Wilkinson talks to Prescott and Phelps

Will Wilkinson wanted to know about the effects of the stimulus package, so he went and talked to Nobel Prize winning economists Edward Prescott and Edmund Phelps. He writes about it in his latest column for The Week.

Wilkinson wanted to know if the stimulus law will work. He writes

"Stimulus is not part of the language of economics," says Arizona State University economics professor Edward Prescott. I talked to Prescott just hours before Obama set the presidential pen to the stimulus bill. "There is an old, discarded theory that's been tried and failed spectacularly, which is where that language of stimulus comes from." The stimulus bill, Prescott told me, "is likely to depress the economy." Not long after Obama wowed the nation with his keynote address at the 2004 Democratic National Convention, Edward Prescott traveled to Stockholm to receive a Nobel Prize, shared with his frequent collaborator Finn Kydland, "for contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles." Which is to say, Prescott is one of his discipline's most influential and authoritative voices on precisely those technical issues behind the stimulus debate.

Wilkinson also talked with Edmund Phelps.

The most recent Nobel Prize awarded for work specifically in macroeconomics--the branch of economics that studies aggregate economic phenomena, the causes of recessions, and the effectiveness of government attempts to stimulate economic performance--went to Columbia University's Edmund Phelps in 2006. When I spoke to Phelps on Tuesday, he was rather less emphatically decisive than was Prescott about the dire prospects of the stimulus. But neither was he optimistic. "We're completely flying blind," Phelps said, suggesting that even the best of the best in macroeconomics don't know enough to predict with confidence how the stimulus will pan out. "There's a chance that some of the infrastructure spending will do the job of creating more work for earth-moving equipment and construction workers, Phelps noted. "I said, 'a chance'," he continued. "Now, there's also a chance that the perceived increase in the role of government of this sort will have some unanticipated effects on the animal spirits of entrepreneurs. These projects may stand as a sort of symbol of the weakening of the private sector."

Phelps is among the world's leading authorities on the way different economic systems enable or thwart the dynamic adjustment and entrepreneurial innovation that delivers long-run productivity and growth. By significantly increasing government involvement in so many sectors of the economy, Phelps worries the enacted stimulus plan could make the climate of investment more rather than less uncertain, and make growth-enhancing innovation less rather than more likely. Potential investors may become spooked by businesses increasingly dependent on government contracts, Phelps notes, since these firms may face additional regulations and bureaucratic requirements which may make them appear less able nimbly to adapt. Additionally, the anticipation of higher future taxes--the price of the current spending surge--could dampen consumer demand and "have a chilling effect upon the desire of entrepreneurs to innovate," Phelps says.

The incentives of entrepreneurs is central to Phelps' thought. Phelps says he "just doesn't understand" the argument that government can spur innovation through top-down subsidies for selected new technologies. Citing his Columbia colleague Amar Bhide, Phelps suspects that "a lot of money will be made by being in the right place at the right time and knowing the right people. Especially knowing the right people." Phelps is disturbed by the thought that we may be shifting from an entrepreneurial economy toward a lobbying economy. "A lot of potential entrepreneurs, who were contemplating making an innovation and launching it in the marketplace, will now think, 'Well maybe the safer thing to do is to try to get that government contract.' ... And nobody does the innovation. They're all too busy trying to get the government contract."

Shifting from an entrepreneurial economy toward a lobbying economy, New Zealand under Muldoon. And, it seems, increasingly under Key. Wilkinson goes on to say

Both [Prescott and Phelps] point to the importance of a stable framework of rules that makes the risk-taking and complex coordination of productive economic activity seem worthwhile. Both point to the hazards of suddenly, dramatically, and haphazardly rewriting the rules mid-game--even if the rules do need revising.

This is an important point that the current government would do well to take note of. Wilkinson ends by saying

Massive discretionary changes in the structure of economic incentives--the kind you get with "the most sweeping economic recovery package in our history"--tend not to brighten expectations and revive animal spirits. These interventions instead tend to unsettle consumers, investors, and entrepreneurs by vividly demonstrating how political discretion can so suddenly throw everything up for grabs. "The scary thing is," Prescott says, "when this doesn't work what do they do? Start panicking and throwing good money after bad?"

Well it's other people's money, so of course good will follow bad.