Ronald Coase has an interesting new piece titled Saving economics from the economics profession. You may like to see What is wrong with Economics on this blog.
Last week, in the US, I heard that the number of Ph.D. graduates coming out vastly exceeds the number of academic job openings. Most economics Ph.Ds. are going to end up in non-academic jobs. In fields like Physics, the basic arithmetic became clear early on. Each academic in a research university produces 12 Ph.D. students, on average, over his or her life. In steady state, 11 of them have to go into non-academic lives. For some time, in Economics, this phenomenon was masked by the rise of business schools and schools of government, which recruited a lot of economists. With that transition largely behind us, the simple logic of 1-in-12 comes back to hit us.
I feel the profession is not doing enough to prepare the 11-of-12 economics Ph.D. students for a life in the real world. I am a sunny optimist on the importance of economics in the real world. Whether it is Google or a hedge fund or a consulting firm: I think a good economist has a lot to say. But what we do to Ph.D. students is pretty bad. The skills required to succeed in academic economics seem to be precisely unlike the skills required to engage with the world. I feel that fairness to the students requires turning this upside down. We should be primarily training Ph.D. students to gear up to be useful in the real world, for only a tiny fraction of them will go back into academics.
Academic economics in India suffers from one additional layer of trouble: the legacy of development economics. India has moved on. Only 15% of Indian GDP is agriculture; the labour force is moving away from agriculture; only 20% of India is below the poverty line. This implies that development economics is of little use in thinking about India. Whether it is P. Chidambaram or Mukesh Ambani, the decision makers of India are not too interested in development economics.
The early days of physics shows us a nice three-step story. First, the datasets fell into place, with Tycho Brahe. Then came the empirical regularities, with Kepler. Once Kepler’s laws were firmly established as hard facts of the data, you could curiously ask: Why might this be the case? And this gave us theory, in the hands of Newton. In economics, and particularly with economics in India, we are struggling with the first phase. We barely observe the economy.
When the physicists did not observe the world, the frontier lay in observation (Tycho Brahe), and not in the guys doing angels on pinheads. But in economics, in the early years, in the absence of data, the field got dominated by mathematicians analysing artificial worlds, the bulk of which was angels on pinheads exercises. Instead of looking at the world, we looked at blackboards and made up assumptions. Research papers got written by looking at other research papers, rather than looking at the world.
I am optimistic about where we will go from here, for the computer revolution is finally giving us datasets where there is high quality observation of the economy. E.g. retail stores are capturing scanner code data, financial exchanges see every order, massive databases of census or tax authorities are being prised open, google trends data is available, satellites measure illumination at night and give us estimates for the GDP of each square kilometre of the country every night, etc. The future of economics lies in data science. Just as astronomers are drowning in the data coming out of telescopes, we in economics will shake our heads in wonder, as we find our way around immense treasures of large datasets of high quality.
Yet, at present, most economists and economics Ph.D. students are focused on theory, or the old perspective where economics is seen as a part of axiomatic mathematics and not as an observational science. For most people in economics, there is a certain willingness to accept bad data and bad econometrics since all this is (in any case) just an excuse to get on with the thing that really matters, the model. Matters are made worse, in India, by the typical Western referee who does not ask questions about data quality. This gives the economist in India zero incentive to be careful about measurement, and gives us an equilibrium replete with garbage-in-garbage-out.
I don’t want to overstate the problem. Things have changed enormously when compared with the 1970s and 1980s, when economics was almost entirely dominated by theory. Today, the most important work in the profession is applied. Applied papers get more citations. The ship is turning. But as Ronald Coase is saying, it’s still far from where it needs to be.
Academic economics is a self-sustaining system, on the strength of the tuition fees paid by a large number of undergraduates who register for these course. There is relatively little pressure to change. The impetus for change will come from four directions:
- While wages for a small number of the superstars of the profession are sky high, most academic economists are not paid that well and are not experiencing real wage growth. This gives an incentive for some to engage with the world through consulting. Their work will matter.
- As Larry Summers has emphasised, a strength of the business school and the school of government (and the think tank) is that they engage with reality. They have incentives to look at the field with new eyes. The work done in these places will matter.
- The 11 of 12 freshly minted Ph.D.s who show up in the real world and puzzle over it matter a great deal. For the vast majority of them, the Economics Ph.D. will recede in their minds like a bad dream. A small fraction of them will do stuff that matters.
- The people with skills in data science will do unexpectedly cool things with the new datasets where we observe the economy. This stuff will matter.
The Monster Employment Index for November was released today, and the index moved down 4 points from last month to a value of 147, but is 10% higher than last November’s value.
At 8:30 AM EDT, the Employment Situation report for November will be announced, and the consensus for non-farm payrolls is an increase of 131,000 jobs compared to 80,000 in the previous month, the consensus for the unemployment rate is that it will remain at 9.0%, the consensus average hourly earnings rate is expected to increase 0.2%, and the consensus for the average workweek is 34.3 hours.
Suppose a young person is going to start a Ph.D. in economics. What essential readings would you recommend prior to this?
In my opinion, the Ph.D. in economics involves a heavy emphasis on tools. But the story isn’t told, about why we are building these tools. The intuition isn’t built, about the world out there that we seek to model. I always joke that economics students who are clueless about reality are like a child studying projectile motion without having ever thrown something into the air.
So I thought it’s useful to pick a set of books that touch on the great themes of the world, often going into troublesome terrain that the models aren’t very good at, so as to lay a foundation of background knowledge and historical knowledge which can pave the way to usefully assimilating what’s taught in the economics Ph.D.
Here’s my compact checklist of books worth reading. Please do suggest books, and disagree with this list, in the comments to this post.
- Good capitalism, bad capitalism, and the economics of growth and prosperity by William J. Baumol, Robert E. Litan and Carl J. Schramm.
- A splendid exchange: How trade shaped the world by William J. Bernstein.
- The elusive quest for growth by William Russell Easterly.
- Invisible engines: How software platforms drive innovation and transform industries by David S. Evans, Andrei Hagiu and Richard Schmalensee.
- Capitalism and freedom by Milton Friedman.
- The great crash of 1929 by John Kenneth Galbraith.
- The age of uncertainty by John Kenneth Galbraith.
- Exit, voice, loyalty by Albert O. Hirschman
- More money than God: Hedge funds and the making of a new elite by Sebastian Mallaby.
- Reinventing the bazaar: A natural history of markets by John McMillan.
- Readings in applied microeconomics: The power of the market edited by Craig Newmark.
- From the corn laws to free trade: Interests, ideas and institutions in historical perspective by Cheryl Schonhardt-Bailey.
- Seeing like a State by James C. Scott.
- The company of strangers by Paul Seabright.
- Information rules: A strategic guide to the network economy by Carl Shapiro and Hal R. Varian.
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Needless to say, a course can be valuable even if unpleasant. Unfortunately, however, most students seem to emerge from introductory economics courses without having learned even the most important basic principles. According to one recent study, their ability to answer simple economic questions several months after leaving the course is not measurably different from that of people who never took a principles course.
What explains such abysmal performance? One problem is the encyclopedic range typical of introductory courses. As the Nobel laureate George J. Stigler wrote more than 40 years ago, “The brief exposure to each of a vast array of techniques and problems
leaves the student no basic economic logic with which to analyze the economic questions he will face as a citizen.” [Emphasis added.
HT: Vox Day
When I took my introductory Econ course in college (nearly a year ago), I quickly saw that I was going to be the only student in that class getting an A. The reason for this was due to a) having a good professor who was a terrible teacher and b) having a textbook that devoted more space to graphs than to words.
The problem with the professor wasn’t simply that she was a neo-Keynesian. Rather, the problem was that she simply couldn’t explain fundamental economic concepts in a way that her students could understand. The money multiplier effect was explained as an equation. Supply and demand was explained as an equation. Price elasticity was explained as an equation.
Of course, virtually all economic rules and relationships can be expressed mathematically, but the professor made the mistake of thinking that real-world examples exist to explain the models when, in fact, it is the other way around. As such, all classes started with theory and occasionally were related to the real world, leaving all my classmates confused and exasperated. The professor would have done well to read Adam Smith’s classic treatise, for the whole discipline of economics (and, really, all other scientific disciplines) exists to explain the real world by using simplified models. There’s a reason the old joke about economists goes “I know it works in the real world, but does it work in theory”.
Since I had been reading economic works since I was fourteen, I was incredibly overprepared for this class. So, I ended up tutoring half my classmates, which turned out to be quite lucrative. In fact, I got Student Services to bend the rules for me so I could tutor my classmates. I also functioned, essentially, as a co-professor because I was called upon quite often to explain various economic principles in ways that my classmates could understand. This had the bonus effect of ensuring that I got the numbers of every girl in that class, which led to a couple of dates. It was great time in my life.
The problem with the textbook was that it was too convoluted. I had difficulty following along, but only because my eyes would glaze over from boredom. The book was needlessly technical, which was off-putting to most students, and most “real-world” examples were too hypothetical for most students to relate to. Most of my classmates would come into class complaining about how they read the book multiple times and still didn’t grasp it.
I ended up drafting a proposal to use Thomas Sowell’s Basic Economics
as the class textbook in order to make it easier for future students to make sense of this relatively simple science.
I have no idea where this proposal stands as of now.
The saddest part of modern economics courses is that they take such a vital and easily understood subject and dress it up in highly technical jargon so as to render it incomprehensible to students. I suppose this enables professors to feel smarter for grasping something so difficult, but the purpose of school is to teach students how to be relatively proficient in a variety of disciplines; the purpose is not supposed to be providing teachers and professors a way to stroke their own egos. And if schools are not going to make an effort to ensure that economics is taught an in easily understood manner, they may as well not offer it at all.
In Friday’s edition of NY Times, David Brooks wrote a very interesting column (link) discussing the state of economics. Although subtle and rigorous in its assertions I doubt that the field of economics needs a fundamental change in the philosophical origins of economic methodology. I agree with the author that economists often ignore the notion of moral philosophy and history in economic analysis but that doesn’t mean that old textbooks on classical microeconomics need to be disposed. The author points out the role of economic forecasters who often appear on the TV, essentially trying to forecast economy’s future path. Econometrics, which constitutes time-series forecasts on which most economic projections are based, is a real discipline to which numerous new scientific articles are devoted, published mostly in The Econometrics Journal and Econometrica. In his famous 1983 article (link) Let’s take the con out of econometrics, Ed Leamer wrote how econometric modeling can be misused if a researchers ditch the true role and significance of assumptions. A prominent example is the study of death penalty on crime deterrence. As you can read in more detail in Leamer’s article, one study found out that each capital punishment deters more than 9 murders while another one found out that each additional capital punishment causes more murders.
The contradicting evidence doesn’t imply the falsification of the scientific method in economics. It merely reveals the hidden difference in how economists set assumptions regarding the behavior of individuals, firms and countries. David Brooks pointed out that economists failed to predict the recent financial crisis. However, many economists (myself included) pointed out the true dangers of an over-leveraged economy and monetary easing which led to subprime mortgage crisis and the consequential aftermath.
Many of us have had clear evidence, models and studies that showed how an over-leveraged financial sector can induce a significant economic downturn. However, many policymakers ignored the evidence of the behavior of the financial system which could be easily compared with chaos theory in mathematics. In my recent paper on Iceland’s financial crisis I showed that the depository banks’ overall leverage and indebtedness in the small country was growing exponentially, beyond the limit of capital adequacy.
As Paul Krugman recently noted, lessons from the Great Depression were not learned because people forgot it too quickly. Although mainstream economics, as every field within economic science, needs some major cures, I disagree with author’s assertion that economics is not a real science but a moral philosophy. True, economics is not exact science because human behavior is not as experimental as particle analysis in physics but economics tries to resemble the scientific methodology through models, data, statistical inference and evidence. In fact, new interdisciplinary fields within economics are emerging such as behavioral economics, neuroeconomics and transport economics in which economic analysis is combined with other disciplines such as law, psychology, sociology and neuroscience.
The limits of mathematical recourse in economics were already discussed by economic thinkers such as John Maynard Keynes. And agreeably, mathematical reasoning is bounded by economic reasoning. However, from the real point of view, we need models to address human behavior mostly because, as F.A Hayek noted, it’s too complex to capture its essence in a scientific entirety. If the necessity of assumptions, models and evidence were not the case, hardly any lessons would be learned from the episodes of crises, booms, busts and periods of economic advancement in human history.
Real gross domestic product (GDP) is the market value of all goods and services produced by a nation within a certain span of time, adjusted for inflation. It includes both the goods and services sold in the marketplace, such as a can of tuna at the grocery or server space leased from a website host, as well as those that are not, such as disaster relief provided by the Red Cross. Because this calculation is for what’s produced, it doesn’t include existing goods (re-sold homes, used cars) or those in transition (empty aluminum cans purchased by Coca-Cola to fill at a bottling facility). Nor does it include the value of stocks or bonds outstanding (although the sales commissions count), which is why the Dow Jones meltdown currently underway has not affected GDP estimates.
The adjustment for inflation is of primary importance. If an economy grew by 2.8% and inflation also rose by 2.8%, then the economy didn’t really grow. The same amount of goods and services were produced as before; only the prices increased. Economist Charles Wheelan calls it the equivalent of exchanging a $10 bill for ten $1 bills; your wallet feels fatter but there’s really no difference.
In the United States, the Bureau of Economic Analysis, a division of the Department of Commerce, keeps an index of inflation adjustments dating back to 1929, giving economists a stable means of comparison for U.S. economic performance across the years.
Nominal GDP has not been adjusted for inflation and is therefore merely raw data, which is why you don’t hear about it all that often.
GDP is measured in two ways: the raw figure, and the percent change from the previous time period. The U.S. real, inflation-adjusted GDP for the third quarter of 2008 reached $14,420,500,000,000.00, even if the economy is currently contracting rather than expanding. The sheer size of that number makes working with the raw figures rather cumbersome and also makes people’s eyes glaze over. It’s more easily understood if we simply say the U.S. economy contracted by 0.5% in the third quarter as compared to the second quarter of 2008, when it expanded by 2.8% over the first quarter.
Taking the real GDP figure and dividing it by that nation’s current population gives per capita GDP, another favorite economic scorecard, this one designed to compare economies by their average (not median) incomes and therefore standards of living. For example, Ireland’s 2007 GDP of $191,600,000,000.00, when divided by its population of 4,156,119, equals its per capita GDP of $46,600—higher than the $45,800 of the U.S.
If a nation’s population is growing, then its GDP must grow at least as quickly just to provide jobs for the new arrivals. An economic rule of thumb called Okun’s Law states that, in the U.S., GDP growth of 3% is required to prevent unemployment from rising. For every gain of 1% above that figure, the unemployment rate should fall by 0.5%. Although this pattern isn’t cast in stone, it’s been fairly consistent since the end of World War II, which unfortunately doesn’t bode well for job seekers through at least the end of this year, considering the current and expected fall in GDP worldwide.
Downsides to GDP
On average, GDP makes for a workable scorecard across economic borders; however, it does have its shortcomings. It doesn’t count values that aren’t easily transcribed into monetary figures, such as cultural, environmental, or historical values. An old-growth forest, in GDP terms, is worth no more than one planted for harvest by a forestry company (and it also doesn’t care what sort of owls call it home), while a building remains the total of its construction materials plus labor no matter who slept there.
GDP also doesn’t count work performed in the home unless it requires the purchase of cleaning materials or new siding. Nor does it count raising children as an investment for the future beyond braces and educational materials.
GDP also doesn’t include the “shadow economy,” constructed to avoid paying a tax or to bypass governmental regulations. The classic example is the waiter who doesn’t report his tips as income. Although it’s obviously difficult to calculate such things with any exactitude, a serious study performed by Friedrich Schneider of the Johannes Keppler Institute Linz claims that this shadow economy in the U.S. is approximately 7.9% the size of the official one, or around $1.14 trillion in 2007—larger than the official GDP of Australia.
Some people would rather rub a raw onion in their eye then try to understand economics. That is unfortunate because the basics of economics are not that hard to understand. The fact is that you and I and everyone else use economics every day of our lives. It is liberating to understand why economic things happen, in the same way that it is liberating to know why a car takes longer to stop on ice or gravel. The essence of politics is the use of economic law to manipulate the behavior of citizens to the will of the politicians. Political motivations become more understandable in that light, though no more moral or justified.
Economics is merely an attempt at understanding the basic laws that work in our lives. It seeks to define and simplify our knowledge of the forces that affect us so we can make appropriate decisions. We similarly use the physical principles of gravity, momentum and force every day of our lives. In both economics and physical sciences, there are relatively few laws, which can be applied in understanding very complex systems. Unfortunately, many modern economists actually add confusion and complexity by repudiating simple economic laws, substituting complex macro-economic theories, mathematical models and personal policy preferences.
With that said, the basic laws of economics are truly straight forward and powerful, and arise from the way that humans act and make decisions. Because the logic of human choice hasn’t changed, the economic laws that governed ancient societies are the same ones that govern our lives today, as well as all future civilizations of any time. We can relate to historical characters from any place on the globe because they acted like we do. Their wisdom and their follies are reflected in our experiences today. All that has changed over time is the technology we use to satisfy our needs and wants.
One of the key concepts in economics is that incentives matter. Humans take specific actions to achieve specific goals. If the incentives change, it will affect the means and the ends chosen by the actors. Related to this is the idea that choices are made at the margin. The law of diminishing marginal utility implies that the higher the quantity of a good a person has, the lower the marginal utility, or value, the next available unit holds for that person. If you are dying of thirst in a desert, you would pay almost any price for the first cup of water. You wouldn’t value the fifth cup nearly as much because your thirst would be quenched. You would value the 1000th cup of water much less because you can’t carry it and it does you little good. It’s marginal utility is very small.
The fact that the current market price for a good is $1 doesn’t mean that everyone is willing to pay a dollar. Some people would have a higher marginal utility and be willing to pay more, while others wouldn’t buy it unless it was cheaper. It only means that, at that price, the number of buyers at the margin, those willing to pay at least $1, are about equal to the number of sellers at the margin, those willing to supply it for $1 or less.
This is typically stated as economic laws of supply and demand. If the price of a specific good is lowered, buyers will be enticed to purchase more. We see this in every day life as retailers so often use discounts and sales to move inventory. If the price is raised, the quantity demanded will be less. On the other side of the coin, suppliers are in business to make profits. It will be difficult to make a profit if prices are too low, and very little will be supplied. As prices increase, it becomes easier to earn money, thus suppliers produce more, and new competitors are drawn to the market. Supply increases with increasing prices.
The incentives for buyers and sellers are at odds, and for every good in a particular market at a point in time, there will be a price where the number of willing buyers about equals the number of willing sellers. Any price above that point will produce an excess of sellers, a glut of goods. Any price below it will produce an excess of buyers, a shortage of goods. That simple relationship is one of the most powerful keys to understanding economic phenomena, whether it is Hurricane Katrina shortages or gluts of labor, more commonly called unemployment. Prices, demand and supply are all mutually dependent and reflect the market environment at a particular time. Imposing an artificial limitation on any of them will have inevitable unintended consequences, often very powerfully.
With this understanding, it is possible to comprehend the bulk of the phenomena occurring in society, and in politics, on a day to day basis. There is a lot more to it, of course. A very important aspect of economic laws and concepts from an overall point of view is that they can help to understand why an economy progresses or regresses over time.
The laws of comparative advantage and division of labor are related and work together in determining the level of productivity and prosperity of an economy. Comparative advantage means that any person, organization or geographic region has specific advantages, whether that is because of natural resources, innate skill, education and any number of other characteristics. If the actors concentrate on those things that they are most productive at and pay other people to do the things they less productive at, everyone will be better off overall. A typical example may be an attorney who may have better secretarial skills than any secretary available. But since attorney’s make a much higher hourly rate than secretaries, the attorney will be better off by doing attorney work than secretarial work. The secretary likewise would probably be better off leaving attorney work to the attorney and concentrating on the areas where relative skills are the highest.
Division of labor is the recognition that everybody has only 24 hours a day. It takes a great deal of time and effort and the right tools to be highly productive in any endeavor. Nobody cannot develop all of the skills and purchase all of the tools needed to be highly productive at all types of activities. People or geographic regions that try to be self sufficient will lead a very poor, difficult life and work very long hours.
A surgeon may be very good with his hands, but will probably hire someone to do his plumbing, carpentry, auto repair and so on. He could probably develop some low level of competence in each of those areas, but in order to do that, he would probably sacrifice very valuable time at which he is most productive. In an advanced society, there is a strong tendency toward specialization because it leads to higher productivity and a higher standard of living.
Because people who specialize are generally more productive, they have more income with which to buy the goods and services of other people. Most people in modern society outsource most of their requirements to other people or businesses. They outsource their food requirements to grocery stores and farmers. They outsource their automobile needs to car manufactures. They outsource their homebuilding needs to experienced carpenters, and so on. By building a high level of competence in one area, you are able to trade with others for the things for which they have built a high level of competence. That is what trade is all about. We outsource our requirements to others who are more highly qualified in those areas, and thus, both sides reap the benefit.
If you define progress in society as that state of affairs where people have to work less hard for less hours in order to provided for themselves and their families, then the higher the level of division of labor and the more people can apply their comparative advantage, the more quickly they will progress to a higher level. The wealth of a society comes from people producing more than they consume. Over time, that wealth can be used for capital investments that enhance the productivity of participants, and thus, further raise their income and standard of living. Societies that restrict trade and inhibit capital accumulation and specialization are those that remain in perennial status of less developed countries.
The laws of economics hold many important lessons on a day to day basis. You can try to disobey them, but it is similar to disobeying the law of gravity. You can step off a tall building and think you won’t fall, but your funeral will be just as sure as if you realized you would fall and die. The most critical lesson that economics can give is that actions have consequences. Good intentions and powerful politicians don’t make a bit of difference. The more we can gauge the true consequences without sentimentality or blinders, the more likely we are to make decisions which avoid the pitfalls and lead us to our goals, as individuals and as a society.
The New York Times published an article today placing blame on the Bush Administration for the current (latest) global economic meltdown. The staff piece recounts the actions of George Bush- in championing home ownership, in allowing banks, brokers, and finance companies to expand home lending, and in failing to reform Fannie Mae and Freddie Mac- and comes to the conclusion that this led to a housing bubble doomed to inevitable collapse and ensuing loss of wealth. This not new thinking, just another biased account focusing on George Bush’s role in this latest mess.
What the authors fail to recognize, however, are three important facts. The first fact is that home prices increased at historic rates after the double whammy of significant capital gains tax changes in the late 90s and historically low interest rates. The second fact is that this led to major investment in housing, and a vast increase in housing in the US- actually a good thing. And the third fact is that the economic tailspin was not created because too many people had houses with mortgages. It was created because 18 Fed rate hikes created a tripple whammy- crushing debt service, reduced homeprices, and slowed business expansion- that turned into rolling financial crisis.
The result is that a normal citizen, the vast majority never having taken a single course in economics, is to believe that championing home ownership is wrong, is to believe that free markets are destructive, is to believe that asset bubble always produce financial crisis. This is akin, however, to believing up is down, and that rocks can fly. It is nearly the opposite of truth.
Home prices rose thanks to the 1997 tax reform bill. Profits from selling a home could now free from taxation up to $500,000 a couple, and no longer limited to a single instance. Coupled with historically low interest rates, the financial incentive for home ownership had never been higher- but this occurred before, and largely independent, or George Bush. And, these incentives were, in fact, productive.
The goal of an economy is to create and distribute goods and services. History has proven that economies are more effective at doing this when excess production can be invested to create additional supply capacity- capital. So, creating more housing is good. This increase in housing meant that there were larger, nicer, and usually more efficient, homes. People had room to put in home offices, home gyms, home workshops, and larger kitchens with more ovens. Meanwhile, houses were purchased by investors and put up for rent, keeping rents lower and more affordable. The NY Times authors prefer to look at this glass as half-empty, citing a former Bush official who felt a housing bubble was evident because rents didn’t rise as fast as home prices. But the effect was to more effectively distribute housing- a good thing.
All this progress did not have to lead to an economic collapse. As of 2004, homebuilding costs were rising, and supply would have begun to catch up with demand, eventually slowing the market. But, ever cognizant of the “Scarcity Paradigm” crowd that was in full voice about “suburban sprawl”, “unsustainable growth”, “global warming”, and an “overheated” economy, the Fed raised rates 18 times, to 6%, between 2004 and 2006. The effects were chilling. As ARM rates climbed, the most vulnerable homeowners were faced with increases in debt service of 50% or more. This led not only to climbing default rates, but responsible homeowners putting their homes for sale- quickly creating excess supply and dropping prices. We all know what happened thereafter- and it didn’t require Fannie and Freddie.
The Federal Reserve has reversed course in a big way, but is learning the lesson that destruction is much easier, and faster, than construction. Monetary stimulus takes time, usually 6-9 months, and the (well-placed) crisis in confidence in our financial system will slow this recovery further. Eventually, inflation will emerge, creating incentives for money to be spent and invested, and economic growth will resume in a world of 3 billion people living on less than $2.50 per day.
But the lesson of this downturn cannot be that production- even if it creates temporary imbalances- is bad. It cannot be that wider distribution- even in the face of risk- is bad. It must be that the Federal Reserve should never increase debt service requirements by a factor of 2-3X on households and companies in less than, say, 5-6 years. Because our economy, like rocks, can fall very fast when they do.
Given that this is an economy blog, it seems the headline is, at least, challenging. After all, economists are held in high regard, as the experts in the scientific field of economy. They have all those complex formulas to explain, predict and plan the economy, haven’t they? They have after all studied the field, act as counselors for the governments, tell us what’s wrong and give us advice in troubling times where the complexity of economic events become overwhelming, do they?
This is not an academic journal, so it would be off the mark to argue about all those „scientific“ claims made by most economists. One of my former co-workers, a Scotsmen, once told me the phrase that “common sense is not very common.” I have to agree. So, this article is based on common sense and how it helps to understand economy.
Since most of us have too much to do to get the daily chores done and to make a living, we have little time to spend understanding fancy phrases and economic babble. And if I had the choice to watch, say Jon Stewart, or read John Maynard Keynes, in my spare time, I would sure switch on the TV and throw the “General Theory” into the bin. Guessing that most of my fellow citizens would do the same, it is no wonder, that economic science rests in an ivory tower guarded by a huge army consisting of terms and phrases that the “common” man does not even know how to spell let alone knows what they really mean. You remember the story of the emperors clothes?
Mind, I am not saying that economy is useless. In fact is is much to important to leave it to the scholars in the ivory towers. Economics is about the essence of our lives and therefor “essential” to all of us. I promise I will try to keep fancy words at a minimum, and where I use them I will explain them.
Well than, let me start with some explanations. Economics as a term is derived from ancient Greek oikonomia – which basically means the rules of the household as oikos is the house and nomos means law. Because we all live in households, and all have, at least some, rules how to run it, we all are engaged in economics. In short, economics is your and my everyday struggle to survive. No need for fancy phrases here so far.
The first question that comes to my mind when I consider this would be, why do I have to struggle to survive anyway? I mean, wouldn’t it be cool to survive without any effort? Indeed, that would be cool. Yet, we as humans have a lot of empirical (another fancy word meaning “by collecting historical data”) evidence that we can not survive by doing nothing. Men has always dreamed about such an environment and we call it paradise. Alas, reality looks different. Question is, what keeps us from being in paradise? Ok, I don’t mean the angel with the sword. There are two things that keep us from the kind of paradise described above. First, scarcity and second uncertainty about the future. Think of all the basic ingredients a human being needs to survive. Air to breath, food to eat, water(well that would be very basic) to drink and, given the absence of a natural fur, shelter.
If you are still with me (which means probably that Jon Stewart is not on the program yet) I ask my next question. Which things of the list above are scarce? Well air is not, unless you are a scuba diver trapped in a wreck 30 feet below the surface of the Atlantic with a half empty bottle of air. Food is sure scarce, even if you have a well equipped fridge with bulks of your favorite Alfredo style Lasagna. The same goes for beverages. While there is no need to search for ways to get air, you can just breath, you need to find ways to get food and drink, and shelter. You have to spend time to get those vital things (unless you still live with your parents that is).
Good, we now know that some stuff we need is scarce and we have to do something to get it. But, why do we have to do something at all? Because, we do not know the future. If we would know everything that will happen in the future, we would not act at all. If I was hungry, and knew that in 2 minutes a roasted chicken would fly into my mouth, why bother to think about going out to hunt? Yet, I am pretty uncertain this would happen ever. Omniscience (well, remember my promise about fancy words), which means to know everything of the past and the future, would prevent us from doing things. Or, to say it in another way, we only act because we are uncertain about the future.
Now, what is action? Action is what we do to achieve our goals. What we do is using means we have at hand, or think we have at hand, to get us closer to the goal we desire to achieve. Wew, starts getting complicated, doesn’t it?
Let me give you an example. If you are hungry, and you are not a masochist, you probably have the desire to feel full, as hunger is a painful feeling. Now, we know that probably not much roasted chicken fly through your kitchen within the next minutes. But, you know there is some bread, tuna, salad and mayonnaise there of which you could produce (hey you are a producer) a tuna sandwich, eat it and fight that painful hunger. So homo economicus, that is you, starts acting. You take your means – bread, tuna, salad, mayonnaise and your skills in preparing those yummy sandwiches of yours- and employ them to make that great product which will be consumed by you and, hopefully, brings you the desired satisfaction -feeling full.
You just encountered one of the economic rules (remember economics means rules of the household) “Humans act, that is they purposefully employ means, to achieve what they desire”.
We have already scratched the surface of another rule when we talked about the difference between air and the other vital things. It is the rule of subjective value. Subjective means, that it is always you, or more accurate, the individual, that gives value to an item. Air has no value to you, as you do not have to act (that is purposeful employing means to achieve ends) to get it. It is abundant in a normal environment. Remember the scuba diver (he is still trapped in that wreck)? To him air is pretty valuable, don’t you think? He probably would put a lot of effort into getting more. To him air is a good.
Another important rule we have here. Goods are things that have a value to individual humans. For something to be a good, it must be a means that an individual can use to achieve what he/she desires and it must be scarce. Bottom line, whether something is a good or not, depends on its usability for individual men. Another word for usability is utility.
Before I close this first short excursion to “common sense” economics another example tho show that something is a good only, if it has a utility for individuals.
Oil was the pest of every piece of land until only a hundred years ago. Whenever a farmer encountered those black, ugly, stinking springs on his land he was probably going to curse, even if he was a puritan(not meant offensive). Oil was not only worth nothing, yes it has been used in ancient warfare to ignite enemy ships, but this was long forgotten, oil was seen as bad luck if you had it on your property. Why? Because no one had any use for it until a guy named Rockefeller showed up and invented a way to make stuff called kerosene out of it. Now Kerosene was pretty useful. You could use it in lamps (can you imagine to have only daylight, how boring nights, especially in winter, must have been…uhm), and some people even experimented with it to build engines that might one day drive coaches without the need for horses which would be called cars or automobiles(which is a bad name because they do not drive by themselves as the name suggests).
All of a sudden, a good rose out of a totally useless thing like oil. And today, we tend to believe, with good reason, that our civilization might fall, if oil vanished.
Economics is not about complex equations in an ivory tower, but about human ingenuity to transfer the natural resources man finds into something useful.
For more than a hundred fifty years, economics has been feared by students, lay people and economists themselves. Not the least source of this fear has been the fact that economics has been labeled as “the dismal science.” The study of economics has been living with its moniker ever since English philosopher Thomas Carlyle ascribed the incorrect predictions of Robert Thomas Malthus concerning overpopulation and the eventual lack of the world’s food as “dreary, stolid, dismal, without hope for this world or the next.”
Malthus’ fears ultimately were far from justified. Technology and science in the intervening century more than solved worldwide starvation. Unfortunately, economics remains the “dismal science” to this day. Harvard’s Walter S. Barker Professor of Economics recently released his book The Dismal Science: How Thinking Like An Economist Undermines Community. The book not only repeats the unfair moniker but misses the point made by thousands of economists, which ultimately leads novices to shy away from the study of economics in general.
The problem lies largely in the assumption that economics is a “science” just like biology or basic logic. It’s not. Economics is just another method of trying to solve the age-old question of what, how and to whom to distribute finite resources. As such, economics is just as much subject to debate as psychology.
The Science of Assumptions
Ever since Adam Smith, the foundations of economics have been presented as scientific fact. The facts presented as economics are really two: an assumption regarding the nature of man as well as a strict belief and usage of logic. Unless someone can show an alternative to thousands of years of developed logic based on fact, we should be able to live with that assumption. More difficult, of course, and subject to endless debate is the assumption regarding the nature of mankind.
Unfortunately, most beginning studies in economics merely accept without questioning the classical economist’s assumption that mankind is greedy and selfish or wants mainly material things. Whether true or not, without stating or questioning that assumption, economic studies immediately delve into the mathematics of graphs and charts and formulas. Some even create the impression that the movement up and down a curve or graph actually makes the economy move! Nothing could be more absurd.
For whatever reason, only a few simple paragraphs and no more might be devoted in a textbook to logic and fallacies in thinking. Some beginners in economics might readily recognize the confusion between facts or values. It is, however, much easier to settle back, comfortable in accepted beliefs, rather than learn why those beliefs first developed. Nearly everyone can recognize the post hoc, ergo propter hoc syndrome, or the difference between “positive” and “normative” economics, after one or two courses in economics. But even professional economists quickly fall into the trap of simple assumptions regarding the nature of man.
Dialogue vs. Mathematics
Perhaps it would dispel once and for all the notion of a “dismal” science if we divided basic economics into two: a discussion of mankind’s nature in its non-quantifiable form as well as a strict mathematical quantification of material things based on fact.
At the graduate level, the latter is known as econometrics. That study, of course, already assumes that you have a reasonable outlook on the nature of mankind through psychology, politics, sociology or religion. Econometrics should be especially suited for those with a mathematical bent rather than those who prefer to focus on lengthy philosophical discussions.
The key for all these “soft sciences” – including economics as we practice it – is that they are all subject to change with the current vogue. Was Karl Marx writing essentially about economics or a solution to political problems? Although basic logic has propelled western civilization forward since the Age of Reason, other societies have chosen different routes, especially in value systems.
Most of economics really depends on a “positive” rather than a “normative” assessment of society’s problems. Whether government or private individuals should make the crucial decisions about resources is virtually irrelevant. It is more a question of politics. The major concern depends on your own view. The questions are the same, as are the quantifiable economic answers.
Economics can be fun, especially when one can illustrate and question the nature of mankind through examples of watching people’s behavior at a local Wal-Mart on a given day.
Too many would-be economists in graduate school or beyond may never really have had asked themselves about the fundamental nature of man.
Once we understand and accept the essentials of mankind, bolstered with valid facts, we should be able to look at the “dismal science” with a much brighter perspective.