Lawrence Summers

By Lawrence H. Summers
The opinions expressed are his own.

Reuters invited leading economists to reply to Mark Thoma’s Op-Ed on the “great divide” in economics and will be publishing the responses. Below is Reuters columnist Lawrence Summers’s reply.  Here are responses from Roger Martin, Ashwin Parameswaran, James Hamilton, Dean Baker, and a recap of Paul Krugman’s.

Mark Thoma is obviously right that academic economists should listen more to practitioners – both economists who who work outside the academy and also, although he does not stress this point, to those who are active participants in the economy as buyers and sellers of products, labor, securities or anything else.  He is also right that much of what goes on in academic economics is rather removed from any reality and that there are all sorts of important practical problems that should get more attention from academics.  However there are a number of respects in which his arguments is naive, incomplete, or goes to far and his analogy with what doctors do is misplaced.

First, there is a proper division of labor between those who develop theories and those who meet day to day challenges.  It is progress, not regress, that today we have physicists who conceive theories and do experiments and civil engineers who build bridges.  This work was done by the same people centuries ago.  In the same way, it represents progress through the division of labor that it is no longer true that academics are the people best informed about the evolution of next quarter’s GDP as was the case even in the 1960s.  While there are exceptions, much of the progress in modern medicine comes from scientific research done by people who do not on a regular basis see patients.  Watson and Crick would have been slowed down, not helped, if they had spent time with MD’s.

Second, as Keynes’ comments on the advantages of being conventionally wrong rather than unconventionally right illustrate, it is a serious mistake to overstate the insights possessed by practitioners in any field.  Anyone in mutual funds will tell you that active managers regularly outperform the market.  Only economic scientists realized they do not.  Contrary to the the implications of Thoma’s column, the best calls on the real estate bubble came from academics like Bob Shiller and Nouriel Roubini, not from any economists involved with the home building or realty industries.

Every industry’s leaders think they understand the economics of trade — protecting their industry is good.  The difficulty of casual induction from practical experience is not confined to economics.  The double blind controlled clinical trial was one of the great medical innovations of the 20th century, precisely because such trials refuted so much of what clinicians knew.

By Lawrence H. Summers
The opinions expressed are his own.

With last week’s tumult in Italian markets, the European financial crisis has entered a new and far more dangerous phase. Where the crisis had been existential for small economies on the periphery of Europe but not systemically threatening to either the idea of European monetary union or to the functioning of the global financial system, it now threatens both European integration and the global recovery. Last week’s drama surrounding bond auctions in Europe’s third leading economy should convince even the most hardened bureaucrat that the world can no longer let policy responses be shaped by dogma, bureaucratic agenda and expediency. It is to be hoped that European officials can engineer a decisive change in direction but if not, the world can no longer afford the deference that the IMF and non-European G20 officials have shown towards European policy makers over the last 15 months.

Three realities must be recognized if there is to be a chance of success. First, the maintenance of systemic confidence is essential in a financial crisis. Teaching investors a lesson is a wish, not a policy. U.S. policymakers were applauded for about 12 hours for their willingness to let Lehman go bankrupt. The adverse consequences of the shattering effect that had on confidence are still being felt now. The European Central Bank (ECB) is right in its concern that punishing creditors for the sake of teaching lessons or building political support is reckless in a system that depends on confidence. Those who let Lehman go believed because time had passed since the Bear Stearns bailout the market had learned lessons and so was prepared. In fact the main lessons learned had to do with how to best find the exits, and so uncontrolled bankruptcies had systemic consequences that far exceeded their expectations.

Second, no country can be expected to generate huge primary surpluses for long periods for the benefit of foreign creditors. Meeting debt burdens at rates currently charged by the official sector for credit – let alone the private sector – would involve burdens on Greece, Ireland and Portugal comparable to the reparations burdens Keynes warned about in The Economic Consequences of the Peace.