Wishful Thinking Isn't Economic Analysis

Friday, April 6, 2012

In the 1985 Reith lectures, broadcast by the BBC, the OECD economist David Henderson coined the phrase “do-it-yourself economics.” These, he argued, were the practical ideas that ordinary people use to understand the economic world around them. In the world of DIY economics, he noted, public spending and exports are good because they create jobs; factories that produce things are more deserving of support than offices that produce intangible services; cheap goods made by foreigners threaten our jobs; and whatever is wrong, it is the government’s duty to do something.

DIY economics is alive and well in many countries. I’ll give three examples: hostility to banking, support for revenge taxation, and demands for more fiscal stimulus. Something of interest in all three cases is the length of causal chains. In the world of DIY economics there is never more than one step from cause to effect. This is one reason for its appeal. DIY economics is concrete and intuitive, and everyone can understand it.

HOSTILITY TO BANKING

The Occupy Wall Street and Occupy London movements have their roots in DIY economics. They contrast bankers’ bonuses with spreading unemployment among the people who make things with their hands. They blame banking for everything that has gone wrong since 2007. This is not an unrepresentative minority; a Pew opinion survey in October 2011 found that 39 percent of Americans supported Occupy Wall Street, more than would have supported the tea party at the time.

In the world of DIY economics, there’s never more than one step from cause to effect.

In the simplified world of DIY economics, if you see the effect, you have to go back only one step to find the cause. The recession began with a credit crunch so, in this view, the suppliers of credit, the bankers, must be to blame. Most certainly, we the people are not to blame.

Behind the recession, however, lies a longer chain of causation that implicates us all. Where did the credit crunch come from? The subprime housing market. Mortgage lenders in Western economies had overextended credit to households that had no hope of repaying out of their incomes. What provided the impetus to excess housing credit? Well-meant government policies that had responded to growing income inequality by promoting and subsidizing “affordable” housing (actually the opposite). Bankers and mortgage lenders colluded actively with this. And it was popular: the voters voted for it, and the families in the subprime urban areas took the money.

So I’m not particularly delighted that part of the British government’s strategy for economic revival is new help for homebuyers. Haven’t we been here before?

REVENGE TAXATION

On both sides of the Atlantic, opinion polls show a deep sense of injustice engendered by financial sector bailouts, when the same courtesy has been held back from households and smaller businesses. At the same time the politicians responsible for the bailouts, who must court the votes of the 99 percent for their own re-election, have colluded eagerly to load the blame onto bankers, obscure their own role, and absolve the voters from their own responsibilities.

Thus the crisis was “caused in part by completely irresponsible action on Wall Street” (President Obama), “those who helped bring about the crisis” are the bankers (President Sarkozy of France) or, more specifically, “white, blue-eyed bankers” (former President Lula da Silva of Brazil says he doesn’t know any “black bankers”).

A remedy that comes straight out of DIY economics is: take our money back. Hence the public support, widespread on both sides of the Atlantic, for a financial-transactions tax. In fact, it’s popularly known as the Robin Hood tax, after the medieval outlaw who stole from the rich to give to the poor.

When French President Sarkozy announced plans for a financial transactions tax in January, he said:

There is absolutely no reason why those who helped bring about the crisis shouldn’t pay to restore the finances. . . . We hope the tax will generate one billion euros ($1.3 billion) of new income and thus cut our budget deficit.

How does this work? In the world of DIY economics, if you take from the rich and give to the poor, the rich (who are few) become poorer and the poor (who are many) become richer, period. In other words, taxes fall on those that write the checks.

The chain of causation suggested by modern economics is somewhat longer, yet each step is still simple and transparent. A tax on profits increases the cost of capital to firms, so that eventually less capital is employed and every worker is less productive. The result is lower wages (as well as smaller profits). A tax on labor increases the cost of labor to firms, so that fewer workers are employed. The outcome is fewer jobs (as well as lower wages and smaller profits).

Whomever you tax, the market economy spreads the burden beyond those who write the checks.

In other words, it matters whom you tax, but whomever you tax the market economy spreads the burden beyond those who write the checks. Whether taxes are levied on capital or labor, the employees will bear much of the cost. The cost, moreover, will exceed the revenue raised (a reason why the revenue should be used well or not at all).

President Sarkozy, like many others, seems to have missed the assessment of a recent EU report:

A stylized transaction tax on securities . . . at 0.1 percent is simulated to cause output losses . . . of up to 1.76 percent in the long run, while yielding annual revenues of less than 0.1 percent of GDP.

Applied to France’s two-trillion-euro GDP, that implies an eventual loss of up thirty-five billion euros of annual income—and this loss would fall largely on thirty million French employees.

As for Sarkozy’s ambition to use the revenue from a financial transaction tax to pay for government spending, this too is likely to fail. France’s average tax rate is more than 40 percent of GDP. If France’s GDP is cut by the sum predicted, its treasury will find itself short to the tune of fifteen billion euros. No help for France’s fiscal problems there.

MORE STIMULUS

Nearly every supporter of administration policies in the United States (and critic of government policies in the United Kingdom) is gripped by the certainty that public spending cuts destroy jobs. In turn, jobs generate incomes, which are taxed, so DIY economists commonly argue that spending cuts for the sake of deficit reduction will be self-defeating, because government revenue will also fall. In this view, only the government can stop the cycle of destruction it has initiated, by restarting the spending chain. In fact, the government should spend its way out of debt!

In DIY economics the self-defeating outcome of public spending cuts is a no-brainer. Suppose a skeptical listener suggested that market forces might make up the employment lost. With lower taxes and a halt to ballooning public debt, private businesses might eventually feel more confident in the future and create more jobs. The DIY economist would likely dismiss this scenario as entirely theoretical or speculative (in fact, just the sort of rubbish you might expect from an economist).

Yet in the long run Western economies have become wealthy because of private enterprise. Good government was a condition for this, but it isn’t government spending that made us rich.

THE STAYING POWER OF DIY ECONOMICS

If economists know all this, why doesn’t our knowledge drive out DIY economics? It would seem that if beliefs based on DIY economics lead people to make false inferences about cause and effect, then they ought to learn from these mistakes and progressively adopt beliefs consistent with economics instead. This doesn’t seem to happen.

Why not? One reason is that real-world causal chains are often so long and complex that effects are far removed from causes in time and space. For Chinese Prime Minister Zhou Enlai, two centuries were famously not enough time to tell the impact of the French Revolution. How can anyone draw personal insight from something that began a lifetime ago and isn’t over yet?

Related to this, economists, who work professionally with complex and uncertain causal chains, themselves often turn out to have conflicting causal beliefs (we call them “models”). The data don’t perfectly discriminate between false beliefs and true ones, and as a result even the professionals can’t agree on how the world works. If that’s the case, what chance do ordinary people have?

Bryan Caplan has noted that most people, faced with complex questions they can’t answer, respond by substituting a simpler question that they can answer and answering that. In this case the initial question might be: “How much should the financial sector contribute to general taxation?” Lost for an answer to that one, the DIY economist asks instead: “How do I feel about bankers, knowing they lost my money and still earn a hundred times what I do?”

France’s and America’s coming presidential elections will surely show that DIY economics is alive and well.