Basic Economics

  THE ROLE OF ECONOMICS

  Among the questions often raised about the history of economic analysis are: (1) Is economics scientific or is it just a set of opinions and ideological biases? and (2) Do economic ideas reflect surrounding circumstances and events and change with those circumstances and events?

  Scientific Analysis

  There is no question that economists as individuals have their own respective preferences and biases, as do all individuals, including mathematicians and physicists. But the reason mathematics and physics are not considered to be mere subjective opinions and biased notions is that there are accepted procedures for testing and proving beliefs in these disciplines. It is precisely because individual scientists are likely to have biases that scientists in general seek to create and agree upon scientific methods and procedures that are unbiased, so that individual biases may be deterred or exposed.

  In economics, the preferences of Keynesian economists for government intervention and of University of Chicago economists for relying on markets instead of government, may well have influenced their respective initial reactions to the analysis and data of the Phillips Curve, for example. But the fact that both Keynesian economists and economists of the Chicago School shared a common set of analytical and empirical procedures in their professional work enabled them to reach common conclusions as more data came in over time, undermining the Phillips Curve.

  Controversies have raged in science, but what makes a particular field scientific is not automatic unanimity on particular issues but a commonly accepted set of procedures for resolving differences about issues when there are sufficient data available. Einstein’s theory of relativity was not initially accepted by most physicists, nor did Einstein want it accepted without some empirical tests. When the behavior of light during an eclipse of the sun provided a test of his theory, the unexpected results convinced other scientists that he was right. A leading historian of science, Thomas Kuhn, has argued that what distinguishes science from other fields is that mutually contradictory theories cannot co-exist indefinitely in science but that one or the other must prevail, and the others disappear, when enough of the right data become available.{1015}

  Thus the phlogiston theory of combustion gave way to the oxygen theory of combustion and the Ptolemaic theory of astronomy gave way to the Copernican theory. The history of ideologies, however, is quite different from the history of science. Mutually contradictory ideologies can co-exist for centuries, with no resolution of their differences in sight or perhaps even conceivable.{xlv}

  What scientists share is not simply agreement on various conclusions but, more fundamentally, agreement about the ways of testing and verifying conclusions, beginning with a careful and strict definition of the terms being used. The crucial importance of definitions in economics has been demonstrated, for example, by the fallacies that result when popular discussions of economic policies use a loose term like “wages” to refer to such different things as wage rates per unit of time, aggregate earnings of workers, and labor costs per unit of output.{xlvi} As noted in Chapter 21, a prosperous country with higher wage rates per unit of time may have lower labor costs per unit of output than a Third World country where workers are not paid nearly as much.

  Mathematical presentations of arguments, whether in science or economics, not only make these arguments more compact and their complexities easier to follow than a longer verbal presentation would be, but can also make their implications clearer and their flaws harder to hide. For example, when preparing a landmark 1931 scholarly article on economics, one later reprinted for decades thereafter, Professor Jacob Viner of the University of Chicago instructed a draftsman on how he wanted certain complex cost curves constructed. The draftsman replied that one of the set of curves with which Professor Viner wanted to illustrate the analysis in his article was impossible to draw with all the characteristics that Viner had specified.

  As Professor Viner later recognized, he had asked for something that was “technically impossible and economically inappropriate,” because some of the assumptions in his analysis were incompatible with some of his other assumptions.{1016} That flaw became apparent in a mathematical presentation of the argument, whereas mutually incompatible assumptions may co-exist indefinitely in an imprecise verbal presentation.

  Systematic analysis of carefully defined terms and the systematic testing of theories against empirical evidence are all part of a scientific study in many fields. Clearly, economics has advanced in this direction in the centuries since its beginnings. However, economics is scientific only in the sense of having some of the procedures of science. But the inability to conduct controlled experiments prevents its theories from having the precision and repeatability often associated with science. On the other hand, there are other fields with a recognized scientific basis which also do not permit controlled experiments, astronomy being one example and meteorology being another. Moreover, there are different degrees of precision among these fields.

  In astronomy, for example, the time when eclipses will occur can be predicted to the second, even centuries ahead of time, while meteorologists have a high error rate when forecasting the weather a week ahead.

  Although no one questions the scientific principles of physics on which weather forecasting is based, the uncertainty as to how the numerous combinations of factors will come together at a particular place on a particular day makes forecasting a particular event that day much more hazardous than predicting how those factors will interact if they come together.

  Presumably, if a meteorologist knew in advance exactly when a warm and moisture-laden air mass moving up from the Gulf of Mexico would encounter a cold and dry air mass moving down from Canada, that meteorologist would be able to predict rain or snow in St. Louis to a certainty, since that would be nothing more than the application of the principles of physics to these particular circumstances. It is not those principles which are uncertain but all the variables whose behavior will determine which of those principles will apply at a particular place at a particular time.

  What is scientifically known is that the collision of cold dry air and warm moist air does not produce sunny and calm days. What is unknown is whether these particular air masses will arrive in St. Louis at the same time or pass over it in succession—or both miss it completely. That is where statistical probabilities are calculated as to whether they will continue moving at their present speeds and without changing direction.

  In principle, economics is much like meteorology. There is no example in recorded history in which a government increased the money supply ten-fold in one year without prices going up. Nor does anyone expect that there ever will be. The effects of price controls in creating shortages, black markets, product quality decline, and a reduction in auxiliary services, have likewise been remarkably similar, whether in the Roman Empire under Diocletian, in Paris during the French Revolution or in the New York housing market under rent control today. Nor has there been any fundamental difference whether the price being controlled was that of housing, food, or medical care.

  Controversies among economists make news, but that does not mean that there are no established principles in this field, any more than controversies among scientists mean that there is no such thing as established principles of chemistry or physics. In both cases, these controversies seldom involve predicting what would happen under given circumstances but forecasting what will in fact happen in circumstances where there are too many combinations and permutations of factors for the outcome to be completely foreseen. In short, these controversies usually do not involve disagreement about fundamental principles of the field but about how all the trends and conditions will come together to determine which of those principles will apply or predominate in a particular set of circumstances.

  Assumptions and Analysis

  Among the many objections made against economics have been claims that it is “simplistic,” or that it assumes too much self-interested and materialis
tic rationality, or that the assumptions behind its analyses and predictions are not a true depiction of the real world.

  Some of the problems of declaring something “simplistic” have already been dealt with in Chapter 4. Implicit in the term “simplistic” is that a particular explanation is not just simple but too simple. That only raises the question: Too simple for what? If the facts consistently turn out the way the explanation predicts, then it has obviously not been too simple for its purpose—especially if the facts do not turn out the way a more complicated or more plausible-sounding explanation predicts. In short, whether or not any given explanation is too simple is an empirical question that cannot be decided in advance by how plausible, complex, or nuanced an explanation seems on the face of it, but can only be determined after examining hard evidence on how well its predictions turn out.{xlvii}

  A related attempt to determine the validity of a theory by how plausible it looks, rather than how well it performs when put to the test, is the criticism that economic analysis depicts people as thinking or acting in a way that most people do not think or act. But economics is ultimately about systemic results, not personal intentions or individual acts.

  Economists on opposite ends of the ideological spectrum have understood this. Karl Marx said that capitalists lower their prices when technological advances lower their costs of production, not because they want to, but because market competition forces them to.{1017} Adam Smith likewise said that the benefits of a competitive market economy are “no part” of capitalists’ intentions.{1018} As already noted in Chapter 4, Marx’s collaborator Engels said, “what each individual wills is obstructed by everyone else, and what emerges is something that no one willed.”{1019} It is “what emerges” that economics tries to predict and its success or failure is measured by that, not by how plausible its analysis looks at the outset.

  Bias and Analysis

  Personal bias is another fundamental question that has long been raised about economics and its claim to scientific status. J.A. Schumpeter, whose massive History of Economic Analysis remains unequalled for its combination of breadth and depth, dealt with the much-discussed question of the effect of personal bias on economic analysis. He found ideological bias common among economists, ranging from Adam Smith to Karl Marx—but what he also concluded was how little effect these biases had on these economists’ analytical work, which can be separated out from their ideological comments or advocacies.

  In a scholarly journal as well, Schumpeter singled out Adam Smith in particular: “In Adam Smith’s case the interesting thing is not indeed the absence but the harmlessness of ideological bias.”{1020}

  Smith’s unrelievedly negative picture of businessmen was, to Schumpeter, an ideological bias deriving from Smith’s background in a family which “did not belong to the business class” and his intellectual immersion in the work of “similarly conditioned” intellectuals. But “all this ideology, however strongly held, really did not much harm to his scientific achievement” in producing “sound factual and analytic teaching.”{1021} Similarly with Karl Marx, whose ideological vision of social processes was formed before he began to study economics, but “as his analytic work matured, Marx not only elaborated many pieces of scientific analysis that were neutral to that vision but also some that did not agree with it well,” even though Marx continued to use “vituperative phraseology that does not affect the scientific elements in an argument.”{1022} Ironically, Marx’s view of businessmen was not quite as totally negative as that of Adam Smith. {xlviii}

  According to Schumpeter, “in itself scientific performance does not require us to divest ourselves of our value judgments or to renounce the calling of an advocate of some particular interest.” More bluntly, he said, “advocacy does not imply lying,”{1023} though sometimes ideologies “crystallize” into “creeds” that are “impervious to argument.”{1024} But among the hallmarks of a scientific field are “rules of procedure” which can “crush out ideologically conditioned error” from an analysis.{1025} Moreover, having “something to formulate, to defend, to attack” provides an impetus for factual and analytical work, even if ideology sometimes interferes with it. Therefore “though we proceed slowly because of our ideologies, we might not proceed at all without them.”{1026}

  Events and Ideas

  Does economics influence events and do events influence economics? The short answer to both questions is “yes” but the only meaningful question is—to what extent and in what particular ways? John Maynard Keynes’ answer to the first question was this:

  . . .the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.{1027}

  In other words, it was not by direct influence over those who hold power at a particular point in time that economists influence the course of events, according to Keynes. It was by generating certain general beliefs and attitudes which provide the context within which opinion-makers think and politicians act. In that sense, the mercantilists are still an influence on beliefs and attitudes in the world today, centuries after they were refuted decisively within the economics profession by Adam Smith.

  The question whether economics is shaped by events is more controversial. At one time, it was widely believed that ideas are shaped by surrounding circumstances and events, and that economic ideas were no exception. No doubt something in the real world starts people thinking about economic ideas, as is no doubt true of ideas in other fields, including science and mathematics. Trigonometry was given an impetus, in ancient times, by the need to re-survey land in Egypt after recurring floods along the Nile wiped out boundaries between different people’s properties.

  That is one kind of influence. A more immediate and direct influence has been assumed by those who believed that the Great Depression of the 1930s spawned Keynesian economics. But even if the Great Depression inspired Keynes’ thinking and the widespread acceptance of that thinking among economists around the world, how typical was that of the way that economics has evolved historically, much less how ideas in other fields have evolved historically?

  Were more things falling down, or was their falling creating more social problems, when Newton developed his theory of gravity? Certainly there were not more free markets when Adam Smith wrote The Wealth of Nations, which advocated freer markets precisely because of his dissatisfaction with the effects of various kinds of government intervention that were pervasive at the time. {xlix} The great shift within nineteenth century economics from a theory of price determined by production costs to a theory of price determined by consumer demand was not in response to changes in either production costs or consumer demand. It was simply the unpredictable emergence of a new intellectual insight as a way of resolving ambiguities and inconsistencies in existing economic theory. As for depressions, there had been depressions before the 1930s without producing a Keynes.

  Nobel Prize-winning economist George Stigler pointed out that momentous events in the real world may have no intellectual consequences: “A war may ravage a continent or destroy a generation without posing new theoretical questions,” he said.{1028} The tragic reality is that wars have spread ruination and devastation across continents many times over the centuries, so that there need be no new issue to confront intellectually, even in the midst of an overwhelming catastrophe.

  Whatever its origins or its ability to influence or be influenced by external events, economics is ultimately a study of an enduring part of the human condition. Its value depends on its contribution to our understanding of a particular set of conditions involving the
allocation of scarce resources which have alternative uses. Unfortunately, little of the knowledge and understanding within the economics profession has reached the average citizen and voter, leaving politicians free to do things that would never be tolerated if most people understood economics as well as Alfred Marshall understood it a century ago or David Ricardo two centuries ago.

  As for what economists today can offer, there have been some very different assessments within the profession. Economics had long been christened “the dismal science” by those unhappy with all the promising-sounding social theories and policy proposals that economists punctured as counterproductive. However, in the wake of John Maynard Keynes’ economic theories, which proposed useful roles for government intervention, there was in many quarters a sense that economists could do much more than provide insights on particular problems or issue warnings against more ambitious but unsound policies. By the 1960s, there were Keynesian economists who spoke of their ability to “fine-tune” the economy. One of these was Walter Heller, Chairman of the Council of Economic Advisors under President John F. Kennedy:

  Economics has come of age in the 1960’s. . . . the Federal government has an overarching responsibility for the nation’s economic stability and growth. And we have at last unleashed fiscal and monetary policy for the aggressive pursuit of those objectives. . . .Interwoven with the growing Presidential reliance on economists has been a growing political and popular belief that modern economics can, after all, deliver the goods.{1029}