Do economists understand economies?

June 21st, 2016 at 6:00 am


–The economist Greg Mankiw had an essay in the NYT last week on five theories as to why growth has been so sluggish for so long (Greg’s focus was on the US, but it could have applied to Europe as well). Mankiw, a Harvard professor and writer of widely used textbooks, has long been at the top of the field. Almost a decade after a deep recession that “no one saw coming” (as is widely claimed) and seven years of a tepid recovery, he presents five different diagnoses, ranging from mismeasurement to weak demand to “policy missteps.” With honesty and candor, he concludes: “Unfortunately, I have no idea which one is right.”

–Take a look at the figure below. It is a series of forecasts of world GDP growth by IMF economists. The solid line is actual inflation-adjusted GDP growth and the dashed lines are forecasts conducted in different years. As you can see, they optimistically kept predicting GDP to turn around, failing to correct their model for persistent forecast errors. But let’s not pick on the IMF, since…

Source: Jay Shambaugh, CEA

Source: Jay Shambaugh, CEA

–…Interest rate projections by various administrations show the same pattern, as do inflation projections by the members of the Federal Reserve board (see first figure below). To their credit, however, if you look at the Fed’s predictions for 2015q4 real GDP growth starting in 2012, by June of that year they’d finally downgraded their forecast (second figure below).

Source: Fed

Source: Fed


Source: Fed

Notwithstanding the Fed’s markdown, something seems quite wrong with contemporary economics. If your car failed to accelerate, even as you hit the gas (i.e., held rates at zero for years), you’d bring it to a mechanic. And if, after seven years of weak expansion, that mechanic (along with most of his fellow mechanics) couldn’t explain the problem, you might legitimately conclude: mechanics don’t understand cars.

Could it be the case that economists don’t understand economies?

Well, there are a lot of different economists out there. Dean Baker quite clearly diagnosed and wrote extensively about the housing bubble well before it burst (so “no one saw it coming” isn’t correct). Paul Krugman long ago correctly diagnosed the crippling problem of austere fiscal policy when economies are not fully recovered and the federal funds rate is stuck at zero.

But broadly speaking, we must ask ourselves not just why we’ve underperformed around the Great Recession and recovery, but why, according to CBO numbers, we’ve been at full employment only around a third of the time since 1980. Given the damage slack labor markets do to the wages, incomes, and opportunities of middle and low-income working households, that’s a tremendous, though too rarely cited, indictment.

Here are a few thoughts about what’s gone wrong:

Old habits correlations die hard. The latest Economic Report of the President included a revealing set of figures showing that a correlation at the heart of macroeconomic analysis and a guidepost for Fed policy—that between labor market slack and inflation—has grown increasingly hard to reliably estimate. Relatedly, the ERP showed that the confidence interval around the “natural rate of unemployment” right now runs from less than zero to about six percent. That implies that economists still operating from this model are likely to get important things wrong.

That word “temporary.” I don’t think it means what you think it means. The Fed keeps talking about temporary headwinds, like the negative spike in energy prices, the strong dollar, slow growth abroad, capital inflows, and wage and price growth that have been largely unresponsive to the tightening job market. But variants of these problems have been around for years now, and the assumption that soon the model will be right again, as in the IMF figure above, is another source of the problem.

Globalization ideology. The assumption that more international trade is always a plus has led too many economists to miss problems in global macro. Most importantly, some of our trading partners suppressed their consumption, boosted their savings, and exported those savings to us such that their trade surpluses become our trade deficits. The need to offset that macro drag, in tandem with large inflows of cheap capital, led to destabilizing bubbles that were missed by most economists.

Finance is much more than an intermediary. Though we’re getting better at this one, for years, macro models treated the finance sector as an intermediary that simply distributed excess savings to its most productive uses. Thus, we mostly missed the fact that the sector was instead misallocating capital to “innovative” financial schemes that systematically underpriced the true risks they engendered, thus both undermining productivity growth and inflating bubbles.

Politically motivated bad ideas posing as economic analysis. This one has become very serious. Most Republicans, mindless budget hawks (those who are always hawkish, regardless of the timing), and anti-government ideologues pushed economic arguments about the “failed stimulus” and the need to pivot to budget austerity. Mankiw, e.g., argues that the Keynesian interventions in 2009 may have been a policy misstep (Blinder/Zandi strongly disagree). Such arguments prompted a shift to budget austerity well before the economy was ready for it. Look, for example, at the following figure from EPI’s research director Josh Bivens, showing per capita government spending (at the federal, state, and local levels) over the past six business cycles. This cycle is a clear, negative outlier which somehow gets missed by the “failed stimulus” crowd. It also brings me to the final point.

Source: Bivens

Source: Bivens

Demand, demand, demand. In response to Mankiw, Dean writes, “…there’s not much complicated about the story. We lost a huge amount of demand when the housing bubble collapsed and there is nothing to replace it.” Bivens, Krugman, Summers and many others agree. Greg talks about this under the rubric of “secular stagnation: a persistent inability of the economy to generate sufficient demand to maintain full employment.” One can see it in interest rates that are hitting historic lows across advanced economies and in persistently low inflation. We’re still, seven years into an expansion, nursing a sizable output gap and elevated underemployment. Wage trends, the most reliable—maybe the only reliable—measure of labor market slack, are strengthening a bit but remain well below target growth levels.

So I think Dean’s right and I don’t really understand why that isn’t obvious (though, to be clear, I respect Mankiw’s uncertainty, which is much better than confidence in an incorrect diagnosis). That could be my own limitation and intellectual blinders, but it strikes me as a simple diagnosis with strong evidence to support it, and one with straightforward prescriptions. We need to create more demand through, for example, infrastructure investment, patience on interest rates, and trade policy focused on lowering the trade deficit.

If I’m right, it’s very important to move on these issues. Because most economists have been having such difficulty spotting bubbles or convincingly diagnosing what’s wrong with the economy and prescribing effective solutions, we’ve lost credibility to the point where Trump’s walls and tariffs, Brexit, supply-side tax giveaways to the wealthy, and congressional attempts to control Fed policy are all gaining traction.

And that is all very dangerous.

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18 comments in reply to "Do economists understand economies?"

  1. Smith says:

    Well, to be kind, and to diplomatically introduce a disturbing topic, Krugman has cited the failure of economists as a profession as a cause for poor economic performance. He’s repeatedly spoken to the fact that they’ve provided sustenance and cover to politicians pursuing agendas set by conservative and wealthy patrons. He’s implied there is an unscrupulous relationship between some economists and conservative think tanks. Mostly, he’s allowed for policy differences caused in part by group think and blinders, forgoing the chance to call out major figures for fraud and corruption. I will make no such distinction. Mankiw is a prime example. It doesn’t matter if he’s willingly ignorant or partly fooling himself, the policies he advocates have real consequences on people’s lives.
    But that’s just the tip of the iceberg. The theory and mystery behind poor economic performance is easily knowable and solved just by looking at self interest. The 1% doubled their share of the economic pie. Slower growth pales in comparison to an extra 10% of GDP, especially when that extra $1.5 trillion is divided among so few 120,000 to 1.2 million households. One thousand million is a billion. A million million is a trillion (1,000,000 * 1,000,000 = 1,000,000,0000,000), You gave the top million a million each, every year in additional income. Actually the bottom of the 1% get a lot less (an extra couple hundred thousand), so the top can get a lot more (the .1% getting several million). Put that in your pipe and smoke it.

    • Smith says:

      As if on cue, this just in…

      “The super wealthy account for a growing share of both parties’ funds. In the presidential election year 1980, the richest 0.01 percent gave 10 percent of total campaign contributions. In 2012, the richest 0.01 percent accounted for an astounding 40 percent.

      “Adding to the cynicism is the revolving door. In the 1970s only about 3 percent of retiring members of Congress went on to become lobbyists. In recent years half of all retiring senators and 42 percent of retiring representatives have done so.”

      • Procopius says:

        Back in the 1940s and ’50s, my father had a friend, William Ayres, who got elected to the House of Representatives from Akron, Ohio. Several years later, I don’t recall if he had lost the election, or just decided to retire. He told my Dad that he intended to stay on in Washington as a lobbyist, because he enjoyed the games of politics so much. I imagine he also expected to make a ton of money, but I don’t think that was his real motivation. He really loved the life as it was then. It doesn’t really matter any more, though. It’s not only Congressmen, it’s congressional aides, clerks in the regulatory agencies, lawyers in the civil service system or appointed, all riding the damned merry-go-round between the regulatory agencies, the big multinational corporations, and K Street.

    • Amann says:

      YES, and I hope they choke on the smoke!!!!!

  2. I'm Ready says:

    I’m getting tired of watching economists claim insanity!

    I’ve seen 2 economists, Jared Bernstein and Dean Baker, that knew all along what was happening. Nobody else.

    Don’t go looking anywhere else. Dean and Jared have this covered. Read them!

  3. I'm Ready says:

    You’re correct, Jared. I’m not a simpleton as much as I want to let on that I am. Keynes was correct in some cases.

    Now what causes low demand? Dean is on to this, but I think it is more complicated than a simple trade deficit. It is the structure of the trade deficit that matters. It is structured around using cheap labor, and labor is the only thing that creates demand!

  4. Sandwichman says:

    “Could it be the case that economists don’t understand economies?”

    Aside from Dean Baker, Jamie Galbraith and, occasionally, Jared Bernstein, it could indeed be the case. There are of course a few others. But those who buy into NAIRU or “flexible labor markets” or rat. choice do not.

    Jamie wrote a devastating critique of NAIRU 20 years ago titled “Time to Ditch the NAIRU.” It has 293 citations. Layard, Nickell and Jackman wrote a book, “Unemployment: Macroeconomic Performance and the Labour Market,” extolling labor market flexibility as the panacea. It has 5824 citations. Based on this empirical evidence, I think it is fair to estimate that 5% of economists understand economics — 95% display the symptoms of Dunning-Kruger Effect.

    The President’s Council of Economic Adviser’s published a report yesterday on “The long-term decline in prime-age male labor force participation.” In it they state:

    “Conventional economic theory posits that more ‘flexible’ labor markets—where it is easier to hire and fire workers—facilitate matches between employers and individuals who want to work. Yet despite having among the most flexible labor markets in the OECD—with low levels of labor market regulation and employment protections, a low minimum cost of labor, and low rates of collective bargaining coverage—the United States has one of the lowest prime-age male labor force participation rates of OECD member countries.”

    As I explain in my latest blog post, The Iatrogenic and Incoherent “Theory” of Flexibility, the flexible labor market mantra is not a theory. It is a dogma based on the pseudo theory of NAIRU that Jamie Galbraith debunked so thoroughly 20 years ago. So why is the CEA so surprised that reality doesn’t conform to this discredited conventional view?

  5. Robert Aylward says:

    I’ll mention two “headwinds”: First, globalization magnified rising inequality, as the level of inequality in developing countries like China is much higher than in developed countries: if excessive inequality causes an imbalance in supply and demand (i.e., a savings glut), then globalization has magnified the imbalance. Second, austerity policies have placed the burden for economic stimulus on central banks, which has magnified the first “headwind”, for while fiscal stimulus is redistributive downward (by increasing employment, etc.), monetary stimulus is redistributive upward (by inflating the value of assets, most of which are owned by the wealthy). Of course, Prof Mankiw has been a dependable defender of inequality; indeed, a promoter of more of it. For Mankiw to identify excessive inequality as a potential problem would require him to reject years of his own work.

  6. Egmont Kakarot-Handtke says:

    Iatrogenic economics
    Comment on Jared Bernstein on ‘Do economists understand economies?’

    You summarize: “… something seems quite wrong with contemporary economics.” That is not quite accurate because economics is wrong since Adam Smith (2014).

    Walrasian, Keynesian, Marxian, and Austrian economists are groping in the dark with regard to the two most important features of the market economy: (1) the profit mechanism, and (2), the price mechanism. The fatal fault lies in the fact that economists argue from the micro level upwards to the economy as a whole. And here the fallacy of composition regularly slips in. To get out of failed economic theory requires nothing less than a full-blown paradigm shift from accustomed microfoundations to entirely new macrofoundations.*

    In the following a sketch of the formally and empirically correct price, employment, and profit theory is given. The most elementary version of the objective structural employment equation is shown on Wikimedia:

    From this equation follows:
    (i) An increase of the expenditure ratio rhoE leads to higher employment (the letter rho stands for ratio). An expenditure ratio rhoE greater than 1 indicates credit expansion, a ratio rhoE less than 1 indicates credit contraction.
    (ii) Increasing investment expenditures I exert a positive influence on employment, a slowdown of growth does the opposite.
    (iii) An increase of the factor cost ratio rhoF=W/PR leads to higher employment.

    The complete AND testable employment equation ― which is systemic and entirely free of green cheese behavioral assumptions like constrained optimization or rational expectations ― is a bit longer and contains in addition profit distribution, public deficit spending, and import/export.

    Item (i) and (ii) cover Keynes’s arguments about the relation between aggregate demand and employment. No much new here, so let us turn to the factor cost ratio rhoF as defined in (iii). This variable embodies the price mechanism which, however, does NOT work as the representative economist hallucinates. As a matter of fact, overall employment INCREASES if the average wage rate W INCREASES relative to average price P and productivity R.

    This is the exact opposite of what standard economics says about the functioning of the price mechanism. Indeed, economists do not understand how the actual economy works and this explains why their standard policy advice regularly WORSENS the situation. In healthcare this is called iatrogenesis (Wikipedia).

    For the relationship between real wage, productivity, profit and real shares see (2015, Sec. 10)

    The correct profit equation reads: Qm = Yd+I-Sm (2014, p. 8, eq. (18)). Legend Qm: monetary profit, Yd: distributed profit, Sm: monetary saving, I: investment expenditure. The profit equation gets a bit longer when import/export and government is included.

    Note that OVERALL profit and by consequence the income distribution has NOTHING to do with productivity or low wages or market power. These and other factors affect only the DISTRIBUTION of overall profit BETWEEN firms. What holds on the firms’ level does NOT hold for the economy as a WHOLE. Not to realize this is the fatal insufficiency of economists’ feeble-minded ruminations about the relationship between (average) wage rate, price, productivity, and employment. In sum, economists got the Phillips curve and the concept of the ‘natural rate of unemployment’ provably wrong (2012).

    The ultimate cause of secular economic stagnation is the secular intellectual stagnation of economists.

    Egmont Kakarot-Handtke

    Kakarot-Handtke, E. (2012). Keynes’s Employment Function and the Gratuitous Phillips Curve Desaster. SSRN Working Paper Series, 2130421: 1–19. URL
    Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
    Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL

    * Students are referred to the working papers for the analytical details

    • Smith says:

      In English, you and the papers cited are couching common sense in still somewhat elaborate jargon and equations.

      Let me take a stab at it.
      Companies and rich people who don’t need to spend all the money they receive (profits and return on capital, compensation beyond necessities) essentially impose austerity. This implies inequality in and of itself contributes to a slack economy.
      An article in Forbes (from a quick google, see link below) argues 1) money saved is productively loaned by banks anyway, 2) corporations are not sitting on that much cash, 3) much of corporate cash is from foreign earnings 4) corporations are borrowing against that cash.

      1) Hah. Money in banks is not the equivalent of money spent on necessities. Rich people like to say that in order to justify higher income, and wealth. The distortions that ensue from a savings glut are legion, even without an asset bubble, and notwithstanding the fact only people/entities that don’t need money can actually borrow.

      2) Somehow a rise of 10% to 13% is not supposed to alarm because ‘3’ is a small number vs. the $700 billion increase (time span not given). Since when is a 3% contraction in the amount of anything, let alone the economy not significant?

      3) The fact that corporate cash is in foreign accounts says two things, a) Globalization is not only unneeded and exploited by elites, it’s harmful and b) Do not give in to blackmail and grant lower rates for repatriation of profits, just close the loophole and tax everything still sitting overseas too.

      4) Corporations dodging tax by borrowing is also going to benefit the wealthy as they spend on buybacks, or buying other companies and consolidating control thereby reducing employment and competition at the same time. That’s what executives are taught to do.

      All this without even going into how inequality distorts econometrics, bidding inflates GDP without useful products, and trading inflated services separates rich from poor while also adding nothing. Paying more for penthouse or artwork adds to GDP, consultant A essentially trades powerpoints with consultant B at $400/hour, also adds to GDP.

      • Anechidna says:

        Concentration of economic activity.

        I understand that approximately 740 odd corporations account for 60 of global economic activity. Of these some 10% account for 40%. With such concentration of influence in the hands of so few entities and their boards of Directors economic activity becomes heavily slanted in their favour.

      • Egmont Kakarot-Handtke says:


        The question of this thread is ‘Do economists understand economies?’ and the answer is NO. Neither Walrasianism, Keynesianism, Marxianism nor Austrianism satisfies the criteria of material and formal consistency. Economics is a failed science.

        Because of utter scientific incompetence economists have never risen above the level of storytelling. This applies also to your post which explains the economy as a machination of rich people. You simply do not grasp the difference between a scientific and a yellow-press explanation.

        Imagine for a moment an aircraft flying from, say, New York to Paris. Now we can ask why? One way to answer the question is to speculate about the motives and reasons of the passengers, the pilot, the crew, the flight controllers, and the managers and stockholders of the airline. The other way to look at the flight is to think about the laws of aerodynamics, thermodynamics and so forth.

        It is pretty obvious that an aircraft does NOT fly because people have a motive to fly. This is animistic thinking. This thinking yields the same trivial psychological crap over and over again. Notice: whatever the subjective motives/actions of passengers/crew are, they do — as a matter of principle — NOT explain the phenomenon of flight in the abstract.

        Just like the phenomenon of flight has to be understood in objective physical terms the functioning of the monetary economy has to be understood in objective systemic terms. What is needed to begin with are the objective laws of economics, for example the Profit Law.

        You, too, have NO idea of what profit is and how markets interact.* Instead, you tell the bad guy/good guy story. People like this sitcom stuff but it is NOT science.

        To recall: since Smith and Marx economics claims to be a science but the feeble thinkers and strong blatherers that call themselves economists have until this day not figured out how the monetary economy works and how the product and the labor market interact and whether the system is self-correcting or not.**

        Either economists stop storytelling and start to do their scientific homework or they will be thrown out of science and sued for damages.

        Egmont Kakarot-Handtke

        * See ‘How the Intelligent Non-Economist Can Refute Every Economist Hands Down’
        ** See ‘Could we, please, all focus on the key question of economics?’

        • Smith says:

          Economists I admire, mostly dead, Keynes and John Kenneth Galbraith, I think they had a pretty good understanding. They were also much better writers than any other economists I’ve read.

          Economics is partly the study of people’s motivations and subsequent actions as economic players, individually and in the aggregate. I can’t understand your complaint that my analysis was focusing on how rich people have a disproportionate and self-rewarding effect on the economy which leads to sub par macro performance. It’s a critique of influential economists who sometimes do and sometimes don’t call other economists phonies, fakes, charlatans, frauds, liars, and crooks, who sell their soul to promote their own career. It’s a gentleman’s club, and few are ready to say or admit to themselves what’s really going on.
          I will fall back on Krugman’s case that the country needs more stimulus, it’s plain vanilla Keynesian economics, something out of the 1930s. To the degree economics is a science, the failure of economics is merely one of willful human corruption, and is not due to ignorance or a misunderstanding. At some level, some of the corrupt economists do believe they are being honest. Even in those cases, it’s most likely because it’s in their interest to deceive themselves, just as some slave holders believed they were beneficent masters, it doesn’t let them off the hook.

          As an aside, I get that profit might put people/workers in debt by definition, but that ignores distribution of profits, luxury trades, and rising inequality. It’s possible to create profit entirely from increased productivity and not by debt. I pay new workers less. They build a new penthouse skyscraper. I buy it.

          • Egmont Kakarot-Handtke says:


            You say: “Economists I admire, mostly dead, Keynes and John Kenneth Galbraith, I think they had a pretty good understanding.”

            You obviously overlook this point: the decisive criterion in science is true/false and NOT like/dislike.

            You overlook, secondly, that Keynes was not such a profound thinker. He defined the formal core of the General Theory as follows: “Income = value of output = consumption + investment. Saving = income – consumption. Therefore saving = investment.” (1973, p. 63)

            This two-liner is conceptually and logically defective because Keynes never came to grips with profit: “His Collected Writings show that he wrestled to solve the Profit Puzzle up till the semi-final versions of his GT but in the end he gave up and discarded the draft chapter dealing with it.” (Tómasson et al., 2010, p. 12)

            Let this sink in, Keynes had NO idea of the fundamental concepts of economics, viz. profit and income. Now it is pretty obvious, because profit is ill-defined the whole theoretical superstructure of Keynesianism is false, in particular all I=S/IS-LM models.

            But things get from bad to worse. Neither Post Keynesians nor New Keynesians nor Anti-Keynesians have realized Keynes’s logical blunder until this day (2011). And ― ridiculous to the extreme ― Paul Krugman bases his economic analysis and policy advice still on IS-LM (2014).

            The question of this thread is ‘Do economists understand economies?’ and the unequivocal answer is NO. From the history of economic “thought” is known that economists swallow every brain-dead junk from utility maximization to supply-demand-equilibrium to I=S without turning a hair. From all scientific write-offs economists are the worst and this certainly includes you.

            Egmont Kakarot-Handtke

            Kakarot-Handtke, E. (2011). Why Post Keynesianism is Not Yet a Science. SSRN
            Working Paper Series, 1966438: 1–20. URL
            Kakarot-Handtke, E. (2014). Mr. Keynes, Prof. Krugman, IS-LM, and the End of
            Economics as We Know It. SSRN Working Paper Series, 2392856: 1–19. URL
            Keynes, J. M. (1973). The General Theory of Employment Interest and Money. London, Basingstoke: Macmillan.
            Tómasson, G., and Bezemer, D. J. (2010). What is the Source of Profit and Interest? A Classical Conundrum Reconsidered. MPRA Paper, 20557: 1–34. URL

  7. Nick Estes says:

    Abba Lerner explained in 1941 in The Economic Steering Wheel how a rational society would maintain high levels of employment without significant inflation. He explained that a sovereign government with its own currency does not need to tax or borrow to obtain the money it needs to spend on its programs, since the government can always create all the money it needs. Instead we tax to limit the amount of aggregate demand to prevent inflation, and borrow and lend to affect the interest rate. If that were understood and acted upon by our public leaders, we would never have to suffer recessions again, nor the absence of near-full employment. We would just set the budget deficit at the amount appropriate to maximize employment while keeping inflation at 2-3%. We wouldn’t borrow to cover the deficit, just create the necessary money as we go along. If, for various debated reasons, private demand is perennially insufficient to yield full employment, it doesn’t really matter–we just run perennial government budget deficits to make up for it. We don’t borrow this money, we create it, so the national debt (which freaks people out) never rises (except as part of managing interest rates). That’s it.

    Our failure to do this completely explains the poor performance of our actual economy. Many things can hamper or improve the growth rate of our potential economy (most of the items listed by Mankiw) but only the level of demand affects how close we bring our actual economy to our potential. The level of demand is completely within our control–if only we knew it. –Nick Estes, Albuquerque

  8. Nick Estes says:

    Please add at the beginning of the previous comment: “Do Economists Understand Economies?” Abba Lerner did.


  9. Jonathan says:

    Everyone interested in this subject (and actually, everyone else too) should read: