Here’s the story so far:
- Sanders, running as a Democrat, has proposed sweeping changes on the campaign trail. Proposals that are quite far to the left of Obama, and arguably further left than any presidential hopeful since Wallace in the 1940’s.
- A letter supporting Sanders was signed by 170 economists.
- Friedman wrote a paper providing economic support for Sanders’ claims.
- This does not attract much attention since the claims sound too good to be true. Sanders has been making claims like that for a while, and he didn’t attract much attention before Christmas.
- Four former chairs of the Council of Economic Advisors (Krueger, Goolsbee, Romer, and Tyson) denounced all the above.
- Galbraith fired back with a letter noting some flaws in that argument, and emphasizing that Sanders’ proposals get big results from big changes.
Now we have a paper from Christina Romer and David Romer. She’s the Romer listed above. They’re both macroeconomists at Berkeley. David Romer wrote the first level Ph.D. macroeconomics text that just about everyone uses (including me when I taught that class from 2008 to 2011 as a guest at another university).
It’s scathing on the majority of issues, and presents them at an accessible level. More on that later (even though this is what the media will focus on).
But they were very diplomatic about a technical issue. They can’t explain a result that Friedman got. But they’re willing to speculate. And their speculation is that he made a conceptual mistake in his economics that led to math errors.
That’s a big deal: presidential candidate makes economic proposals that sound too good to be true supported by economist that can’t do the economics right.
Even better, the mistake is at an advanced undergraduate level, and related to issues covered in your handbook. They relate to growth vs. level effects, and permanent vs. transitory effects of macroeconomic shocks.
An example from retirement planning may be helpful.
When investing, everyone tries to get an edge: either a better return from the same risk, or the same return from less risk. If you can do that, you can permanently outperform your competitors. Not surprisingly, an investment edge that yields permanent performance improvements is very hard (if not impossible) to find. Instead, most of the time if you get an edge it’s transitory: you beat the market for a bit, but someone mimics what you’re doing until that edge is arbitraged away.
As to growth and level effects, which would you rather have gifted to you: access to a better return on your investments, or a lump-sum gift? Most people would prefer the access to a better return, because with compounding eventually you’ll make more money. That’s a growth effect because it helps your investment grow. A lump-sum gift, like an inheritance, is a level effect: it increases the level of your investment … but just once.
The way that it works almost any time someone gets an investment edge is that they get a transitory growth effect, that makes permanent improvements to the level of their investment. Basically, good luck makes your investment bigger, but you can’t plan on it. The whole point of learning about efficient markets in your finance classes is that permanent growth effects are very hard to come by, and if you could develop one it would require a lot of input on your part each period to sustain.
That whole argument carries over to macroeconomics. We think most shocks have transitory effects on growth rates, so to maintain a growth effect you need to somehow continue providing beneficial shocks to the economy. If you do that, you could get a bigger level effect every period.
So what do Romer and Romer find in Friedman? They can’t explain some of his more outlandish assumptions about growth. Here’s what they suspect: Friedman presumed that a temporary shock to growth rates had a permenent effect on them, leading to estimates of ongoing growth and level effects. In the investment example, this is like assuming that one lucky stock pick in turn makes all your stock picks lucky … forever … and your investment nest egg pulls away rapidly and permanently from your competitors. The implication is that Friedman’s work is no better than a fairy tale.
We have a conjecture about how Friedman may have incorrectly found such large effects. Suppose one is considering a permanent increase in government spending of 1% of GDP, and suppose one assumes that government spending raises output one-for-one. Then one might be tempted to think that the program would raise output growth each year by a percentage point, and so raise the level of output after a decade by about 10%.
To the public, this sounds like jargon. To a macroeconomist, this sounds like “made a mistake on Tufte’s ECON 3020 Exam 3 that he’ll take off full credit for”.
I remarked above that the surface issues of Romer and Romer are more accessible to the general public. Here’s their summary of what they find (their original had emphasis that does not come through a cut and paste operation):
Unfortunately, careful examination of Friedman’s work confirms the old adage, “if something seems too good to be true, it probably is.” We identify three fundamental problems in Friedman’s analysis.
• First, all the effects of Senator Sanders’s policies that he identifies are assumed
to come through their impact on demand. However, his estimates of those
demand effects are far too large to be credible—even given Friedman’s
• Second, in assuming that demand stimulus can raise output 37% over the next
10 years relative to the Congressional Budget Office’s baseline forecast,
Friedman is implicitly assuming that the U.S. economy is (and will continue to
be for a long time) dramatically below its productive capacity. However, while
some output gap likely still exists, the plausible range for the output
gap is much too small to accommodate demand effects nearly as
large as Friedman finds. As a result, capacity constraints would likely lead
to inflation and the Federal Reserve raising interest rates long before such
high growth rates were realized.
• Third, a realistic examination of the impact of the Sanders policies on
the economy’s productive capacity suggests those effects are likely to
be small at best, and possibly even negative.
I encourage you to, but won’t require you to, read the Romer and Romer paper. It’s fairly accessible, and has lots of clear thinking about the data, different viewpoints, and how economists assess policy.