The Truly Dismal Science

by | Jan 22, 2003

In science, you start with a hypothesis. Then you conduct an experiment to see if your hypothesis is true. If the experiment proves the hypothesis wrong, you throw it out and come up with a new hypothesis based on what you’ve learned. I guess economics must not be a science. Because in economics you stick […]

In science, you start with a hypothesis. Then you conduct an experiment to see if your hypothesis is true. If the experiment proves the hypothesis wrong, you throw it out and come up with a new hypothesis based on what you’ve learned.

I guess economics must not be a science. Because in economics you stick with the hypothesis no matter what the experimental evidence tells you. If the world doesn’t work the way you thought it did, then there’s something wrong with the world.

Thus the joke about the economist who told his wife that he found a $20 bill on the sidewalk on his way home from work. Did he pick it up? Of course not — the Efficient Market Hypothesis told him that it didn’t exist.

President Bush’s tax-cut proposal if one of those $20 bills. As I wrote in this column last week, the idea of ending the double-taxation of corporate earnings (by eliminating shareholder taxes on dividends, and excluding retained earnings from capital gains) is brilliant. It will instantly raise the after-tax returns on all investments, and as any investor will realize intuitively, that will stimulate a renaissance in investment and risk-taking. The result: one economic recovery, coming up on the double.

But some economists — especially the ones who are willing to use the language of economics and their own academic credentials for political purposes — are saying that this $20 bill can’t exist. And they’re trying to keep you from picking it up. But don’t be fooled.

One politically liberal economist, UC Berkeley professor J. Bradford DeLong, has come up with a particularly nasty way to use highfalutin economic theory to oppose Bush’s plan. Last week on his website he published a section from a college economics textbook written by Glenn Hubbard, the White House economic advisor who has been the primary architect and advocate of the Bush plan. According to DeLong, Hubbard’s own theories in his own textbook contradict the good things he’s said about the tax-cut — so DeLong is screaming for Hubbard’s resignation, and a rejection of Bush’s plan. It’s the kind of infighting that academics are famous for, but it’s hardly appropriate as a means of deciding public policy.

Here’s the issue. Hubbard presented in this textbook a standard formula that links tax rates, government deficits and interest rates. According to this formula, all else equal, when you cut tax rates the deficit goes up, and because the government has to sell bonds to finance the debt, interest rates go up too — and that would be bad for economic growth. But in advocating Bush’s tax-cuts, Hubbard has been telling the press that in the real world all else isn’t really equal: it doesn’t really work the way it says in the textbooks. Tax-cuts can and do change economic behavior — they make people invest more and work harder — and the resulting increase in economic growth can end up taking care of any deficits.

Hubbard the textbook writer is right. The formula is correct as far as it goes — the problem is that it doesn’t go very far. It’s nothing but a thought-model, an abstraction. The textbook never said that it should be applied uncritically to public policy choices without considering all the complexities of the real-world of human behavior.

So Hubbard the policy advocate is right, too. In the real world, even if tax-cuts end up producing deficits, deficits don’t necessarily lead to high interest rates. Take a look at this chart, prepared by economist David Gitlitz, my colleague at Trend Macrolytics. One glance tells you that the relationship between deficits (the blue line) and interest rates (the red line) are hardly as simple as a textbook model would suggest.

In the early 1990s rates fell as the budget surplus grew — just like the textbook said they would. But then, starting in 1999, interest rates began to soar even as the surplus continued to grow. Now, as the surplus has turned to deficit, rates have fallen again — to once-in-generation lows, no less.

That’s the scientific experiment, folks — and it’s telling the economists to go back and come up with a new hypothesis. But the economists don’t want to do that — especially the ones who have a political agenda, and who take delight in trapping a high administration official in a “gotcha.”

So despite the experimental evidence to the contrary, on Friday we find that Princeton economics professor Paul Krugman has written about DeLong’s “gotcha” of Glenn Hubbard on the editorial pages of no less prestigious a newspaper than the New York Times. Krugman has never tried to hide his political agenda — he’s admittedly pro-Democrat and rabidly anti-Bush. And that’s fine — it’s what newspaper columns are for. But I can’t stand by in silence while the science of economics is misused for obviously political motives.

Bush’s plan is the most exciting pro-growth tax policy in two decades. If enacted, it will trigger an economic boom that will wipe out any deficits it may temporarily create along the way. It’s economic growth that creates surpluses — surpluses don’t create economic growth.

And I write this not as a Republican (I’m not one) nor as a particular fan of President Bush (I’m not one). I write this as an investor — as someone who wants economic growth — as someone who can see a $20 bill on the ground, and has enough common sense to pick it up.

If you’re reading this, you’re probably an investor, too. What does your common sense tell you?

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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