Category: Basics of Economics

In this series of articles, I use the term “mainstream economics” to illustrate what I believe to be the consensus views of economists and the ideas taught at most universities and found it most economic textbooks. However, for this post, I want to be a bit more specific about what I mean by mainstream economics. Perhaps more than anything else, what defines a mainstream economist today is the belief in Keynesian economics, or more precisely a Keynesian explanation of economic downturns and a Keynesian solution to economic downturns.

This view has dominated mainstream economic thought since the 1930s with a brief interruption in the “stagflation” days of the 1970s.  Ever since the global financial crises of 2008-2009, the Keynesian view has effectively monopolized economics.  Certainly in the U.S., and in most of the world, virtually all tenured economics professors, columnists, political advisors and central bankers adhere to the Keynesian religion.

Before we go any further, let me very briefly explain the Keynesian (and mainstream) tale of economic recessions.  First, what do mean by the term “recession?”  Conceptually, let’s call a recession a widespread (or economy-wide) reduction in economic activity (i.e. GDP) accompanied by high or rising unemployment.

The economy is merrily galloping along at full employment and in equilibrium.  Economic growth is robust and everyone who wants a job has a job.  Then, BOOM, out of the blue comes some unpredictable “shock” to the economy.  This shock causes consumer confidence to decline, which results in consumers spending less money than they should, which results in businesses having to cut investment and layoff workers.  With fewer employed workers, consumers as a whole spend even less money, businesses invest even less, layoff even more and  there is a vicious spiral leading to poor (or negative) economic growth and high unemployment.

In econ-speak, the economy suffers from “insufficient aggregate demand.”  That is to say, consumers are not spending enough money to keep the economy running as it had been prior to the “shock.”  In contrast to a free market view of  a self-correcting economy, due to somewhat mysterious structural reasons, such as sticky wages, the Keynesian economy now gets “stuck” in an “equilibrium” of less than full employment.  Finally, the economy cannot get “unstuck” and back to full employment without the aid of government (fiscal and/or monetary) stimulus.

In the next post in this series, Myth #4, we’ll discuss the Keynesian viewpoint that government (especially through monetary policy) can both prevent recessions and get us out of them.  Here, however I want to focus on the first part of the story, the Keynesian myth that insufficient aggregate demand is the cause of recession.

Now, let’s return to the mainstream, Keynesian story of recession.  To believe the Keynesian explanation requires four major assumptions, all four of which are unsatisfactory and/or false.  The first assumption is that the “shock” to the economy, that is the proximate cause of recession, is unpredictable. The second assumption is that the post-shock amount of aggregate demand is below the “correct” or so called “equilibrium” level. The third assumption is that the reduction in aggregate demand is due to “confidence” issues.  The fourth and final assumption is that it is demand, rather than supply that is the key driver of the economy (at least in the short-term).

Let’s start with the first assumption, that the “shock” is unpredictable.  In a small or undiversified economy, it is reasonable to say that some unexpected event might cause an economy-wide downturn.  For example, an economy highly dependent on agricultural output might experience recession due to drought.  An economy dependent on a single commodity (oil, for example) might experience recession if there is a decrease in the global price of that commodity.

However, in a large, diversified economy such as the United States, recessions are not caused by some unpredictable, exogenous shock.  They are caused by an unsustainable expansion of money and credit leading to an unsustainable expansion of investment.  When the “unsustainable” becomes realized, you get a recession.   In the old days, much wiser people than today’s economists and politicians understood that what we now call “recessions” where part of a business cycle.  And not for nothing did they call it a “boom-bust” cycle.  You don’t have the bust without the boom.

The second key erroneous assumption made by mainstream economists is that in a recession, the level of aggregate demand drops below what had been the “natural” or “equilibrium” level.  Of course, there is no question that demand drops from previous levels in a recession. However, if you believe that modern recessions always follow credit and investment booms, as I do, then you should understand that the previous (boom) level of aggregate demand was actually higher than it should have been and not some natural or equilibrium level.  Incidentally, whether equilibrium even exists (preview:  it does not) is something we will cover in Myth #9.

The third foundation of the Keynesian view of recession is that aggregate demand is reduced due to issues of “confidence.”  To paraphrase Keynes himself, “animal spirits” of both consumers and businesses in an economic downturn are depressed.  No doubt this is true.  But poor confidence is a cop-out reason for weak economic activity.  For low confidence is a symptom, not a cause of recession.

The fourth and final problem with the Keynesian explanation of recessions relates to the focus on demand rather than supply.  As we’ve stated already, the “boom” part of the economic cycle is a result of an unsustainable expansion of money, credit and investment.  This investment boom results in over-supply, whether it be over-supply of houses or factories or stores or mines or social networking apps.  When the investment bubble bursts, as it inevitably must, this over-supply must be pruned before robust economic growth can once again return.  It is the painful pruning of over-supply, through bankruptcies, layoffs, closures and investment cuts that is the true driver of the recession part of the cycle.  Hence, it is far more intellectually honest to refer to the cause of recession as excess aggregate supply (stemming from the boom) rather than insufficient aggregate demand (stemming from low confidence).

Long story short, I believe that the mainstream or Keynesian explanation for recessions is positively wrong.  Recessions are not caused by some unpredictable shock which leads a positive feedback loop of poor confidence and low aggregate demand.  Instead, recessions are the inevitable result of an economic boom fueled by an expansion of money, credit and investment.  More or less, this is the story espoused by the non-mainstream economists known as the Austrian school, and in future posts, I’ll cover this explanation in much greater detail.

Finally, as we have done and will continue to do in each of the articles in this series of mainstream economic myths, let’s ask ourselves why this topic is of vital importance.  Once again, we answer that what matters is not so much the explanatory, but the remedies inferred from the explanatory.

If recessions are indeed caused by insufficient demand then government can “cure” recessions by artificially creating more demand (i.e. spending) through the use of monetary or fiscal stimulus.  This is exactly the Keynesian prescription and exactly what economists have advised, and governments have implemented since the Great Depression of the 1930s and in unprecedented scale since the financial crises of 2008/9.

However, if the true cause of recession is the inevitable aftermath of an investment boom fueled by money and credit, then further stimulus is exactly the wrong thing to do.  Stimulus, among many other deleterious things, exacerbates the problem of oversupply, delays the inevitable correction and encourages the kind of risk-taking that caused the boom in the first place.

So as I hope you can see, understanding the root cause of recession is of vital importance to the long-term health of the economy.  And unfortunately, today’s consensus explanation is utterly wrong, and has caused immeasurable damage to the global economy.  We must fight to remedy this.

I freely admit that I have a faith in free markets that few possess.  Yet anyone who believes that markets are perfectly efficient or result in an optimal condition or some kind of utopia is utterly naive.  Such conditions don’t exist in the real world.  However, it is equally wrong to believe that market failures are common, an assumption made by mainstream economists today.

There are two problems with the mainstream view that market failures are common.  The first problem stems from the mainstream definition of a “market failure.”  Economists define a market failure as anytime an outcome is less than perfectly efficient.  Perfection is a pretty high bar.  And I’m sure you can also appreciate that equating the word “failure” to anything less than utter perfection is a little bit unfair, demonstrating both mainstream economics’s misunderstanding of markets and its inherent anti-free market bias.

The second problem is to identify a “market failure” in situations where no market actually exists.  As we’ll see in a minute, this is more frequently the case when discussing so-called market failures such as externalities and public goods.

What do economists mean by market failures?  There’s a number of broad categories and I’ll very briefly address the ones that are most common.  First, that individuals are irrational.  As I’ve already discussed in Myth #1, this is viewed as a market failure justifying government action.

A second type of market failure is what is knows as information asymmetry.  For example, if I am a used-car salesman and you are in the market to purchase a used car, I clearly have more information about the cars I have to sell than you have about the car you might buy.  That I might be less than scrupulous and sell you a lemon of a car is considered a market failure and justifies to most economics government involvement in this transaction through regulation.  Yet, there are plenty of free market solutions that do a much better job than the government of dealing with information asymmetries.  These include reputation, branding and marketing, consumer agencies, consumer reviews, civil/tort law and insurance.

Simply put, information asymmetry is the every day state of the world.  It is impossible (except in silly economic models) for all parties in a transaction to have perfect information.  But as long as a transaction is fully voluntary to all involved parties, information asymmetry does not represent a market failure.

Another commonly assumed market failure is the natural monopoly.  Monopoly is indeed the enemy of free markets.  Yet, in a free market, there is no such thing as a natural monopoly.  Over the long-term (and that long-term need not be very long), the free market will always provide incentives for innovation that will result in substitutes and break a short-term monopoly.  This is true even for industries requiring substantial investment and exhibiting substantial economies of scale, such as transportation (e.g. roads and railways), utilities and telecommunications networks.  The only monopolies that can subsist are those that are government created, government sponsored, government subsidized or government itself.

A fourth category of market failure about which economists are fond of speaking is externalities and public goods.  A prime example of an externality is over-fishing, which is sadly all too common in waters that have no ownership.  Paradoxically, inefficiencies cause by over-fishing is viewed by economists as a market failure when it should be viewed as a failure of government to create a market.  You cannot have a market failure when you have no ownership of the underlying assets.  Timber is a good example.  Where forests have no private ownership you see over-foresting.  Where forests are owned by private enterprises you do not.

There is no question that externalities such as over-fishing, environmental damage, pollution and global warming are big issues to communities large and small.  But to use these examples to shout “market failure” in the absence of a market is wrong and unfair.

That last type of market failure that I’ll briefly mention is the economy’s ability to recover from an economic downturn.  That the economy does not return to full employment is viewed by mainstream economists as another failure of free markets.  We’ll discuss this issue in greater depth later on, but as a preview, I note that this view incorporates three errors:  1) not understanding the true cause(s) of the downturn, 2) not appreciating that government intervention inhibits the market from recovering and 3) faith in a very silly economic concept called equilibrium.

Before I leave this post, I want to answer the question, “so what.”  Why does it matter whether something represents a market failure or a failure to have a market?  It matters not so much in the classification of economic phenomena, for that is semantic, but in the remedies proposed.

Anytime economists spot what they believe to be (correctly or more than likely incorrectly) a less-than perfect economic outcome, they immediately point to government as the savior, usually in the guise of more regulation.  They rarely ask themselves whether a much better outcome would be to create a market where none existed.  And even in cases where that might not be possible, they infrequently bother to ask, or properly analyze, whether the government “solution” would result in even worse efficiency or outcome than the supposedly market failure itself.  But that’s a story for another post.

I know what you are thinking.  Did I make a typo here?  Don’t most economists believe in perfect rationality?  So isn’t the myth that people are rational?  No and No.

It is true that up until 10 or 20 years ago, the assumption of mainstream economics was of rationality.  Yet thanks (or no thanks) to the explosion of the (sub)field of behavioral economics, mainstream economists today operate with the assumption that individuals make all sorts of “irrational” decisions.  And economics use this assumption of irrationality to explain all sorts of so called “market failures” (see Myth #2) and to justify all sorts of government intervention to counteract these irrationally fueled market failures.

The truth is that individuals are indeed rational, yet neither the economists of yesteryear nor the economists of today get it right because they both are using a poor definition of the word “rational.”  The correct definition of a rational decision is one that you believe will make you best off (to be technical, that you believe will maximize the present value of your future utility).  It is not necessarily the decision that you believe will maximize your income or wealth.  It is not necessarily the decision that you believe will maximize your current utility or happiness.  It is not necessarily the decision that will actually make you best off.  You may make a poor decision for lack of information, due to miscalculation, stupidity or any other reason, but as long as you believe you are making the best decision for you, you are acting rationality.

Virtually all of the so-called “anomalies” to rational behavior that behavioral economics have “discovered” in recent decades are not truly “anomalies” if you use the proper (and colloquial) definition of rationality.  In other words, behavioral economics, though sometimes mildly interesting, is hardly worthy of the attention it has received.

And by the way, financial bubbles (which can and do exist) have absolutely nothing to do with investor irrationality.  I’ll have a lot more to say about the subjects of utility and rationality in a future post, but in the meantime remember to be skeptical whenever you hear economists justify government intervention in markets due to “irrational behavior.”

I am of the opinion that mainstream economics gets most things wrong.  Mainstream economists pretend to be scientists when they are not, use unrealistic assumptions to create simplistic models, confuse correlation with causation, ignore history, are biased towards action over inaction and favor the short-term over the long-term.  Perhaps more importantly than anything else, mainstream economics has forgotten the lessons of Adam Smith and fails to appreciate what a free market really means, and does not mean.

My criticisms are not original.  In fact, many if not all of them are held, though not widely held, by those outside the economics community.  Naturally, if economists were like all other members of the social sciences, these criticisms would be, well, academic, just like economists are supposed to be.

But economists are not just academics.  To paraphrase Keynes, policy makers are, “usually the slaves of some defunct economist.”   Economists have escaped from the ivory tower and have become entrenched in both government and finance.  In fact, economists have come to influence our world more than members of perhaps any other profession.  Worse, they have become the policy makers, but with less oversight and more power.

This has not been to the world’s benefit. I will go as far to say that economists, especially through their role as central bankers, have done more damage to the world than anything since World War II.  And not because they are malicious or evil like Hitler or Stalin.  Economists mean well.  They believe they are helping.

No, it is because they are clueless.  Not simply clueless to the damage they have caused (for they will of course deny this), but clueless to even the power they possess. And not because they are dumb.  On the contrary, they are mostly smart.  In many cases very smart.

Modern society fetishizes intelligence.  We are educated to believe and thus take for granted that smart people make the right decisions.  This is wrong.  It is not high intelligence that is the making of good policy, but wisdom.

Wisdom requires self awareness.  You must know what you don’t know.  Wisdom requires humility.  You must be able to admit what you don’t know.  Wisdom requires an understanding of history.  You must be able to see and appreciate the bigger picture.  Wisdom requires an understanding of human nature.  You must be able to interpret what fundamentally motivates people.

Economists don’t lack intelligence.  But they do lack wisdom. They have a false understanding of what drives decision making.  They are required to learn no history in their economic studies.  They act before they understand.  And most importantly, they take for granted what they should question.  It is not simply that they rely on assumptions that are unrealistic or wrong.  It is that they make assumptions that they don’t even realize they are making.

Over the next ten posts, I will highlight, in no particular order, what I believe are the ten largest myths of mainstream economics.  These are assumptions that I believe economists get wrong because they are unwise.  And the world is much worse-off because they get these assumptions wrong.  On many of these myths, I will have much more to say in the future.  But for now, I ask you to settle for rather short explanations.

Myth 1: People are irrational

Myth 2:  Market failures are common

Myth 3:  Insufficient aggregate demand causes recessions

Myth 4:  Central banks can micromanage the economy and prevent recessions

Myth 5:  Deflation is always bad

Myth 6:  Moderate inflation is good

Myth 7:  Liquidity in financial markets is always good

Myth 8:  There is such a thing as fundamental value

Myth 9:  Equilibrium exists

Myth 10:  Entrepreneurship is always good

Bonus Myth:  “In the long run we are dead”

Let’s start with this:  there is no single correct definition of economics.  But in textbooks and other resources about economics you tend to see variations of two definitions.

1) Economics is the branch of social science that studies the production, distribution and consumption of goods and services.

OR:

2) Economics is the branch of social science that studies how individuals and groups make decisions to allocate scarce resources.

My personal definition is bit more comprehensive (and perhaps a bit cynical).  Economics is the branch of social science that knows how to use (and misuse) basic math and statistics.  To me, economics encompasses all of social science.  There are really no boundaries between the questions economists ask and those asked by, for example, psychologists, sociologists or political scientists.  What separates economists from those other social scientists (for better or for worse), is the former’s ability (and the latter’s lack of ability) to pose and answer their questions using math and statistics.

So rather than define what economists study, let’s define what social scientists study.  Here, I think a variation of the second mainstream definition mentioned above, is a good starting point.  Social science is the study of how individuals and groups make decisions, and how those decisions in turn affect the individual and the group.  I personally think the words “allocating scarce resources” are unnecessary since absent perhaps only breathable air (at least on the surface of Earth), ALL resources are scarce.

As you probably know, economics is almost always divided into two categories:  microeconomics and macroeconomics.  Studying how individuals and groups make decisions is essentially the generally accepted definition of microeconomics.  But I’d argue that macroeconomics is really a subset of microeconomics.   Rather than study the decisions of individuals or such groups as a firm, macro-economists are studying the decisions of a specific type of group, called a government, and analyzing data of a specifically defined aggregate of individuals and groups, called an economy.