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Economics 101 for Voters

A strikingly high proportion of America’s college students these days take at least one economics course as part of their studies. Judging from most campaign rhetoric, though, candidates assume an electorate having next to no understanding of the subject. To help voters grasp some of the basics, I’ve prepared a brief tutorial in a friendly Q and A format.

Q: Does the President run our economy?
A: Certainly not. The U.S. has what economists call a “market economy.” Most economic decisions are made by companies and individual workers, consumers, managers, investors, and property owners. Communist dictators tried to run economies in Russia and China and still do so in North Korea, but economists agree that a top-down economy is unlikely to be efficient.

Q: Is it true that the best way the government can help the economy is to get out of the way of businesses?
A: Yes, this is certainly true for companies that make products whose safety consumers can easily evaluate, for companies that operate in competitive markets and face competition when trying to hire workers, for companies that create no negative externalities like pollution, and for companies that don’t expect to be bailed out by government rescue packages. For those businesses to which one or more of those conditions fail to hold, however, economics teaches that government can help to produce more efficient outcomes.

Q: What about stimulus and government deficits? Hasn’t Keynesian theory been debunked and aren’t government deficits our main problem today?
A: Keynes argued that markets on their own don’t effectively guarantee the full employment of either labor or capital. There can be bouts of depressed demand which set in train spirals of economic decline: companies lay off workers because demand for their products falls, this reduces demand for other companies’ products and leads to still more layoffs, those layoffs cause further declines in demand, and so on. Increased government spending can reverse and thus reduce the severity of these bouts, called recessions. Policy-makers around the world continued to use Keynesian remedies until the most recent crisis, when the view that deficits are the main threat to growth began to shove the old consensus aside. The new view wasn’t based on economic analysis but simply on anti-tax and anti-government sentiment. As Paul Krugman argues, it may be condemning us to a decade of economic stagnation.

Q: Does tinkering with the distribution of income harm economic growth?
A: There’s no evidence that progressive taxes and expenditures harm economic growth. Actually, a large body of evidence shows that countries with more equal distributions of income enjoy faster economic growth. The United States itself enjoyed faster growth under the progressive tax systems of the 1950s through ‘70s than under the less progressive codes of more recent years. Inequality is bad for growth because it prevents quality education from getting to those with the greatest potential talents, leaving education to serve more as a credentialing device for already-advantaged children than as a way to build a society’s competitiveness. The low quality of education associated with weak public funding of schools in the United States is the most important reason to fear near term economic decline of our country.

Q: Why re-elect a president with a weak track record on the economy?
A: President Obama listened to economic advisors who counseled overly timid measures, wasted precious time trying to reach agreement with intransigent opponents, failed to demand reasonable conditions from the financial institutions he bailed out, and paid too little attention to the reforms needed to prevent the next financial sector meltdown. But the alternative is a return to the policies that put us into the economic hole we’ve been in since 2008. Returning Obama to office may help the economy little, though, unless we also elect representatives who’ll work for national economic recovery. Were Massachusetts to return Scott Brown to the Senate because they like his nice guy demeanor and his pickup truck, they’ll be depriving Democrats of a vote they desperately need in the Senate. They’ll thereby be failing ECON 101 and indicating that economists have it all wrong when they assume that people can be counted on to act rationally in their own interest.


With a Hands-Off Economic Philosophy, No Mitt, Nor Glove, Nor Experience Is Required

(this piece appeared in the Huffington Post on August 28, 2012)

Something’s not quite right with this year’s presidential contest. Former Massachusetts Governor Mitt Romney has been doing violence to traditional conservative ideology as well as to textbook economic theory, so much so that I’m not sure what to tell my students any more. Romney contends that if he were to head our Federal government, he would be well-placed to fix our economy thanks to his business experience. That’s a pretty odd claim for someone calling himself a conservative to be making given that both philosophical conservatism and traditional economics textbooks hold that in a market economy, the government’s only roles are to provide a stable currency, assure the rule of law, and raise tax revenues to pay for public goods like defense, sanitation, and policing. Apart from those limited roles, “that government which governs least governs best.”

Its liberals and Keynesians, not conservative Republicans, who argue that government needs to be an active player in the economy to obtain good results. Keynesians in particular contend that, contrary to free market ideology, the economy does not regulate itself, so the government often has to step in to fix problems of excessive or inadequate aggregate demand. It makes sense for liberals, not conservatives, to judge a president’s performance by the performance of the economy. To conservatives, the market is self-regulating and the government’s only job is to “get out of the way.” For a Republican to depict the role of president as a sort of CEO of the economy seems intellectually incoherent, if not dishonest.

Consider, also, the awkward public relations dance around what Romney did or didn’t do as CEO of Bain Capital. (Yes, Bain is a company, so it has a CEO—in its early years, Romney.) The intellectually honest position would be the one taken by Milton Friedman, the Nobel Prize-winning economist and proponent of free markets, who argued that a business has no social responsibility apart from generating as much financial return as possible for its shareholders. On countless occasions, markets have rewarded companies for laying-off workers because investors judged this to be what was needed to raise profits and share value. So the companies were fulfilling their social responsibilities by laying-off the workers in question, Friedman would have said.
If Romney, as head of Bain Capital, oversaw episodes of corporate downsizing or outsourcing, that would provide no reason at all for calling into question his claim of having been a talented manager and a good agent of his shareholders. But just as it would be silly for us to hold Romney responsible for creating jobs during his years as a venture capitalist, it would be equally silly to imagine that his business experience will help him to bring millions of new jobs into being if we were to put him at the helm of our government.

As things turn out, while he’s happy to encourage the notion of the president as the manager of our economy, Romney’s economic proposals are in fact non-activist, just as one might expect from a true conservative. He proposes to return to the agenda of reducing government involvement in the economy that’s been pursued by Republic presidents since Ronald Reagan. Never mind that those policies brought slower economic growth than in pre-Reagan decades, never mind that they’re associated with more than a generation of stagnating living standards for the majority of Americans perhaps for the first time in U.S. history, and never mind that the return to their “deregulation first” agenda not only offers no guarantees that the financial meltdown of 2008 will not be repeated, but (say many) increases the likelihood of its repetition. What’s most incongruous, from the present vantage point, is Romney’s claim that one needs business experience and acumen to preside over such a ‘hands off the economy’ brand of government. An empty suit is all that’s needed to preside over a hands-off government and to not interfere with the marketplace. If I were a conservative, I’d be lining up right now to vote for Romney.

Now consider, in contrast, those who, like F.D.R., John Maynard Keynes, Paul Samuelson, Paul Krugman, and a substantial share of the contemporary economics profession, believe that an active government role can improve the functioning of the economy. It is members of this group, not economic and philosophical conservatives, that have reason to look for the right qualities and understanding of the economic role of government in those whom they elect to public office. Unfortunately for the liberals, it’s not clear that the present incumbent is up to the task. As Krugman argues in his 2012 book End This Depression Now, the Obama administration’s failure to fight for an adequate stimulus package when it still had a congressional majority made the job of liberal economists far harder by discrediting stimulus, much as conservatives hoped. The administration’s refusal to put real conditions on the bail-outs of giant banks and insurance companies, its failure to push for more serious reform of the financial sector, and its surrender to deficit hawks when the economy remained in its worst slump since the Great Depression, rightly gives liberals pause. So economic conservatives have a reliable candidate in Romney, despite his abuse of the ‘president runs the economy’ idea to pander to the ill-informed. Liberals, in contrast, have much less reason for confidence in the available alternative.

If Obama and his team really do believe that government isn’t always the problem but must be part of the solution, then they need to explain this clearly and forcefully, admit their past miscalculations, and at the same time put the appropriate share of the blame for our economic malaise on opponents who set political warfare ahead of national well-being. They need to insist that what’s needed is not just four more years of holding the line on the further dismantling of the mixed economy, but a chance to address the economy’s current doldrums forcefully. And this, even more dauntingly, would require electing a Congress that isn’t hell-bent on returning to the 1920s.

Senate vote a baby step in the larger battle against a divided society

(this piece appeared as an Op Ed in The Providence Journal, August 23, 2012)

Recent Senate passage of the Democrats’ plan to maintain Bush era tax cuts for all but the richest Americans is the latest salvo in what promises to be an active battle throughout the presidential campaign season over the equity of the U.S. fiscal system and, more broadly, the problems of widening inequality and of disproportionate political influence of the rich. So far, mainstream Democrats and the White House have staked out only a fairly modest centrist position, with continued scathing criticism of the administration’s handling of the 2008 – 09 financial crisis coming from critics on the left, and with the usual countercharges about attacking “job creators” and “playing the class warfare card” coming from the right.

In his new, hard-hitting book, The Price of Inequality: How Today’s Divided Society Endangers Our Future (Norton, June 2012), Nobel Prize-winning economist Joseph Stiglitz, a professor at Columbia University who is President of the International Economic Association and a one-time economic adviser to Bill Clinton and Chief Economist at the World Bank, bemoans Obama’s failure to grasp the opportunity handed him in 2008 to begin reversing America’s thirty year trend of rising economic and political inequality. Stiglitz argues that increasing inequality is not simply the result of market forces but also reflects the capture of government by financial and economic elites and resulting massive transfers of wealth from those of low and middle income to the top 0.1% via subsidies, bail-outs, and tax breaks.

Right wing ideology claims that we need essentially unchecked inequality to spur economic activity because human nature makes private rewards the only effective motivator of effort. Stiglitz’s book and a growing body of research in behavioral economics shows this to be a grossly oversimplified picture. That research shows most people to care about fairness and to be willing to make sacrifices both to support the deserving poor and to punish unfairness. And it shows that, rather than damaging productivity, arrangements such as the sharing of profits with workers actually stimulate output by enhancing teamwork and a sense of “buy in” to enterprise goals. Historically, the U.S. has enjoyed faster economic growth in those periods in which it had a more progressive tax system, and globally, countries with more equal distributions of income have better performing economies than do more unequal ones.

The current ideological battle is partly over whether the system as a whole is fair, i.e. gives opportunities to those who work hard. This is important because research shows that people support a strong social safety net if they believe that those in need are not there for lack of trying. Economists and political scientists have long explained the greater support for progressive tax and expenditure systems in Europe than in the United States by the fact that Americans are more likely than are Europeans to believe that hard work pays off. Stiglitz shows, however, that perceptions are greatly lagging realities, as the U.S. has become not only one of the most unequal of the high income democracies but also one with less opportunity for the children of the poor and middle class to advance economically.

Stiglitz shows convincingly that the vast majority of Americans would benefit from the restoration of a more progressive tax system and from a drastic reduction of corporate welfare and creation of a more competitive and less coddled financial system. That polls show only a small majority favoring such measures is a reflection of the success of the right in convincing so many ordinary Americans that their own interests coincide with the interests of those at the narrow top of the income pyramid. An important and ironic factor behind the right’s success is that starvation of the American education system for vast numbers of ordinary students has created fertile ground for disseminating disinformation, while helping to increase income inequality and reduce economic mobility. Reducing inequality in our educational systems is thus a core task for those who would join Stiglitz in trying to reverse America’s slide into a divided society of haves and have-nots.

Social capability: its historical persistence and its meaning going forward

In the last post, I provided a brief sketch of the mounting body of evidence that there has been persistence over centuries and millennia of advantages in technology and social organization. I was responding, in part, to Acemoglu and Robinson’s stimulating book, Why Nations Fail.  As evidence that the quality of economic and political institutions is critical, those authors point out that the places that became the U.S., Canada, and Australia were technological and political backwaters in the 15th century while the ones that became Mexico, Peru and Bolivia were the homes of agrarian civilizations which were advanced, by comparison.  Today, the first three countries are among the world’s richest and are ranked highly for the quality of their economic and political institutions, using criteria such as prevalence of corruption, security of property, and rule of law.  The last three, by contrast, are middle income countries scoring more poorly on those institutional scales.  In Acemoglu and Robinson’s  view, this helps to prove that institutions are the main determinants of economic growth. 

But both institutions and growth could be due to a third factor, the persistent strengths and weaknesses of societies and the people who comprise them.  Between 1500 and the 20th century, the U.S., Canada and Australia came to be populated mainly by the descendants of immigrants from countries that were technologically and socially more advanced than Mexico, Peru and Bolivia in 1500.  The homelands of most of the rich countries’ ancestors—mainly in Europe—had experienced two millennia of literate civilization, metallurgy, horse-drawn vehicles, improving methods of navigation and ship-building, and had developed the use of the plow, the printing press, paper, and many other technologies.  The people in the now middle-income countries mentioned had, by comparison, a shorter history of civilization, worked only soft metals for ornamentation, lacked the horse and wheel, the plow, printing, paper, and so forth.  It didn’t help that on the way to becoming modern Mexico, Peru and Bolivia, those people and their cultures were treated brutally by Spanish conquerors who built societies rife with class conflict, starting from the virtual enslavement of their native populations.  But we’ll never know to what degree the poorer outcomes, so far, of Mexico and the others are due to the way the conquest played itself out, and to what degree it simply reflects the persistence of earlier relative advantages.  That Mexico and the others, with roughly two thirds of their ancestors being Amerindian, are poorer today than the U.S., Canada and Australia, with 80% or more of their ancestors being from Europe, might be sufficiently explained by the persistence of whatever advantages gave Europeans and not Amerindians the horse, wheel, steel, printing, and the rest.

Many readers will recognize the similarity of my discussion of European versus Amerindian technological progress before 1500 to the widely read and deservedly acclaimed book, Guns, Germs and Steel, by Jared Diamond.  Diamond’s book mostly focused, though, on explaining why Europeans had the technological advantages that allowed them to easily conquer all of the Americas, Oceania, and less advanced portions of Africa and Asia.  My interest is much less in why some societies gained advantages over others and much more on the fact that those advantages, which were already becoming apparent two thousand years ago, have persisted to the present day.

To begin with the colonial era itself, Diamond argued that Europe’s ability to subjugate the Americas and Oceania was due not so much to distinctly European advantages as to the exchange of technological knowledge and other ideas across civilizations spanning the entire Eurasian landmass, an exchange that had been intermittently occurring since the first agrarian civilizations of Mesopotamia, Egypt, China and India.  Most important technological advances attained by Europe after the Roman Empire collapsed had originated in China or in the Muslim world.  Lack of contacts across the major oceans meant that they failed to reach the Americas and Oceania until Europeans arrived. 

Diamond’s general insight on colonization and technological advantages is supported by a new study I recently completed with Arhan Ertan and Martin Fiszbein, where we show in a formal statistical analysis of data on 111 non-European countries that the level of technological development in those lands in the year 1500 is a strong predictor of whether they were colonized at all by Spain, Portugal, Holland, England, France or more minor Western colonizers, and if so in what year.  No lands that had been part of the Eurasian technological exchange was colonized in the 15th and 16th centuries.  The eventual colonization of some of those lands waited until Europe obtained a decisive technological advantage around or after the onset of the industrial revolution.  And countries including the Turkish core of the old Ottoman Empire, Persia, China and Japan, were never colonized by Europeans.

An equally interesting fact not considered in Diamond’s book is one concerning economic growth in the post-colonial world, especially since the 1970s.  Until that time, the only relatively rich and industrialized countries in the world were either located in Europe or were overwhelmingly populated by Europeans.  The one exception, Japan, in a sense proves the rule, because its sprint to industrialization began in the 1880s on a relatively advanced pre-industrial technological base.  The fastest growing economies after the 1970s were all former participants in the old Eurasian technological exchange, including Japan itself, South Korea, Taiwan, China, and more recently India.  Upper middle income countries like Turkey and Iran were also modernizing their economies from technological bases not so far behind Europe’s.  Even the higher-income economies of Latin America have large populations of Old World origin.    

As I wrote in the last post, I don’t view the evidence for the importance of the skills, knowledge, and attitudes passed down from generation to generation within given populations as implying that countries with less propitious pre-modern developmental endowments—for instance the two Congos or New Guinea or Guatemala—should expect to wait a few thousand more years for their own days in the sun.  The ways in which knowledge and skills can spread from person to person are far different today from what they were in the remote past, and a world determined to close the economic gaps between its rich and poor could do much to speed development if it gave the human factor more attention.

My fundamental point is that we need to move on more than the institutions front emphasized by Acemoglu and Robinson, as well as on more than the front of combatting diseases and other tropical geographic disadvantages emphasized by Jeffrey Sachs, if we are to successfully close the economic gaps between the world’s rich and poor.  Those factors are also important, but we need to focus at least as much of our attention on what makes the people of poor countries different from those of rich ones.  Genes, skin color, and the like have nothing to do with it, what’s inside people’s heads everything.  That includes knowledge, but also attitudes towards learning, and the social attitudes that govern everything from the prevalence of corruption to the dedication of public servants and the vibrancy of democracy.  All of this and more, which might go under the heading of “social capability,” should be top target of policy making, and learning how to upgrade social capabilities more effective should be a top priority in development research.Image

Why Nations Fail and Why Investing in People is a Pre-requisite for Building Both Strong Institutions and Strong Economies

In his 2006 book The End of Poverty, then U.N. Millennium Development project director and Columbia University professor Jeffrey Sachs argued forcefully that if countries at the bottom of the ladder of economic well-being were helped to get a footing on that ladder’s lower rungs, they then could complete the job of pulling themselves out of poverty.  But the same year, NYU economist William Easterly published his The White Man’s Burden with its argument, summarized in the subtitle, that “the West’s Efforts to Aid the Rest Have Done So Much Ill and So Little Good.”  In his 2007 book, The Bottom Billion, Oxford’s Paul Collier, earlier a director of the Development Research Group at the World Bank, emphasized corrupt governments, civil wars, blood diamonds, and ways that the international community might help poor countries escape from their adverse political spirals.  MIT economists Abhijit Banerjee and Esther Duflo’s 2011 entry, Poor Economics, turned away from issues of international action to highlight the randomized trial method of program analysis which they’ve helped to pioneer, also shining a spotlight on the survival strategies of the world’s poorest.  2012’s Why Nations Fail by MIT’s Daron Acemoglu and Harvard’s James Robinson, takes, instead, a big picture and historical focus.

Since 2008, of course, a great many people in what were once more easily labeled the “rich countries” have been feeling a lot less rich, and accordingly they might have less guilt to assuage over matters of responsibility to the world’s poor.  The debate about the causes of wealth and poverty matters, however, even to those who feel they no longer have the luxury to worry about the poorest, because it has equal bearing on questions crucial to future American jobs and prosperity, including those that revolve around the prospects of China and other “emerging” economies.  If Acemoglu and Robinson are correct, China’s recent decades of economic growth are attributable to economic policy reforms that will ultimately run out of steam due to the unwillingness of the ruling Communist Party to open the door to “inclusive political institutions.”  But based on a more geography-centered view like that of Sachs, which focuses on factors like coastal access, climate and disease along with the critical requirement of generating enough savings to invest in its people and infrastructure, China can continue to reap the blessings of its temperate climate and coastal location.  This might especially hold true if recent massive investments in transportation infrastructure succeed in unlocking also the potential of the country’s vast interior, home to more than a half billion people whose economic well-being has been less decisively improved by China’s mostly coastal growth sprint.

Why Nations Fail makes a valuable contribution by focusing attention on the importance of political and economic institutions, and on the interactions between them.  But its insistence on assigning all responsibility for differences in growth outcomes to the presence of bad vs. good institutions overlooks numerous facts, and if taken too seriously, could stand in the way of better local and global policy decisions.

In my research on long run determinants of global inequality, I point out that much of the pattern of differential economic outcomes distinguishing world regions such as rich versus lower income countries of the Americas, the advantages of western versus eastern Europe, the plight of sub-Saharan Africa, the recently improving conditions in South Asia, and the breakneck growth of the Far East, can be explained by first understanding how geographic factors determined the origin and spread of agriculture and the subsequent uneven growth of urban/agrarian civilizations in some but not all parts of the world, then adding atop this picture an analysis of how the era of European colonization and domination of the world beginning in the 15th century led to the shifting of populations and technologies among continents and to the industrial revolution and the still greater technological lead of Europe and its overseas offshoots like the United States.  With such background, one can then take a closer look at the era, mostly beginning in the late 20th century, in which other once-advanced agrarian societies including Japan, Korea, China, and most recently India, began a process of rapid catch-up, while societies lacking such previous advantages remained stuck in extreme poverty, and the already industrialized societies of Europe, North America, and Australia/New Zealand worked to consolidate and protect their advantages.  The main outlines of this approach are laid out in chapters 8 and 9 of my book The Good, The Bad and The Economy: Does Human Nature Rule Out a Better World?

Why Nations Fail pays plenty of attention to the colonial era and its consequences, too, but by downplaying the prior differences in technological and political development that made it possible and paying insufficient attention to the movements of population to the New World, Australia and New Zealand, and even to Old World locales like Taiwan, Singapore, and South Africa that resulted from colonial rule, they misread the record of uneven economic growth during the past five hundred years as one demonstrating the importance of institutions alone, while missing the indications of strong persistence of  advantages in human skill and social capability.  In their view, for example, the overtaking of the then advanced Mexico and Peru of the pre-colonial era by the then less developed lands that became the U.S. and Canada is all about the more liberal, investment-promoting economic and political institutions that were put in place in the latter because the colonizers found there a smaller indigenous population to be exploited through extractive policies.  Although there’s much truth in such observations, they miss the point that there’s been no actual overtaking of “advanced” peoples by “backward” ones due to the magic of good institutions.  Rather, emptier, temperate lands simply invited an influx of people from more technologically and politically advanced lands to what became the U.S. and Canada, whereas Mexico and Peru had the dual disadvantage of bad institutions and of populations predominantly descended from societies which did remarkably well under difficult circumstances but which had been cut off from the myriad advances in metallurgy, mathematics, literature, and other fields that occurred on the Eurasian land mass during the thousands of years after their ancestors crossed over into the New World.   Related observations correlating the civilizational advantages of different peoples before 1500 with the economic status of the countries of today, while accounting for large scale migrations, help to explain the comparative developmental advantages today of countries ranging from Taiwan and Singapore to Jamaica, Fiji, and Papua New Guinea.

The sober recognition of the extent of persistence of social advantages that my research points to might well be seized on by proponents of a racialist fatalism, but this is not my view at all.  Quite the contrary, my goal is to understand better the true reasons why some are rich and others poor so as to find more effective ways to help close the gap.  I see my research as pointing to the importance, alongside more obvious factors like economic policies and institutions, of the human dimension in economic and social development, which includes not just formal education but a wide array of skills, practices, and attitudes.  Finding ways for societies to invest in their people, as Taiwan and South Korea have done—and as the U.S. needs to redouble its efforts to do better—is probably the most important thing that can be done to end poverty.  Unfortunately, spending money on education isn’t sustainable without generating the means to pay for it in the short to medium term.

Having opened the door on such a vast topic without intention of writing another book here, let me break the discussion off and return shortly.