Economics and Abstraction, ctd.
Karl Smith at the Modeled Behavior blog has responded to my recent post on the problems in using some kinds of economic theory to guide policy interventions. His reaction is critical, to put it mildly. It also seems to me to be an almost perfect illustration of the attitude that I was trying to describe.
Smith begins by saying that I have some “wrong ideas” about economics, and then quotes this portion of my post:
In practice, the problem of excessive abstraction by economic theory that Brooks identifies becomes increasingly severe as we try to evaluate the effects of proposed interventions and programs over years and decades, rather than months and quarters.
He then immediately says this about it:
First, this is backwards. With cyclical policy its generally speaking easier to access the effect of interventions over longer and longer horizons because the economy increasingly resembles a frictionless market as you extend time in to the future.
For example, if you asked what effect would properly done fiscal stimulus today have on the economy 20 years from now, the fairly easy and straight forward answer is, none.
Stimulus is not central planning or industrial policy. It should have no lasting effects. If it does, then you did it wrong. What’s more difficult is the short run.
Unless he is using “properly done” as tautologically implying his conclusion, then I’m not so sure he’s right about this.
A stimulus action is designed to change behavior in the real world – some investment decisions must change. Imagine, as an illustrative example, that a stimulus program in country X executed in 1820 resulted in the digging of a large number of canals that otherwise would not have been constructed. This makes incremental investment in shipping capacity and development of improved shipping technology more attractive over the next several decades than it would otherwise have been, as compared to the development of land-based transport systems. X then develops a greater reliance on ship than rail transport. This leads to some gains beyond what was unanticipated in 1820. Over the succeeding decades, X becomes a world leader in the shipping industry; by 1850, total output in country X is higher than it would have been had no canals been dug.
Countries that had not built early canal networks invest relatively more building out rail networks, just as X would have done had it not built all those canals in 1820. When, hypothetically, a set of technical innovations occur, it becomes suddenly apparent in the second half of the 19th century that rail is now a superior form of transport. Country X finds itself behind, and by 1880, total economic output is significantly below where it otherwise would have been. Further, increased competition with a neighboring country over shipping lanes leads to escalating tensions, finally resulting in a full-scale war in 1890 that would not have occurred had X’s shipping industry been smaller, which further reduces total output.
Of course, the exact opposite situation could have obtained, in which the decisions changed by the stimulus action turned out to position the society unexpectedly well for future developments through the end of the 19th century. It’s also possible that, as per Smith’s assertion, that building all those canals would have turned out to have had no material effect after decades.
But how could any of this be predictable in 1820 when making the stimulus decision? For that matter, how could we even know after the fact in 1890 what the effect of this decision was on total output, since this would require that we know what the counterfactual path of development would have been in the absence of the stimulus?
Changing, for example, the rate of economic activity today will lead to changes in actual investment decisions taken today in the context of the opportunities that are perceived to be available today. This will to some extent, and potentially to a material extent, change the array of choices available to us in the future. Professor Smith’s confident assertions notwithstanding, this change in the future option set may or may not change total future output materially. I believe the fancy name for all of this is path dependence.
Jim
Sorry if I came off as harsh. Didn’t mean to. I am, of course a fan of your blogging.
I’ll post more but again I think you are mixing industrial policy – should we build a canal – with stimulus – should we build the canal today. For stimulus reasons you shouldn’t build a canal that otherwise would not have been built , you should build it now while resources are slack as opposed to later when they will be tight.
Industrial policy is about trying to adjust the path of economic development. Stimulus is about smoothing the already existent path. This is my basic point. But I should be more clear when I get back to the office.
— karl smith · Nov 19, 06:03 PM · #
Karl,
No problem, and same here.
I get the distinction you are drawing, and agree with it. But I guess what I’m trying to describe is that, in rough terms, if we were to pull forward $1 of investment that would have occurred in period 2 into period 1, even if we employ markets to make the best possible investments given the information available to in period 1, then we will have created a different set of assets going into period 2 than we would have had if we had not pulled forward that investment. This means that the circumstances the market faces in period 2 are different than they otherwise would be. Therefore even if we assume market allocation in period 2, we will end up with different economic activity than we otherwise would have had. So even though no planner ever decided to favor one industry, sector, geography or whatever over another, the intervention can still have this effect.
— Jim Manzi · Nov 19, 07:30 PM · #
I think we can take Jim Manzi’s arguments a few steps further to get a more rigorous analysis of the economic effects of fiscal policy.
See, one day while canals were being dug in country X, a lucky construction worker happens to find a magic ring in one of the puddles. Excitedly putting it on he realizes that upon wearing it, he becomes invisible!
Years go by and soon enough the colossal war with neighboring country Y rages on. Country X the naval superpower versus country Y the rail-way based superpower. As the dramatic and climatic chapter of this bloody war approaches, country Y’s leaders decide to use their train launched nuclear weapons against their sworn enemies.
Right before the onset of the nuclear apocalypse, planet A’s race of benevolent alien overlords who have kept watch on this sector of the galaxy for eons, decide countries X and Y’s leaders have gone too far and decides to intervene by launching a full scale invasion of countries X and Y.
All hope now rests of course on a young decendant of the aforementioned construction worker and the ONE ring!
Yeah… so, given all these possibilities (path dependence is like, AWESOME), predicting the effects of fiscal policy is a truly hopeless task, I have to agree.
— Yan · Nov 20, 08:58 AM · #
Yan,
Thanks for your contribution!
I'm sure that attitude will work out real well for you.— Jim Manzi · Nov 20, 09:58 AM · #