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Economics Does Not Lie

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Economics Does Not Lie

The dismal science is at last a science—and the world is the beneficiary. Summer 2008
Economy, finance, and budgets
The creation of complex financial instruments brings about economic progress: nothing real has ever been produced without first being financed.
marinus claeszon van reymerswaele, “the banker and his wife”/The Art Archive/Museo del Prado Madrid/Alfredo Dagli Orti
The creation of complex financial instruments brings about economic progress: nothing real has ever been produced without first being financed.

Though economics as a discipline arose in Great Britain and France at the end of the eighteenth century, it has taken two centuries to reach the threshold of scientific rationality. Previously, intuition, opinion, and conviction enjoyed equal status in economic thought; theories were vague, often unverifiable. Not so long ago, one could teach economics at prestigious universities without using equations and certainly without the complex algorithms, precise (though not infallible) mathematical models, and computers integral to the field today.

No wonder bad economic policies ravaged entire nations during the twentieth century, producing more victims than any epidemic did. The collectivization of land in Russia during the twenties, in China during the fifties, and in Tanzania during the sixties starved hundreds of millions of peasants. The uncontrolled printing of currency destabilized Weimar Germany, facilitating the rise of Nazism. The nationalization of enterprises and the expulsion of entrepreneurs ruined Argentina during the forties and Egypt a decade later. India’s License Raj—requiring businesses to obtain a host of permits before opening their doors—froze the country’s economic development for decades, keeping millions impoverished.

On an even larger scale, the century witnessed a war between two economic systems: state socialism and market capitalism. In the socialist system, property was public, competition forbidden, and production planned. In the market system, property was private, competition encouraged, and production determined by entrepreneurs. Faced with the choice of which system was superior, nations hesitated and economists remained divided.

The state of affairs today is entirely different. When the Soviet Union crumbled, the socialist model that it embodied imploded, too—or, more precisely, the Soviet Union fell because the socialist economic system proved unworkable. Now only one economic system exists: market capitalism. Virtually everywhere, the public sector has given ground to privatization; currency has escaped state control, to be governed by independent central banks; competition has taken wing, thanks to the deregulation of markets and the opening of borders; taxation has become less progressive, so as to encourage entrepreneurs and create jobs.

The results have been breathtaking. Opening economies and promoting trade have helped reconstruct Eastern Europe after 1990 and lifted 800 million people, many of them in China, Brazil, and a now-license-free India, out of poverty. Even in Africa and the Arab Middle East, nations that have embraced capitalism have begun to escape from the terrible underdevelopment that has long plagued them.

Behind all this unprecedented growth is not only the collapse of state socialism but also a scientific revolution in economics, as yet dimly understood by the public but increasingly embraced by policymakers around the globe. The revolution began during the sixties and has finally brought economists to a broad, well-founded consensus about what constitutes good policy. No longer does economics lie; no longer would Baudelaire be able to write that “economics is a horror.” For the mass of mankind, on the contrary, it has become a source of hope.

If economics is finally a science, what, exactly, does it teach? With the help of Columbia University economist Pierre-André Chiappori, I have synthesized its findings into ten propositions. Almost all top economists—those who are recognized as such by their peers and who publish in the leading scientific journals—would endorse them (the exceptions are those like Joseph Stiglitz and Jeffrey Sachs, whose public pronouncements are more political than scientific). The more the public understands and embraces these propositions, the more prosperous the world will become.

1. The market economy is the most efficient of all economic systems. Adam Smith’s eighteenth-century take on market efficiency was metaphorical, nearly metaphysical: he said that it seemed to be guided by an “invisible hand” that produced outcomes beneficial to society. In the mid-twentieth century, Friedrich Hayek observed that no central-planning institution could possibly manage the huge quantity of information that the market organized automatically and spontaneously by pricing resources. More recently, Berkeley economist Gérard Debreu has used computers to demonstrate that the spontaneous order that Hayek postulated does indeed exist in a mathematical world.

Market mechanisms are so efficient that they can manage threats to long-term development, such as the exhaustion of natural resources, far better than states can. If global warming does become a real problem, for example, price mechanisms or a carbon tax would easily encourage a more efficient use of energy. It’s worth recalling that during the 1970s, when an excess of sulfur in the atmosphere was sometimes producing acid rain harmful to North American forests, the U.S. government didn’t ban sulfur emissions outright. Instead, it created a market in which companies could buy and sell the right to pollute above a certain amount or “cap,” pricing emissions so that factories had a financial incentive to turn to non-sulfurous technology, which was already available. Over time, companies shifted to cleaner technology and the acid rain disappeared—to the dismay of many green activists, who tend to prefer doomsday discourse to efficient market solutions.

Some economists favor free markets not only for their efficiency in allocating resources but for political reasons as well, fearing that central planning or excessive bureaucratic controls could, in the guise of rationality, stifle individual freedom. Markets leave us “free to choose,” wrote Rose and Milton Friedman, and society is the better off for it—though not all economists embrace their libertarian political vision.

2. Free trade helps economic development. As Smith observed when his native Scotland began to benefit from free trade, it is through access to the world market that poor nations become rich. They never do so by trying to become self-sufficient. Free trade also makes rich countries richer, economists agree. By importing less expensive goods made in low-wage nations like China, wealthy nations effectively increase their own citizens’ income—and the main beneficiaries are poor and middle-class people, who can buy cheaper clothes, electronics, and myriad other goods. In addition, importing cheaper components—computer chips, say—lowers the cost of equipment in wealthier economies. In fact, economists have long understood the law of comparative advantage: whenever differences in the cost of producing goods exist between two countries, both will benefit from free trade, a mechanism that allocates their resources most effectively.

Free trade not only generates the greatest possible growth; it tends to distribute it widely, both within nations and among them. For evidence, consider the emergence of vast middle classes in all free-market societies, as well as the economic convergence among nations that have embraced capitalist economics. After less than 20 years of market-driven growth, Brazil, China, and India—whatever their injustices—are closer to the Western level of development than they were before that growth got under way.

This does not mean, as some observers fret or gleefully predict, that the United States is about to stop leading the world economically. Other nations may draw closer to it—Western Europe in 1950 had a per-capita income half that of the U.S.; now it’s 80 percent—but the American economy has remained the world’s most vigorous for more than a century because of its superior efficiency, demographic dynamism, and innovation (today, for example, the U.S. is the world leader in the hugely promising fields of nanotechnology and biotechnology). One might add that no globalization, with all its economic benefits, could take place without a global security framework to protect shipping from piracy and to contain border conflicts. Today the U.S. military provides that security, just as the British navy once did.

3. Good institutions help development. The research of Stanford University economist Avner Greif makes a forceful case for this proposition. Back in the twelfth century, he notes, Genoese merchants competed fiercely with the Maghrebis, Jews from northwest Africa. The Maghrebis relied entirely on family and tribal connections to raise funds for their business ventures; powerful as they were, this tribalism limited their resources and hence the reach of their commercial expeditions. The Genoese, on the other hand, built institutions to bolster good economic practices, such as private contracts, insurance firms, bills of trade, bank credit, courts of appeal to handle disputes, and a financial market, from which they could raise capital to finance far-flung journeys. The Genoese also founded a city-state, probably the first state to follow the rule of law. Over time, they won the competition and the Maghrebis faded away. Familial trust proved no match for reliable, neutral institutions.

All economists acknowledge today that economic development requires an independent and reliable legal system to enforce contracts and ensure fair competition. Institutions that improve market transparency are particularly important, since they counter what Nobel laureate George Akerlof calls “asymmetrical information.” Economic actors don’t all have the same information at their disposal. Without institutions to improve transparency, insiders can easily manipulate markets, making outside investors lose faith in the system and withdraw their funds. This is why the government bans insider trading.

In complex free economies, private informational intermediaries, such as ratings agencies, also spring up, helping economic actors make relatively well-informed decisions in the labyrinths of global finance. These intermediaries aren’t perfect, of course, as financial crises like the Enron collapse in 2001 or the current mortgage meltdown show: investors, relying on them, believed for far too long that Enron was a healthy company and that bonds backed by subprime mortgages carried virtually no risk. But in general, the intermediaries improve the operation of modern markets.

Some argue that a new field of research, neuroeconomics, inaugurated by the psychologist Daniel Kahneman, who won a Nobel in economics in 2002 for his work, demonstrates the need for greater activity by the most powerful institution of all: government. This field shows that economic actors tend to behave both rationally and irrationally. Laboratory work has demonstrated that one part of our brain bears blame for many of our economically mistaken short-term decisions, while another is responsible for decisions that make economic sense, usually taking a longer view. Just as the state protects us from Akerlof’s asymmetry by forbidding insider trading, should it also protect us from our own irrational impulses? To a certain extent, it already does—for example, by giving borrowers a grace period in which they may decide not to take out a loan after all. Jean Tirole, a French expert on the subject, suggests that knowing about our irrationality should compel the private sector to inform consumers better about the consequences of their actions—again, the mortgage crisis comes to mind—but that it would be preposterous to use behavioral economics to justify restoring excessive state regulations. After all, the state is no more rational than the individual, and its actions can have enormously destructive consequences. Neuroeconomics should encourage us to make markets more transparent, not more regulated.

There is less agreement among economists on which other institutions are essential, and less still on how to create them. Democracy, for example: its relation to economic development resists any unequivocal description, as each seems to evolve on its own plane. (There are cases of capitalism without democracy—such as China—but none of democracy without market capitalism.) Analyses also diverge, but these days only marginally, on the roles of culture, history, and religion in creating the institutional conditions for prosperity. Until the sixties, many sociologists, embracing Max Weber’s cultural determinism, believed that culture was the cornerstone of economic development. According to Weber, Confucianism was incompatible with economic growth. But the rise of South Korea and Taiwan has put paid to that theory. Some today say that Islam impedes development, but both Turkey and Indonesia are growing at a fast clip.

4. The best measure of a good economy is its growth. Unlike other proposed measures (happiness, for example), economic growth can be determined objectively: it is the rate of increase in a country’s gross domestic product (GDP) over a given period. Yes, some economists believe it necessary to temper that purely quantitative measurement with such factors as quality of life and efficient management of resources, and there is wide agreement that GDP omits important aspects of economic activity, such as home production. But all economists agree on growth’s importance: while a high rate of growth doesn’t solve every problem, its absence doesn’t solve any.

Economic science also distinguishes between long- and short-term growth. As Nobel Prize winner Edward Prescott has shown, long-term growth—in the West, roughly 2 percent per capita per year over the last century—results from capital accumulation and, above all, technological innovation, which makes labor ever more productive. States have few ways to promote this long-term trend, but those they do have are key: improving the rule of law, securing property, developing infrastructure, and enhancing the quality of education.

Governments also have the capacity to intervene and create seemingly positive outcomes when it comes to short-term growth, which is subject to incessant fluctuation. Yet the eventual effects of such interventions, which are more likely to have political than economic motivations, are always costly and can ultimately slow growth. The U.S. government’s recent rebate checks are a good example. While taxpayers have a few more dollars in their pockets right now, perhaps giving the economy a brief boost, the checks add more than $100 billion to the nation’s debt and could push inflation higher, adding to long-term economic woes.

The Anglo-Bengali economist Amartya Sen, another Nobel laureate, has distinguished—usefully, to my mind—growth that takes place under democratic conditions from that which occurs under tyranny. In China’s case, the Communist Party channels the country’s newly generated wealth less to benefit the people than to build a powerful state with imperial ambitions (see “The Empire of Lies,” Spring 2007). But in a democracy like India, where popular demands cannot be ignored, the wealth trickles down to the people, improving the daily lives of most Indians. Over time, Sen argues, democratic institutions provide a more stable basis for development, since they are predictable, whereas authoritarian rule is not.

5. Creative destruction is the engine of economic growth. As the Austrian economist Joseph Schumpeter famously argued, capitalism unleashes a “gale” of innovation that “incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” This ceaseless replacement of the old with the new—driven by technical innovation and entrepreneurialism, itself encouraged by good economic policies—brings prosperity, though those displaced by the process, who find their jobs made redundant, can understandably object to it.

6. Monetary stability, too, is necessary for growth; inflation is always harmful. No reputable economist today would deny that a stable money supply encourages investment and bolsters social cohesion, since it helps people save for the future. Inflation, on the other hand—always caused by governments’ spending more money than they have, and then printing extra money or borrowing to finance the expenditure—destroys entrepreneurship, slows growth, and generates social inequality. It is an incentive not for investment but for speculation: those who can afford to will buy goods, wait, and then resell them at higher prices, a process that creates

nothing at home—least of all, new jobs. Those with less money fall victim as wages and pensions lag behind prices. It’s no surprise that hyperinflation often leads to revolution. Milton Friedman’s advocacy of monetary stability, “monetarism,” considered revolutionary when first proposed in the sixties, is now common wisdom.

The best way to restrain inflation, economists now understand, is to transfer money management from governments to independent central banks like the Federal Reserve and the European Bank, which—monetarists all, these days—try to create only enough credit to provide liquidity and prevent the financial panic that often accompanies credit crunches, resisting vocal politicians who believe that printing more would generate new jobs. Even in a slowdown, the banks seek to keep money stable in order to stimulate investment.

7. Unemployment among unskilled workers is largely determined by how much labor costs. So regulating the labor market (with a minimum wage, for example) adds to labor costs, economists acknowledge, and increases unemployment. No solution to excessive unemployment is conceivable without reducing such regulations. The rigidity of European labor markets—in France, for example, firing an employee requires paying him a large indemnity and obtaining a judge’s consent—is likely one reason that the unemployment rate in European countries remains much higher than in the United States.

8. While the welfare state is necessary in some form, it isn’t always effective. Economists recognize that government assistance always produces incentives that may affect, for good or ill, recipients’ behavior and well-being. The key is to avoid making individuals and groups dependent on state assistance, locking them into sustained semi-poverty. This economic truth is now better accepted in the U.S., where welfare reform triumphed in the nineties, than in statist Western Europe. Central and Eastern European countries, because of their socialist experience, are more attuned to the dangers of welfare dependency.

9. The creation of complex financial markets has brought about economic progress. These sophisticated instruments, like derivatives, have facilitated risk-sharing on a global scale, boosting innovation and hence prosperity. There is no economic rationale for distinguishing this “virtual capitalism” from “real capitalism”: nothing real has ever been produced without first being financed. The new instruments aren’t free of problems, as seen in the subprime failure. Financial enterprises are enterprises like any other—they think up new ideas, try them out, and sometimes crash. But even in a time of financial crisis, the global benefits of the new financial markets have surpassed their costs. The debate among economists today concerns only the degree of transparency and regulation necessary for their effective functioning.

10. Competition is usually desirable. Beyond that, there is no unanimity: some economists believe that under certain circumstances, a private or public monopoly may contribute to innovation or progress. What kind of protection to extend to intellectual property is also disputed. Economists remember that a British patent protected James Watt’s steam engine from competitors from 1769 through 1790, stalling the Industrial Revolution. To what extent do patents for computer software or drugs slow or enhance progress? The most creative period in Silicon Valley’s history took place before the patenting of software, it’s worth noting. Stanford University’s Paul Romer, the leading U.S. economist in this field, suggests that the answer may be “soft property”—short-term property rights that would make research worthwhile without hindering competition unduly.

These ten propositions should guide all economic policymaking, and to an increasing degree they do, worldwide. Does this mean that we’ve reached an “end of history” in economics, to borrow a phrase made famous by Francis Fukuyama, by way of Hegel and Alexandre Kojève? In one sense, perhaps: economic science will never rediscover the virtues of hyperinflation or industrial nationalization. Some critics charge that economics is not a science in the way that, say, physics is—after all, economists can’t make precise predictions, as an exact science can. But this isn’t quite true: economists can predict that certain bad policies will lead necessarily to catastrophe. If economics, a human science, lacks the precision of physics, a natural one, it advances the same way—evolving from one theory to the next, each approximating a reality that eludes our complete grasp.

But if we understand the end of history in economics to mean the complete realization, in practice, of the findings of economic science, then it has not arrived. The free market still has enemies and critics, ranging from those who dream of a world more just, more spiritual, or transformed in some other utopian way to those who simply seek to defend their own narrow material interests to those legitimate researchers who try to look beyond the market. And we must not overlook ignorance: economic principles aren’t widely understood among the public or even among lawmakers. The indisputable fact that the world has experienced a long period of growth as global trade has expanded remains strangely unknown. Doubtless the news is too good.

In the future, the threat to the beneficent influence of economic science will come less from tired socialist revolutionary rhetoric than from new dangers, such as terrorism and epidemics. Terrorism is, in part, a consequence of globalization: young, uprooted people unable to adapt to a dynamic, capitalist world invent new global ideologies and seek to put them into practice with global weapons. Globalization can also accelerate the proliferation of deadly illnesses. The AIDS epidemic was the first global attack by a mutant virus; SARS, avian flu, or some unknown illness could follow, surging from uncontrolled Chinese, Indian, or African backwaters and following the massive migrations of a global economy. Terror and epidemics could both unleash political upheavals that would undermine the market order itself.

Then there’s the fear of ecological disturbances, which could result in incoherent policies that wouldn’t necessarily diminish risks to the environment but might prevent development and thus harm the interests of the poorest peoples. One example: prohibiting genetically modified organisms—which, evidence suggests, pose no threat whatsoever to the environment—will hurt the productivity of farming at a time when global demand for food will grow.

Another danger is inseparable from the very nature of economic systems: growth is cyclical. Despite the present anxiety about a recession, the time of major global economic crises seems to have passed, in large part because the progress of economic science allows governments and economic actors to understand crises and manage them better. The Great Depression probably couldn’t happen again, since the political mistakes that aggravated it, such as protectionism and the drying-up of credit, aren’t as likely to be repeated in the future: the Federal Reserve, the European Central Bank, and the Bank of England have demonstrated as much in the current mortgage crisis by supporting the banking system. But smaller crises are inevitable, bound up as they are with innovation—and as the new drives out the old in creative destruction and forces sometimes painful adaptations, we find these upheavals harder to bear as we grow more accustomed to perpetual growth.

Similarly, free trade means that some people will lose their jobs, as we all know; foreign competition can wipe out entire companies or even entire industries. We all know it because, as Friedman argued, layoffs and closings get disproportionate media coverage. Meanwhile, nobody talks about the ongoing reduction in prices for consumers and investors, scattered among a huge number of beneficiaries. That helps explain why politicians are prone to deride free trade and voters are too often ready to agree.

To help the losers in the free market, government shouldn’t back away from either free trade or creative destruction and start subsidizing doomed and obsolete activities, a protectionist course that guarantees only economic decline. Instead, it should help the losers change jobs more easily by improving educational opportunities and by facilitating new investment, which creates more employment. An essential task of democratic governments and opinion makers when confronting economic cycles and political pressure is to secure and protect the system that has served humanity so well, and not to change it for the worse on the pretext of its imperfection.

Still, this lesson is doubtless one of the hardest to translate into language that public opinion will accept. The best of all possible economic systems is indeed imperfect. Whatever the truths uncovered by economic science, the free market is finally only the reflection of human nature, itself hardly perfectible.

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