Unlearning Economics

There is a common misperception that the essence of economics is predicting whether GDP will fall by 2 percent or 1 percent next quarter. In fact, this is the weakest part of economics. The strongest part explores whether our descriptions of economic behavior make sense. Of late, we’ve been ignoring the best of the field’s findings.

Economists such as Nobel Laureate Robert Lucas showed the economic implications of the aphorism “you can’t fool all the people all the time.” If people have a reasonably good grasp of how the world works, policies like Keynesian fiscal stimulus will encounter some serious difficulties. If you borrow lots of money on people’s behalf, they will understand that these bills must be paid back or inflated away in the future. That diminishes or eliminates the impact of the stimulus. This led the distinguished macroeconomist Tom Sargent to state in January that the calculations behind the Obama stimulus package “ignore what we have learned in the last 60 years of macroeconomic research.”

More recently, the administration and Congress have moved on to contravene another seminal finding in macroeconomics. Finn Kydland and Edward Prescott won their Nobel Prize for showing the costs a government will incur if it is untrustworthy. Building on the same insight that it’s difficult to fool people, they described situations in which a government would promise restraint, lure in businesses, then switch the rules once the businesses had committed. That works so long as businesses are gullible. Once they wise up, however, their new suspicion of the government makes effective economic policy much more difficult.

Bait-and-switch seems to be the current approach to dealing with banks and GM’s creditors. In October of last year, then-Treasury Secretary Hank Paulson set out terms for banks to receive government money under the TARP. Those terms have since been criticized as too lenient, but this critique often neglects what Paulson was trying to do. Had he driven a hard bargain so that only the most desperate banks would have accepted funds, this would have been an open invitation to start a run on those banks—the government would have separated out the weak from the strong. Instead, Paulson offered terms that were sufficiently generous to draw both the weak and the strong into the program. It was tough to tell which was which; that was the point.

Once these banks were lured in, though, the terms began to change. In February’s stimulus package, the Congress imposed limits on executive compensation and on the hiring of immigrants. These limits applied not just to newcomer banks to the program, but retroactively to those that were already committed. More recently, the Congress has begun to argue that if a bank is receiving public funds, it really should be more charitable toward troubled borrowers, whether a fraying clothier or a rickety automaker. It is not clear how this charity is supposed to strengthen the balance sheets of the troubled banks.

There’s little sympathy for financial institutions right now, but we are unlikely to have an enduring economic revival without them. With the shifting rules of the last 100 days, a banker would have to be either foolish or exceedingly desperate to partner with the federal government. Yet, the Obama administration’s principal plan for salvaging the financial sector is the “Public-Private Investment Partnership.” This has been met with some skepticism.

The other ailing part of our financial structure consists of non-bank lenders, such as bondholders. They, too, have gotten to experience the arbitrariness of recent government policy. In trying to keep GM out of bankruptcy, the administration task force has put forward a plan to trade debt for stock. There are three big creditors: the bondholders, the United Auto Workers, and the government. In bankruptcy court they could all expect to be treated equally. Under the administration-backed plan, according to the Wall Street Journal, the bondholders would get about five cents on the dollar, the UAW about 76 cents on the dollar, and the government about 87 cents on the dollar. Whether or not there are underlying political motives, as the WSJ suggests, there is an arbitrariness that must serve as a warning to future lenders.

President Obama has admirably urged the country to invest in our future. He has highlighted needs in education, health, and infrastructure. He should not neglect another critical area that cries out for investment–government credibility. By resisting the temptation to change the rules in the middle of the game to take advantage of those who have already committed their money, a government makes economic policy much easier for future generations. Or, at least, that’s what our brightest economic minds have found.

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