Why the Solution to Our Economy's Woes Isn't Easy

There has been a lot of talk about how to fix the economy. Unfortunately, the answer isn't simple, and that's why we're seeing so many issues with deciding on an appropriate course of action. I'll give you my take, but then I'll show you why my take is no better than the hundreds of others giving their opinions.

Personally, I believe the Fed should lower both its discount rate and the rate it pays banks on their deposits at the Fed. As to fiscal policy, I would recommend two things:

• A budget plan along the lines of the Simpson Bowles commission, attacking the long term deficits and the unsustainability of Social Security, Medicare and Medicaid
• A flat tax (including no estate tax at all) -- cutting rates, but eliminating all deductions so that it on first blush it would be revenue neutral

Now, here's why my take isn't any different than anyone else's. While the economy continues to suffer from the effects of the financial crisis of 2008, economists offer a wide variety of suggestions to get us out of the quagmire. What may seem strange is that often the suggestions are diametrically opposed. For instance, some recommend more stimulus, while others suggest that more federal spending would only exacerbate the problem.

There's an equal amount of disagreement about monetary policy. Some members of the Federal Reserve Board of Governors believe that more accommodative monetary policy actions are required -- such as cutting the discount rate, lowering the rate paid on deposits at the Fed and engaging in another round of quantitative easing. On the other hand, some members believe that any potential benefits aren't worth the costs in terms of the risk of future inflation.

How do we know what the right policy is? Unfortunately, despite the passion and confidence with which many economists proscribe policy, we can't know whether a particular policy will work. In fact, in some cases we won't know if the solution (even my solution) will do more damage than good.

Unfortunately, economics isn't a hard science like physics. It's a social science like history, political science, humanities or psychology. Thus, there's little that we know for sure when it comes to whether policy actions will be productive or counterproductive. Consider the following story from Barron's.

When Friedrich Hayek won the Nobel Prize for economics in 1974, he embarrassed many economists by noting their failures. Speaking in the midst of great inflation that caused a greater loss of stock-market wealth in the U.S. than the Great Depression, he noted that the inflation was "brought about by policies which the majority of economists recommended and even urged governments to pursue." He added, "We have indeed at the moment little cause for pride: As a profession, we have made a mess of things."

Perhaps all of this uncertainty is why economics has been called the "dismal science." I offer the following two alternative explanations for why economics is called the dismal science.

Bad Track Record The first is the dismal track record of economic forecasters. If we can't even know which set of policies are the right ones to implement, it's no wonder there are no good forecasters. The academic literature provides us with compelling evidence that there are no good forecasters of markets or economies. And if there are no good forecasters, those offering solutions should perhaps be a lot more humble about the wisdom of their suggestions. (For those interested in the subject, I highly recommend Philip Tetlock's Expert Political Judgment and William Sherden's The Fortune Sellers.)

Negative Views The second reason is that economists often point out the negative (and often unintended) consequences of policies typically offered by politicians. The benefits come in the short term, but the negatives arrive only after elections are won or politicians are out of office. The unintended consequences result from failing to ask: "And then what?" For example, rent controls sound good and work in the short term. However, in the long term they typically lead to deteriorating housing stock, shortages and higher rents. Similarly, increases in the minimum wage sound good, but they can lead to higher unemployment and the loss of opportunity for many to obtain badly needed experience and skills.

I'm often asked to comment on the economic situation, including for my opinions (and due to my training as an economist I usually have one). My response is always that while I have my opinions, I usually don't act on them because my crystal ball is always cloudy. The evidence presented should convince you to ignore all market forecasts. Instead, you should focus your energy and attention on developing a well-designed plan and have the discipline to adhere to it. You should also rebalance and manage losses for tax purposes as opportunities present themselves and only alter your plan when any of your assumptions about your ability, willingness or need to take risk have changed.

Photo courtesy of genericface on Flickr.
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