Are Canadian Economists as Smart as Paul Krugman thinks?

Unfortunately Krugman’s hopes that the policy conversation in Canada is more enlightened than in the US is dashed once again. Here is the set-up which is lifted from the comments section over at WCI*:

Posted by: [JR] | September 10, 2010 at 06:44 PM

The problem with central banks just targeting inflation is that no-one is responsible for unemployment. The ethically critical task for economists is to figure out how to get the NAIRU down.

Posted by: Stephen Gordon | September 10, 2010 at 06:58 PM

Are you sure? Because there’s a really cheap and easy way to do that: abolish Employment Insurance and social assistance. Be careful of what you wish for.

OK lets leave JR’s confusion over the unemployment rate and the NAIRU to the side as even US senators botch it badly. Let us also leave the dubious scientific validity of the NAIRU to one side (the empirics are bad). Let us also refrain from mentioning that he sounds a lot like the shrill Niels Veldhuis of the Fraser Institute which Stephen has decried as not belonging to the evidence based community.

Stephen’s flippant response (and in perfect accord with the Fraser institute) is I suspect the widely held gut instinct of scientific liberals** (aka orthodox economists). But I think even here Stephen has transgressed the boundaries of the received wisdom and is attempting to push the argument further than can be sustained on its own terms–i.e. accepting the internal validity of its logic.

The supposed link between welfare, EI and the NAIRU is that IF replacement rates (the benefit paid out) are too high then unemployment will stay too high because workers will not accept jobs below their replacement rates. That is the micro mechanism. The macro-consequence is that prices (wages) will not stall or fall because the economy is already at a de-facto full employment rate. If replacement rates are left untouched and the government tries via fiscal policy or the central bank tries via monetary policy to stimulate the economy in an attempt to decrease the ‘”officially recorded” unemployment rate THEN they would simply increase inflation (and at an accelerating rate to boot if they kept stimulating) because they would essentially be stimulating a supply constrained economy (on the labour market side).

The NAIRU can thus be thought of as the Phantom Menace in this morality play: in which the abridged moral of the story, as is often the case, boils down to a cliché–the road to hell is paved with good intentions–trussed up in quasi-scientific garb (hey if the relationship is not stable and it fluctuates without major changes in the social protection legislation and despite increasing labour market flexibility then I am being REALLY charitable here).

I slightly digress. Let us come back to causation and replacement rates. The average welfare rate in Ontario is around 600$ and the average minimum wage job pays around, after taxes and deductions, 1100$ (assuming a 35hour work week). Which means that the replacement rate for welfare is about 55%, or near half the value of a minimum wage job. Employment insurance replacement rates are an equally dismal 55%.

There are thus two major flaws in Stephens extreme logic that “there’s a really cheap and easy way to do that [lower the NAIRU]: abolish Employment Insurance and social assistance.”

The micro foundations of the NAIRU rely on the relationship between the incentive to work and the incentive to idle. True, all things being equal if I could collect something close to my existing salary without actually having to work I would probably dedicate most of my time to strictly speaking over the short term non pecuniary pursuits. We might call it leisure or we might call it investment the proof of the pudding would be in the eating. That is another story. The point is 55% of my salary leaves me and I suspect most Canadians declaring bankruptcy if sustained for too long a time. The replacement rates are already so low as to make me willing to take any job at anything above 60% of my existing salary with the hopes of shopping-up when times get better. That implies massive flexibility which implies a hefty downward shift in the NAIRU.

Here is the analogue. Imagine the Bank of Canada is sets real interest rate at 0% (O.K. you do not need to imagine they are already there and have been for some time; negative in fact). So you are pushing on a string: your are out of ammo. Replacement rates work the same way. Once they have been pushed so low any further decreases deliver infinitesimally less effect on the NAIRU. Stephen forgets his ilk already won that war. But like a good soldier fighting the last war he needs to ring the bell again!

Fine, old wars and instincts die hard.

But here is the really shrill part of Stephens logic. Abolishing EI and welfare would not lower the NAIRU under present conditions. We are demand constrained. We only become supply constrained on the labour supply side of things if and only if according to accepted wisdom if high unemployment persists for too long: i.e., hysteresis kicks in (you know the idea that Wayne Gretzky forgets how to pass and shoot hockey pucks after a year).

Yep I am willing to swallow all that bullshit and I still can’t get to Gordon. Hey it is an inside job I am pulling here.

Re-focussed. If you killed EI and social assistance right now, the consequences would be devastating. Demand would plummet by the equivalent value of payments, business would register the defective demand through declining inventories and decreased investment and prices would begin a deflationary death dance. True the NAIRU would be heading south: -4 or 6%% anybody? BUT so what? The recorded unemployment rate would go to 14-20% and if we accept that skills are like lettuce those figures would become persistent and the tax base totally eroded. Now if Stephen Gordon thinks that is a cheap solution to the NAIRU then I can only conclude that he has joined the ranks of the, what was the phrase he used?, ohh yes: “not belonging to the evidence based community”

*The name of the innocent was changed to protect the innocent.
**Take a political theory course if you do not know what a liberal in the political theory or original sense of the word means.

Macro Models, Reality and Policy

Testimony of David Colander Submitted to the Congress of the United States, House Science and Technology Committee for the Hearing: “The Risks of Financial Modeling: VaR and the Economic Meltdown.”
September 10, 2009

Some non-economists have blamed the financial heart attack on economist’s highly technical models. In my view the problem is not the models; the problem is the way economic models are used. All too often models are used in lieu of educated common sense, when in fact models should be used as an aid to educated common sense. When models replace common sense, they are a hindrance rather than a help.

Modeling the Economy as a Complex System

Using models within economics or within any other social science, is especially treacherous. That’s because social science involves a higher degree of complexity than the natural sciences. The reason why social science is so complex is that the basic unit in social science, which economists call agents, are strategic, whereas the basic unit of the natural sciences are not. Economics can be thought of the physics with strategic atoms, who keep trying to foil any efforts to understand them and bring them under control. Strategic agents complicate modeling enormously; they make it impossible to have a perfect model since they increase the number of calculations one would have to make in order to solve the model beyond the calculations the fastest computer one can hypothesize could process in a finite amount of time…..

This recognition that the economy is complex is not a new discovery. Earlier economists, such as John Stuart Mill, recognized the economy’s complexity and were very modest in their claims about the usefulness of their models. They carefully presented their models as aids to a broader informed common sense. They built this modesty into their policy advice and told policy makers that the most we can expect from models is half-truths. To make sure that they did not claim too much for their scientific models, they divided the field of economics into two branches—one a scientific branch, which worked on formal models, and the other political economy, which was the branch of economics that addressed policy. Political economy was seen as an art which did not have the backing of science, but instead relied on the insights from models developed in the scientific branch supplemented by educated common sense to guide policy prescriptions.

In the early 1900s that two-part division broke down, and economists became a bit less modest in their claims for models, and more aggressive in their application of models directly to policy questions. The two branches were merged, and the result was a tragedy for both the science of economics and for the applied policy branch of economics.

It was a tragedy for the science of economics because it led economists away from developing a wide variety of models that would creatively explore the extraordinarily difficult questions that the complexity of the economy raised, questions for which new analytic and computational technology opened up new avenues of investigation.[1] Instead, the economics profession spent much of its time dotting i’s and crossing t’s on what was called a Walrasian general equilibrium model which was more analytically tractable. As opposed to viewing the supply/demand model and its macroeconomic counterpart, the Walrasian general equilibrium model, as interesting models relevant for a few limited phenomena, but at best a stepping stone for a formal understanding of the economy, it enshrined both models, and acted as if it explained everything. Complexities were just assumed away not because it made sense to assume them away, but for tractability reasons. The result was a set of models that would not even pass a perfunctory common sense smell test being studied ad nauseam.

Initially macroeconomics stayed separate from this broader unitary approach, and relied on a set of rough and ready models that had little scientific foundation. But in the 1980s, macroeconomics and finance fell into this “single model” approach. As that happened it caused economists to lose sight of the larger lesson that complexity conveys —that models in a complex system can be expected to continually break down. This adoption by macroeconomists of a single-model approach is one of the reasons why the economics profession failed to warn society about the financial crisis, and some parts of the profession assured society that such a crisis could not happen. Because they focused on that single model, economists simply did not study and plan for the inevitable breakdown of systems that one would expect in a complex system, because they had become so enamored with their model that they forgot to use it with common sense judgment.Italics added to original.