Goldman Sachs Model Evokes Blood-Sucking Leeches: Caroline Baum

Macroeconomics really is stuck in the Dark Ages.

Take “fiscal stimulus,” for example, the idea that the government can step in to fill the void when the private sector isn’t spending and boost economic growth in the process.

Economists have been debating the pros and cons of fiscal stimulus since the 1930s, when John Maynard Keynes diagnosed the problem as one of inadequate private investment and prescribed public spending, financed by borrowing, as the cure.

The discussion hasn’t advanced very much in eight decades. Sure, economists have devised elegant mathematical models that purport to show that $1 of government purchases translates into -- take your pick -- no increase in gross domestic product (the multiplier is zero, according to Harvard’s Robert Barro) or $1.50 of GDP (a multiplier of 1.5, according to Berkeley’s Christina Romer, who was chairman of President Obama’s Council of Economic Advisers when the $814 billion stimulus was crafted in 2009). They haven’t really proven anything.

Keynesian economics went into hibernation in the latter part of the 20th century following an array of stimulus failures on the part of both Democratic and Republican administrations in the 1970s. The only thing the spending stimulated was stagflation.

In the 1980s, inflation came down, the Berlin Wall came down, economists thought the volatility of the business cycle had come down, and the notion of government as the solution went out of vogue.

Keynesians All

All it took was a good financial crisis for the Keynesians to come out of the woodwork.

The debate over fiscal stimulus went viral last week (at least in the geek world) with an economic forecast from Goldman Sachs Group Inc., a counter from Stanford University economist John Taylor (he of the Taylor rule), and an addenda from Goldman yesterday.

The Goldman gang projected an economic drag (that would be the opposite of stimulus) on GDP growth of 1.5 to 2 percentage points in the second and third quarters if House-passed budget cuts of $61 billion for the remainder of fiscal 2011 become the law of the land.

Asked about the Goldman forecast Tuesday following testimony to the Senate Banking Committee, Federal Reserve Chairman Ben Bernanke demurred.

“Our analysis doesn’t get a number quite like that,” he said. “Two percent is an enormous effect.”

He could have added: “especially when the rest of government is growing.”

Wrong on Everything

“Total government spending is up 6.7 percent in 2011 from 2010,” Taylor told me in a telephone interview.

Defense spending is rising, as are non-discretionary outlays for programs such as Medicare and Social Security that are on automatic pilot.

The proposed cuts would reduce non-defense non-security discretionary spending, a teensy share of the federal budget, back to 2008 levels.

In a Feb. 28 blog post, Taylor said Goldman’s analysis was “wrong.” He criticized it for failing to consider the beneficial effects that expectations of lower future deficits and smaller tax increases would have on the economy. He criticized the methodology for relying on the same “large multiplier theory” used to justify the 2009 stimulus. And he criticized the assumption that proposed spending equates with actual spending, which trickles out over time.

Aside from that, Mrs. Lincoln, the Goldman analysis was spot on.

‘Alchemists and Quacks’

This fundamental disagreement among professional economists about whether government spending helps or hurts represents the state of the art, or science, today. In what other science do practitioners design a treatment plan based on inconclusive proof that the medicine does any good?

There are no control studies in economics, no way to hold everything else constant to determine the impact of one variable, no way to falsify conclusions that models spit out. Financial Times columnist John Kay, writing yesterday about risk modelers, referred to them as “alchemists and quacks.”

A bit harsh, perhaps, but he’d probably hold macroeconomic models in the same high regard.

Whenever oil prices spike, modelers instantly project how much the increase will subtract from GDP growth. No mention of why prices are rising. Is it the result of a supply shock, which results in higher prices and reduced quantity demanded, or an outward shift in the demand curve, which equates with higher price and quantity demanded? There is a difference.

Known Knowns

In microeconomics, which is the study of how individuals and firms interact in specific markets, certain truths are self-evident. Which doesn’t mean economic planners can see them. Governments across Asia right now are using subsidies and price controls to ease the pain of higher oil and food prices even though their actions will exacerbate the crisis.

Goldman countered Taylor’s critique with a clarification. The projected 1.5 to 2 percentage point hit to GDP was to the quarterly annualized growth rate, not to the level. Thanks for that.

As I said before, we entered the 21st century with macroeconomics still looking for an Age of Enlightenment.

Five thousand years ago in ancient Egypt, medics used leeches to suck the blood of ill patients, believing the practice could cure everything from fevers to food poisoning.

Today’s physicians have largely forsaken bloodsuckers for modern medicine. It’s about time macroeconomics emerged from the Dark Ages as well.

(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)

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