Counterfactuals and economic analysis

As the debates on monetary and fiscal policy options during the sub-prime crisis and Great Recession have shown, macroeconomic theories can rarely explain with certainty whether one set of policies are superior to another or are certain to succeed in a given circumstance.

For every example of success with a certain set of policies, opponents are quick to show failures with them. They also point to apparent successes with an alternative set of policies. And in any case, no two situations are the same. Such debates usually end in a stalemate over the relative merits of two opposing theoretical and ideological positions. Further, in such ideological battles, even blatantly untenable views have remarkable persistence. Ideologies are not easily buried.

Since successes or failures with a specific set of policies are rarely cut-and-dry, post-mortems of economic policies too are never non-controversial. For example, despite overwhelming evidence about how TARP and ARRA prevented a complete financial meltdown, created employment and off-set deeper output contraction, sceptics refute the evidence.

Supporters who claim success with a set of policies would face opposition from those arguing that an alternative approach would have yielded better results. Even more, they would argue that conditions would have been better off without those policies - Wall Street would have recovered faster and stronger if there were no bailouts.

Supporters will counter by saying that the recovery would have been more swifter and stronger if their prescriptions were applied in full. For example, economists like Paul Krugman have long argued in favor of much stronger fiscal stimulus measures to mitigate the hardships of the Great Recession. Counter-factuals can only be debated about, never satisfactorily, leave alone conclusively, proven.

The NYT reports of the latest example with such from Europe.

Another missed opportunity for Europe? Over the last year, the European Union and the International Monetary fund have pledged 640 billion euros ($890 billion) to bail out distressed economies on the Continent’s periphery. Yet the interest rates on benchmark bonds in Greece, Ireland and Portugal remain at or near their record highs.

Critics of the bailout will surely see the persistent high interest rates as arising from an inability to convince the confidence fairies and a failure of the policy itself. Supporters would argue that there would have been sovereign defaults from Greece and Ireland in the absence of such bailout backstops.

In simple terms, economic policy are equally handicapped in explaining their policies both ex-ante and ex-post.

Update 1 (28/9/2011)

Paul Krugman has this excellent description of the counterfactual debate on stimulus spending in the US.