Economic humility

Pity poor Ben Bernanke. A scholar of the Great Depression and of the Fed's response, he is getting hit from both sides for his reaction to the recent financial turmoil. Half of the professional economists are blaming him for acting too slowly and the other half are blaming him for acting at all. The third half (remember, each economist gets two opinions - "on the one hand and on the other hand") doesn't know what to think -- they are waiting for the empirical evidence.

Even two of my favorite economic columnists are split. James Surowiecki of the New Yorker worries about moral hazard (where investors act recklessly knowing that someone will bail them out) and argues against the move (Beware Bailouts):

Cutting the discount rate is not going to help subprime borrowers get new loans, nor will it get the housing market moving again. What it will do is reassure investors and save some money managers from well-deserved oblivion. It may be that the risk of a full-fledged credit crunch was high enough to make this worth doing. But there is something unseemly about watching the avatars of free-market capitalism rely on the government to pay for their bad bets. And there is something scary about contemplating the even bigger bets they’ll make in the future if they know that the Fed is there to bail them out.

Here's a question for all those carping about how the Federal Reserve, in offering to pump cash into the financial system last week, was bailing out lenders and investors from the full consequences of their bad decisions:
Why have a central bank, if not to do precisely that?

The original purpose of the Fed was not to try to manage the ups and downs of the business cycles or prevent the outbreak of inflation, though those have become the central focus in decades since World War II.

Rather, it was for the government to step in when investors and lenders get so fearful that they begin to pull back from making even sound loans and investments, draining from the economy the credit that is its lifeblood. That's what happened during a series of financial panics in the late 19th and early 20th centuries. And it was to prevent a recurrence of those panics that the Fed was created.

My own sense is that the moral hazard concept is one of those ideas that is better in theory than in practice. It has too long been a crutch used to argue against any government action -- such as bank deposit insurance. The personal history of those who have made bad financial mistakes is not full of forget-and-forgive stories. As one manager was quoted as saying about the risk of not playing it conservatively and switching to safe short-term Treasuries, "we will lose our bonus and may get fired."

We won't know for awhile whether the Fed's recent move was the right thing to do. In fact, I doubt there will even be consensus. We have just seen a new revisionist history of the Great Depression that says Roosevelt got it all wrong (and apparently extols the virtues of Andrew Mellon - the great liquidator whose solution was to just let the collapse happen -- “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. . . . Purge the rottenness out of the system.” as Surowiecki quotes). I will leave it to economist who have studied history, such as Brad DeLong, to articulate the other side. Re-fighting the Great Depression is just the economists version of one of our great American past times, just like some people like re-fighting the Civil War.

We certainly won't agree on economic ideology. What the current argument over the Fed (and the never ending argument about the Great Depression) should teach us is a little economic humility. If we can't agree about what happened almost 70 years ago, if we are still fighting over interpretations of facts and theories of events those past event, then how in the world can we be so certain about our interpretation of events from less than a week ago.

Economics, lacking the controlled experiment, will always be a matter of interpretation. And that is just another word for "after the fact rationalization of a guess." Add on the uncertainty of understanding the I-Cubed Economy. Then layer on the political and ideological dimension. With all that, it is amazing that any decisions get made at all.

Given the circumstances, the best we can hope for is some economic humility. Let’s just admit that we really don’t know – and get on with it.

Then again, that would put all commentators (including this author) out of business.