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What We Know We Don't Know

A few economic predictions, with a dash of a humility.

11:00 PM, Dec 11, 2008 • By IRWIN M. STELZER
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"Don't project beyond the range of the known observations" is a rule followed by careful economists. In plain English this means, for example, that we know how American consumers behave when gas prices move between $1 and $4 per gallon, "the range of the known observations". But we haven't much of an idea what they would do if prices rose to $5. No experience, no data to inform our forecasts. Which is why we have to be very careful--humble, really--when predicting the effect of the various policies that are being adopted to fight the current credit crisis and recession. We simply have no good experience with this combination of events, and the magnitudes of the changes.

So we have reason to worry about the galaxy of stars Barack Obama has assembled to help him right the American economy. They are so bright, so self-confident, so accustomed to being the smartest guy or girl in the room, that doubt is not one of the emotions with which they are familiar, as was true of the bright young "quants" (mathematical economists) who designed the models used to manage the risk taken on by Lehman Brothers and AIG. Something about hubris and nemesis comes to mind.

Consider this. Treasury Secretary Hank Paulson persuaded congress to give him a $700 billion pot of money with which to buy the rotten IOUs on banks' balance sheets. The theory was straight-forward: relieved of this burden, the banks would resume their role of lenders to potential homeowners, businesses, and consumers. Sounded like a good idea. But almost immediately it occurred to Paulson that British Prime Minister Gordon Brown had a better idea--recapitalize the banks by buying shares so that they could begin lending again. That, too, was confidently touted as a good idea. But we have moved beyond the range of what we know about credit crunches. All we know is that the results so far have not matched the predictions of the proponents of these policies. Which is one reason why Paulson decided not to use the second half of his $700 billion, and to leave it to the next congress and the incoming president to decide whether it might not be better to pass the remaining $350 billion directly to home owners falling behind in their mortgage payments. Surely that would reduce foreclosures and repossessions, thereby easing the glut of unsold homes, raising prices, and helping to bring the recession to an end. Surely? Better, perhaps.

Then there is the soon-to-be bailout of the Big 3 domestic auto makers, GM, Chrysler and Ford, with the particular fund to be tapped unclear at this writing. Never mind that Ford doesn't need cash, and that Chrysler is owned by private investors desperate not to put their own cash into the business, and now have succeeded in getting the taxpayer to foot the bill. This is all about General Motors, which a combination of avaricious unions and inept management has brought a short step from running out of cash. There will be a bailout of all three companies, although after the Senate's refusal to buy into the plan concocted by the Democratic majority and the Bush administration, it is not clear which honey pot will be dipped into. Funds will be fund so that the Bush administration can avoid responsibility for a GM bankruptcy, and the incoming Obama team can keep its word to the trade unions that played so important a role in its victories in key states.

Policy makers tell us that the newly created "car czar" will bang heads together and get the unions and the auto dealers to make concessions that will turn GM into a lean, green, competitive machine. Critics say there is no hope that even the most imperious czar will make it unnecessary for the auto makers to beg, "Please sir, I want some more", perhaps $125 billion more in addition to the $15 billion first installment. But does anyone really know, know as in "I know the sun will rise tomorrow morning"? It might be that the procedure set up will shrink GM down to manageable size, with the unions giving up lots of benefits and jobs, and dealers getting bought out on reasonable terms. But it is equally probable that it will not (more probable in my humble view).

Then there are all those plans for a stimulus. More than half of Americans expect Barack Obama to turn the economy around, and the president-elect has said he will spend at least half-a-trillion dollars, more likely a trillion, to do just that. Roads, bridges, schools and all sorts of other things fitting under the title of "infrastructure" will be built, providing 2.5 million jobs. So say Obama's distinguished team of economists.