Economics: Disease and Cure

Humans appear to have been practicing medicine since before civilization. Early medicine was based on a mixture of experience, folklore, and superstition. This or that herb or practice sometimes helped this or that condition. Surgery gradually improved with knowledge of anatomy, and the discovery of bacteria gave insight into the nature of many kinds of disease. Advance beyond superstition and nostrum required understanding of how the machine worked at the cellular level and below, though.

Economics, I think, seems firmly lodged in the era of superstition and nostrum. Neoclassical economics has developed elaborate mathematical models, but they lack predictive power and depend on approximations that are too unrealistic to support them. The first requisite for a scientific approach to a cure is to identify the disease and its process. It’s at this point that neo-classicism meets its most fundamental challenge – its optimization assumptions essentially deny the possibility of disease. In Chicago, the economy always lives in the best of all possible worlds.

No doubt you have noticed that I slipped in a possibly suspicious assumption here: the analogy of the economy to an organism, and moreover the assumption that certain states of the economy were disease states. Certainly the economy, or any national economy, is as much a super-organism as any ant colony, bee hive or termite colony, and it’s entirely reasonable to speak of health and disease in such aggregations.

Paul Krugman has a diagnosis of our current distress, and a suggested cure. The diagnosis is probably not so controversial:

America’s economy isn’t a stalled car, nor is it an invalid who will soon return to health if he gets a bit more rest. Our problems are longer-term than either metaphor implies.

And bad metaphors make for bad policy. The idea that the economic engine is going to catch or the patient rise from his sickbed any day now encourages policy makers to settle for sloppy, short-term measures when the economy really needs well-designed, sustained support.

The root of our current troubles lies in the debt American families ran up during the Bush-era housing bubble. Twenty years ago, the average American household’s debt was 83 percent of its income; by a decade ago, that had crept up to 92 percent; but by late 2007, debts were 130 percent of income.

All this borrowing took place both because banks had abandoned any notion of sound lending and because everyone assumed that house prices would never fall. And then the bubble burst.

What we’ve been dealing with ever since is a painful process of “deleveraging”: highly indebted Americans not only can’t spend the way they used to, they’re having to pay down the debts they ran up in the bubble years. This would be fine if someone else were taking up the slack. But what’s actually happening is that some people are spending much less while nobody is spending more — and this translates into a depressed economy and high unemployment.

What the government should be doing in this situation is spending more while the private sector is spending less, supporting employment while those debts are paid down. And this government spending needs to be sustained: we’re not talking about a brief burst of aid; we’re talking about spending that lasts long enough for households to get their debts back under control. The original Obama stimulus wasn’t just too small; it was also much too short-lived, with much of the positive effect already gone.

It’s true that we’re making progress on deleveraging. household debt is down to 118 percent of income, and a strong recovery would bring that number down further. But we’re still at least several years from the point at which households will be in good enough shape that the economy no longer needs government support.

The cure is the more controversial part. Krugman wants a long term government stimulus. This would inevitably pile up a lot of government debt. It’s a good tradeoff, says Krugman. The government can borrow cheaply right now, and the stimulus would boost the economy enough to make up a big chunk of the lost revenue. The core of the argument is that everybody loses when a large fraction of the work force is idle – the goods they could produce if they were working would make everybody richer.