Australia's." But that is no basis for comparing policies at all. To make a fair comparison, one would need to know New Zealand's income per person versus Australia's in 1980, before the reforms. Quiggin does not present this number. It turns out that New Zealand's income per capita in 1980 was 77 percent of Australia's and fell to 70 percent in 2000. This is a decline, and so it mildly supports quiggin's claim--but because he fails to give this baseline, many readers will probably come away with the mistaken thought that per capita income in New Zealand took a huge drop relative to Australia's.
Also, disappointingly, given Quiggin's belief in basic Keynesianism, he never mentions what 1960s Keynesians saw as the problem leading to high unemployment: wage rigidity. The ultimate in a rigid wage is the minimum wage. Actually, that is an understatement because the U.S. minimum wage is much higher than it was two years ago, and reducing it by 20 percent would probably cut the unemployment rate by a few tenths of a percentage point. Keynesians like Paul Samuelson, James Tobin, and Franco Modigliani--all Nobel Prize winners--were harsh critics of the minimum wage, but Quiggin says nothing about it.
Great Moderation | He scores some points against the idea of the "Great Moderation." This idea became common among macroeconomists in the late 1990s. The idea is that in the late 1980s, the United States--and, possibly, other advanced economies--entered an era in which inflation would be low and recessions would be mild, short, and infrequent, making the growth of real GDP less volatile. Of course, the current U.S. recession, which lasted quite a long time and from which recovery is slow, is the big counterexample to this idea of a great moderation.
Quiggin presents evidence against the Great Moderation. While he agrees that the standard deviation of output growth, a measure of volatility, fell between the 1960s and the 1990s, it did not fall relative to the average growth rate because growth was higher in the 1960s.
The big question, though, is why the United States experienced such a deep recent recession and is having such a slow recovery. My own candidates for the cause of both are: the Troubled Asset Relief Program (TARP), which put government in the position of choosing winners and losers and made property rights less certain; the extension of unemployment benefits in many states to 99 weeks, which reduced the incentive to find work; the misnamed "stimulus bill," which diverted many resources to wasteful uses; the Obama administration's shutting down offshore oil drilling and then allowing it only to those companies that satisfy the administration's new stringent requirements; and passage of Obamacare, which is creating uncertainty for employers. At no point in his book does Quiggin seriously consider any of these as potential causes of the deep recession and the slow recovery.
Most people who used the term "Great Moderation" thought that monetary policy had been tamed. Maybe it was tamed, but the other factors I mentioned above are the main causes of our current troubles. The bottom line is that it is too soon to say whether the Great Moderation, assuming it ever existed, is over.
Efficient markets | Quiggin is unpersuasive on his three other candidates for "zombie" ideas: the Efficient Market Hypothesis (EMH), supply-side economics (which he calls "trickle-down economics"), and privatization.
The Efficient Market Hypothesis (EMH) has various versions. The "semi-strong" version is the idea that the prices of financial assets reflect all publicly available information. If this version is right, then an investor can do better than the market only by luck or by having information that is not publicly available. Quiggin rejects this version, arguing that if it were correct, there would never be asset price bubbles--that is, prices of assets that are well above the prices that would reflect the earnings of those assets. Because Quiggin believes that such bubbles exist, this, for him, is enough evidence to reject the EMH.
But if you never know there is a bubble until after it has burst, is the EMH incorrect, or is it just that we do not have enough information? Many people have claimed, after the prices of assets have dropped, that the markets in those assets were bubbles. Hindsight is 20/20. But it is much less common to correctly call a price too high in advance. One economist who did claim that stock prices reflected "irrational exuberance" was Yale University's Robert Shiller. He sounds spot on, right? Not exactly. The reason is that he made this claim in December 1996. That month, the Dow Jones Industrial Average ranged from a low of 6,268 to a high of 6,560. Today, of course, the Dow averages over 11,000. In other words, it rose by a compounded annual average of 4.2 percent; that does not include earnings from those shares, which would make the returns even higher.
Moreover, even if there are bubbles, what policies follow from that? Quiggin claims that if stock prices do not reflect all publicly available information, the "appropriate response is [for the government] to intervene in finance markets to restrict the unsound lending practices that drive the growth of such imbalances." He and I agree that there were unsound lending practices. But then would it not make more sense to end government's role in sponsoring those practices? Quiggin mentions Fannie Mae and Freddie Mac, but he does not suggest that these previously government-sponsored enterprises, which are now outright government enterprises, stop fostering such practices. Quiggin also seems to see his case against EMH as a justification for returning to Keynesian policies--but he never makes that case.
Supply-side economics | Perhaps Quiggin's biggest disdain is reserved for what he calls "trickle-down economics." He admits that his term is pejorative and is used mainly by critics. What, according to Quiggin, is trickle-down economics? He quickly narrows it down to supply-side economics and one of its most important contributions, the Laffer curve, which shows that at both a 100-percent and a zero-percent tax rate, government revenue collections are zero. The reason is that the higher the marginal tax rate, the stronger is the disincentive to work. At a 100 percent tax rate, there is no incentive to work.
Quiggin seems conflicted about the Laffer insight. On the one hand, he claims that the Laffer curve threw the supply-side school "into disrepute." On the other hand, he claims that the Laffer curve "seemed too obvious to bother spelling out." So how could something that is obviously true throw a school of thought into disrepute?
When he gets to his analysis, Quiggin's objection is not to the Laffer curve per se, but to what he calls the "Laffer hypothesis," the idea that a cut in marginal tax rates will increase government revenue. Quiggin points out, correctly, that some advocates of tax cuts have claimed this and that the case is hard to make. Although he references economist Lawrence Lindsey's 1987 article in the Journal of Public Economics, he does not mention Lindsey's main empirical finding: that the drop in the top marginal income tax rate from 70 percent to 50 percent in the early 1980s raised more revenue from high-income people.
Quiggin claims that flatter tax schedules have contributed to the large degree of income inequality in the United States. But this has to be incorrect. It could be true of after-tax income, but the standard measures of inequality are of before-tax income. To the extent that cuts in the top marginal tax rates of the highest-income people cause any increase in their labor supply--and he must think they do, or else he would not say that the Laffer curve is "obvious"--this added labor supply will cause their before-tax incomes to fall, reducing income inequality.
But let us consider the issue of income inequality and his arguments on their own merits, aside from the discussion of "trickle-down." Quiggin claims that "many high income earners pay a smaller proportion of their income in tax than the population as a whole." He gives no source for this claim and no data to back it up. He could be right, if by "many" he means "a few thousand" out of the millions of high-income earners. But the standard sources on this issue find that the higher-income the person, the higher a percent of income he pays in total federal taxes, not just income taxes. A 2007 Congressional Budget Office study of all federal taxes in 2005, for example, found that the average federal tax rate for households in the lowest quintile of income was 4.3 percent, for households in the top quintile was 20.5 percent, and for households in the top one percent was 31.2 percent. It is true that state taxes tend to be regressive, but the states' portion of overall taxation is low enough that they would not reverse the federal results.
Few people care about income inequality if everyone is doing better over time. But Quiggin argues that "real incomes for the lower half of the distribution have stagnated." To his credit, he does point out that his data understate income growth for two reasons. First, household size has decreased, and so the households that appear to have the same income as earlier actually have more income per person. Second, he points out that until the 1990s, which was halfway through the period of apparent stagnation he discusses, the consumer price index used to compare real incomes over time overstated declines in real wages and real incomes. Quiggin does not point out that the people being compared over time are different people. "Where this really matters is for immigrants. Newly arrived immigrants are disproportionately in the lowest income category and, by their standards, they are doing well or else they would not have immigrated to the United States. So the data over time can show stagnation even if everyone is doing better.
Quiggin does address the issue of upward mobility. He points out that 42 percent of American men with fathers in the bottom quintile remain there. This seems like a high number to him, although to me it indicates substantial mobility--58 percent have moved to a higher quintile. It also seems strange, in this country where women are approximately half of the labor force, to focus only on men's income.
Quiggin shows that this 42 percent is above the number in the Scandinavian countries. But it is unclear what to make of this. Could one reason be that incomes are more compressed in Scandinavia and that, therefore, moving from the bottom quintile to a higher quintile is easier there because there is less distance to cover? Quiggin does not mention that possibility in his book, although, in an Econtalk podcast with economist Russ Roberts, he admitted as much.
Privatization | Finally, Quiggin turns his rhetorical guns on the idea of privatization. He points to enterprises that were originally run by the British government, privatized, and then re-nationalized. He argues that the re-nationalization happened because the privatization had been a failure, but he does not give enough data to persuade the reader that various privatizations failed.
Quiggin does not oppose privatization per se but argues that it makes sense when the enterprise in government hands makes losses. This was the rationale for Margaret Thatcher's privatization of council housing, the British term for government-provided housing.
Pick up almost any U.S. economics textbook from the 1960s and early 1970s and you will find the U.S. economy described as a "mixed economy," a mixture of capitalism and socialism. But sometime in the 1980s, the language switched, and textbook authors started referring to the U.S. economy as a "market economy." One refreshing aspect of Quiggin's book is that he restores the term "mixed economy" to its rightful place.
It is disappointing that there is one zombie idea that Quiggin does not bury and still buys into: the idea that a government with a lot of coercive power over people' s lives can be trusted to use that power for good ends. In saying this, I am not making the point that many public choice economists make: that governments tend to serve special interests. Indeed, Quiggin's book references his own 1987 critique of public choice, a critique that I find persuasive. I am making a more basic point: I believe that governments with significant power over people--whether or not the governments are controlled by special interests--are dangerous.
Quiggin has much more faith in government's benevolence than I do. His zombie view is still stalking the land.
DAVID R. HENDERSON is a research fellow with the Hoover Institution and an associate professor of economics at the Graduate School of Business and Public Policy at the Naval Postgraduate School in Monterey, CA. He is the editor of The Concise Encyclopedia of Economics (Liberty Fund, 2008). He blogs at www.econlog.econlib.org.
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|Author:||Henderson, David R.|
|Article Type:||Book review|
|Date:||Mar 22, 2011|
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