Weekend Economists Wild, Wild, World Roundup February 17-19, 2012

[Demeter]

3. When Models Trump Common Sense

http://timiacono.com/index.php/2012/02/16/when-models-trump-common-sense/

More evidence that U.S. economists are particularly ill-suited to run the U.S. economy comes via the fascinating exchange in recent days between St. Louis Federal Reserve President James Bullard and a small army of bloggers with PhDs in economics, nearly all of the latter ganging up on Bullard after he suggested that the “output gap” theory for what ails the U.S. economy may be fundamentally flawed and that attempts to boost overall demand to close that gap through freakishly low interest rates and other super accommodative Federal Reserve policies might end up doing more harm than good.

Bullard threw a cat amongst the pigeons in this speech(.pdf) when he noted the following:

The recent recession has given rise to the idea that there is a very large “output gap” in the U.S. The story is that this large output gap is “keeping inflation at bay” and is fodder for keeping nominal interest rates near zero into an indefinite future. If we continue using this interpretation of events, it may be very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates. This could be a looming disaster for the United States. I want to now turn to argue that the large output gap view may be conceptually inappropriate in the current situation. We may do better to replace it with the notion of a permanent, one-time shock to wealth.

Recall that I’ve railed on this subject a number of occasions over the years, the last time being this offering from about six months ago when it was noted:

The theory posits that it is not important what level of overall demand an economy has reached or how it got there, but that, when all the wheels fall off the wagon as they did back in 2008, the imperative is for the government to somehow restore that level of demand. Otherwise, you get another Great Depression.

It makes no difference if, back in 2005, people making $40,000 a year were buying no money down $500,000 homes and then, after the home’s value went up to $600,000 in 2006, pulling out their $100,000 in brand new home equity to put in a pool, buy a motor home, and install big screen TVs in every room of the house because, once you reach a certain level of demand and it begins to drop like a rock because everyone has become indebted up to their eyeballs, it must be restored.

At that point, it simply becomes a question of how much taxes must be cut or how much money must be borrowed or printed to accomplish that goal.

Of course, I don’t have any models to back up the contention that an unusually large portion of economic output we saw in the middle of the last decade was “artificial” due to the housing bubble, but economists do have models, and that’s the crux of the problem. As Bullard noted, the models economists use to determine the “potential” of the U.S. economy, in essence, extrapolates from the pre-2007 period to the post housing bubble period and, as a result, you end up with a big gap between potential and actual output that policy makers are now seeking to close by borrowing and printing money on a scale never before witnessed by Mankind. For those of you preferring pictures to words, the chart below by Neil Irwin from this neat little interactive graphic at the Washington Post might be helpful.



Being more detached from reality than the population at large, economists seem to prefer the idea of debating ways to close the gap that has developed in recent years rather than thinking about whether the output gap even makes sense as Bullard has suggested. The failure to deal with the real world rather than how that reality is reflected in models and the reluctance to venture outside of their analytical comfort zone to embrace common sense (as Bullard clearly has) have clearly produced yet another example where models – whether they’re good, bad, or indifferent – rule.

MUCH MORE AT LINK