How to think about the economy
A regular theme of my writings is that we can’t really predict the future. My focus when emphasizing that point has tended to be on the economy and electoral politics, but it applies to many other areas, too. While we can’t really predict the future, especially the distant future, that’s not the same thing as saying we know nothing at all. We have plenty of history to look at as well as things going on now that we can observe.
Over the last fifteen years, we have learned a lot about the economy, both domestically and globally. That may or may not be a guide to the future, but it has told us things we didn’t know before or had forgotten. I have no hard, fast rule for trying to understand the economy of today. It’s unlike anything we have ever lived through.
What can be frustrating about dealing with economic downturns is that each one is caused by something different. The effects can be similar, i.e., a rise in unemployment, but the cause is from completely different sources. That means any long-term reforms enacted will have to address different things. For example, a downturn caused by the financial sector should be dealt with in part by addressing shortcomings that existed in the financial system.
A subtheme of my writings has been warning against believing in what I call One Neat Trick. That’s the idea that if you just do this one thing it will work every time. Very few people explicitly say something like that, but many imply they believe it. There’s no such thing. There’s no one thing you can do that will always work no matter what. That applies in economics and politics, but probably applies most everywhere else.
Although there are no absolutes when it comes to dealing with economic downturns, there are some broad ideas that I think almost always have their place. One of those is to avoid fighting the last battle. For example, in the case of dealing with the economy after the financial crisis, enacting reforms that dealt with the financial sector was right. It would not have been right had it been done in reaction to the pandemic. Bash banks all you want for what happened in 2008, but they had nothing to do with what happened in 2020.
It should be clear from the last two downturns that demand can be impacted by government policy for the better. The failure to provide adequate stimulus after 2008 was the reason the recovery was so slow. Economists and others came up with many alternative reasons for why the recovery was so slow such as the “skills gap,” video games, government benefits and job automation. None of that was true.
Today, there seems to be a consensus that inadequate stimulus was the reason for the slow recovery. That was a good thing in 2020 as just about everyone supported the CARES Act when it was passed as the pandemic was taking hold. Because of the huge amount of aid provided in 2020 and 2021, demand was boosted and didn’t fall along with supply. Not only was a depression averted, but the recession that happened was over in a matter of weeks.[i]
In a market economy, the private sector is what drives the bulk of demand. A downturn is usually what happens when it doesn’t do that. When the private sector doesn’t do that, the federal government can step in and temporarily substitute for it. Exactly what form it should take and how big it should be depends on the circumstances. That’s Keynesian economics in a nutshell.
We don’t know what the economy will look like even in a short while. What we do know is that policy can have a big impact on it. Economics is supposed to be a science, but it has much more in common with philosophy than chemistry. There is no economics equivalent of Newton’s laws of motion.
That’s very unsatisfactory because it makes things much more complicated, but it’s the reality of how economies work. The fact is sometimes things can be needed and others times not. I just talked about how important stimulus measures are to boosting demand when the private sector isn’t doing it. However, that's only something that should be done when the economy is taking a hit. It also has to be weighed against other considerations such as inflation and interest rates. Those should not have been concerns in 2008 or 2020, but they are now.
When interest rates and inflation are high, stimulus measures are usually not desirable. Stimulus measures are also temporary and are not meant to become permanent programs. As for interest rates, whether they should be high or low varies as well.[ii] Higher interest rates today are justified because of high inflation whereas for the prior fifteen years they weren't given how low demand was.
What is the economy most like?
It seems like many, if not most, in the economics profession view the economy as similar to a computer. Economists aren’t the only ones I think are guilty of that. Many people in the business and financial world seem to think like that. The last three years alone should drive a stake through the heart of that analogy.
In the computer analogy, mathematical models can be used to predict the economy’s every move. Like a computer, the economy can only do the things it’s programmed to do. Creating the right model isn’t easy, but once it’s done it can predict where things are headed with solid accuracy. By looking at past events, future events can be predicted with virtual certainty. For example, the inflation of the 1960s and 1970s followed a certain path and ended with a recession. Therefore, it’s going to happen again.
Historically, when central banks deal with inflation, unemployment goes up. There has long been a tradeoff between unemployment and inflation and so it will happen again. We know that because models can look at datasets incorporating every past episode. Just plug in some variables and play around with them and you get every possible outcome.
Math and statistics, combined with historical experience, tell us what the possibilities are. In the case of inflation today, it can only be brought down with a rise in unemployment. Achieving a soft landing where inflation goes down without a recession is impossible.
If it sounds like I’m being snarky, that’s because I am. The last year has discredited that idea and many others that were long thought to be on solid ground. As I wrote in a piece about the economy recently, if we have a recession it won’t be inevitable. It will be a policy choice.
To state the obvious, I think the computer analogy is wrong. The economy and computers are both created by people and that’s where the similarities end. In my view, the economy should be thought of as more like the weather and climate. Both of those are things we’re knowledgeable of, but both are things that still catch us off-guard. Weather frequently does that with natural disasters of all sorts.
Weather and climate are things that we don’t control although we can have some influence, i.e., climate change. To the extent we have an influence on the climate, it’s in the aggregate through our collective actions, i.e., energy usage. Economies are like that, too. The US and global economy are way too big for any individual to have a meaningful impact although Beyonce and Taylor Swift come close.
Like the weather and climate, economies can throw curveballs at us when we’re expecting a fastball. Recessions tend to happen when nobody expects them to. Things that seemed like sure money makers turn out to be worthless. Things that were thought to have no correlation suddenly turn out to be highly correlated, i.e., housing markets across the US.
I like to think of the immediate and shorter term economy as like the weather and the longer term economy as like the climate. We’ve had plenty of difficulty predicting the post-pandemic economy just a few months out. We have no way of knowing what the economy in thirty years will look like.
I use the weather/climate analogy for lack of a better one. I think it’s better than comparing the economy to a computer, but it’s not perfect. Climate isn’t necessarily easy to predict but there are some broad assumptions that are very reasonable. For example, in Houston right now it’s boiling hot and it’s safe to assume that will be the case during the summer in thirty years. What will the economy here look like? Some broad assumptions can be made, i.e., we’ll have a big energy sector, but beyond that nobody knows.
It seems highly likely that in thirty or more years the world will be warmer than it is now. That will probably be true almost everywhere. There will still be cold winters, but they may not be as cold as they are today. What kind of effects will that have? It almost certainly will have big impacts on many aspects of life, but exactly what, when and where are unknown. Despite those uncertainties, predicting what the climate will look like decades from now is much easier than predicting what the economy will look like.
As with predicting the climate, predicting the weather is easier than predicting the short-term economy. It’s not hard to predict where the economy will be in a week, but in six months is anyone’s guess. It may be better than it is now or it may be worse. With weather, we know broadly what things will be like in a few months, but that doesn’t tell us about what kind of natural disasters will happen, if any. For example, how bad the winter storm that hit Texas in 2021 was going to be didn’t become apparent until it was happening.
I think natural disasters can be somewhat analogized to recessions, but the emphasis is on somewhat. Recessions are notoriously difficult to predict, especially by economists. I’m not sure what the meteorologist track record is with predicting natural disasters, but I’m hard pressed to think it’s worse. Natural disasters can often be predicted, which is good as it gives people a chance to protect themselves. The window to do that is usually short, but it can give people enough time to prepare and can be the difference between life and death.
There are some possible recession signals, but none are scientific like what we have for hurricanes. What makes the recession/natural disaster analogy even more fraught is the problem of definitions. Natural disasters are very well-defined. For example, the wildfires in Hawaii are undisputedly a natural disaster. The same is true with blizzards, floods, hurricanes, tornadoes and the like.
The word recession is tossed around all the time, but, believe it or not, there is no official definition of it. A commonly cited definition is used by the National Bureau of Economic Research, which says a recession is “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” There are other definitions used such as the Sahm Rule, but its namesake has emphasized that it’s not absolute and may not apply right now.
For normal people, what constitutes a recession is even more amorphous. In polls taken during the last year, most Americans believed the economy was in a recession. Whatever competing definitions economists use, none of them would have included this year or last year. A normal person can believe the economy is in a recession based on vibes alone no matter what economic statistics show.
The upshot
The differences between weather/climate and the economy are why I think the analogy isn’t without many flaws. One area where I think it helps is in justifying policy. It’s true that we know little about what future economies will look like and that we’ll be in for many surprises. It’s wrong to conclude that means we should have no policies in place. The same is true for the weather and climate.
When it comes to weather, we have plenty of policies in place to deal with natural disasters. That’s one of the few areas that has managed to mostly avoid contamination by partisan politics. As for climate change, there is a lot we don’t know. There is a lot that we do know and I believe it’s enough to justify taking action on it. That’s why I think the Inflation Reduction Act is very good and why I advocate for permitting rule changes to make it easier to expand all kinds of clean energy.
It’s true we don’t know exactly what kind of effects climate change will have in the future. It could be that whatever changes happen are minimal and we adjust easily. Conversely, the effects of it could be very bad. Even if the chances of the latter are low, that’s not a risk we should take. That’s why we should move away from dirty sources of energy although not in the way many environmental advocates want to.
Similarly, we don’t know what the economy will look like decades from now or even a year from now. What we do know is that we have tools available to deal with downturns. We know from 2020 and 2021 that fiscal and monetary policy can make a big difference when used adequately. I don’t think policymakers should try to prevent downturns from happening altogether. There's just no way to know, for example, what is a bubble and/or when it will burst. The best approach is to be ready to act when it happens.
In dealing with economic downturns, it’s prudent to be leaner in good times. I think the focus on deficit reduction was wrong in the 2010s, but is right today when interest rates and inflation are high and unemployment is low. Simpson-Bowles was wrong in 2010, but would be right if it happened now. Setting up a similar committee would probably be a good idea.
As necessary as it was to run high deficits during the pandemic, it’s over now and running big deficits as a matter of due course isn’t good. If another downturn happens necessitating large stimulus measures, the federal government will need to have low borrowing costs. If the current fiscal trajectory continues, that may not happen.
Like with fiscal policy, monetary policy should be prudent as well. That means no longer having interest rates at zero for years. The situation today is very different from what it was in the 2010s. I don’t know what the federal funds rate will be in a year nor do I have any idea how long it should stay where it is. Still, it’s likely to be necessary for it to be above zero going forward. That will be good because if the economy starts to slow significantly, the Fed can step in to cut it.
I’m sure someone can think of a better analogy for the economy than the weather/climate. For now, it’s the best I can think of. No matter what analogy is used, if any, the computer analogy should be thrown out. The economy isn’t something whose every move can be predicted. Models can make guesses, but they’re just that and they’re highly unlikely to able to predict things that have never happened before.
What good would come from throwing out the computer analogy? For starters, a lot more needed humility. That’s something many professions seem to sorely lack. An acknowledgement that we can’t really predict the future and are all fallible would be a welcome development. Just because someone has a 190 IQ, a PhD in math and went to college at age twelve doesn’t mean they have a crystal ball. They’re just as clueless as the rest of us when it comes to prognosticating and it would be nice for them and everyone else to recognize that.
On policy, recognizing that things aren’t set in stone should lead to better decisions. If we believe, for example, that inflation can be brought down without a recession, that opens the door to more and better options when dealing with it. It allows us to solve one problem without having to cause another. Tradeoffs exist, but they aren’t always set in stone and sometimes we can have nice things.
[i] That doesn’t mean everything was wonderful and great. Job losses ended relatively quickly, but it took a while for all of it to come back.
[ii] I hate it when people are referred to as inflation hawks or doves. There are times like now when being a hawk is good and times like last decade when being a dove is good. Nobody should ever always be one of those things.