Making Sen$e of 2010: Conventional Wisdoms That May Be Wrong

What is the economic conventional wisdom with which you most disagree?

Dan ArielyProfessor of behavioral economics at MIT and author of Predictably Irrational

With the advent of the industrial revolution in the 19th century, the field of rational economics was really heating up. The British novelist George Eliot saw the problem with rational economics even then. In one essay, Eliot described the strange way economists view mankind, even suggesting the approach behavioral economists would take more than a century later:

The tendency created by the splendid conquests of modern generalization, to believe that all social questions are merged in economical science, and that the relations of men to their neighbours may be settled by algebraic equations … none of these diverging mistakes can co-exist with a real knowledge of the People, with a thorough study of their habits, their ideas, their motives. [“The History of Natural German Life,” Westminster Review, July 1856]

Like Eliot, behavioral economists point out that markets are entirely man-made and man-powered, and therefore just as prone to faults and shortcomings as other inventions of mankind. Think about the financial crisis of the last few years as one expensive example of this principle. Some of the assumptions of rational economists like Alan Greenspan — that people always make the best decisions, that mistakes are less likely when the decisions involve a lot of money, and that the market is self-correcting — have led to disastrous consequences. The point is that unless we understand and work round our irrational nature we are likely to continuously move from one economic disaster to another.

Dean BakerCo-director of the Center for Economic and Policy Research in Washington, D.C.

There is a widely held view among people who are well enough educated to know better that the United States and much of the rest of the world faces a huge demographic problem due to falling birth rates. This view displays an incredible ignorance of basic economics and requires ignoring the world that we see in front of our face.

In the United States, the projections of deficit horror stories 30 or 40 years in the future are usually presented as a demographic story. All the baby boomers will be collecting Social Security and Medicare and there will be a relative smaller number of workers. In fact, it is easy to show that this is a broken health care system story. If U.S. healthcare costs were controlled, then the projected deficits would be easily manageable.

More generally we have been repeatedly warned that in Europe, Japan, and even China , lower birth rates are projected to lead to a crisis due to a shortage of workers. Okay, it’s econ 101 time.

In market economies we don’t get shortages. Prices respond to market signals. In this case, the price of labor would be expected to rise. This means that ordinary workers will get more money as their wages are bid up. (Are you scared yet?)

Higher wages will price workers out of the least productive lines of work. We might not have all-night convenience stores open all night or greeters at Wal-Mart. We might have more cafeterias and fewer sitdown restaurants. Valet parking would be less common. Hotels would not change sheets every night for their guests.

The demographic horror story sounds great to me. In a world that is plagued by disastrous levels of unemployment, the image of a world where ordinary workers have their choice of jobs would be a huge step forward.

And, has anyone heard of global warming? As a first approximation, if we have 20 percent more people, we have 20 percent more greenhouse gas emissions. Countries that contained their population have done an enormous service for the planet. If only we had a policy elite that understood the most basic points of logic it would be a huge step forward.

Arvind SubramanianSenior fellow jointly at the Peterson Institute for International Economics and the Center for Global Development

The conventional wisdom that I most disagree with is that economics and economists failed us during this global financial crisis.

For sure, Alan Greenspan and Ben Bernanke (among many others, including rapacious financiers) have a lot to atone for. They helped create a belief system that elevated markets beyond criticism. They failed to see, and hence failed to act against, the destructive power of the untrammeled workings especially of financial markets. But crises will always happen and most big crises almost always creep upon us from unsuspected quarters. As Keynes said, “The inevitable never happens. It is the unpredictable always.”

So, if economics cannot really help us prevent crises its arguably more important role is to help in responding to them. And here, economics stands vindicated, with a vengeance.

How so? Recall that the Great Depression was caused by a combination of three factors: overly tight monetary policy; overly cautious fiscal policy (especially under FDR in 1936 when tighter fiscal policy led to another sharp downturn in the US economy), and sharp increases in trade barriers worldwide. The impact of this global financial crisis has been significantly limited because on each of these scores, the policy mistakes of the past were strenuously and knowingly avoided.

On monetary policy, Bernanke was true to the word he gave to Milton Friedman: “Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” He found conventional and some very unconventional ways of not doing “it” again. On the fiscal side, policy-makers enacted huge stimulus packages, taking the cue from Keynes’ writings in providing public demand for goods and services where private demand had collapsed. And, surprisingly, despite the unprecedented collapse in trade, few countries erected any significant trade barriers, in part because they were aware of its devastating consequences.

The Greatest Depression that could so easily have happened but did not is the tribute that is owed to economics.


Making Sen$e of 2010: The Next Crisis

Making Sen$e of 2010: Economic Surprises in Store

Making Sen$e of 2010: Economic Indicators to Watch

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