My freshman year in college, I took a course in physics and learned about the Ideal Gas Law. This a “scientific” law that says for any gaseous material, the volume that it will occupy is going to vary with changes in the temperature and pressure. So if we change one of these variables it will result in proportional changes in the other two. I learned the simple formulas that went with this law and was led to believe that the relationship worked with any gaseous material. A few years later, in an engineering course, I learned that there was no such thing as an “ideal gas” and while the relationships between temperature, pressure and volume that I had learned in physics were essentially correct, if I designed something to work in the “real world” I would need to apply an empirically derived correction factor (engineering fudge factor?). The correction factors would vary dependent on the elemental make-up of the gas and the temperature and pressure ranges with which I was working.
In 1936, John Maynard Keynes effectively established the field of “macro-economics” or Keynesian Economics, by postulating a relationship between government fiscal policy and the volume of economic activity. Essentially he suggested that government could “control” the volume of economic activity by varying taxes and spending. Reduced to a formula, it was a simple relationship among three variables. Sound similar to the “Ideal Gas Law”? In the 20 years after WWII, it became fashionable to attempt to define many fields of college teachings as a “science”. Economics was no exception, and Keynesian Economics was central part of this effort. Keynesian Economics also gave economists a reason and a doorway into advising government on policy. This of course not only raised their status, but gave them a seat at the table in Washington policy discussions – regardless of the subject.
The thing that I don’t think is generally recognized is that – like the Ideal Gas Law – Macro-economic theory is an oversimplification of the real world and government policies based on these economic ideas need to be modified with a “correction” factor which is dependent on a number of other variables. The difficulty is that the economic concepts, compared to physics concepts, are much more difficult to consistently correct for. Two reasons for this: (1) there are many more other variables that can significantly effect the economy than there are for an ideal gas, and (2) one of these variables is how people will react to government actions, and people don’t always react the same way because of a myriad of factors that are difficult to predict. Unfortunately, not all economist seem to recognize the need for “engineering fudge factors”. For example, raising the expenditure levels or reducing taxes should make the level of economic activity grow (and the resulting deficit to a balanced budget – while it may not be good – is not a problem if one is trying to raise the level of the economy). Also low-interest rates should spur growth. None of that has worked particularly well in the last few years. That is not to say the Keynes was wrong, but rather to suggest that his model may need some “correction factors” due to the effect of other factors in the mix.
A couple of examples:
- A couple in their 20’s or early 30’s who are trying to establish a household for themselves and their growing family might really benefit from lower interest rates to finance houses, cars, etc. On the other hand people who are in retirement and have much of their savings and income in fixed income securities such as CD’s may need the same or higher interest rates to help them maintain their standard of living.
- Company’s who might want to make investments which would provide additional sales and additional jobs might be deterred from doing so by high interest rates, but in the absence of growing demand they might not invest regardless of how low the interest rates go.
- Government deficits might put more money back in people’s hands, but if it gets to be too much, people may begin to fear negative results to the economy. And with countries – such as Greece in the news these days – that may have a lot of people concerned.
In 1960’s and 1970′ we had the beginnings of the baby boomers coming of age, starting families and acquiring property. For them, low-interest rates would let them do more. Today those same baby boomers are in, or nearing, retirement. They are downsizing and living like my father-in-law on Social Security with interest bearing accounts supplementing their income. Lower interest rates mean less income and less they can do. In the 1960’s the individual/family savings rate was 10%, since then it has fallen to 2% so those nearing retirement need to save more and lower interest rates are not a help. In addition, too much debt at the beginning of the Great Recession, has had people “de-leveraging”. This is probably good in the long run, but it doesn’t help increase their demand for goods and services. So with demand not growing, company’s aren’t going to invest even at a 0% interest rate. With the population worrying about debt levels, low-interest rates and additional government debt may not help. In the 1960’s, we had paid off most the war debt and had what was judged to be a balanced budget at full employment. Given all these changes, empirical data from the 1960’s may not be valid in today’s environment.
A better scientific model than physics and engineering for economists might be the medical profession. I would not argue that economics is not a science, only that we may have the wrong model to follow. My Father used to say that the best family doctor was one who was the best diagnostician. Medical professional doctors try to diagnose before they proscribe a remedy. They know that different underlying, core problems can have similar symptoms. So the first thing they try to do is some testing and analysis before they propose a solution. They also recognize that some problems are better left to the natural bodily processes to solve. If they do make a prescription for medication, they will check back with the patient when it has a chance to make an improvement. If no improvement has been made, they will most likely change the medical approach, because they know that even with the same person the same approach may not work every time.
Our government, the Fed as well as other branches has been trying the same solution for much longer than it has taken to see improvement before without much of the expected improvement. There does not appear that they have spent much time trying to diagnose this specific problem. Rather they have proscribed routinely accepted proscriptions. While these may have worked in previous situations, today’s recession appears to be different enough that previous actions may not provide the best alternatives. And even though they have regularly checked back with the patient, with little improvement they seem to have no inclination to change the prescription. And there doesn’t appear to be much visible open-minded problem analysis. It may be time to re-examine our pre-conceived notions. What do you think?
In the next post, I will suggest what I think should have been done differently, and why.