President Obama’s inaugural address includes an apparent attack on ideology:

What the cynics fail to understand is that the ground has shifted beneath them–that the stale political arguments that have consumed us for so long no longer apply. The question we ask today is not whether our government is too big or too small, but whether it works….

Furthermore, Christina Romer, the chairperson of Obama’s Council of Economic Advisers, is often described as a non-doctrinaire economist who simply follows the data wherever they may lead.

What appears to be a sensible idea to turn our problems into purely technical ones is, on the contrary, profoundly unscientific and, more generally, anti-intellectual.

This is a big subject and deserves comprehensive treatment. Let it suffice here to make a few crucial observations.

In the first place, this point of view is not new. I cannot trace here the full extent of its intellectual roots–they are deep and wide–but we can find it in such essays, relevant to our current concerns, as “The End of Laissez Faire,” (1926) by John Maynard Keynes.

Keynes believed that one of the most important functions of economics is to determine what belongs to the State’s agenda and what does not. “The important thing for Government is not to do things which individuals are doing already, and to do them a little better or a little worse; but to do things which at present are not done at all.” Keynes was referring to decisions that fall outside of the sphere of the individual, “to those decisions which are made by no one if the State does not make them.”

Actually, the sphere to which Keynes referred is the aggregate outcomes of individual decisions. He did not have much confidence in the spontaneous order of the market. He rejected what he thought were the “metaphysical or general principles upon which, from time to time, laissez-faire has been founded.” So, “[w]e cannot settle on abstract grounds, but must handle on its merits in detail . . . to determine what the State ought to take upon itself to direct by public wisdom.”

1. Ideology as a Presumption

Keynes is rejecting any presumption that the “results of human action but not of human design” (F. A. Hayek citing Adam Ferguson) are beneficial. He seems to be saying that we can operate without any presumptions at all; we can simply look at each “problem” on its own merits and make an individualized decision in each case. But a presumption is not an arbitrary belief; it is not “metaphysical” in the sense that it is completely impervious to new evidence. A presumption is a belief we accept until sufficient evidence to the contrary is forthcoming.

However, evidence is rarely definitive or overwhelming. We need to begin from somewhere. The Bayesian statisticians say that we begin with prior probabilities and then update them with new evidence. Prior probabilities are only slightly modified with incremental evidence. These priors function in a manner similar to a presumption. So, for example, a person may think that a large urn contains 95 percent red balls and 5 percent blue ones–say, because someone he thought reliable told him so. But if he starts drawing balls from the urn and keeps getting blue ones, he will soon revise downward his estimate of the proportion of red balls, although drawing only one blue ball will not affect his estimate very much.

2. Ideology as Scientific Framework or Research Program

In the realm of scientific hypotheses, even the “falsificationist” Karl Popper accepted a principle of tenacity, which had it that hypotheses are not to be dropped in face of just any conflicting evidence. No hypothesis will have 100 percent of the evidence in its favor. (A falsificationist is a scientist or philosopher who believes that data can count against a theory and enough such data can refute it. However, he is careful never to say that data can definitively prove a theory.)

Is this rational? It depends, in part, on the nature of the prior probabilities or the prior hypothesis. Suppose someone says: “By and large the free market is best, among all the feasible alternatives, at promoting human welfare.” Is this ideology? I think most people would say it is. What is it based on? Well, for some people it may be a religion or faith of sorts. But then its negation can be as well. However, it need not be a faith.

I think that for almost all economists who subscribe to the statement, it is a generalization based on evidence. The evidence is in the form of a general way of looking at the world–a framework or research program that is supported in many specific cases. Note that the statement itself goes beyond the individual specific cases. It must go beyond them to deal with new problems and new events. It must function, in a specific application, as a conjecture about novel situations.

Looked at in this way, “ideology” is useful in scientific discourse. In fact, I suggest it is indispensable. How else can we approach new problems when the likely outcome of our search for specific evidence is inconclusive?

3. Ideology as a Window on Indirect or Long-Run Consequences

One of the difficulties attendant upon looking at each problem and each solution individually is the tendency to ignore indirect or long-run effects. For example, we were told, “Consider the ‘problem’ of insufficient homeownership, and just solve it.” So this was done. A solution of subsidized homeownership and very low interest rates was put into effect. Should we not have cared about the longer-run effects of such policies? It would have been impossible to predict when and to what extent problems would have occurred. So many thought it was foolish to worry. Those who did worry were dismissed as dogmatically anti-Fannie/Freddie and anti-flexible Fed policy. And here we are.

Ideologies stress the interconnections among policies and problems. They may point us in the direction of the general principle implied by a policy and hence the implicit rationalization of further policies. They may make us alert to unintended changes in incentives in related problem areas, especially when this worsening of other problems has happened time and again. They show us that when the State intervenes there is more than just some pinpointed technology involved.

4. Ideology as Shortcut for Rationally Ignorant People (Most of Us)

Most people are not scientists, economists, or intellectuals. They are not testing hypotheses. They have other things to do. They are often  rationally ignorant. How can they make up their minds about public policy? Many, though not all, are ideological. They choose a set or complex of beliefs that comports best with their observations and experience. For them, too, it is not rational to give up the worldview because some (few) observations seem to conflict. Forgive some of them who are not willing to throw away long-held beliefs on the say-so of a president whom most never heard of two years ago.

5. Ideology as an Ethical Framework

Public-policy questions are not simply technical questions. They involve ethical issues. The economist John Neville Keynes (the father of John Maynard Keynes) divided economics into science, ethics and art. (See J. N. Keynes’s The Scope and Method of Political Economy, Chapter II). The science is the technical aspect: causes and effects. The ethics involves the standards that are applied to determine whether a state of affairs is good or just. And the art involves the sometimes intuitive judgments of how to apply the science to get (or allow) the outcomes policymakers want.

An ideology can serve as a rough guide to ethical considerations. For example, some people believe that it is immoral to “reward” people for irresponsible economic behavior. Maybe a policy wonk disagrees because he thinks that systemic effects are all that matter. Is the citizen to be faulted for acting or evaluating on the basis of her belief, regardless of the wonk’s opinion? In general, the belief makes good sense. As a long-run rule of behavior, the idea that economic actors should bear both upside and downside risk would have saved us, for example, from the Fannie/Freddie overexpansion in the first place as shareholders would not have believed in implicit guarantees. Is this an idea we want people to give up without resistance? I do not think so.

Ideology is okay. It is fine to be ideological. It is indispensible to effective analysis of the world. Just make sure that the ideology makes real sense.

Things have gotten so bad that no dissention can be tolerated. The German Chancellor Angela Merkel was harshly criticized for not going along, at least to the requisite degree, with the stimulus consensus. She stood out as “Frau Nein” until she went along with a “moderate” package.

I am not a macroeconomist. I am not even a financial economist. So much of my reaction to the current financial and economic problem may seem out of step with what most commentators are saying. Yet I think it is important.

Collective Irrationality

The macroeconomic frame of mind is quite peculiar. In the name of the emergency, this way of thinking dismisses most concerns about the efficient allocation of resources and throws almost total emphasis on maintaining levels of expenditure and employment. The implicit assumption is that the central problem is a collective irrationality that inhibits people from spending on consumption or investment. The root of the central problem, conceived in this way, is the initial financial meltdown. This involved a kind of domino effect in which the collapse of the housing market and of mortgage-backed securities, packaged in many complex ways, undermined the liquidity and even solvency of many financial institutions. The system’s ability to provide credit and thus expenditure was compromised, although at this writing the reduction in bank credit available has been relatively small.

Thus the solution, we are told, lies in returning to the status quo ante. Restore the condition of the financial institutions—perhaps by buying toxic assets or perhaps by infusing capital into the institutions. Restore the conditions of the housing market by getting the Fed and/or Treasury to buy Fannie and Freddie mortgage securities, thus sending capital into housing and lowering mortgage rates. Restore the condition of industries with large numbers of employees and others indirectly dependent on them. (So far, the automobile industry qualifies.) In general, restore the pattern of expenditure that prevailed before the crisis.

I realize that no economist believes that complete restoration to the previous situation is possible, but the basic philosophy is clear. Once economic agents believe something like this will take place, confidence will be restored.

The critical issue is this: Has the current situation—triggered by unsustainable levels of mortgage credit and production in the housing industry as well as in other interest-rate-sensitive areas—gone so far beyond its cause that we no longer need to worry about these previous misallocations of capital? In other words, is the correction of the cause now irrelevant to the cure?

Stimulus ex Machina

To discover the answer to this question, let’s step back a bit. We must understand the respective roles of causes and feedback effects. This is the “Keynesian” argument. Suppose a fall or collapse in markets X, Y, and Z causes F (a financial meltdown). Then F itself causes X, Y, and Z to fall further. Some of this is deleveraging, and some is the result of falling confidence in, say, the creditworthiness of counterparties. There is a general lack of clarity about what resources and financial instruments are worth. The future begins to look radically uncertain rather than simply risky. A collapse of confidence thus contributes to a fall in production and employment in areas far removed from the initial bubble-burst. The process is not dampening but explosive in the absence of the deus ex machina—that is, fiscal or monetary intervention.

Now let us imagine a cure that ignores the original misdirection of resources to the degree that it treats the collapse in these markets as mainly due to some exogenous loss of confidence. The Federal Reserve decides, as it actually has, to buy mortgage-backed securities, causing credit to become available in the housing market at lower interest rates. This also causes the prices of homes to stop falling and to begin rising. When will the Fed stop this infusion of newly created money, and hence a relative rise in resources, into the housing market? Presumably it should stop when the sector is brought back to a level that is simply a correction of the previous excess. In other words, the Fed should prevent the additional, “irrational” decline due to “feedback” effects.

Where is the feedback-sanitized point? I doubt anyone knows. Consider what it means to know. The planners would have to know the array of housing prices corresponding to the normal fundamentals of the housing market. This would be the prices that prevailed when the market was not overexpanded. However, it would not correspond simply to the average of recent values because the housing market has been overexpanded for so long. Recently, two economists have attempted to estimate these prices. (“First, Let’s Stabilize Home Prices,” by R. Glenn Hubbard and Chris Mayer, Wall Street Journal, Oct. 2, 2008.) Unfortunately their attempt is marred by the same extrapolation of historical experience that seems to have gone terribly wrong in the assessment of the risk associated with derivatives and mortgage-backed securities. More importantly, however, it seeks to determine normal market prices in the absence of a freely functioning market.

Suppose, however, the Fed is realistic and admits it doesn’t know. It will then simply try to get the housing market (and other similar interest-sensitive markets) to such a point where general production and employment are considered non-recessionary. The standard, practically speaking, will be the status quo ante. This is because of the lack of theoretical-empirical guidance discussed above and because the various sectors, bolstered by various politically powerful pressure groups, will not be satisfied until they are made whole. At this stage we would be left with the unsustainable direction of resources more or less back in place. The direction is unsustainable because, as the original bubble revealed, it was not consistent with the preferences of consumer-saver-investors.

Why it Won’t Work

Therefore the conventional macroeconomic diagnosis and proposed cures ignore many important structural or microeconomic factors, including the following:

1. The “irrationality” is not primarily in the system’s response to the initial financial impulse but in the unsustainable expansion of the housing and other capital markets in the first place. Proposals to prop up the housing market as if its contraction is some kind of unfortunate overreaction are not credible. Too many resources went into the housing market due to the low-interest-rate policy the Fed followed for too long. While housing prices have fallen recently in many markets, they need to fall further. Markets should be allowed to equilibrate.

2. Equilibrium in the housing market would provide greater transparency to the value of mortgage-backed securities. Lack of certainty about housing prices and the ultimate extent of foreclosures only adds to the problems surrounding the illiquidity of these securities.

3. Government infusion of capital with the purpose of restoring the status quo ante ignores the facts: Fannie and Freddie were overexpanded, the domestic automobile industry is a destroyer of scarce capital, some financial firms did a poor job of allocating risk, banks extended loans under the pressure of the government to people who should not own homes, and so forth. Resources were misallocated.

Confidence Follows Correction

Recessions are not simply crises of confidence or of insufficient demand (due to increases in the demand to hold money). They also have their allocational—or microeconomic—aspects. I suggest that these systemic distortions have an important role in creating the aggregate phenomena we are witnessing. To treat these distortions and their cure as relatively unimportant is a mistake. Lasting investor and consumer confidence follows the correction of the underlying causative distortions and does not precede them. In fact, the dominant macroeconomic policy framework does not leave room for correcting distortions at all because its basic theme is to restore, prop up, and maintain the current direction of resources.

The hastily approved macroeconomic schemes of the Bush and Obama administrations will not succeed in promoting lasting recovery because they ignore the microeconomic fundamentals. The direction of spending and hence resource allocation they generate are fragile—they are not consistent with the preferences of consumers, savers, and investors. Therefore, once the putatively temporary stimulus is complete, the corrective forces that are now trying to undo previous resource misallocations will reassert themselves.

In the longer term, the threat of significant inflation looms large. After the U.S. Treasury has incurred the additional trillions of dollars in national debt (at least one trillion in George W. Bush’s response to the crisis and a minimum of one more in Obama’s response) and the Federal Reserve has completed expanding its balance sheet (thus creating new money) by some trillion or more, what will happen? Will the federal government abolish the stimulus programs, raise taxes to pay off the increases in the national debt (or even to service the debt), and cut entitlement programs? The constituencies that will be formed by the stimulus spending will resist. Will the Fed begin a contractionary monetary policy to absorb all the excess money it created in the name of the emergency? That would raise interest rates and the cost of servicing the huge national debt. What is probable is that we will see an effective repudiation of part of the national debt through inflation. The temptation will be all but irresistible to inflate ourselves out of this mess. The economic consequences of the “cure” will be worse than the disease.