Thursday, March 26, 2009

The Obama Economy

A Response to “The Obama Economy” editorial in The Wall Street Journal on March 3, 2009.

There are two flaws in this critique of Obama, which is coming from someone who I presume would be criticizing him regardless of the performance of the stock market or the economy. The editorial is yet another example of the post hoc ergo propter hoc flaw of logic that is all too common in political and economic discourse. For the sake of expedience, allow me to quote the Wikipedia entry:
Post hoc ergo propter hoc, Latin for "after this, therefore because (on account) of this", is a logical fallacy (of the questionable cause variety) which states, "Since that event followed this one, that event must have been caused by this one." It is often shortened to simply post hoc and is also sometimes referred to as false cause, coincidental correlation or correlation not causation. It is subtly different from the fallacy cum hoc ergo propter hoc, in which the chronological ordering of a correlation is insignificant.
Post hoc is a particularly tempting error because temporal sequence appears to be integral to causality. The fallacy lies in coming to a conclusion based solely on the order of events, rather than taking into account other factors that might rule out the connection. Most familiarly, many superstitious beliefs and magical thinking arise from this fallacy.

The form of the post hoc fallacy can be expressed as follows:
A occurred, then B occurred.
Therefore, A caused B.
When B is undesirable, this pattern is often extended in reverse: Avoiding A will prevent B.

From Attacking Faulty Reasoning by T. Edward Damer:[1]

I can't help but think that you are the cause of this problem; we never had any problem with the furnace until you moved into the apartment." The manager of the apartment house, on no stated grounds other than the temporal priority of the new tenant's occupancy, has assumed that the tenant's presence has some causal relationship to the furnace's becoming faulty.

From With Good Reason by S. Morris Engel:[2]

More and more young people are attending high schools and colleges today than ever before. Yet there is more juvenile delinquency and more alienation among the young. This makes it clear that these young people are being corrupted by their education.

The decline of stock markets since Obama took office is not proof that his policies caused the decline nor that his policies are not the appropriate ones to improve the economy. The Dow Jones Industrial Average (DJIA) closed at 14,164.53 on October 9, 2007. On Election Day, November 4, 2008, the DJIA closed at 9,625.28. On January 20, 2009, the day of President Obama’s inauguration, the DJIA closed at 7,949.09. The stock markets were in decline long before Obama was elected or took office. The decline in the Dow since Obama became President is (7949 – 6763)/7949 = 0.149 or about 15%. The author picked an arbitrary date in January to imply a bigger decline. The decline in the Dow before Obama became President was (14164 – 7949)/14164 = .438 or about 44%. So if one wanted to use post hoc ergo propter hoc (and remember one shouldn’t), a more reasonable conclusion is that the last 15 months of President Bush’s policies were much more damaging to Wall Street than Obama’s have been.

Another flaw in this editorial is the presumption that whatever is good for stock markets is good for the economy. I agree that health-care stocks have declined because of Obama’s plans to save taxpayers money by reining in rapidly rising medical costs. But that does not prove that Obama’s policies are detrimental to the economy as a whole. Consider the opposite. If Obama announced that he would give trillion dollar gifts to all the corporations in the Dow Jones Industrial Average for no use other than to make them more profitable, the stocks of the benefitting companies would undoubtedly rise. But such a policy would add tremendously to the public debt burden of future generations without doing anything to increase the productivity of the economy or improve its long-term health. It is a mistake to assume that anything that benefits the wealthy or business interests (such as tax cuts and deregulation) is necessarily good for the economy. Some increases or decreases in taxes and government regulation of business may be beneficial to society as a whole. Others are not.

The author is critical of the income transfers in the stimulus package, preferring spending on public works. But the fundamental cause of this recession is insufficient overall spending on newly produced goods and services. The logic behind the income transfers is that they are a quick way to inject purchasing power into the hands of those most likely to spend. The biggest downside of income transfers is that the money might not be spent on newly made U.S. products. It could be used to pay down credit card debt or to buy foreign-made products, such as the many Chinese goods at Wal-Mart. If the government spends the money directly, such as on infrastructure projects, it can ensure the money goes to U.S. companies with American workers. And there is a lasting benefit from public works spending because the new highways, repaired bridges, and more energy efficient government buildings will continue to provide benefits for many years to come. The largest downside of public works spending is that these projects can take a long time to complete and the economy needs the increased spending immediately. Indeed, the best criticism of the stimulus package is that by the time some of its spending occurs, the recession might be over. (Then again, it might not.)

The criticism that the tax cuts are “devoted to income maintenance rather than to improving incentives to work or invest,” is a gilded way to assert that they should have been given to rich people and wealthy corporations rather than to low and middle-income Americans. By preserving incomes with tax reductions, the government is trying to maintain the purchasing power of the overall economy and prevent the recession from worsening. Tax policy can be used to alter society’s behavior, such as to encourage research and development or investment in physical capital. But those effects kick in much later than the immediate impact of income maintenance. And many of the tax cuts advocated by the rich are not structured to have targeted benefits to the economy. And I have always had difficulty with the theoretical argument that tax cuts increase the incentive to work. Everyone I know with a 9 to 5 job works 40 hours per week regardless of which tax bracket they are in. I have never had anyone tell me he or she works more or less because of changes in tax rates.

Anyone who has taken a class from me should know I am a huge advocate of markets and capitalism. But it is not a blind or ideological devotion. Capitalism and the markets it creates have a potentially destructive aspect. Unregulated markets can cause massive damage to society. (In the absence of government regulation, the market system allowed so much pollution into the environment that in 1969 the Cuyahoga River in Cleveland, Ohio literally caught on fire.) The important question is the appropriate degree of regulation. In a capitalist system, banks, like other profit-seeking businesses, should be allowed to fail. Yet, banks play a much different role in our economy than other businesses. The ability to borrow money does facilitate the overall spending that maintains our economy. And it is the inability to borrow and a lack of confidence in the financial sector that are critical components of our current economic troubles. Most financial experts believe failing to prop up these financial institutions would be devastating to our economy. Indeed, a common criticism of the handling of the financial crisis by President George W. Bush’s Secretary of the Treasury, Hank Paulson, is that he allowed the Lehman Brothers financial services company to go bankrupt, worsening the meltdown. In the absence of sufficient government regulation, banks became too large, too intertwined, and were allowed to engage in activities with too much risk. I believe the biggest mistake was to allow individual banks to become “too big to fail.” If government regulation had prevented much of the consolidation in the banking industry and had maintained a financial system with numerous smaller banks, it would be much easier to forego bailouts and let the worst ones fail.

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