William Baumol of New York University has written a very intersting stuff relating to the dismal science (read economics) and thinks economics "is particularly vulnerable to mistaken ideas contributed from the outside."
ECONOMIC ERRORS THAT DAMAGE THE INDIVIDUAL
Sometimes it is the individual committing an economic error who alone bears the cost. An example is the investor who seeks out and follows financial analysts' advice on the purchase and sale of stocks, despite overwhelming statistical evidence demonstrating that, even if such advice were offered without cost, it would generally be valueless or worse. Professional recommendations on stock market purchases and sales have repeatedly been shown to be totally unreliable. Indeed, they must be so because, as the data demonstrate, the behavior of securities prices approximates what statisticians call a "random walk." Random behavior is, by definition, inherently unpredictable even by the best-informed and most intelligent analyst. But stock market analysts' advice is even worse than this for the investor, on two scores. First, it is not costless. The investor is forced to pay for bad information and is thereby put in the position of a bettor in a gambling casino, where the outcomes are not just random but are systematically biased to bring a predictable rake-off to the gambling house. Second, whether or not as a deliberate dereliction of duty, frequent sales and purchases of securities that benefit the stock market analysts' own firms are characteristic of their recommendations. These transactions multiply the investor's total payments to these firms and, incidentally, materially increase the investor's tax bill.
DAMAGE TO THE SOCIETY: THE CASE OF MISTAKEN COUNTERCYCLICAL POLICY
…notable example was the belief that an essential step in extracting an economy from recession or depression is elimination of deficit spending by the government. While there is no longer agreement by economists that expansion of such spending is invariably a sensible step, it is recognized that the simpleminded argument that leads many non-specialists to conclude that such deficit spending threatens to bankrupt the nation is an exercise in the "fallacy of composition." This fallacy is the presumption that a relationship that is valid for each individual must automatically be valid for the entire group of these persons. One elementary example entails voluntary exchange between two informed and rational individuals and the conclusion that such an exchange must offer some benefit to each of them, or at least no loss to either (otherwise, the prospective trade participant who stood to lose from the transaction would simply refuse to trade). The fallacy of composition enters when this insight about trade between individuals is applied to trade between two countries, where it is neither self-evident nor generally true that exchanges must invariably benefit both countries.
Turning to the issue of deficit spending, the standard view stems from the observation that an individual who is in financial difficulty because of persistent spending beyond his means must somehow succeed in curtailing his overspending now and in the future if he is to avoid exacerbation of his financial troubles. The inference from this observation drawn by analogy for a depression-beleaguered government--whose tax revenues have fallen as a consequence of reduced incomes and whose expenditure has been driven upward by rising obligations--was that, just as in the individual case, fiscal retrenchment was essential. Governments in that position characteristically find themselves plagued by rising debt and the evident, if questionable, conclusion was that material retrenchment was urgent and unavoidable if financial catastrophe for the country was to be avoided.
But, one of the central propositions to emerge in the course of the Keynesian revolution was that this prescription for retrenchment was the precise opposite of what such a situation requires. Rather, an effective governmental weapon--indeed, a critical component of the counter-depression policy that Abba Lerner dubbed "functional finance"--is enhancement of deficit spending, entailing rising public debt, with the shortfall to be made up during the other end of the business fluctuation, when inflation replaces unemployment as the primary threat to the economy.
The way in which the fallacy of composition enters the matter is quite straightforward. Increased spending by an individual (without any offsetting rise in earnings) spells financial peril. For the community of individuals, taken as a group, the situation is, at least in the simplest Keynesian view, usually the reverse of this. The more the government increases spending without a corresponding rise in tax revenues, the better off the community will be economically. This act of magic occurs because the very deficit spending must put purchasing power into the hands of the public, which in turn will serve to raise demand for goods and services. And in a depressed economy, anything that serves to offset lagging demand must be helpful, because it will expand sales, elicit enhanced production, and provide additional jobs. So deficit spending by government is a stimulus of economic activity and a source of added income for the society as a whole. This stimulus effect also helps to cut the government's budget shortfall by automatically adding to total tax revenues as private incomes rise, and by cutting needed government expenditures, such as outlays for support of the unemployed. As Keynes himself pointed out, the apt parable is that of the legendary widow's cruse, which kept refilling itself as its contents were extracted. For, if the argument is valid, it indicates that the more the government overspends, the more net income it can hope to have available in the near future.
This argument, though not universally accepted by economists today, was certainly rejected by many, including President Franklin D. Roosevelt, in the 1930s. It is at least arguable that the resulting efforts to curb government overspending protracted the Great Depression, creating a second economic decline toward the end of the decade, with termination of the Depression left to the onset of the Second World War, which once again imposed substantial deficit spending on the government. If it is true that insufficient government spending exacerbated the effects of the Depression, then it is surely difficult to dispute the conclusion that here was an economic error that caused great and widespread harm, increasing unemployment, reducing incomes, and keeping output and accumulated wealth of the society down well below what it might otherwise have been.
There is an associated popular misunderstanding, which strengthened the determination of the opponents of deficit spending. This is the conclusion that government deficit must constitute a "burden upon our grandchildren." There are, it must be admitted, circumstances in which this could be true, and one must not go so far as to deny the possibility of any detrimental consequences of government debt for future members of the community. But the common and assuredly naive variant of the idea is yet another example of the fallacy of composition. That assets lost by injudicious expenditure during an individual's lifetime can impoverish her heirs is evident. But for a nation, matters are far different. Thus suppose, for example, that a government greatly increases its current expenditure on military equipment, financing it by borrowing, through the issue and sale of additional government bonds. The labor, steel, power, and other inputs that are used to manufacture the armaments immediately become unavailable for civilian use. This is a burden that fails upon the public at once and need not in any way affect future generations whose supply of factors of production need not thereby be diminished. The labor that today is shifted from production of autos to the manufacture of tanks does not reduce the availability of labor to consumers 20 years hence. Reduced resource availability that results from government deficit spending, then, is primarily a burden upon the current generation, not those of the future.
It is not even true that government debt incurred today need entail a financial problem tomorrow, when the debt is to be repaid. But from what source is the repayment to be made? Suppose, for concreteness, that the government bonds that financed the debt are scheduled for redemption 20 years after the deficit spending occurred, and that at that date the government raises taxes by an amount just sufficient to cover the X-dollar debt. Then that is surely a burden for those who must pay the X dollars in taxes, but it is accompanied by a rise of exactly X dollars in the cash that becomes available to the bondholders. If the bonds are not held by foreigners, what will happen at the date of repayment is that the money that financed the purchases will simply have been transferred from one group of citizens to another. Indeed, even that need not take place to any marked extent. If, for example, the government bonds are held by individuals roughly in accord with their incomes, the wealthier the individual, the greater his holdings, then if the tax is also proportioned to income, the repayment process need not incur any significant transfer of purchasing power. The money will be taken from the wealthy, and promptly returned to the same individuals. In the words of Adam Smith, what will have been entailed is simply a transfer of money from the right pocket of the taxpayer to the left.
In short, viewed in terms of its substance, the burden of government expenditure is a burden upon the present, not upon the future. Yet this was apparently not understood by earlier generations of economists and certainly not by the general public. And the error was not just a matter of academic interest. Rather, by preventing the actions that promised a speedy recovery from recession or depression, it had marked and unfortunate consequences for the general welfare.
PUTTING PRODUCTIVITY GROWTH DIFFERENCES TO WORK FOR SOCIETY
… to the key misunderstanding, in terms of policy, engendered by the failure to understand the nature of the cost disease: the idea that the cost disease will force society (or the government that provides the finances) to retrench and eventually cut back on vital health care and education because of the mistaken belief that their rising cost must make them increasingly unaffordable to society. This belief, it turns out surprisingly, is virtually the reverse of the truth.
In actuality, the very forces that create the cost disease make these services ever more affordable to society. This is so because the source of the problem is that, although productivity is growing in almost every industry, in some industries (particularly personal services) it is growing more slowly than in others. But if output per worker and output per work hour are rising in virtually all industries, then a given quantity of any bundle of outputs requires an ever smaller share of the labor force for its production. What society must do is use part of the cost savings from the industries (like manufacturing or telecommunications) in which productivity is growing at a rapid rate to pay for the personal services (like health care and education) in which productivity is growing at a relatively slower rate. It is simply not true that society cannot afford those costs. On the contrary, rising productivity means that society can afford to consume more of each and every product. It is this observation that led the late Senator Daniel Patrick Moynihan to describe the cost disease analysis as a profoundly optimistic diagnosis.
The danger is that governments, the primary source of financing of these services in most countries, will decide that the cost burden is beyond their capacity to finance, and will decide that cutbacks are their only option. This is already happening in many of the industrialized countries, where an increasing set of medical procedures are denied to patients and cutbacks in financing of universities and their teaching and research activities are all too common. This is unfortunate because, as is shown by the cost disease analysis, their unaffordability is a fiscal illusion, and retrenchment of these arguably vital activities is an unnecessary if understandable response to this illusion. Here, surely, is a case in which misunderstanding can result in totally avoidable damage to the social interest.
CAN PRICE INCREASES EVER SERVE THE PUBLIC INTEREST?
The possibility that, in a wide variety of circumstances, a rise in price may be a substantial benefit to the public is something that people untrained in economics always find extremely difficult to accept. ..If a price, such as the price of crossing a crowded bridge or the price of environmentally damaging gasoline, is set very low, then consumers will be provided an incentive to exacerbate the problems. These market signals will induce them to add to the crowding or to the environmental damage even further….. One telling illustration is the way that landing privileges at crowded airports are often priced. Airports become particularly congested at peak hours, just before 9 a.m. and just after 5 p.m. This is when passengers most often suffer long delays. But many airports continue to charge bargain landing fees throughout the day, even at those crowded hours. That makes it attractive for small corporate jets or other planes carrying only a few passengers to arrive and take off at those hours, worsening the delays. Higher fees for peak-hour landings can discourage such overuse, but they are politically unpopular, and many airports are run by local governments. So we continue to experience late arrivals as a normal feature of air travel.
We know that inappropriately low prices caused nationwide chaos in gasoline distribution after the sudden drop in Iranian oil exports in 1979. In times of war, constraints on prices have even contributed to the surrender of cities under military siege, deterring those who would otherwise have risked smuggling food supplies through enemy lines. Low prices have also discouraged housing construction in cities where rent controls made building a losing proposition. Of course, in some cases it is appropriate to resist price increases--as when unrestrained monopoly would otherwise succeed in gouging the public, and when rising prices fall so heavily on poor people that rationing becomes the more acceptable option. But before tampering with the market mechanism, we must carefully evaluate the potentially serious and even tragic consequences that artificial restrictions on prices can produce, particularly when scarcity threatens or is already damaging the public welfare.
It is not easy to accept the notion that higher prices can serve the public interest better than lower ones. Politicians who voice this view imperil their jobs. Because advocacy of higher prices courts political disaster, the political system often rejects the market solution that automatically raises prices when resources suddenly become scarce. And that only enhances the shortages.
MUST OUTSOURCING TO OTHER NATIONS ALWAYS BENEFIT BOTH AFFECTED COUNTRIES?
…. economists are usually strongly predisposed to favor free trade, globalization, and market-driven apportionment of industries among nations. But this orientation has led many of them to conclude that when a portion of an economic activity or even an entire industry moves from a high-wage to a low-wage country as a result of an increase of productivity in the latter, both the gainer and the loser of the industry can be expected to benefit. In particular, while some individuals in the country from which the activity has emigrated will evidently be harmed, on this view the country as a whole will normally benefit from the reduced costs of the products whose production has moved abroad, and benefit sufficiently to compensate for the damages and more.
Those who believe that macroeconomic policy can effectively limit involuntary unemployment have reason to conclude that loss in the total number of jobs is not an inevitable consequence of globalization, though it does undoubtedly threaten the working positions of at least a few directly affected individuals, for whom the consequences must not be taken lightly. But though we may reject the popular view that globalization is a major threat to employment and an instrument of extensive job loss, we cannot deny that there is reason to be concerned with at least the short-term effects on wages in both developing and developed lands. International competition can influence relative input prices and thereby determine whether machinery will be substituted for labor, for example, or whether skilled labor will be substituted for unskilled. There are, also, more direct implications for wages. Surely, the increased use of computer programmers in India can be expected to reduce the demand for such skills in the United States below what it might otherwise have been.
For the developing countries, economic history suggests that an industrial revolution initially tends to depress real wages and real living standards, thus supporting the concerns of those who fear the consequences of globalization for the world's less prosperous nations. Though the British industrial revolution is usually considered to have taken off about 1760, it was probably not until approximately 1840 that wages began to rise. Data on life expectancy and average height also indicate that the spread of innovation was accompanied by worsening of the economic status of wage earners, perhaps in part as a result of the move from the countryside to crowded, unsanitary slums; the evidence indicates that the US labor force underwent a parallel trajectory. One may surmise that part of the explanation was a rise in the power of employers and an inability of the workers, in the absence of labor organizations, to resist.
The opponents of globalization draw attention to a similar phenomenon in twenty-first-century globalization, with multinational employers subjecting their employees to disturbingly low wages and shocking working conditions, particularly on the criteria widely accepted in the affluent economies (though by no means always adhered to even there). Thus, even if globalization is a very promising influence for the more distant future prospects of the developing countries, there is good reason to fear that in the short run the workers in those lands may gain little and may even lose out in the initial stages of globalization.
It can be argued that all this is transitory and that in the long run the lower-income groups in the developing countries will be better off, as has indeed been true in the developed economies. But the process can easily take decades. We cannot just ignore decades of very substandard earnings that amount to preservation of grinding poverty in a developing country or the permanent structural unemployment in a developed economy that can beset older workers whose skills are made redundant by innovation, and for whom the acquisition of new skills is not a practical option. These are hardships that constitute an extremely painful economic pathology for the affected individuals. At the very least, one can argue that those who stand to benefit from the process should be expected to agree to provide systematic and substantial assistance to the victims, presumably through government channels, and supported liberally by the wealthier communities. If that is not acceptable politically, there is surely little that can be said convincingly in support of a contention that the suffering of the victims will be justified by the promised future benefits to their descendants.
ANYONE CAN ERR
If the arguments of this paper are not themselves in error, what I have shown is that the economics profession can, indeed, sometimes show the layperson the error of his or her more common-sense thoughts. But not always. Sometimes the errors and the route toward correction go the other way. This observation is not meant in any way to denigrate the work of my colleagues. After all, it is only through careful analysis that one can discover where it is the specialist who has been wrong and where the often exceedingly fallible common sense of those with no formal training in the field has turned out to be closer to the underlying reality. We have also seen that misunderstanding in the field of economics can have consequences beyond pushing researchers and teachers in misguided directions. Perhaps as much as any discipline, erroneous economic analysis and conclusions can elicit policies severely damaging to the public interest. And, in this, I believe that we economists do have something to answer for. We are all too prone to put more faith in the implications derived from our quite appropriately simplified models, and to draw from those implications policies that really only apply universally in the artificial world of the constructed model…
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