The title of this post, by regular Triple Crisis contributor Jeff Madrick, references the adage “It’s the economy, stupid!”—coined by leaders of Bill Clinton’s successful 1992 presidential campaign, as a reminder to emphasize economic issues. Madrick, however, argues that both major political parties in the United States are afflicted by bad economic ideas, especially simplistic “invisible-hand thinking.” These bad ideas, he argues, result in bad policy, including a view of government deficits as an unmitigated evil, a fixation with very low inflation rates, and a tolerance of excessive inequality.
How much do ideas in economics matter? I raise the issue because I just published a book called Seven Bad ideas: How Mainstream Economists Have Damaged America, and some commentators have doubted the potency of ideas themselves. At the heart of the damage I describe—stagnant wages, inequality, a dearth of public investment, a growing class culture, repeated financial crises—is an over-simplified faith in the invisible hand, which in mainstream thinking not only rules individual markets fairly but also the entire economy with no interference from government. Demand and supply will meet as prices shift to establish a balance between then two. The faith in such general equilibrium continues strong because partly it makes economics so much easier to do. It also conforms to the ideological turn in America against trust in government.
There is absolutely no proof that general equilibrium actually exists, however, which Jonathan Schlefer has taken pains to point out. I’d argue the Democrats got a whipping in the mid-term elections because of such faith in the invisible hand and related ideas—to put it simply, because of bad economic ideas. I will explain further.
Economists will always deny that they take the invisible hand that seriously. They acknowledge that for it to work as Adam Smith suggested requires many assumptions: a free flow of information, complete lack of monopoly power, a pure and simple mechanism to discover the right price. It is a metaphor for how markets could work, not how they do work.
But as I stress in the book, it is too alluring an idea. Kenneth Arrow, who understands its limitation better than anyone, called it one of the most important contributions in history of intellectual thought. James Tobin called it one of the greatest economic ideas of all time. But, as I say, this idea is so beautiful, it overpowers good sense.
For all economists’ professing that they understand the many obstacles to the practical application of pure laissez-faire thinking, consider how until the last ten years or so economists believed minimum wages would almost invariably cost jobs. That’s an invisible-hand conclusion: the price of labor goes up and jobs are lost. It took a lot of excellent empirical research to show otherwise, beginning with the famed work by David Card and Alan Kreuger. In the real world, there may well be no loss of jobs. The reason is that the labor market does not set the wage according to purist invisible hand thinking; very often workers don’t make what they deserve.
A corollary of the invisible hand is Say’s law, stated by the French economist J.B. Say about a generation after Adam Smith wrote. To skip a couple of steps, it argues that savings will always be productively invested by business. Thus, the key to growth is to raise the savings rate—and the stock of savings.
This is an invisible hand-type idea. Raise the supply of savings and interest rates—the price of investment—will fall. Business will then invest. Keynes of course devoted his classic 1936, The General Theory for short, to debunking this over-simplification. Increased savings will lead to a vicious downward spiral as demand is reduced. Lack of demand will restrain investment, lead to less growth or even recession, and raising savings by, say, cutting budget deficits will only make matters worse.
Despite Keynes, economists have not been able, on balance, to shake off this destructive myth—this arch example of invisible-hand-type thinking. Thus, so many of them argue that the way to growth is to cut deficits even in periods of recession; deficits eat into national savings and crowd out private investment. How else could well-trained economists like Harvard’s Kenneth Rogoff and Carmen Reinhart come up with the claim that an economy with public debt of 90 percent of GDP could almost fall off a cliff regarding growth. We know they made serious analytical and computation errors, but I have no doubt they thought they were on the side of the angels and this influenced them. To be fair, Rogoff proposed fiscal stimulus for the U.S., but he had clear limits in mind. Alberto Alesina at Harvard had enormous influence with his since-contested research in favor of austerity.
But this claim about deficits seeped deeply into the public consciousness. The media, chock full of mainstream acolytes and wannabe’s, were all too willing to give it full hearing.
And it is forgotten that this obsession with the deficit is not just Republican by any means. Democratic economists were making the case against deficits using Say’s Law thinking in the 1980s. President Clinton’s economists were doing the same in the 1990s when they paid down debt with the surpluses generated rather than invest in public goods like infrastructure and education. Reporting shows that they basically made a pact with Alan Greenspan to do so.
President Obama contributed considerably to the fear of big deficits when he appointed the deficit reduction commission to be lead by a conservative Democrat, Erskine Bowles, and a very conservative Republican, Alan Simpson, even before he formulated the fiscal stimulus package. These two commission leaders are still issuing deficit warnings even as their predictions of catastrophe did not come true and the federal deficit has fallen below 3 percent of GDP. The president didn’t turn to a real jobs program led by fiscal stimulus until after the 2010 election losses, and even then it was tepid. To the contrary, reports suggest his administration proposed the sequester, which resulted in reduced spending in 2013 and took a chunk out of economic growth and job creation.
Which brings me back to the recent mid-terms. The Democrats failed because they had no clear message about how to restore jobs and raise wages. The reason they had—and have– no clear message is because they remain wed, as do many of their economic advisers, to a fear of big deficits and too much government. They want to offer social programs and public investment and they also want to cut government spending and therefore the deficit. Aiming for two different targets, they hit neither.
Contrast this to the Republicans, who remorselessly trade on the fear of deficit and government, which to them go hand in hand, and make no bones about it. What will get America moving again? Cut government spending and regulations, and fire up the engines of American capitalism. Never mind that corporate profits are already at soaring highs.
What do the Democrats counter? They are befuddled. They propose some new social and public investment programs but they don’t want to do too much for fear of raising the budget deficit. Schizophrenia is no campaign platform. What a message to the electorate. Better to avoid the subject altogether.
The problem is not merely that Democrats want to cater to the public, which seems to believe wholeheartedly in the deficit-is-the-devil myth. Why shouldn’t the public? Both political parties, as I note, have been selling it.
But many Democrats probably also actually believe it. Moreover, there is that primitive human bias that we must always pay for our excesses. No pain without gain. Too much borrowing can’t be good. And on.
But America has few fiscal excesses, except those created by low taxes on investment income and tax loopholes for corporations—and I’d argue insufficient taxes on high-income people. If Obama stood up in praise of serious social programs and against misconceptions about the deficit, he might take some initial political fire but he would win in the long run. My guess is, however, he’s swallowed the anti-deficit idea himself. He also pandered to the public’s misplaced fears. This makes him a Clinton New Democrat at best, which is a long way along the path towards full-fledged Republicanism.
There are other awfully damaging mainstream ideas that have seeped thoroughly into the national consciousness. Inflation should be no higher than 2 percent a year, which is particular nonsense. Educational inequality can almost fully account for income inequality; the myth disguises America’s class system. An international framework is unnecessary to deal with major trade and capital flow imbalances because the free markets will handle them through adjustments to floating currencies. Speculation often breeds stability not instability. And competition means that even dark markets, as was the case with derivatives, will still work efficiently.
In sum, ideas matter and bad ideas do a lot of harm. Keynes also dealt with doubts about the value of ideas raised in his time and left us this too-often-quoted thought: “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 slaves of some defunct economist.”
But if the quote has lost power through constant repetition, it remains right. The commonly accepted ideas of the mainstream consensus of economists have been damaging. It is changing some, but not enough. Two percent inflation targets are still with us. Deficit fears as well. Modest financial reform is all we get. Inadequate attention to inequality defines social policy, such as a refusal to develop aggressive programs to combat child poverty. We can go on.
My fear is that the ideological rigidity of today’s economics will continue to lead us down the wrong path. That’s why I wrote my current book. Economists have developed many exciting ideas but they are now being misused. They have too often become simple rules of thumb instead of flexible tools to think about each new problem. The world is dirty but economists treat it as if it is pristine. That is unintelligent, misleading, and damaging. America needs aggressive public investment, more redistribution policies, a higher inflation target, and immediate substantial fiscal stimulus. But the primary battle remains, as recondite as this may seem, over ideas.
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