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The Economic Naturalist's Field Guide
Common Sense Principles for Troubled Times
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In an essay written in 1879, Francis Amasa Walker tried to explain “why economists tend to be in bad odor amongst real people.” Walker, who went on to become the first president of the American Economic Association, argued that it was partly because economists disregard “the customs and beliefs that tie individuals to their occupations and locations and lead them to act in ways contrary to the predictions of economic theory.”
More than a century later, the general public continues to regard economists with suspicion. My fellow economists often object that this attitude stems from the fact that our positions on many important public policy issues remain poorly understood. Although not the whole story, it’s a fair point.
For example, economists commonly advocate auctioning rights to discharge atmospheric pollutants, leading critics to bemoan our willingness “to let rich firms pollute to their hearts’ content.” The statement betrays a comically naive understanding of the forces that guide corporate behavior.
Firms don’t pollute because they take pleasure in fouling the air and water but because clean production processes cost more than dirty ones. Requiring firms to buy pollution permits gives them an incentive to adopt cleaner processes. To avoid buying expensive permits, firms that have access to relatively cheap, clean alternative production methods will be quick to adopt them. A firm will buy pollution permits only if it lacks such alternatives.
Auctioning pollution rights makes sense because it concentrates the burden of pollution reduction in the hands of those who can accomplish it at the lowest cost. It minimizes the total cost of achieving any given air quality target—an outcome that is clearly in the interest of all citizens, rich and poor alike. Evidence suggests that the more people learn about the auction method, the less likely they are to oppose it. For instance, although environmental groups once bitterly opposed pollution permit auctions, they now endorse them enthusiastically.
But misunderstandings of this sort are not the main reason that economists remain “in bad odor.” There are at least three other important sources of skepticism about my fellow practitioners of the dismal science. One is that our traditional models of human behavior, which emphasize narrow self-interest, strike many as overly cynical. Self-interest is clearly an important human motive, but it isn’t the only one. We vote in presidential elections, for example, even though voting entails costs and a single vote has never proved decisive. We leave tips in restaurants we will never visit again. Lost wallets are often returned to their owners with the cash intact. Focusing exclusively on self-interest, in addition to seeming mean-spirited, prevents us from saying anything interesting about an important aspect of human behavior.
A second source of skepticism is that economists’ traditional models assume, against all evidence, that consumer decisions take place in social isolation. The plain fact is that evaluations of all types depend heavily on social context. For example, the same car that offered brisk acceleration in 1950 would seem sluggish to most drivers today. Similarly, the 3,000-square-foot house that seemed spacious to a corporate executive in 1980 would probably seem cramped today. And the right suit for an interview has always been one that compares favorably with those worn by other applicants for the same job.
Once we acknowledge that context shapes evaluation, many of my profession’s most cherished propositions go out the window. Traditional models say, for example, that when rational people weigh decisions about how many hours to work each week and how much to spend on various goods, the resulting patterns tend to promote the interests of society as a whole. But that’s not true when context matters.
Deciding how much to spend on a suit for an interview is a simple case in point. Experiments demonstrate that a job candidate who is better dressed than others is more likely to get a callback. This creates an obvious incentive to spend more on interview suits. Yet if all applicants tripled their expenditures on suits, the jobs would go to the same ones as before. Under the circumstances, it would be better if everyone spent less on suits and more on, say, preventative medicine and safer cars.
A third source of skepticism about economists is our traditional assumption that people are rational and dispassionate when choosing among various alternatives. Like the assumption that context doesn’t matter, this one claims that socially benign results occur when people are free to transact with one another without restrictions. For instance, if someone with a poor credit history agrees to borrow $500 for two weeks from a payday lender at an annual interest rate of 1,000 percent, standard models insist that the state harms both the borrower and the lender if it prevents the transaction.
Since the beginning of recorded human history, however, most societies have seen fit to forbid loan contracts of this sort, ostensibly because people are not nearly as rational and dispassionate as traditional economic models assume. For instance, people often assign insufficient weight to costs and benefits that occur in the future. This makes the benefit of borrowing money seem misleadingly large in relation to the cost of having to repay it, suggesting a clear rationale for usury laws. These laws undoubtedly prevent at least some mutually beneficial transactions from taking place. Yet few societies have embraced economists’ suggestion to eliminate them. In light of many people’s inability to weigh current benefits against future costs, such bans don’t seem mysterious.
In short, much of the widespread skepticism about advice dispensed by economists may be rooted in well-founded misgivings about the wisdom of the advice itself. If traditional economic models rest on inaccurate behavioral assumptions, why should advice predicated on those models be taken seriously?
Recent years have witnessed a revolution in how economists think about human behavior. The emerging field of behavioral economics devoted its earliest efforts to documenting the existence of anomalies that contradict the predictions of rational actor models. More recently, researchers in this field have introduced new models that better describe how people actually behave when confronted with economic choices. In these models, narrow self-interest is no longer the only important human motive, context shapes evaluation, and the consequences of systematic cognitive errors are explicitly taken into account.
Although these innovations have enabled behavioral economists to offer more realistic accounts of how people make economic choices, residual skepticism about economics continues to hamper our efforts to discuss these choices in public forums. Because the predictions made by our traditional models are often wrong, readers tend to discount our arguments even when the models are right. For example, when George Stephanopoulos of ABC News challenged Senator Hillary Clinton to name a single economist who favored her proposal to suspend the federal tax on gasoline in the summer of 2008, she defiantly responded, “I’m not going to put my lot in with economists!” Opinion polls suggested that the senator’s decision to throw economists under the bus helped inflate her winning margins in the subsequent West Virginia and Kentucky primaries.
The insights of behavioral economics make it possible to discuss the economic choices we face in ways that don’t insult the reader’s intelligence. Since the late 1990s, I have been writing newspaper columns about such choices. Some have examined the economic decisions confronting policy makers in Washington. Others have considered the savings and investment decisions that flow through Wall Street. Still others have addressed the decisions we confront as individual consumers. This book is a collection of selected columns, most of which originally appeared in the New York Times, either on the op-ed page or in the business section. Although all of them were written prior to the inauguration of President Barack Obama, they speak directly to many of the political, financial, and personal decisions we’ll confront in the years ahead.
Grouped thematically, the selections cover a broader spectrum of questions than many readers might expect to encounter in economics, ranging from why John F. Kennedy’s “Ask not . . .” appeal was so effective to why people voluntarily disclose unfavorable information about themselves. If you accept my view that economics is all about choice in a context of scarcity, then virtually all choices are economic ones.
The behavioral economics revolution has done nothing to alter the fundamental economic problem implicit in every such choice: while human desires are boundless, the resources necessary to satisfy them are limited. We confront trade-offs at every turn; having more of one good thing always requires making do with less of others.
Failure to think through these trade-offs results in waste. Traditional economic discourse—as exemplified in the late Arthur Okun’s 1975 book Equity and Efficiency: The Big Tradeoff—has conditioned us to think of efficiency and equality as competing goals. Consequently many believe that we must tolerate a certain measure of waste in the name of fairness. But I argue here for the opposite claim—that efficiency is always and everywhere the best way to promote equity.
In one sense, this claim is true by definition. After all, any step that makes the economic pie larger necessarily makes it possible for everyone to have a larger slice than before. Of course, there is no guarantee that everyone will automatically get a bigger slice. Redistribution is often necessary.
But efficiency and equity are often harmonious at a deeper level. Traditional economic discourse holds that while a more progressive tax system might be desirable on equity grounds, it would impoverish the nation by inhibiting effort and innovation. Recent developments in behavioral economics, however, suggest precisely the opposite effect. As I explain in my examination of the financial advice industry, for example, reducing the tax rates on top earners likely increased the number of aspiring hedge fund managers and reduced the number of aspiring teachers and engineers. Because we live in a world with too few qualified teachers and a huge surplus of people hoping to become money managers, these tax cuts have almost surely made the economic pie smaller.
In this and numerous other ways, recent developments in behavioral economics have rendered obsolete many of the long-standing disputes between traditional liberals and conservatives. As I argue in my discussion of John Kenneth Galbraith, when these developments support the traditional liberal position on an issue—as they often do—it is typically for different reasons. Liberals have long argued, for example, that safety regulation is needed to protect workers from exploitation by firms with market power. Yet as conservatives have consistently pointed out, such regulation typically has its greatest impact in the very labor markets that are most competitive by traditional measures. A more plausible account is that workers favor safety regulations for the same reason that hockey players favor rules requiring them to wear helmets.
As the Nobel laureate Thomas Schelling explained, hockey players gain a competitive edge by skating without helmets, perhaps because they are able to see and hear a little better. Yet when all players skate without helmets, each team’s odds of winning remain the same as if all players wore them. And hence the attraction of helmet rules.
A similar logic explains the attraction of workplace safety rules. By accepting a riskier job, a worker can earn extra money to buy a house in a better school district. Yet when all workers accept riskier jobs, they succeed only in bidding up the prices of such houses. As before, half of all workers must send their children to bottom-half schools.
Once economic reasoning is untethered from the constraints of the narrowest rational actor models, it becomes clear why conventional ideology provides an essentially useless guide for the economic choices we face. These choices are always best made pragmatically—by carefully weighing the relevant costs and benefits of competing options. Thus in a choice between two mutually exclusive programs, the better choice is the one whose benefit outweighs its cost by the larger margin. Always.
Suppose, for example, that the choice is between two methods for reaching a given air quality target in Los Angeles. Program A would require all cars, new and old, to meet reasonably strict emissions standards. Program B would exempt cars more than fifteen years old from these standards but would require stricter standards for newer vehicles. Both programs would yield the same overall air quality, but because program B’s stricter standards for new vehicles are costly, it is more expensive overall than program A.
The cost-benefit test identifies program A as the better option. But supporters of program B argue that despite its higher cost, it is still the better choice, since imposing the burden of meeting emissions standards on the mostly poor drivers who own older vehicles would be unacceptable.
As I explain in my discussion of this issue, however, this argument makes no sense. More than 80 percent of the smog in LA now comes from exempt older vehicles. The money saved by eliminating the exemption and adopting less strict standards for newer vehicles would have been more than enough to give every owner of an older vehicle a voucher sufficient to buy a compliant late-model used car.
Distributional objections are more difficult to address in some domains than in others. But it is almost always an error to regard them as insurmountable. Again, when a policy change makes the economic pie larger, it is always possible for everyone to get a larger slice than before. Astonishingly, however, many politicians continue to describe such policy changes as “politically unthinkable.”
My grandest hope for this volume is that it will encourage you to join me in accusing these leaders of political malpractice. Waste makes fewer resources available to meet important human needs. And since so many important human needs remain unmet, easily avoidable waste is inexcusable.
On a more modest scale, I hope to advance the pedagogical mission I launched in my 2007 book, The Economic Naturalist, arguing that a relatively small handful of basic principles do most of the heavy lifting in economics. Mastery of these principles is enormously helpful in dealing with the many difficult decisions that life serves up. Unfortunately, however, introductory economics courses generally leave no measurable trace on the students who take them. When they are tested on basic economic principles six months after taking one of these courses, they score no better, on average, than others who never took the course at all.
This dismal performance, I believe, stems largely from the fact that most professors try to teach their students too much. When students are peppered with literally hundreds of terms and concepts, many of them couched in gratuitous mathematical formalism, everything tends to go by in a blur.
The good news is that the most important economic principles can be mastered with little difficulty by applying them repeatedly to interesting questions from familiar contexts. That’s what I’ve attempted to do in the columns selected for this book. As learning theorists remind us, the key to mastering new concepts is repetition. So much information bombards us each day that our brains have evolved this simple rule of thumb for avoiding overload: if you see a new piece of information only once, ignore it; but if it recurs frequently, develop new circuits for dealing with it. Since I draw on the same handful of economic principles to answer a broad range of questions, you will see the same arguments deployed repeatedly. If the prospect of learning to apply these arguments appeals to you, I hope you’ll view this repetition as a feature, not a bug, of this volume.
Even if my reasoning doesn’t persuade you to oppose waste in all its forms, I’m confident you’ll master that distinctive mind-set known as “thinking like an economist.”
Talking Back to Rush Limbaugh
In the long run, governments, like individuals and families, must live within their means. Although Republicans used to take pride in championing fiscal discipline, the national debt exploded on their watch. This resulted partly from rapid increases in government spending, but mostly it was a consequence of large tax reductions concentrated on the wealthiest families.
There are essentially two ways to reduce the federal deficit—cut government spending or raise revenue. Every presidential candidate since Harry Truman has campaigned on a promise to reduce government waste, and some presidents have made energetic attempts to do so. But not one ever managed to halt the upward march of federal spending. Deficit reduction has occurred only when the amount collected in taxes has increased.
Because no one likes to pay taxes, proposals to raise them rarely generate praise. So I’ve learned to anticipate a flood of angry emails whenever I write a column about the government’s need to raise additional revenue.
The day after one such column appeared, I started getting messages from students saying that Rush Limbaugh was attacking me on his show. I don’t have a radio in my office, but that evening I listened to Limbaugh’s remarks on his website. No surprise. He merely reprised his familiar “It’s your money” argument—people have a moral right to spend their pretax income in whatever way they please:
It’s none of your business, Mr. Frank, what people do with the money they earn. It’s not your business to judge it. It certainly isn’t your business to start making tax policy and economic policy based on it. But that’s who the educated among us are, folks. These are the smart people, these are the learned ones. They know better than you and I.
It’s easy to see why variants of this argument have long been among the most effective arrows in the right-wing rhetorical quiver. Because most people work hard for their money, they feel resentful when government takes some of it away. Yet consider the absurdity of the claim that we have a right to spend every nickel of our pretax income. If taxes were purely voluntary, our government would not be able to raise revenue to build roads or schools. It could not field an army, and if we were invaded by some other country, we would end up paying compulsory taxes to that government.
Perhaps those who oppose compulsory taxation should just move to a country where taxes are voluntary. But there is no such country. Given that reality, our best option is to have an intelligent conversation about what services we want government to provide and who should be taxed to pay for them.
THE columns selected for this chapter dissect the objections of those who, like Limbaugh, want to shut down that conversation. The first selection, written as the Bush administration was pressing for additional tax breaks for top earners in the fall of 2005, points out that although the earlier Bush tax cuts produced no real gains for their wealthy beneficiaries, the spending changes made necessary by those same cuts imposed significant costs on them.
1. Did the Bush Tax Cuts Actually Help the Rich?
When market forces cause income inequality to grow, public policy in most countries tends to push in the opposite direction. In the United States, however, we enact tax cuts for the wealthy and cut public services for the needy. Cynics explain this curious inversion by saying that the wealthy have captured the political process in Washington and are exploiting it to their own advantage.
Yet a careful reading of the evidence suggests that even the wealthy have been made worse off, on balance, by recent tax cuts. The private benefits of these cuts have been much smaller and their indirect costs much larger than many recipients appear to have anticipated.
On the benefit side, tax cuts have led the wealthy to buy larger houses, in the seemingly plausible expectation that doing so will make them happier. As economists increasingly recognize, however, well-being depends less on how much people consume in absolute terms than on the social context in which consumption occurs. Compelling evidence suggests that, for the wealthy in particular, when everyone has a larger house, the primary effect is merely to redefine what qualifies as an acceptable dwelling.
So, although the recent tax cuts have enabled the wealthy to buy more and bigger things, these purchases appear to have had little impact. As the economist Richard Layard has written, “In a poor country, a man proves to his wife that he loves her by giving her a rose, but in a rich country, he must give a dozen roses.”
On the cost side of the ledger, the federal budget deficits created by the recent tax cuts have had serious consequences, even for the wealthy. These deficits will exceed $300 billion for each of the next six years, according to projections by the nonpartisan Congressional Budget Office. The most widely reported consequences of the deficits have been cuts in government programs that serve the nation’s poorest families. And since the wealthy are well represented in our political system, their favored programs may seem safe from the budget ax. Wealthy families have further insulated themselves by living in gated communities and sending their children to private schools. Yet such steps go only so far.
For example, deficits have led to cuts in federal financing for basic scientific research, even as the U.S. share of global patents granted continues to decline. Such cuts threaten the very basis of our long-term economic prosperity. As Senator Pete Domenici, Republican of New Mexico, has said, “We thought we’d keep the high-end jobs, and others would take the low-end jobs. We’re now on track to a second-rate economy and a second-rate country.”
Large deficits also threaten our public health. Thus, despite the increasing threat from microorganisms like E. coli 0157, the government inspects beef processing plants at only a quarter the rate it did in the early 1980s. Poor people have died from eating contaminated beef but so have rich people.
Citing revenue shortfalls, the nation postpones street and highway maintenance, even though that means spending two to five times as much on repairs in the long run. In the short run, bad roads cause thousands of accidents each year, many of them fatal. Poor people die in these accidents but so do rich people. When a pothole destroys a tire and wheel, replacements cost $63 for a Ford Escort but $1,569 for a Porsche 911.
Deficits have also compromised the nation’s security. In 2004, for example, the Bush administration reduced financing for the Energy Department’s program to secure loosely guarded nuclear stockpiles in the former Soviet Union by 8 percent. Sam Nunn, the former United States senator, now heads a private foundation that raises money to expedite this effort. And despite the rational fear that terrorists may try to detonate a nuclear bomb in an American city, most cargo containers continue to enter the nation’s ports without inspection.
Large federal budget deficits and low household savings rates have forced our government to borrow more than $650 billion each year, primarily from China, Japan, and South Korea. These loans must be repaid in full, with interest. The resulting financial burden, plus the risks associated with increased international monetary instability, fall disproportionately on the rich.
At the president’s behest, Congress has enacted tax cuts that will result in some $2 trillion in revenue losses by 2010. According to one recent estimate, 52.5 percent of these cuts will have gone to the top 5 percent of earners by the time the enabling legislation is fully phased in. Republicans in Congress are now calling for an additional $69 billion in tax cuts aimed largely at high-income families.
With the economy already at full employment, no one pretends these cuts are needed to stimulate spending. Nor is there any evidence that further cuts would summon outpourings of additional effort and risk taking. Nor, finally, does anyone deny that further cuts would increase the already high costs associated with larger federal budget deficits.
Moralists often urge the wealthy to imagine how easily their lives could have turned out differently, to adopt a more forgiving posture toward those less prosperous. But top earners might also wish to consider evidence that their own families would have been better off, in purely practical terms, had it not been for the tax cuts of recent years.
New York Times, November 24, 2005
GOVERNMENT bashers have also advanced their cause by citing vivid examples of wasteful public spending, ranging from the Pentagon’s $600 toilet seat to Alaska’s $250 million bridge to nowhere. The next selection concedes the point but then goes on to argue that even greater waste pervades the private sector.
2. Is Government the Only Wasteful Spender?
With President Bush’s proposed tax cuts for top earners struggling to get political traction in early 2001, Representative Tom Osborne, Republican of Nebraska, rose to defend the White House.
“The bottom line is that it’s your money,” he said, “and you know how to spend it much better than anyone in Washington, D.C.”
In the years since, variations of this statement by the president and other government officials have kept opponents of high-end tax cuts consistently on the defensive.
This talk has been effective in part because it appeals to common sense. After all, people have an obvious incentive to exercise care when spending their own hard-earned dollars. Why would a faceless bureaucrat in Washington, who is spending someone else’s money, be nearly as careful?
The “it’s your money” line is also buttressed by widely reported examples of government paying far more than necessary to get a job done. Famously, the Pentagon once spent $640 for a single toilet seat and on another occasion paid $435 for an ordinary claw hammer.
But paying more than the market rate is just one form of wasteful spending. Another is paying a fair price for something that serves little purpose. This second form of waste is more common in private spending, and is made even worse as the chief beneficiaries of the tax cuts race to outdo one another.
- On Sale
- Apr 27, 2010
- Page Count
- 240 pages
- Basic Books