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‘What’s the Matter with Economics?’: An Exchange

In response to:

What’s the Matter with Economics? from the December 18, 2014 issue

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To the Editors:

Alan S. Blinder’s review of Jeff Madrick’s Seven Bad Ideas asks: “What’s the Matter with Economics?” [NYR, December 18, 2014]. Blinder concludes that except for some right-wingers outside the “mainstream” and politicians’ refusal to accept economists’ recommendations, little is the matter and Seven Bad Ideas constitutes “serial exaggeration.” I wish that it was so, but economists’ thinking, based on an ill-conceived view of human behavior and addressed to the wrong problem, is a powerful force in policy circles.

Blinder’s textbook, written with William Baumol, is the standard for the mainstream. Both are extraordinarily good economists, liberal and not doctrinaire. I have used their text myself when teaching.

Economists, however, have been unable to forecast accurately based on the exposition put forth in B&B and most texts. For example, the Federal Reserve Board’s belief in (mostly) efficient markets led to it missing the signs of the Great Recession; as late as June 2006 the Fed raised interest rates fearing that “some inflation risks remain.” For years, the Fed had rejected board member Ned Gramlich’s warnings that the practices of subprime lenders were not consistent with the assumptions of the Fed’s economists (and chairman). Mainstream economists did not predict the effects of eliminating Glass-Steagall, thereby allowing large banks to design and sell the products that helped bring about the collapse.

Although recognizing that markets can be flawed, B&B states that minimum waste “can be achieved extraordinarily well by letting markets operate more or less freely” and that market methods can remedy the few flaws in the market. The role of economists is removing barriers to the markets’ efficient allocation of usually scarce resources (they assume full employment). For the perhaps 200 million unemployed worldwide the more important issue, however, is the chronic underemployment of potential resources. Economists do not build the distribution of income into their models; but 80 percent of the world population lives on less than $10 a day, which surely wastes substantial human resources. A reexamination of the efficiency of markets, especially financial markets, is in order.

Arnold Packer
The Johns Hopkins University, Retired Former Assistant Secretary of Labor in the Carter Administration
and Former Chief Economist of the US Senate Budget Committee
Baltimore, Maryland

To the Editors:

Alan Blinder is one of the finest mainstream economists around. But to read his review of my book, you’d think that nothing was wrong with economics in recent decades except as it is practiced by a few right-wingers.

This is of course not the case. For example, as I write, mainstream economists claimed until the eve of the 2008 catastrophe that they had at last learned how to manage the economy well. This was quite an error of analysis and thinking, and did not principally come from the right. The leaders of this mainstream analysis were centrist Ben Bernanke, the former Federal Reserve chairman, and moderate liberal Olivier Blanchard, chief economist of the International Monetary Fund.

They argued that the stability of the GDP since the 1980s—what they called the Great Moderation—was an indication that the problem of macroeconomic adjustment had been solved. Stability is fine, but over this period debt soared, growth slowed on average, wages stagnated or fell, inequality rose, and there were at least seven American financial crises. Then came disaster in 2008. What were they talking about?

Blinder wonders, who believed that low inflation was mostly all that mattered? Until the crisis, Bernanke did, and so did many others. You can’t exonerate Bernanke, as Blinder does, because he finally rescued the economy. Bernanke wrote that the Great Moderation was mostly a result of targeting low stable inflation.

And didn’t policymakers listen to these ideas? They still do at the Federal Reserve, where foolish bickering over whether inflation will reach 2 percent a year still goes on. Stale, discarded ideas? Hardly.

Blinder illustrates my deepest concerns about the mainstream when he says the invisible hand is like Galileo’s law of falling bodies, which only works in a vacuum. The same is more or less true of the invisible hand, however. Blinder complains that he and others are aware of the imperfections that impede the pure functioning of the invisible hand. But in fact, economists rely on a fairly pure version of the invisible hand most of the time. And Blinder seems to agree that they should. “I don’t think any mainstream economist doubts that free, competitive markets perform their core functions far better than any alternative mechanism,” he says.

The alternative to a strong faith in the invisible hand is not central planning, as Blinder implies, which is the cheap way to refute my criticism. It is serious government regulatory vigilance and public investment. Mainstream economists, and not just the right wing, have contributed significantly to failures on both fronts.

Simplistic faith in the invisible hand is also at the intellectual root of the financial deregulation that took hold of the nation under Republican administrations, was perpetuated by Democratic governments, and culminated with the 2008 crash.

Blinder exhibits merely wishful thinking when he says that Say’s Law, which is an argument for austerity economics and a self-adjusting economy, was defeated by the Depression. Blinder cites a survey showing that most economists agreed that the Obama stimulus was effective. Sure, after the sharpest drop in GDP since the Great Depression. As some facetiously put it, we are all Keynesians in a foxhole.

In truth, some liberal Democratic economists had been railing against budget deficits using Say’s Law logic since the 1980s, claiming they would undermine private investment. IMF economists, led by Olivier Blanchard, supported the extreme anti-Keynesian austerity of Britain’s David Cameron in 2010. On we can go. It was not just Harvard’s Alberto Alesina at all.

It’s Blinder’s skepticism about the influence of ideas themselves that is most surprising to me. Let me cite an even greater economist than George Stigler, whom Blinder quotes on the matter. “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood,” wrote John Maynard Keynes in 1936. “It is ideas, not vested interests, which are dangerous for good or evil.”

Regarding Blinder’s final claim that economics explains growth better than other disciplines, it reflects the typically narrow focus of a top mainstream economist. Sociology and political history are critical to understanding Chinese economic development, for example. The recently famous Hyman Minsky, who is now cited constantly for his work on speculative bubbles, was more sociologist and psychologist than technical economist. I’d doubt one could make a case that the invisible hand was first among equals in explaining the industrial revolution. There were new technologies, huge new markets for goods, highly efficient shipping by waterways, and so on. The invisible hand is a powerful, alluring idea with serious limitations, and many other factors have been critical to economic development.

Jeff Madrick
New York City

Alan S. Blinder replies:

According to both Jeff Madrick and Arnie Packer, I claim “that except for some right-wingers outside the ‘mainstream’…little is the matter” with economics. (These are Packer’s words; Madrick’s are similar.) But it’s not true. I think there is lots wrong with mainstream economics.

For starters, my review explicitly agreed with Madrick that (a) ideological predispositions infect economists’ conclusions far too much; (b) economics has drifted to the right (along with the American body politic); and (c) some economists got carried away by the allure of the efficient markets hypothesis. I also added a few indictments of my own: that we economists have failed to convey even the most basic economic principles to the public; and that some of our students turned Adam Smith’s invisible hand into Gordon Gekko’s “greed is good.”

My review naturally focused on Madrick’s Seven Bad Ideas. Had I been drawing up the indictment, I would have focused on a very different list of flaws—such as the propensity to elevate modeling technique over substance. But I kept such matters to myself because they (a) are not germane to policy, (b) are only slightly related to Madrick’s complaints, and (c) are very much “inside baseball” stuff—and hence boring to readers of this Review.

Madrick criticizes economists’ fascination with the “Great Moderation,” the years between 1984 and 2007 when the variability of both output and inflation was extraordinarily low. Given the mess that followed, thinking that the Great Moderation demonstrated that the business cycle had been tamed does sound a bit silly. But was that economists’ verdict? In fact, in the years before the crisis struck, several mainstream economists had engaged in serious scientific debate over whether macroeconomic management (as practiced by the Federal Reserve) had been extraordinarily skillful or the US economy had just been extraordinarily lucky.

Both Madrick and Queen Elizabeth are right that hardly any economists saw the financial crisis and the ensuing Great Recession coming. Packer also bemoans our poor forecasting record. Fair enough; but we had lots of company. Among our many failings were not realizing how large the subprime mortgage market had grown, or how dodgy the mortgages packaged into mortgage-backed securities were; not understanding the crazy quilt of exotic derivatives that had been built on this weak foundation; and not believing that house prices would fall as far as they did. Guilty as charged. But that guilt is widely shared.

However, faulty macroeconomic management was not among the causes of the horrors. That may sound like hiding behind a wonkish division of labor; but it certainly does not exonerate the Fed, whose supervisory and regulatory performance was dreadful. My point is that the Great Moderation did not end because of macroeconomic policy errors. It ended because of a financial crisis brought on by the bursting of a house-price bubble in an overleveraged, overly complex, and underregulated financial system.

Yes, underregulated—which brings me back to the invisible hand. I thought I had laid this issue to rest by agreeing with Madrick that “the Invisible Hand is an approximation, usually not applicable in the real world without significant modification” (his words). That’s right. And those modifications point toward, inter alia, antitrust laws, consumer protection, fair labor standards, health and safety regulation, financial regulation, and much more. As I noted, conservatives reject many of these interferences with free markets, but the (more liberal) mainstream accepts them.

Yet Madrick still insists that “economists rely on a fairly pure version of the invisible hand most of the time.” Not us mainstreamers. I’m a member of the tribe, I live among these people every day, and—trust me—we really don’t apply the “pure version” to the real world. For example, many of us see reasons for a minimum wage, mandatory Social Security, progressive taxation, carbon taxes, and a whole variety of financial regulations—to name just a few. On the other hand, we do normally view the invisible hand as the best “mechanism for delivering the right goods and services to the right people at the lowest possible costs” (my words, in the review).

Packer observes that the invisible hand does not guarantee low unemployment (true, that’s why we have monetary and fiscal policy) or that income is distributed equitably (true, that’s why we have progressive taxation and the welfare state). But every mainstream economics textbook makes both of these points.

Packer’s letter begins, and Madrick’s concludes, by disputing my claim that economists’ influence on policy decisions is greatly exaggerated. I suppose we could debate the meaning of “greatly exaggerated” forever. I didn’t mean that economic thinking has no influence at all. But when it comes to choosing between a policy that is good economics but bad politics or a policy that is bad economics but good politics, it’s nolo contendere.

Madrick quotes John Maynard Keynes’s famous statement that “the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood.” Continuing the thought, Keynes went on to write that “practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.” Notice the adjective: “defunct,” which I’ve always interpreted as “long gone.”

Here’s a poignant case in point: even today, seventy-eight years after Keynes taught the world how to end recessions, many politicians in many countries refuse to follow his (now very mainstream) advice. That’s not a good show for what Packer calls “a powerful force in policy circles.”