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.