The Perils Of Having A Little Knowledge

James Kwak at The Baseline Scenario has a post that fits my own educationalo experience to a “T”:

The Perils of Studying Economics

Patrick McGeehan at the New York Times recently wrote about a New York Fed study finding that studying economics makes you a Republican. The headline conclusion is that the more economics classes you take, the more likely you are to be a Republican...

...Studying economics also affects your position on several public policy issues. Of seven issues, economics courses were significantly associated with the five following positions (Table 6):

-Tariffs are bad.

-Trade deficits are not so bad.

-The government should not cap oil prices in response to a supply shock.

-Raising the minimum wage increase unemployment for low-wage workers.

-Income distribution should not be more equal.

These are all pro-free market, anti-government intervention positions.

What I thought was particularly interesting, however, was that on some issues people who study undergraduate economics are more doctrinaire free marketers than professional economists...The Ph.D. economists were more likely than economics majors to hold the textbook position on tariffs or the minimum wage. However, they were also more likely than economics majors (or, frankly, any majors) to think that income inequality should be reduced and that government spending should not be reduced, and they were somewhat less worried about federal budget deficits.

This is something I’ve mentioned in passing often. I think that basic economics, the way it is taught today, tends to give people reflexive pro-free market, anti-government positions — positions that are not held by people with a deeper exposure to economic thinking. When your understanding of government finances is based on reading the newspaper, it’s somewhat eye-opening to come to college and learn that free markets lead to maximum societal welfare and taxes impose a deadweight loss on society — the pictures are so simple and compelling. That’s why a little bit of economics makes you more likely to be a Republican.

But when you learn more about principal-agent problems, information asymmetries, and so on, you learn that those simple pictures are simplistic to the point of being misleading. That’s why Joseph Stiglitz argues in Freefall that understanding economics is crucial to understanding why free markets often lead to suboptimal outcomes. The problem isn’t knowledge per se; it’s a little bit of knowledge.

Notwithstanding my position on subsidies, I’m not in the camp that says that all government intervention is bad, and all policies that create freer markets is good. It depends very much on how intelligently government policy is designed.

There is a good case for saying that, by definition, government policy cannot in fact ever be as truly efficient or effective relative to a free market-based solution. But if market solutions themselves result in suboptimal social welfare outcomes – not unreasonable since few if any real world markets have the necessary characteristics for full efficiency; nor do market solutions always have a moral or social welfare dimension – then government intervention is a valid second-best solution.

Too much of undergraduate economics is based on basic neo-classical/neo-Keynesian theory, which while necessary as a foundation, doesn’t go into the nuances that colour the application of these theories in a real world context. Nor is there any exposure (even at the graduate level) on alternative/heterodox schools of economic thought – you have to discover those on your own.

Spreading knowledge of economics is good, as I’ve always thought of basic economic theory as thought at the undergraduate level as primarily a framework for thinking and discussing policy issues. We’d have a better public discourse on policy and social issues. But as James says, a little knowledge is more dangerous than ignorance – the last thing we need is a revival of the Washington Consensus.

What Kind Of Economist Am I?

WY asks what school of economic thought I support. The answer in a nutshell is...whatever works.

Here's the story - strike that, here's my summary of the history of economic thought:

The classical school - Adam Smith, David Ricardo, Hume, Bentham, Marx, Marshall and many others - really set the foundations of economic thought. They gave rise to many competing ideologies which didn't necessarily agreed with each other. For instance libertarianism and the Austrian school take freedom as the sole guiding principle of economic organisation, while Marx suggests the diametric opposite. Both are considered on the lunatic fringe in modern economics.

The classical school eventually gave way to the neo-classical school, which attempted to describe economics within a mathematical framework. The Great Depression and the rise of the Keynesian revolution derailed this movement momentarily, but it revived and assimilated Keynesian thought under the neo-classical synthesis starting with John Hicks (the ever popular and still relevant IS-LM model).

The 1970s brought stagflation and the breakdown of heretofore established macro-relationships, bringing about a resurgence of classical ideas, with an emphasis on micro-foundations for macro analysis - the new classical school.

The 1960s-70s also coincided with the rise of monetarism, which combined some of the ideas of the Austrian school with the neo-classical synthesis. Also known as the Chicago School from its identification with Milton Friedman, monetarism reduced economic policy management to essentially one tool: "2% money supply growth" (see Goodhart's law to see why this failed).

The new keynesian school essentially takes a cue from the new classical school by applying micro-foundations to keynesian macro analysis. These two competing schools of thought comprise mainstream economics today.

Then there is the heterodox school. Well not really a school per se, but rather a loose term covering economists who don't fall under a convenient label. These include people like Joseph Schumpeter and JK Galbraith.

The reason why you see economists disagree in the current crisis on seemingly basic questions like the effectiveness of fiscal stimulus or its structure, or whether it will work at all, goes back to their basic ideologies:

1. New classicals believe in complete markets and rational agents, and that government is less efficient in allocating resources. As such fiscal stimulus is less likely to be effective, and if stimulus has to be done, tax cuts are preferred.

2. New keynesians believe that markets can fail and prices are sticky, in which case there is a strong case for government to step in. Inefficient allocation of resources is better than no use of resources at all.

3. Monetarists don't believe fiscal stimulus works. All we need is 2% money supply growth.

4. Austrians and libertarians don't believe in government. All we need to do is go back to the gold standard and abolish all the central banks.

5. Marxists believe capitalism is doomed to fail. All we need is...never mind.

Where do I stand in this milieu? I admit I began my career a monetarist, with some leanings toward libertarianism. Age and (hopefully) some wisdom now puts me somewhat left of centre - markets do fail, frequently in fact. I also have some sympathy for some of Galbraith's and Schumpeter's ideas, which while often in conflict, do a better job of describing the real world then either mainstream school. It's hard to accept the efficiency of price signals, when competitors are essentially oligopolistic.

Having said that, I think my approach to economics is purely pragmatic. Some ideas work at some times, but not at others. It is a mistake to take a one-size-fits-all approach, especially when contemplating a developing country with immature markets and institutions. Just as important, I lean on empirical evidence rather than relying purely on the dictates of theory.

Theory only provides a framework for thinking, and it pays to listen a little to all the schools of thoughts - even Marxists and Austrians occasionally have something worthwhile to say.