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Economics: How to Cure a Sick Discipline

Economics / Economic Theory May 01, 2010 - 07:49 AM GMT

By: Ian_Fletcher

Economics

Best Financial Markets Analysis ArticleAmerica’s financial mess and our festering trade crisis were both caused by bad policies that mainstream economics told us were OK.  This has made the public cynical about economists, but has produced few specific suggestions on how to actually fix the discipline.  So—what should we do to restore its ability to give sound advice?


For a start, the brittle and overly mathematical way in which economics has mostly been practiced in the U.S. for the last 60 years must go.  Instead, it should instead proceed using the following fourfold test of every idea:

1. Analytical storytelling. This is what ordinary people think of when they think of economics. It means reasoning largely without numbers or graphs or statistics—the kind of thinking that Adam Smith, Karl Marx, and Alexander Hamilton engaged in. It means basic concepts such as supply and demand. It means politicians praising free enterprise and criticizing exploitation. It means business magazines talking about how various industries function. It means value-judgments like “prudent.”

2. Mathematical or computer modeling. This is the part that academic economists tend to be obsessed with, particularly the former. It ultimately amounts to rigorous ways of expressing the same ideas as the stories above. It has its place, and in some areas (quintessentially, financial economics) it is impossible to practice valid economics without it. But it must not be allowed to crowd out other kinds of reasoning.

3. Government statistics. Despite their reputation for being among the most boring creations of humankind, government statistics—when accurate, complete, and accessible—are worth their weight in gold for settling public policy questions. The U.S. government should spend more money on collecting better statistics, and less on subsidizing the construction of more useless mathematical Tinkertoy models.

4. Real-world experience. Economics, unlike climatology (another slippery and bitterly controversial discipline), deals in deliberate human actions with immediate practical effects. This enables us to ask whether people actually live by any given economic idea. (As noted in my book Free Trade Doesn’t Work, real international businesses would go broke if they relied upon the theory of comparative advantage, the key justification for free trade.)

Nothing in this list is, of course, an original suggestion. What is perhaps mildly original is the idea that this fourfold test should be imported into the discipline itself. This would make economics very different from, says, physics, the discipline it currently desperately tries to imitate. Instead, it would become more of a professional field like medicine, law, or engineering, and less of an academic discipline per se.  (The great British economist John Maynard Keynes once noted that all he wanted was for economists to become as useful as dentists.)

One advantage of these tests is that three out of the four are at least somewhat within the reach of ordinary citizens. This is important because it provides a sanity check to protect economics against the dangers attendant upon becoming the intellectual property of an inbred academic priesthood—or those who pay them (sometimes indirectly).   

Any claim passing only three out of the four tests is a theory in need of further refinement. Any claim passing only two out of four is an intriguing falsehood. A claim surviving merely one is either ideology (if it passes one or two), or special interest pleading (three or four).  This set of criteria would probably have prevented economics from falling for a lot of the dumb ideas, from efficient financial markets to free trade, that it has embraced in recent decades.

So far, so good.  But there’s an even bigger payoff : the kind of economics that can survive broad-based confirmation in theory usually is precisely the kind that leads to broad-based prosperity when used as the basis of real-world policymaking. Conversely, economics comprehensible only to an intellectual elite leads to correspondingly elitist real-world results.

The most important example of this is that sound economics appears to show that competently implemented paternalism towards ordinary workers benefits not only them, but the economy as a whole.  An economy in which productivity gains don’t just flow to increased profits, but are split between owners and workers, sounds quasi-socialistic to early 21st-century Americans, numbed by three decades of free-market propaganda. It is basically the opposite of how the U.S. economy has operated since the late 1970s, where almost all gains have gone to capital and the professional classes that service it (roughly the top 10-15 percent of the population), while everyone else’s income has stagnated. But it is, in fact, the original American tradition, from Alexander Hamilton by way of Abraham Lincoln to Henry Ford. Even Republican presidents as late as Richard Nixon fall into this category to a large extent. 

By present-day standards, Henry Ford was mad to say something like this:

There is one rule for industrialists and that is: make the best quality of goods possible at the lowest cost possible, paying the highest wages possible. (Emphasis added.)

Why would anyone in his right mind want to pay the most for anything? And yet Ford was brilliantly successful (and become extremely rich) with this philosophy, famously doubling the wages of his workers to five dollars a day on January 5, 1914. This move helped create the two sine qua nons of a consumer economy: a disciplined, productive workforce, and workers capable of buying the products they produced. The 1950 “Treaty of Detroit,” in which the United Auto Workers won health insurance, pensions, cost-of-living adjustments, and income protection during economic downturns, in exchange for accepting management control of core business decisions (which unions had once aspired to share), was perhaps the most explicit codification of this philosophy in American economic history. 

This mentality of shared gains was once taken for granted at the highest levels of corporate America: as late as 1981, the Business Roundtable, the umbrella group for Fortune 500 CEOs, wrote in its official “Statement on Corporate Responsibility” that:

Balancing the shareholder’s expectations of maximum return against other priorities is one of the fundamental problems confronting corporate management. The shareholder must receive a good return but the legitimate concerns of other constituencies (customers, employees, communities, suppliers and society at large) also must have the appropriate attention.

By 1997, this organization had shifted (with some obfuscation) to the view that a business exists only to serve its shareholders. This ideological turning point was first made explicit around 1981, when Ronald Reagan’s mass firing of striking air traffic controllers was taken as signifying federal approval of a new and more adversarial era in labor management relations, made feasible largely by the increasing dispensability of American workers. 

This dispensability is, in fact, the key political problem of free trade. If American workers are no longer needed as producers, then capital has no incentive to care about their productivity, the ultimate basis of their standard of living. And American workers are not needed as consumers either, if the rest of the world is an open market. Unfortunately, because capital is disproportionately powerful in America’s political system, this means that free trade will tend to render our government indifferent to the economic interests of ordinary Americans. 

Thus the greatest benefit of protectionism is not directly economic but political: protectionism is an device that forces capital to care about the economic fate of ordinary Americans. If capital must (mainly) turn a profit by selling goods made by Americans to Americans, then it must care about Americans’ capacity to both produce and consume.

One corollary of returning to this older view of economics is that the idea that corporations ought to be motivated purely by the pursuit of profit (or that they perform best when they are) is not an obvious truth of capitalism. It is, in fact, not the way things worked for two generations (circa 1930-1980) in the U.S.   It is based on a primitive and unempirical notion of human motivation and organizational behavior.

Tellingly, the prime exponent of this extremely dumb idea was none other than University of Chicago economist (and libertarian ideologue) Milton Friedman. And Friedman was, significantly, also the economist who argued, in a still hotly-debated 1953 scholarly article that set the tone for two generations of economists, that it doesn’t matter if economic theories make unrealistic assumptions about reality, just so long as they make the right predictions. As he put it:

Truly important and significant hypotheses will be found to have ‘assumptions’ that are wildly inaccurate descriptive representations of reality, and, in general, the more significant the theory, the more unrealistic the assumptions (in this sense).

The problem is that this approach let the idea that free markets are everything—which is certainly a very potent predictive tool in many contexts—become entrenched despite being untrue.  The real-world consequences have bedeviled us for 30 years, and we are only now beginning to escape them.

Ian Fletcher is the author of the new book Free Trade Doesn’t Work: What Should Replace It and Why (USBIC, $24.95)  He is an Adjunct Fellow at the San Francisco office of the U.S. Business and Industry Council, a Washington think tank founded in 1933.  He was previously an economist in private practice, mostly serving hedge funds and private equity firms. He may be contacted at ian.fletcher@usbic.net.

© 2010 Copyright  Ian Fletcher - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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