ECONOMICS AS AN EMPIRICAL SCIENCE

Straight thinking is hard work. Few of us have acquired the careful, orderly mental habits and disciplines demanded by straight thinking.

For many people, straight thinking in eco- nomics is especially difficult. Not that economics is inherently more difficult or more complex than many other fields. It isn’t. But economics is so mixed up with our everyday lives that, without realizing it, we’ve accumulated a mass of opinions, ideas, hearsay, and half-truths that subtly domi- nate our minds when economic questions arise.

When we want to build a bridge, it never occurs to us to start without calling in expert engineers to design it. If we want expert advice on physics, we ask the physicists. Few people con- sider themselves experts on bridgebuilding just because they drive across a bridge every day going to work, or on physics just because they live in the physical world. Yet many people, especially if they’ve “met a payroll,” somehow feel that they’re experts on economics simply because they suc- cessfully earn a living in the economic world.

It’s not surprising that most people have views on the big economic issues outlined in Chapter 1. They’re in the newspapers every day, in every election campaign. And the tendency for every man to be his own economist is strength- ened by the fact that economics is close to the pocketwebsite. It is especially hard to be objective about things that affect us intimately. But merely living in the economic world or meeting a payroll doesn’t make us experts on how the economy operates, any more than having teeth makes us experts on dental health and how to fill cavities. Economics is concerned with the way the whole economy operates, not with how to run a better  grocery or bank. And these are quite different things.

The purpose of this chapter is to provide a broad-brush picture of the way economics can help you to do your own intelligent thinking about economic issues. It’s about the way economists analyze these problems, and about the way you can learn to analyze them for yourself.

THE TAX CUT OF 1964 AN EXAMPLE

Let’s begin with an example—a highly sim- plified analysis (since this is merely an introduc- tory overview) of the way economics helped us to understand a major economic issue and to predict the consequences of an important tax change. After this introduction, we will look more syste- matically at modern economics as an empirical science, and at the problem of doing your own straight thinking in economics.

In the early 1960’s, the economy was per- forming reasonably well. Most people had jobs with good pay, profits were substantial. Yet there was substantial unemployment—the economy was operating well inside its production possibilities frontier. Over 5 per cent of the labor force was unemployed. If this figure could have been re- duced to 3 or 4 per cent, the nation could have had perhaps $30 to $40 billion worth of additional goods and services. We had the productive capac- ity in men and machines, but it was wasted because total demand for goods and services was not large enough to make it profitable for businessmen to hire workers and produce this extra output.

To remedy this situation, Presidents Ken- nedy and Johnson, following the advice of many economists, recommended a major cut in income taxes on individuals and businesses, without a corresponding reduction in federal spending. They reasoned that if consumers had more money left to spend after paying their tax bills (that is, if their “disposable incomes” were larger because of lower tax bills), total spending on goods and services would increase and businesses would hire more workers and increase output to meet this demand.

They proposed a tax cut of about $10 billion. They argued that, in fact, aggregate spending and hence incomes received by workers and others in the society would actually rise by more than $10 billion—possibly by $20 or $25 billion as a result of this tax cut. This would occur because the new consumer expenditures would be received by others who would in turn spend more, hire more workers and buy more goods. This spending would in turn increase the incomes of others, who would in their turn have more to spend. This respending effect, called the “multiplier” effect by economists, would thus help substantially to raise incomes and reduce unemployment.

Consider the essential steps in the reasoning. In essence, these economists had a “model,” or “theory,” of how the economy functions, and of how the effects of the tax cut would work their way through this economy. Their first assumption was that if consumers received an increase in dis- posable incomes (because their tax bills were re- duced), other things eqwil they would spend a large portion (probably over 90 per cent) of this increased disposable income on consumer goods and services, rather than use it to pay off debts or just hold on to it. Second, the economists had a model of typical business firms which indicated that in response to increased consumer spending these firms would hire more workers and furnish more goods, in the process paying out more in- comes to those whom they hired and to suppliers from whom they bought raw materials. Third, in the economists’ model, the government would borrow funds to maintain government spending unchanged after the tax cut, and this borrowing would not produce an offsetting reduction in pri- vate spending by drawing away spendable funds from private consumers or businesses. If the bor- rowing should correspondingly reduce private spending, obviously the desired increase in total spending on goods and services would not result. Fourth, to provide the specific estimate that total national income would rise by about $25 billion as a result of the $10 billion tax cut, their model had to include estimates showing how much con- sumer spending would rise per dollar of additional disposable income (perhaps 95 cents), how many new workers would be hired per dollar of addi- tional consumer spending, and the like.

Many people were skeptical of the argument for the tax cut. For example, they argued that  consumers would in fact not increase their spend- ing on goods and services by anything like 95 cents for each dollar of new disposable income, but would in effect hoard the additional income they received or use it to pay off debts. Skeptics raised other objections as well, but let us focus attention for now on this particular counterargument.

Most economists firmly rejected the counter- argument. Why? Because economists have made elaborate empirical (factual) investigations of the relationship between consumers’ disposable in- come and their spending. These studies have con- sistently showed that, other things equal, for high- employment periods of moderately stable growth such as we had during the 1960’s consumers spend a remarkably stable proportion of additional dis- posable incomes—generally around 94—96 per cent, given some months to adjust to larger in- comes. Sophisticated economists know that this figure is only a first approximation, and that it reflects a complex interplay of forces behind the scenes. But as a rough approximation it was a safe assumption that, barring other special forces at work, consumers would spend the largest portion of their new disposable income on goods and services within, say, six months to a year.

Who was right? After the tax cut was passed by Congress in early 1964, the effects on the economy were very close to the predictions of the economists who advocated the cut. Although it is difHcult to measure precisely the results of any action in a complex economy, consumers did be- have almost exactly as the model predicted, and the national income did rise by almost exactly the $25 billion predicted. The tax cut’ was widely ac- claimed a great success.

What is the point of this example? It is both (1) to show you, in a very simplified way, how economists use models of major economic rela- tionships to predict what will happen under differ- ent circumstances, and (2) to emphasize that such models must rest on careful empirical research about the behavior patterns assumed if they are to be reliable. Without such a model of consumer and business behavior and of the interactions between them, the impact of the tax cut would h~ve been pure guesswork.

The results in 1964 were impressive. But a warning! We have only seen ‘that employment and national income in 1964 following the tax cut turned out about the way many economists pre- dicted they would. This result lends credibility to the economic analysis used and to the claim that the good results were caused by the tax cut. But this is not necessarily so. The cause may have been something else. In fact, some economists argue that the happy results came about primarily be- cause another part of the government, the Fed- eral Reserve System, rapidly increased the supply. of money available to consumers and businesses through the banking system, and that the in- creased spending and employment reflected mainly this increase in the stock of money. These other economists have a different model (which we shall spell out later), and the results were also consistent with their model. Thus, it is not clear from this evidence which of the two big causes (the tax cut or increased money in the economy) deserved the most credit.

In our complex world it is never possible to be absolutely sure about the consequences of major public actions when several things are going on at once. But the stakes are large, and we must make decisions on economic policy issues, like those aimed at eliminating undesirable unemploy- ment. In the 1964 case above, our models give us a strong presumption that both causes were im- portant, as we shall see later on. The better our models are, the more fully validated they are by empirical evidence on the major interactions among the variables, the more confident we can be of our ability to predict the consequences of alternative economic policies.

ECONOMICS AS AN EMPIRICAL SCIENCE

Against the backdrop of this oversimplified example, turn now to a more systematic look at how modern economics operates as an empirical science, and how it can help you towards straight thinking on economic issues.