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March 23, 2008

Economics doesn’t work as advertised

Category: Economics,Editorial,Little Things,Rants,Save Electricity,Save Fuel – Tom Harrison – 3:25 pm

I got an Economics degree almost 25 years ago. I think I might like a refund, as it has not lived up to its promise.

My Wonderfully Simplistic View Of Economics

(also, possibly why I was not at the head of my graduating class)

Macro Economics describes the behavior of countries: GNP, Inflation, Monetary policy, supply and demand, and markets as a whole. The invisible hand was supposed to guide the economy towards a good direction. Profitable enterprises would thrive; unprofitable enterprises would falter, and profits would accrue to the benefit of countries as a whole.

Not a perfect system, but less bad than any other. Yes, there would be inequities; some people would be rich, some would be poor, but these were temporary, mainly due to cases where the transfer of information was less than perfect. But over time, the incentives of a market economy would want to bring up the poor people, and wouldn’t let the rich get too rich, unless they truly deserved it.

Micro Economics claims to describe the behavior of businesses in the economy: profit motives, human resource, equity and so on. The main engine of micro is the corporation, which is an organization that provides the opportunity to work and contribute towards society through productive actions, while compensating employees for their contribution to the benefit. Companies that used resources efficiently would be able to charge a lower price and pay their workers better.

To be fair, economics was never painted as a “moral” process; indeed, it was argued that it harnessed the power of greed to the benefit of all. Economics was also never thought to be perfect; the science was based on some rather remarkable assumptions, for example, markets need “perfect information” in order to work efficiently.

The responsibility of governments was to operate their levers of fiscal and monetary policy in such a way as to provide the greatest benefit — in effect, to compete with other countries. The degree to which this was necessary was a subject of great debate; some felt a hand’s on, central government role was important.

Others, notably the late Milton Friedman, argued that almost no government involvement was required, and indeed, any government involvement introduced inefficiencies, whereas (almost) completely free markets would solve social ills and could be used as a competitive weapon against regressive and totalitarian governments.

My Observations of Reality Compared to Theory

In the last 20 or so years, I can’t say that I have seen any consistent realization of the kinds of larger outcomes predicted by the dismal science. Monetary policy seemed to be working really well there for the tenure of Alan Greenspan … but lately it doesn’t seem quite so great (which can’t possibly be the fault of Bernanke, since nothing moves that fast).

Bigger communist countries have fallen or acquiesced to free markets … but it’s not clear to me that the countries or more importantly their people are a lot better off as a result. I guess I would say that I don’t see utopia breaking out all over.

On the contrary, I see our most powerful entities, countries and corporations, becoming even more corrupt and even more despotic. It seems much easier to me to rattle off the names of corrupt, regressive and murderous capitalist governments, and the names of corrupt and regressive corporations.

I don’t actually blame this on a failure of the theories underlying economics: they still seem plausible, but only once the underlying assumptions upon which these theories are based are in place.

And there’s the rub. Economics suggest that markets will be most efficient when they have perfect information. One might assume that in the last quarter century, during which computers and the Internet have proliferated, information would be more immediate and accurate. While this may be true, the more profitable use of these technologies (more profitable even than pornography and gambling) is the use of algorithmic trading whereby computers look for tiny little inefficiencies in markets and exploit utilize them to make money at someone else’s expense.

Another assumption of economics is that money is a good tool to measure value. The thing is, certain things are more difficult to put a price on than others, and some simply are not measured at all. This latter group is what is known as an externality; pollution is often used as an example. We drive our cars, or run our lights and generate pollution, but nothing in the economic model driving the pricing or our behavior accounts for the impact of pollution. We used to think pollution just smelled and looked bad, or made us ill. Perhaps now it seems more like it is making our planet ill.

There are several other assumptions (my favorite: people will act rationally) that just don’t seem to actually exist in reality.

So as a science, this puts economics in the realm of astro-physics or theoretical mathematics: interesting and quite likely true, but of little actual consequence to our daily lives. The difference with economics is that it is assumed to be mostly right, and thus is the foundation of much of our policy. In fact, even if economics is mostly right, its small failings may have such a huge impact as to lead the main powers of the world, governments and corporations, in a very wrong direction.

And all of this from a guy who graduated from one of our nation’s leading fonts of economic theory. I bet they are glad they gave me such a low grade.

4 Comments

  1. […] while I am very, very glad to have the world now understand externalities, and while I always trust everything all economists say, I must admit that my non-scientific side thinks that perhaps the cost of CO2 emissions from cars […]

    Pingback by Freakonomics Gets It Right/Wrong (Completely) | Five Percent: Conserve a Little Energy — April 18, 2008 @ 10:53 pm

  2. […] Ridership on public transit has increased. Gas prices rise, and people react by taking more public transit. In recent posts, I have argued that economics does not work. […]

    Pingback by Gas Prices Up, Public Transit Usage Up | Five Percent: Conserve a Little Energy — May 10, 2008 @ 11:11 am

  3. Could you explain more about externalities?

    What are the externalities of a murder-for-hire business?

    Comment by Michael Ejercito — May 12, 2008 @ 2:26 am

  4. Well … that’s an interesting example.

    Not all economic activity produces significant externalities, which is loosely defined as a cost that is not accounted for in the transactions associated with the activity (see the link in the post for more detail).

    So in this case let’s say the costs include the murder weapon and ammunition, the fee charged by the hit-man, travel costs, and then funeral costs, police work, legal and other costs. Most of these costs are accounted for “internally” through business transactions so are not externalities.

    Not having any particular expertise in the murder-for-hire business, I cannot say if there are other factors I have not considered.

    Comment by Tom Harrison — May 13, 2008 @ 9:22 am

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