Adam Creighton

Mod­ern econ­o­mists do a lot of num­ber-crunch­ing, but even the num­bers aren’t enough to an­swer some ba­sic ques­tions, writes

The Australian - The Deal - - Economist -

ECO­NOMIC the­o­rems “are de­rived not from the ob­ser­va­tion of facts, but through de­duc­tion”. Early 20th-cen­tury econ­o­mist Lud­wig Mises’ dec­la­ra­tion might seem odd to­day, when econ­o­mists with­out data to back up their ar­gu­ments aren’t taken se­ri­ously. But “arm­chair” eco­nom­ics used to be the norm. Keynes’ fa­mous and in­flu­en­tial 1936 book The Gen­eral The­ory of Em­ploy­ment, In­ter­est and Money was used to jus­tify govern­ment in­ter­ven­tion in the econ­omy, but was highly ab­stract, teem­ing with jar­gon that barely touched on the real world. Adam Smith’s sem­i­nal 1776 work The Wealth of Na­tions – the clos­est thing eco­nom­ics has to a foun­da­tion doc­u­ment – used his­tory and ex­am­ples to ex­plain how free mar­kets un­der­pin pros­per­ity, but his rea­son­ing was largely de­duc­tive.

In fair­ness, the sort of data se­ries that econ­o­mists now take for granted, such as GDP, the dis­tri­bu­tion of in­comes and wealth, and un­em­ploy­ment, didn’t ex­ist then – not to men­tion the com­put­ing power. But be­fore World War II, econ­o­mists, no­tably those work­ing at the Univer­sity of Chicago, be­gan in­sist­ing that eco­nomic the­ory was use­less with­out em­pir­i­cal back­ing. By the 1960s Mil­ton Fried­man, who em­bod­ied the “Chicago school” of eco­nom­ics more than any other, had used data to set­tle a rag­ing de­bate over the causes of the Great De­pres­sion. By painstak­ing ex­am­i­na­tion of mon­e­tary and fis­cal sta­tis­tics from the 19th cen­tury on­wards, Fried­man showed that the US Fed­eral Re­serve – not the “free mar­ket” or a lack of govern­ment stim­u­lus – was re­spon­si­ble. Rather than bol­ster the US money sup­ply, as Fed chair­man Ben Ber­nanke did in 2008, the in­sti­tu­tion in the 1930s let the US money sup­ply shrink by a third, pre­cip­i­tat­ing a dis­as­trous fall in prices.

Chicago econ­o­mists, armed with a grow­ing bat­tery of so­cial and fi­nan­cial data, ex­tended the scope of eco­nom­ics to crime, mar­riage, wel­fare and the bu­reau­cracy, to show that peo­ple’s pri­mary mo­ti­va­tion was self-in­ter­est, what­ever they might like to be­lieve.

Chicago econ­o­mists weren’t against the­ory, but it had to earn its keep, with Fried­man declar­ing that the hall­mark of a suc­cess­ful the­ory was its abil­ity to pre­dict ac­tual out­comes. Fit­tingly, his own con­vic­tion that hold­ing money sup­ply growth con­stant would guar­an­tee sta­ble price in­fla­tion was un­der­mined by the re­al­ity of the 1980s.

While us­ing ad­vanced sta­tis­tics to test eco­nomic the­ory is now stan­dard, some of the thorni­est ques­tions re­main unan­swered. For a start, data can be of poor qual­ity. Up un­til its 1985 edi­tion, Paul Sa­muel­son’s best-sell­ing text­book Eco­nom­ics was still tout­ing the eco­nomic su­pe­ri­or­ity of the Soviet Union, which col­lapsed four years later.

The in­abil­ity to un­der­take con­trolled ex­per­i­ments, hold­ing other fac­tors con­stant, be­dev­ils eco­nomic anal­y­sis. Do de­grees boost grad­u­ates’ in­comes, or were they al­ready more able? Would growth have been slower with­out debt-fi­nanced stim­u­lus? The data can­not an­swer that defini­tively.

And the world’s top econ­o­mists dis­agree about the op­ti­mal rate of in­come tax, with es­ti­mates go­ing all the way up to 90 per cent. De­spite strong ev­i­dence that higher top rates pro­mote tax avoid­ance and eva­sion, whether they ac­tu­ally de­ter in­di­vid­ual ef­fort is much harder to pin down.

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