Models and Hunches
By Arnold Kling
I am possibly going to speak on a panel in a few weeks on the issue of U.S. unemployment. I am thinking of trying to convey two ideas (is that too many? I only have ten minutes).
1. Do not trust anyone who answers the question, “How many jobs will (or did) policy X create?” If economic models were as reliable as decision-makers wanted them to be, we would not be where we are today.
2. Policy going forward will necessarily be based on hunches. Keynes’ hunch was that there was too much saving. This was part of his general antipathy toward Victorian values. My hunch is that the recovery depends on profits. This is part of my general antipathy toward firms that raise funds from capital markets rather than from sales to customers (I had a front-row seat during the Internet bubble, when going public without profits was the standard business model).
I will elaborate a bit below.1. Models and Delusions
Early in my career, I worked on econometric forecasting models at the Federal Reserve Board. I became very disillusioned with the reliability of those models. I still do not believe that we can use econometrics to answer important questions in macroeconomics. I should point out that the models that claim to estimate that the stimulus helped to increase employment are the same models that forecast that by now unemployment would be under 7.5 percent an falling.
The next step in my career was to work at Freddie Mac on models to forecast house price defaults. I think that those models were useful, but decision-makers did not want to hear how uncertain we were about our results. I remember when my boss and his managers had our first meeting with the Chief Operating Officer, and the COO asked us about the accuracy of our estimates of likely default costs in multifamily.
At the time, I was young and naive, so I blurted out an honest answer. I said, “factor of 2.”
“Do you mean 2 basis points?” asked the COO. That would have meant that if we said expected default costs were 50 basis points, the right answer was between 48 and 52 basis points.
“No,” I replied. “I mean that if we estimate 50 basis points, the answer could be anywhere from 25 basis points to 100 basis points.” The COO became so incensed at my seeming flippancy that when we left we thought that he was going to fire all of us by the next day. Fortunately, that did not happen.
Years later, I can see that communication about the uncertainty in model estimates was not so blunt. If it had been, then nobody would have been convinced that you could create so much AAA paper out of subprime mortgages, or that regulators could allow the kind of leverage that they did at banks, which presumed narrow margin of error in estimates of mortgage defaults.
2. Hunches and Policies
John Maynard Keynes was part of a generation that rebelled against Victorianism. Keynes thought that the Victorian focus on saving and deferred gratification was excessive and outmoded. One can regard his macroeconomic recommendations as influenced by this visceral antipathy toward saving.
My own prejudice is that I dislike firms that raise funds in capital markets. I prefer firms that make profits and reinvest internally. My macroeconomic recommendations reflect this prejudice. I would like to focus on increasing profits and the demand for labor.
1. Eliminate the corporate income tax.
2. Eliminate all housing and mortgage subsidies, including the mortgage interest deduction.
3. Make all compensation taxable, including health insurance.
4. Eliminate the employer contribution to the payroll tax. This might be phased back in as the economy returns to full employment.
I am not sure how these four policies balance out in terms of the Budget. If they would increase the deficit, then I would try to find other spending programs to cut. If they would reduce the deficit, then I would not try to find offsetting tax cuts or spending increases.