Limits in predicting economy's response to major policy changes

The analysis of academic economists will only go so far in predicting how the economy will respond to major policy changes.

The analysis of academic economists will only go so far in predicting how the economy will respond to major policy changes.

Over the last month, reporters have been calling academic economists and asking important practical questions. Health economists have been asked how the Obama health care legislation will affect the budget deficit. Environmental economists have been asked how California's climate change mitigation legislation (AB32) will affect the state's economy? Will this legislation accelerate California's growth or prolong the current recession?

On health care reform, here is the CBO's attempt to crunch the data.

Here is the California Air Resources Board's updated economic analysis of the scoping plan.

"The Climate Change Scoping Plan provides California’s blueprint for reducing its greenhouse gas (GHG) emissions to 1990 levels by 2020 as directed by AB 32, California’s Global Warming Solutions Act of 2006. In approving the Scoping Plan, the California Air Resources Board (ARB) directed ARB staff to update the analysis of the economic effects of implementing the Plan. That updated economic analysis, documented in this report, profited from consultation with members of the Economic and Allocation Advisory Committee (EAAC), appointed by California Environmental

Protection Agency (Cal/EPA) Secretary Linda Adams and ARB Chairman Mary Nichols. EAAC consists of top economists, business and financial leaders."

Subtle thinkers should note that the Lucas Critique is highly relevant in both cases. "The Lucas critique, named for Robert Lucas′ work on macroeconomic policymaking, supports that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data."

In both the health reform case and the California carbon mitigation case, I don't believe that economists have been completely honest about the fundamental uncertainty lurking here. The policy makers are getting ready to run two major policy experiments but economists can't be confident that we know what will happen next. The main reason for this is that we are not strong at predicting how technological change's "direction" is affected by major government policy shifts. We also do not know the key "elasticities" of how behavior will change as the policies shift incentives. For example, in the case of health care reform --- will the uninsured, who will now be covered by insurance, take better care of themselves and how healthier will they be?

In economic policy discussions, economists are used to being asked smaller questions such as; "if we raise the minimum wage from $7 to $8 will this have unintended consequences?" Compare this "small" policy change with the major incentives changes bundled into the health care bill and the carbon mitigation legislation. When modest economists shrug and say, "I don't know" what will happen next? The vacuum is filled by "policy entrepreneurs" (recall Krugman's term) who fill the void by providing the politicians with convenient numbers that they would not be able to defend in an academic setting.

Despite my deep reluctance to support the use of macro CGE models to judge the effects of California's carbon regulation, I am confident about its likely medium term beneficial effects. My optimism is based on the regulation's core focus of "green incentives". If credible (and not repealed by future Republican Govenors), this regulation will nudge households and firms within California to adapt and make choices to decarbonize. This will stimulate induced innovation and the next generation of "green products" through the home market effect. The rest of the U.S and the rest of the world will gain from California being a first mover. I do think that the Obama Administration should think about rewarding California for being such a voluntary guinea pig.

As I get older, I now am starting to believe that the "Nelson/Winters" ugly line about the evolutionary nature of capitalism is the first order issue here.

Static efficiency doesn't interest our students. They care about distribution. Dynamic efficiency --- how we improve our standard of living by innovating our way out of the major challenges we face (cancer, climate change) remains the key question for determining capitalism's benefits.

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