The Enemy is Still Within Jude Wanniski July 25, 2003

Memo To: Website Fans, Browsers, Clients
From: Jude Wanniski
Re: America's "macro-economists"

This is an op-ed I wrote for The Wall Street Journal on June 27, 1991. I offer it today only to demonstrate how little has changed in the last dozen years. The same institutions make the same mistakes. Note the reference to Harvard's Gregory Mankiw. He is now the chairman of President Bush's Council on Economic Policy.

MACROECONOMICS: The Enemy Within
By Jude Wanniski

Here we are in the last decade of the 20th century, the cold war behind us, Communism a failed experiment, and yet around the world we see almost nothing but economic distress.

Why is the U.S. in recession? Why are Canada, England, Australia and Sweden in recession? Most of Europe is suddenly struggling to stay on a growth track. Japan's stock market is in steady retreat and its dizzy economic growth has slowed. And how is it that so much poverty, unemployment, inflation and debt plague the Third World countries of Asia, Africa and Latin America?

Economists' Advice

These questions lead to a larger one: With so many Nobel laureates in economic science handed out in Stockholm in the past generation, why does the economics profession have so little to show for its skills? Reading these lines, these distinguished gentlemen will huff, "These misfortunes occurred because my counsel was not heeded." Regrettably, the opposite is true: All this misery befell the nations of the world precisely because they acted according to the advice of the economics profession.

Conventional macroeconomics is the most discredited branch of the profession. Harvard's N. Gregory Mankiw apologized for the macro model in a recent essay in "The Journal of Economic Literature" by comparison to astronomy: "At the time it was proposed and for many years thereafter, the Copernican system did not work as well as the Ptolemaic system [showing the sun orbiting the Earth]. For predicting the positions of the planets, the Ptolemaic system was superior.... If you had been an applied astronomer, you would have continued to use the Ptolemaic system."

Yet the influence of macroeconomics dominates the policymaking of a majority of the world's governments. American economic policy is now fettered to the macro model, as surely as Marx's theory guided the Soviet Gosplan. As a result of the budget agreement between the Bush administration and the Democratic Congress, the macro computers actually control policy. A tax rate can't be reduced unless the computers predict positive revenue effects. The most damaging error results from the computer assessment of the president's proposal to cut the capital-gains tax.

The same model is responsible for most of the economic misery in the Third World, thanks to the International Monetary Fund. Faced with galloping inflation and collapsed tax revenues, the IMF's macro model recommends devaluations and tax hikes to reduce demand. In every case, these measures have increased inflation and lowered tax revenues, as individuals defy government attempts to steal their savings and confiscate their income.

Macroeconomics founders upon a grotesquely elitist premise, namely that manipulation of aggregate demand or money supply or some other "macro" variable can homogenize the behavior of millions of individuals. The economics profession, liberal and conservative, peddles this elitism under the guise of "science." If we assume that individual human beings behave as uniformly as hydrogen molecules, we can write mathematical equations describing an economy. The academic economics curriculum has become as mathematical as the physics department. The further away economics strays from reality, the better it can be sold as "scientifically precise." We have been beguiled by the mirage of scientific surety, giving up in exchange the free exercise of economic policy.

Throughout the past few centuries, up until the late 1940s, economics was thought to be, at best, a behavioral science, no more precise than psychology or political science. Indeed, men and women who practiced it thought of themselves as "political economists," the two disciplines inextricably linked. They only could guess at how human beings would react under different economic circumstances triggered by various political events.

By liberating themselves from political science, economists were free to convert economic behavior to mathematical notation. In the 1940s, John Maynard Keynes's Marxist students at Cambridge University attempted to deal with the mathematician John von Neumann's proof that no mathematical model could cope with innovation. Changing technology, von Neumann proved, would collapse any possible system of equations. Common sense tells us the same thing: How does a mathematical model of vacuum-tube production predict the future output of micro-chips?

The economics profession, though, turned von Neumann's argument inside out, and excluded consideration of innovation in order to promote their mathematical model. In the early 1950s, a young American still in his Marxist phase, Lawrence Klein, refined this work into the first econometric model of the U.S. economy, for which he won the 1980 Nobel Prize. Mr. Klein's work provided the foundation for Wharton's econometric model, and altered the outlook of the economics profession ever after.

By treating individuals like identical hydrogen molecules, macro models crank out policies that manipulate demand, while destroying individual incentives to produce. Relying on their equations, economists in the early 1970s confidently asserted that the dollar could be devalued with predictable, beneficial results. If the dollar could buy fewer Japanese yen, the U.S. would import less. If the yen could buy more dollars, Japan would import more from the U.S. Almost without exception, liberal and conservative Ph.D. economists agreed on the general outcome. In 1971, President Nixon was persuaded to end the dollar's gold guarantee in order to permit devaluation.

People, through, are not hydrogen molecules. They did not sit still in accordance with the economic assumptions built into the computers, passively accepting the government's manipulation of the currency. As they saw their hard-earned dollars and dollar assets losing purchasing power against gold and foreign exchange, they shed dollars for gold and foreign exchange. The "velocity" of dollars, which monetarists assumed would remain constant, increased dramatically as citizens tried to get rid of them in favor or more reliable assets. None of the gains promised by the gains promised by the economists was realized in the inflation that followed. The world's central banks are now groping their way back to monetary stability.

Another massive failure of the econometric models is at the heart of the current U.S. recession. This is because the econometricians, unable to convert "risk taking" and "innovation" to mathematical notation, banish them from their equations. Economic growth, thought, results from individual initiative and innovation. The U.S. now subjects policies designed to foster innovation to computer models that explicitly exclude innovation from consideration. While the capital gains tax is not the only example, it is surely a clear one.

A lower capital-gains tax increases the after-tax reward for risk-taking and innovation. The federal tax burden has increased enormously during the past 20 years of inflation and in a micro-economic (or supply-side) analysis, has been smothering economic growth and will continue to do so. Cutting the rate to 15% and eliminating it entirely after a three-year holding period would have dramatic effects on economic growth and increase state and local revenues as well as federal revenues. It also would revive American competitiveness with Japan, where capital gains have been taxed little or not at all.

Ignore Innovation

Yet when the computers are asked what happens to economic growth with a lower capital-gains tax, they answer: "Not much." They have been programmed to ignore the effects of risk-taking and innovation.

Perhaps some day a brilliant macro-economist will find a way to capture the divine, infinite variability of human behavior in mathematical notation. We might then consider turning policy- making in the world economy over to the computers. Until that day, they are a menace to us all. They are the enemy within.