No Wonder They Call It The Dismal Science!

Economics is sometimes know as "The Dismal Science." Some people who have had to endure introductory university courses taught in a huge auditorium interspersed with lectures from barely coherent teaching assistants think they know why.

But the real reason is demonstrated by the incoherence of the practitioners at the highest levels of government.

Greg Mankiw has held the position of Chairman of the Council of Economic Advisers (CEA). On his excellent blog, the professor today comments on the proposed stimulus package of the incoming administration as analyzed by CEA Chair-designate Christina Romer. The stimulus package is going to be made up of both tax cuts and government spending.

Now I don't want your eyes to glaze over, but these tax cuts and spending proposals have impact on the economy beyond their immediate value. For example, if you cut my taxes by a dollar, I'll probably go spend that dollar at, say, a restaurant. The dollar then gets utilized by the restaurant to purchase more food (raw materials) and if enough people like me decide to go to the restaurant, the owner has to hire an extra cook. That additional spending and hiring results in additional economic activity The initial dollar "multiplies"!

In fact, economists call the amount of the multiplication a "Spending Multiplier." The benefits that you read about in analyses of government programs are all based on "models" (those are just a bunch of formulas) that use assumptions (those are just guesses) about a lot of things including these multipliers.

Now no one really knows what the values are for the multipliers. The models all involve a lot of simplifications and guesses about how the economy works. But, the formulas are calculated by a computer and the results are published by very sober authorities like the Congressional Budget Office so a lot of people (think reporters) believe them and think they are very accurate!

So what is the point of all this? Well, Obama's CEA Chair-designate Christina Romer has used some multipliers in her analysis of the stimulus plan. What are they? Greg Mankiw skips to the penultimate page and discovers that the fiscal policy mutlipliers are:

• For government purchases, their multiplier is 1.57
• For taxes, 0.99

Reasonable? Perhaps. But Mankiw goes on to note:

the recent research of Christina and David Romer, who conclude:

tax changes have very large effects on output. Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent. Our many robustness checks for the most part point to a slightly smaller decline, but one that is still well over two percent.

That is, Team Obama assumes that tax changes are less than half as potent in influencing the economy as the new CEA Chair estimated them to be in her own research.

Mankiw's best advice?

...it is prudent to take any research, including that of the very careful, very sensible Romers, with a grain or two of salt. The same can be said of the mainstream models on which Team Obama is relying.