A Tale of Two Economists

Paul Krugman and Edward Prescott are two distinguished, world class, award winning economists. Krugman has several awards under his belt including the John Bates Clark Medal, "given biannually by the American Economic Association to the economist under 40 who has made the most important contributions to economics." Edward Prescott won the 2004 Nobel Prize for Economics (along with Finn E. Kydland) "for their contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles."

As far as I can tell, these two economists are diametrically opposed on just about every economic policy issue. For example, here are a few of the things Krugman has said regarding the Bush tax cuts:

"The astonishing political success of the antitax crusade has, more or less deliberately, set the United States up for a fiscal crisis."

The tax cuts are "unlikely to inspire any of the positive economic impacts touted by the Bush administration."

"And don't forget that President Bill Clinton's 1993 tax increase ushered in an economic boom."

There are "dire implications for Americans of 25-year crusade against taxes."

So I think it's fair to say that Krugman is thoroughly convinced that Bush's tax cuts were a truly terrible idea.

On the other hand, here are some of the things Edward Prescott has said regarding those same tax cuts:

"President Bush's tax rate cuts were 'pretty small' and really should have been bigger. "

"Lower tax rates provide increased incentives for people to work harder and lead to future economic growth."

"Why Americans work more than Europeans these days. ... Higher European tax rates, which kill the incentive to work harder and longer."

"Reagan's 1986 across-the-board cut ... lowered U.S. tax rates while collecting the same revenue."

"In the early '90s the economy was depressed by the tax increase in '93..."

So not only does Prescott think that the Bush tax cuts were an important step in the right direction, he also thinks that the tax cuts were not nearly big enough. My favorite contrast between the two economists is that Krugman thinks the '93 tax increase "ushered in an economic boom" while Prescott believes that "the economy was depressed by" that very same tax increase.

How about Social Security reform? Here's what Krugman thinks:

"I knew that the commission on Social Security reform appointed by George W. Bush would produce a slanted report, one designed to bully Congress into privatizing the system. But the draft report released last week is sheer, mean-spirited nonsense."

"Privatization dissipates a large fraction of workers' contributions on fees to investment companies. It leaves many retirees in poverty."

"Privatization will fatally undermine Social Security."

One "problem is 'transition costs', ... it's an enormous one."

"So the Bush administration wants to scrap a retirement system that works, and can be made financially sound for generations to come with modest reforms. Instead, it wants to buy into failure, emulating systems that, when tried elsewhere, have neither saved money nor protected the elderly from poverty."

Krugman is strongly against any privatization of Social Security.

On the other hand, Prescott thinks privatization of Social Security is a great opportunity:

"The benefits of such reform extend beyond the individual retirement accounts of U.S. citizens (although that would be reason enough for reform) they also accrue to the economy."

"Regarding labor supply, any system that taxes people when they are young and gives it back when they are old will have a negative impact on labor supply."

"Some politicians have vilified the idea of giving investment freedom to citizens, arguing that those citizens will be exposed to risks inherent in the market. But this is political scaremongering."

"There are no transition costs ... Re-labeling debt is not a cost."
"Further, about two dozen countries have reformed their state-run retirement programs, including Chile, Sweden, Australia, Peru, the U.K., Kazakhstan, China, Croatia and Poland. If citizens in these countries can handle individual savings accounts, especially citizens in countries without a history of financial freedom, then U.S. citizens should be equally adept."

Here again, Krugman and Prescott have absolutely opposite positions. As the last quote from each economist shows, they even point to the same evidence to support their opposite conclusions. Krugman looks at privatization schemes in other countries as evidence of why the United States should not privatize Social Security and Prescott cites foreign approaches as evidence as to why we should privatize Social Security.

This stark difference in viewpoints leads to several questions. Are one or both of these economists insane? Are they on drugs? Are the organizations that have awarded them their prizes in economics dysfunctional? Do they live in alternate universes? What gives?

The problem is that economic systems are so complex that it is usually impossible to prove or even show with any statistical confidence that various policies will have effects, that in total, are beneficial. Even the most simplified economic models of subjects such as taxation and entitlements have many degrees of freedom and there is simply nowhere near enough data to support multivariate statistical analysis of these models. Very simple and specific questions sometimes have clear answers based on analytical and empirical analysis. For example, everyone agrees that prices rise when demand increases but supply remains constant.

But even slightly more complicated questions lead to intense and unresolved debates. For example, does a higher effective wage make it more likely that a person will work longer hours? According to the older, more traditional view, the higher wage makes working additional hours more attractive, but it also makes leisure time more attractive since you have more money to spend during that leisure time. According to the traditional view these two incentives tend to more or less cancel each other out, causing little change, on average, in working habits due to changes in effective wages. However, as explained by Arnold Kling, a more modern theory

"re-casts the trade-off as between "market time" and "non-market time." In addition to TV and Bon-Bons, you spend some of your non-market time producing goods and services, such as home-improvement projects, meals cooked at home, housework, and child care. Thinking of the choice in those terms, an increase in your wage rate could have a significant effect on your labor supply. The higher your wage rate, the more it makes sense for you to "outsource" household chores. If I can earn enough in six hours of work to pay for someone else to do eight hours of household chores, then I can get more hours for TV and Bon-Bons by increasing my "market time." Working six more hours but spending eight fewer hours on household chores gives me a net saving of two hours."

So a fairly simple and fundamental question generates two competing theories which lead to totally different conclusions. Since tax policy directly affects effective wages (lower taxes mean higher effective wages), disagreement on this fundamental question completely changes the rest of the analysis of almost every important economic policy. And this is just one of many unresolved fundamental economic questions upon which economic policy is based.

The bottom line is that the experts are unable to answer some pretty basic questions, at least not with any precision, and without knowing the answers to those questions, policy recommendations are pretty much wild guesses. As a result, my preference, especially since I think the state of economy is actually very good, is to not change things too much or too quickly. Since we don't really know what the effects are of the changes that we might consider making, there's no reason to tamper with success.