How to think like an economist (and why it matters)
Presentation by Diane Coyle at IPEG, University of
Manchester, 30 May 2003 PART 2
Complexity, however, does
torpedo the machine metaphor that underlies most day-to-day
forecasting and comment. The kind of macroeconomics that
gave us the Phillips Machine - representing the flow of
income in the economy, with colored water flowing along
tubes to indicate the pace of consumer spending, and valves
to indicate the tightness or otherwise of monetary policy -
gives a bogus impression that it's possible to fine-tune
the economy with a bit of twiddling here and there. Bogus
because there won¹t be a fixed relationship between the
amount spent by consumers and 'levers' like interest rates
or government spending if you also factor in individual
consumers being influenced by fashions, general 'feelgood'
mood, or herd psychology in the stockmarket. The economy is
not controllable, at least in any straightforward
mechanical way. Perhaps a machine was a good metaphor in
the immediate post-war era when even in non-communist
countries the economy was in fact much more highly
regulated and controlled. It no longer holds good in
modern, liberalized economies.
This underlines the fact that macroeconomic forecasting is
now a lot more pragmatic, a kind of guerilla warfare waged
against the tides of history, the ambiguities of the data
and the sheer unpredictability of all the millions of
people whose behavior is being forecast.
There is, too, a much greater respect in macroeconomics now
for the gritty details of the real world rather than the
abstractions of grand theories, and this must be good news
too. There has been a resurgence of interest in
institutions and in economic history, kindled to a large
extent by the process of globalization. For example, why is
the same person many times more productive the minute he
moves from Haiti to the United States to do the same job?
It can't be anything to do with the person, who hasn't
changed, or the nature of the job, which is the same, so it
must be something to do with America having institutions
and arrangements that enhance the capacity of individuals.
Why do countries that seem very similar in terms of the
availability of technology and skills of the workforce,
like the US and Germany, have different rates of
productivity growth? What is it about developing countries
that keeps them poor when technology and finance for
investment are more freely available anywhere than they
have been for more than a century?
I haven't mentioned yet the fantastic blossoming of
microeconometrics since the mid-1980s, made possible by
cheaper computer power and the ability to manipulate large
data sets. There are more and more specific policy
questions on which it is possible to provide well-founded
answers.
Economists know they can really offer a lot of insight on
questions like these. Typical articles in the leading
professional journals will look at issues like why
businesses in one industry but not others will use a
certain kind of exclusive contract with their suppliers,
whether welfare payments work best in cash or as vouchers,
what effect growing up in a public housing project has on
earnings potential, whether maternal education cuts high
birth rates in poor countries and if so by how much, what
kind of personality traits help people get jobs, what kind
of interconnection charges in the telecommunications
industry encourage use of the Internet, and so on.
Similarly, the government's most useful policy tools are
all concerned with microeconomics, or the supply side as
it's more often called in this context. Supply-side
economics got a bad reputation in some quarters because it
was warmly embraced by President Reagan and Mrs Thatcher
and therefore seen as a veil for favouring big business and
the rich. But two decades on, now the political heat has
died down, it's clear supply side issues are very important
for the health of the economy, and are intimately bound up
with government actions. Is the degree of regulation of a
particular industry tough enough, but not too tough? Is it
easy, but not too easy, to set up a new business? Is the
banking system secure and well-capitalized? Can damaging
monopolies be forced to allow competition into their
markets? Are certain tax rates so high they damage
investment?
Posing such questions also underlines the fact that the
interesting question about government is not 'how big is
it?' but rather how it sets the institutional and
regulatory framework in which markets operate. This ties
the microeconomic questions to the big picture about how to
generate growth and jobs. It also links the Adam Smith of
the Wealth of Nations to the Adam Smith of the Theory of
Moral Sentiments or the positive and normative approaches
to economics.
There are in fact more and more answers, with modest
margins of uncertainty, to many such detailed questions
thanks to the co-development of large data sets and more
powerful computers. And there are of course many more
questions left to address, not least because the world
keeps changing. The research agenda is incredibly rich and
exciting. The payoff in terms of our understanding of
society in applied microeconomics, applying the tools of
economic analysis to all sorts of subjects outside the
traditional boundaries of the profession, has been
enormous.
Finally, on this note of optimism, there is a vast amount
of exciting interdisciplinary work going on. There's the
spillover from psychology into behavioural economics and
especially finance. There's the revival of economic
geography and economic history. The richer understanding of
monopolistic competition, network industries, auctions,
trade theory and so on.
The fact that there are such compelling developments in the
discipline, ranging from the fantastic successes of
microeconometrics in the past 15 years to the revival of
interest in institutional economics and economic history,
is very encouraging. It suggests economists might be
escaping the intellectual straitjacket that so many
practitioners of economics imposed on themselves for
decades.
The tactical error of the unorthodox, post-autistic
economists is that they downplay these developments and
with them all the strengths of conventional economics. They
do indeed set up a straw man, although rightly pointing out
that the straw man version is still being taught to
students. We urgently need to see reform of the curriculum
in schools and universities, including a reintroduction of
economic history. I'd keep all the formalism the have now,
and add the teaching of much, much greater respect for data
and statistical theory.
I'm passionate about banging the drum for economics. If the
message got through to more people, we might one day find
fewer opinion polls showing majorities in favour of both a
cleaner environment and lower taxes on fuel, fewer calls
for an end to sweatshop labour from people who also want to
buy their clothes as cheaply as possible. The bottom line
is that any informed and active citizen needs to understand
the economic method of thinking. The more of us that can
apply a little scepticism and an ability to weigh up the
evidence to any public policy issue, the healthier our
societies will be and the wealthier our nations. But if
this is ever to be achieved, economists will have to be a
lot more persuasive, and that means living up to the
promise of our discipline.
It's actually pretty straightforward to think like an
economist. It doesn't matter if you never quite get your
mind around the minutiae of the Brouwer or Kakutani fixed
point theorems used in proving the existence of general
equilibrium. As John von Neumann, the mathematician and
economist who developed game theory in the 30s, once wisely
advised a student: "Young man, in mathematics, you don't
understand things, you just get used to them." I've boiled
it down to 10 simple rules (extracted from Sex, Drugs and
Economics).
1 Everything has a cost. Or 'There's no such thing as a
free lunch'. Even when acquiring something doesn't involve
handing over money it will have an opportunity cost. Most
of us have limited financial resources and all of us a
fixed amount of time. We have to allocate those scarce
resources.
2 Things always change. This is another way of saying that
economies are made up of millions of people who, peskily,
react to the environment in which they find themselves.
Human initiative is bad news for policymakers because it
means a policy drawn up on the basis that people behave in
a certain way can be undermined if they change the way they
behave in response to the policy. Much economic theory is
based on the so-called 'ceteris paribus' assumption, that
all other things will remain unchanged apart from whatever
the specific thing is that you're trying to analyze. The
assumption is necessary because without isolating certain
aspects of a problem it can't be analyzed at all. But it's
essential at the end of the process to think about what
will change in practice and whether that sheds any new
light on the analysis. The deeper moral is that economic
policy is not a matter of exercising control over anything
at all. For much of the post-war era policy was based on
the idea that the economy was a machine about whose cogs
and mechanisms we could steadily gain greater expertise,
complicated but stable and predictable. No such luck.
3 Metaphorical 'time bombs' don't explode. This follows
from the above. Time bombs are all based on false ceteris
paribus assumptions, when in fact unsustainable trends
always lead to changes in people¹s behavior precisely
because they are unsustainable. Environmentalists are
particularly keen on time bombs, which is why economists so
often seem to be anti-green. One example is the so-called
population time bomb. In 1968 environmentalist Paul Ehrlich
wrote a best-seller with this title, predicting that
over-population meant hundreds of millions of people would
die of starvation during the 1970s, including many millions
in the developed world. Not only did it not happen, but
average calorific intake has increased by more than 50%
since 1961, food prices have fallen steadily in real terms
and the proportion of people who are starving has fallen
dramatically to about 18% of those living in the developing
world. Where did Ehrlich go wrong? Birth rates decline as
people become richer, and the world population is now
expected to stabilize at about 10 billion in 2100.
Improvements in agricultural technology like the green
revolution of the 1970s mean we are now more productive at
feeding people. The main cause of starvation is not lack of
food but lack of democracy, as it is in war-torn
dictatorships that famines occur.
4 Prices make the best incentives. Changes in prices are
usually what defuses time bombs and much else besides.
People respond to prices. Everybody loves a bargain, and
somebody always responds to a great profit oportunity. On
the other hand, many people don't like to do something or
not do it just because somebody in authority says so.
Government regulations are essential in any economy. Market
economies only work well if they are based on solid
institutions, the rule of law, the control of monopoly
power, the adequate provision of public goods and so on.
The question is really how governments can best achieve all
these desirable conditions. Often, price incentives can
achieve the desired aims far better than any direct
controls. Whereas people will try to get around
regulations, they will respond to prices, and in ways that
reflect their own needs and preferences so the outcome is
likely to be one that makes as many people as content as
possible.
5 Supply and demand work. If you restrict the supply of
some item, its price will go up at a given level of demand,
whether it's Ecstasy or the construction of new housing in
central London or Manhattan. If demand for something
increases at a given level of supply, the price will go up.
The example that leaps to my mind is whatever happens to
become the most popular toy at Christmas when the item was
made and shipped to distributors six months before kids
start thinking about what they want as presents. Following
on from this, if the price can't adjust upwards for some
reason you will get shortages and queues. This imposes
other costs like time lost hunting around or waiting and
general irritation on buyers. They pay one way or another.
If prices can't adjust down sellers are left with unsold
inventory, which imposes other costs such as storage and
wasted investment on them.
6 There's no easy profit. There's an old joke about an
economist and her friend spotting a $10 bill lying on the
sidewalk. The friend says they must pick up the money, but
the economist says not to bother if it were really there
somebody would already have picked it up. Or in another,
about how many economists it takes to change a lightbulb.
The answer is none, because if the lightbulb needed
changing, market forces would already have done it. The
valid point, however, is that somebody always takes
advantage of opportunities for profit, even if it does not
happen as fast and seamlessly in life as it does in
economic theory. Arbitrage happens. (It is obviously not
the case that every activity is equally profitable, though.
People who take bigger risks, whether financial speculators
or business entrepreneurs, tend to earn higher rewards on
average. If they didn't expect to do so, there'd be no
point in taking the risk. They might as well opt for a
quieter life.)
7 People do what they want. All economic activities are
equally desirable, or people wouldn't be doing them. There
are caveats to this statement: it needs to add something
like: 'at the current set of prices and given the
constraints on technology and government rules and
regulations.' Still, it's basically a way of saying that
people adjust to do what will suit them best given the
current state of the world - it sounds obvious when spelt
out but seems hard for non-economists to grasp in many
real-life contexts. There are countless examples. Companies
can choose to locate their factories in high wage countries
where productivity is high or low wage countries where
productivity is low. If they are lucky enough to find a low
wage country where productivity is actually pretty high,
they will be joined by lots of other manufacturers building
factories, and wages will get competed up. And a country
where wages are kept higher than warranted by productivity
levels, by vigorous unions, for example, will find its
industry relocating elsewhere, slowly but surely.
8 Always look up the evidence. Economists have an unfair
reputation for playing fast and loose with the facts. (As
yet another joke demonstrates. Question: What does two plus
two equal? Economist: What do you want it to equal?)
Pundits who pitch up on TV or are quoted in the newspapers
fling around a lot of factual claims. Some of these are
highly dubious. But it is easy to look up the some figures
and discover that global poverty rates and the number of
child workers have been in decline, that inequality
globally has not been increasing much unless measured in
one specific way, and that in most countries corporations
have been paying more, not less, tax. However, one caveat.
you need more than raw data. Sometimes you have to think
about it too.
9 Where common sense and economics conflict, common sense
is wrong. Take the two most frequent examples. Contrary to
many people's natural belief, imports are better than
exports; and there is no fixed number of jobs to go around.
There is a macho view that the bigger the exports the
better the economy, but the only point in exporting
anything is to earn the currency to buy the imports that
give people more choice and lower prices. The second is the
'lump of labor fallacy', an old favourite. There were only
13 million people working in Britain in 1870 compared with
27 million in 2000. That's a doubling in the number of jobs
in 130 years. Yes, sometimes unemployment has been high,
when people who wanted to work couldn't find jobs. But in
general as economies grow so do both employment and real
earnings. Workers become more productive, so they grow more
prosperous, and there are more of them too.
10 Economics is about happiness. Economic welfare is
improved by being able to buy more and better goods and
services with the same amount of work, or preferably less.
At a given time rich people are happier than poor people,
although the level of happiness has not trended upwards as
strongly as average incomes over time despite the
corresponding gains in health and longevity. The biggest
gains in happiness seem to come with economic growth from a
low level of income. Winning the lottery makes people very
happy indeed, but only for a year or two before the effect
wears off. The key point is that economic welfare is about
consumption not production. Just as exporting is what a
nation does in order to import, work is what the individual
does in order to consume. Although everybody thinks work is
the basis of capitalism, in fact, it's about everybody
having a good time and being comfortable.