Authors: Charles Wheelan
Economics is evolving, like every discipline. One of the most interesting and productive areas of inquiry is the field of behavioral economics, which explores how individuals make decisions—sometimes in ways that aren’t as rational as economists have traditionally theorized. We humans underestimate some risks (obesity) and overestimate others (flying); we let emotion cloud our judgment; we overreact to both good news and bad news (rising home prices and then falling home prices).
Most of this was obvious to Shakespeare, but it’s relatively new to mainstream economics. As
New York Times
columnist David Brooks noted, “Economic behavior can be accurately predicted through elegant models. This view explains a lot, but not the current financial crisis—how so many people could be so stupid, incompetent and self-destructive all at once. The crisis has delivered a blow to classical economics and taken a body of psychological work that was at the edge of public policy thought and brought it to front and center.”
4
Of course, most of the old ideas are still pretty darn important. Federal Reserve chairman Ben Bernanke was a scholar of the Great Depression before leaving academe, a fact that has had implications far beyond the Ivory Tower. Chapter 10 will make the case that Bernanke’s creative and aggressive interventions at the Federal Reserve, many of which were inspired by what went wrong in the 1930s, prevented a bad situation from getting much, much worse.
This book walks through some of the most powerful concepts in economics while simplifying the building blocks or skipping them entirely. Each chapter covers subjects that could be made into an entire book. Indeed, there are minor points in every chapter that have launched and sustained entire academic careers. I have glossed over or skipped much of the technical structure that forms the backbone of the discipline. And that is exactly the point: One need not know where to place a load-bearing wall in order to appreciate the genius of Frank Lloyd Wright. This book is not economics for dummies; it is economics for smart people who never studied economics (or have only a vague recollection of doing so). Most of the great ideas in economics are intuitive when the dressings of complexity are peeled away.
That is naked economics.
Economics should not be accessible only to the experts. The ideas are too important and too interesting. Indeed, naked economics can even be fun.
M
any waves of people have helped to bring this project to fruition, almost like a relay race with fresh legs pushing me toward the finish line at every stage. In the beginning, Tifanny Richards was a strong believer that there would be a market for an accessible book on economics. Her wonderful encouragement moved this book off the starting line. Tabitha Griffin brought the project to W. W. Norton, something for which I will always be grateful.
Then came the second leg. When Tifanny and Tabitha went on to other opportunities, I was fortunate to end up in excellent hands once again. Tina Bennett is everything that one could hope for in an agent: smart, supportive, and always interested in new ideas. Meanwhile, I was lucky to have Drake McFeely take on the task of editing the book. Who knows how the man can find time to run the company, edit books, and cavort with Nobel Prize winners, but he does and I am a beneficiary of his experience and judgment. Of course, Eve Lazovitz is the one who made Drake’s trains run on time for the first edition, albeit with a delicate touch. Jeff Shreve was a kind but stern taskmaster for the second edition. Without their support (and deadlines), this book would still be an unfinished manuscript scrawled on legal pads.
Mary Ellen Moore and Danielle Kutasov offered excellent research assistance, finding the facts, figures, and anecdotes that had eluded me. Three accomplished economists were kind enough to take time from their busy schedules to read the first edition manuscript and make helpful comments: Burton Malkiel, Robert Willis, and Kenneth Rogoff. These three men are giants of the profession, and each had many other things that they might have done with their time. Robert Johnson was kind enough to read the international economics chapter that has been added to the second edition. I appreciate his willingness to share his expertise on the topic.
I owe a debt to my former editors at
The Economist.
John Micklethwait was generous in allowing me to disappear for a stretch while I finished the first edition of this book and was also willing to read and make comments on the finished product. I owe Ann Wroe credit for her clever subtitle. The fact that both John and Ann find time to edit one of the world’s great publications while also raising families and writing books of their own continues to be an inspiration.
More recently, the Harris School of Public Policy at the University of Chicago and Dartmouth College have both offered me an intellectual “home” where I have the privilege of teaching great students and working on projects like this one. At the Harris School, former Dean Susan Mayer was a particularly enthusiastic supporter of my ongoing quest to make important academic ideas more accessible to the lay public. At Dartmouth, Bruce Sacerdote has been both a terrific intellectual companion and a great water-ski buddy.
I also owe a different kind of debt. The vast majority of ideas I describe in this book are not my own. Rather, I am a translator whose work derives its value from the brilliance of the original, which in this case is centuries of work done by great thinkers. I hope this book reflects my enormous respect for that work.
Last, I would like to acknowledge those who inspired my interest in the subjects that make up this book. I’ve made the case that economics is often poorly taught. That is true. But it’s also true that the discipline can come alive in the hands of the right person, and I was fortunate to work and study with many of them: Gary Becker, Bob Willis, Ken Rogoff, Robert Willig, Christina Paxson, Duncan Snidal, Alan Krueger, Paul Portney, Sam Peltzman, Don Coursey, Paul Volcker. My hope is that this book will help to transmit their knowledge and enthusiasm to many new readers and students.
Who feeds Paris?
I
n 1989, as the Berlin Wall was toppling, Douglas Ivester, head of Coca-Cola Europe (and later CEO), made a snap decision. He sent his sales force to Berlin and told them to start passing out Coke. Free. In some cases, the Coca-Cola representatives were literally passing bottles of soda through holes in the Wall. He recalls walking around Alexanderplatz in East Berlin at the time of the upheaval, trying to gauge whether there was any recognition of the Coke brand. “Everywhere we went, we asked people what they were drinking, and whether they liked Coca-Cola. But we didn’t even have to say the name! We just shaped our hands like the bottle, and people understood. We decided we would move as much Coca-Cola as we could, as fast as we could—even before we knew how we would get paid.”
1
Coca-Cola quickly set up business in East Germany, giving free coolers to merchants who began to stock the “real thing.” It was a money-losing proposition in the short run; the East German currency was still worthless—scraps of paper to the rest of the world. But it was a brilliant business decision made faster than any government body could ever hope to act. By 1995, per capita consumption of Coca-Cola in the former East Germany had risen to the level in West Germany, which was already a strong market.
In a sense, it was Adam Smith’s invisible hand passing Coca-Cola through the Berlin Wall. Coke representatives weren’t undertaking any great humanitarian gesture as they passed beverages to the newly liberated East Germans. Nor were they making a bold statement about the future of communism. They were looking after business—expanding their global market, boosting profits, and making shareholders happy. And that is the punch line of capitalism: The market aligns incentives in such a way that individuals working for their own best interest—passing out Coca-Cola, spending years in graduate school, planting a field of soybeans, designing a radio that will work in the shower—leads to a thriving and ever-improving standard of living for most (though not all) members of society.
Economists sometimes ask, “Who feeds Paris?”—a rhetorical way of drawing attention to the mind-numbing array of things happening every moment of every day to make a modern economy work. Somehow the right amount of fresh tuna makes its way from a fishing fleet in the South Pacific to a restaurant on the Rue de Rivoli. A neighborhood fruit vendor has exactly what his customers want every morning—from coffee to fresh papayas—even though those products may come from ten or fifteen different countries. In short, a complex economy involves billions of transactions every day, the vast majority of which happen without any direct government involvement. And it is not just that things get done; our lives grow steadily better in the process. It is remarkable enough that we can now shop for a television twenty-four hours a day from the comfort of our own homes; it is equally amazing that in 1971 a twenty-five-inch color television set cost an average worker 174 hours of wages. Today, a twenty-five-inch color television set—one that is more dependable, gets more channels, and has better reception—costs the average worker about twenty-three hours of pay.
If you think that a better, cheaper television set is not the best measure of social progress (a reasonable point, I concede), then perhaps you will be moved by the fact that, during the twentieth century, American life expectancy climbed from forty-seven years to seventy-seven, infant mortality plunged by 93 percent, and we wiped out or gained control over diseases such as polio, tuberculosis, typhoid, and whooping cough.
2
Our market economy deserves a lot of the credit for that progress. There is an old Cold War story about a Soviet official who visits an American pharmacy. The brightly lit aisles are lined with thousands of remedies for every problem from bad breath to toe fungus. “Very impressive,” he says. “But how can you make sure that every store stocks all of these items?” The anecdote is interesting because it betrays a total lack of understanding of how a market economy works. In America, there is no central authority that tells stores what items to stock, as there was in the Soviet Union. Stores sell the products that people want to buy, and, in turn, companies produce items that stores want to stock. The Soviet economy failed in large part because government bureaucrats directed everything, from the number of bars of soap produced by a factory in Irktusk to the number of university students studying electrical engineering in Moscow. In the end, the task proved overwhelming.
Of course, those of us accustomed to market economies have an equally poor understanding of communist central planning. I was once part of an Illinois delegation visiting Cuba. Because the visit was licensed by the U.S. government, each member of the delegation was allowed to bring back $100 worth of Cuban merchandise, including cigars. Having been raised in the era of discount stores, we all set out looking for the best price on Cohibas so that we could get the most bang for our $100 allowance. After several fruitless hours, we discovered the whole point of communism: The price of cigars was the same everywhere. There is no competition between stores because there is no profit as we know it. Every store sells cigars—and everything else for that matter—at whatever price Fidel Castro (or his brother Raul) tells them to. And every shopkeeper selling cigars is paid the government wage for selling cigars, which is unrelated to how many cigars he or she sells.
Gary Becker, a University of Chicago economist who won the Nobel Prize in 1992, has noted (borrowing from George Bernard Shaw) that “economy is the art of making the most of life.” Economics is the study of how we do that. There is a finite supply of everything worth having: oil, coconut milk, perfect bodies, clean water, people who can fix jammed photocopy machines, etc. How do we allocate these things? Why is it that Bill Gates owns a private jet and you don’t? He is rich, you might answer. But why is he rich? Why does he have a larger claim on the world’s finite resources than everyone else? At the same time, how is it possible in a country as rich as the United States—a place where Alex Rodriguez can be paid $275 million to play baseball—that one in five children is poor or that some adults are forced to rummage through garbage cans for food? Near my home in Chicago, the Three Dog Bakery sells cakes and pastries
only for dogs.
Wealthy professionals pay $16 for birthday cakes for their pets. Meanwhile, the Chicago Coalition for the Homeless estimates that fifteen thousand people are homeless on any given night in that same city.
These kinds of disparities grow even more pronounced as we look beyond the borders of the United States. Three-quarters of the people in Chad have no access to clean drinking water, let alone pastries for their pets. The World Bank estimates that half of the world’s population survives on less than $2 a day. How does it all work—or, in some cases, not work?
Economics starts with one very important assumption: Individuals act to make themselves as well off as possible. To use the jargon of the profession, individuals seek to maximize their own utility, which is a similar concept to happiness, only broader. I derive utility from getting a typhoid immunization and paying taxes. Neither of these things makes me particularly happy, but they do keep me from dying of typhoid or going to jail. That, in the long run, makes me better off. Economists don’t particularly care what gives us utility; they simply accept that each of us has his or her own “preferences.” I like coffee, old houses, classic films, dogs, bicycling, and many other things. Everyone else in the world has preferences, which may or may not have anything in common with mine.
Indeed, this seemingly simple observation that different individuals have different preferences is sometimes lost on otherwise sophisticated policymakers. For example, rich people have different preferences than poor people do. Similarly, our individual preferences may change over the course of our life cycle as we (we hope) grow wealthier. The phrase “luxury good” actually has a technical meaning to economists; it is a good that we buy in increasing quantities as we grow richer—things like sports cars and French wines. Less obviously, concern for the environment is a luxury good. Wealthy Americans are willing to spend more money to protect the environment
as a fraction of their incomes
than are less wealthy Americans. The same relationship holds true across countries; wealthy nations devote a greater share of their resources to protecting the environment than do poor countries. The reason is simple enough: We care about the fate of the Bengal tiger
because we can.
We have homes and jobs and clean water and birthday cakes for our dogs.
Here is a nettlesome policy question: Is it fair for those of us who live comfortably to impose our preferences on individuals in the developing world? Economists argue that it is not, though we do it all the time. When I read a story in the Sunday
New York Times
about South American villagers cutting down virgin rain forest and destroying rare ecosystems, I nearly knock over my Starbucks latte in surprise and disgust. But I am not they. My children are not starving or at risk of dying from malaria. If they were, and if chopping down a valuable wildlife habitat enabled me to afford to feed my family and buy a mosquito net, then I would sharpen my ax and start chopping. I wouldn’t care how many butterflies or spotted weasels I killed. This is not to suggest that the environment in the developing world does not matter. It does. In fact, there are many examples of environmental degradation that will make poor countries even poorer in the long run. Cutting down those forests is bad for the rest of us, too, since deforestation is a major contributor to rising CO
2
emissions. (Economists often argue that rich countries ought to pay poor countries to protect natural resources that have global value.)
Obviously if the developed world were more generous, then Brazilian villagers might not have to decide between destroying the rain forest and buying mosquito nets. For now, the point is more basic: It is simply bad economics to impose our preferences on individuals whose lives are much, much different. This will be an important point later in the book when we turn to globalization and world trade.
Let me make one other important point regarding our individual preferences: Maximizing utility is not synonymous with acting selfishly. In 1999, the
New York Times
published the obituary of Oseola McCarty, a woman who died at the age of ninety-one after spending her life working as a laundress in Hattiesburg, Mississippi. She had lived alone in a small, sparsely furnished house with a black-and-white television that received only one channel. What made Ms. McCarty exceptional is that she was by no means poor. In fact, four years before her death she gave away $150,000 to the University of Southern Mississippi—a school that she had never attended—to endow a scholarship for poor students.
Does Oseola McCarty’s behavior turn the field of economics on its head? Are Nobel Prizes being recalled to Stockholm? No. She simply derived more utility from saving her money and eventually giving it away than she would have from spending it on a big-screen TV or a fancy apartment.
Okay, but that was just money. How about Wesley Autrey, a fifty-year-old construction worker in New York City. He was waiting for the subway in Upper Manhattan with his two young daughters in January 2007 when a stranger nearby began having convulsions and then fell on the train tracks. If this wasn’t bad enough, the Number 1 train was already visible as it approached the station.
Mr. Autrey jumped on the tracks and shielded the man as five train cars rolled over both of them, close enough that the train left a smudge of grease on Mr. Autrey’s hat. When the train came to a stop, he yelled from underneath, “We’re O.K. down here, but I’ve got two daughters up there. Let them know their father’s O.K.”
3
This was all to help a complete stranger.
We all routinely make altruistic decisions, albeit usually on a smaller scale. We may pay a few cents extra for dolphin-safe tuna, or send money to a favorite charity, or volunteer to serve in the armed forces. All of these things can give us utility; none would be considered selfish. Americans give more than $200 billion to assorted charities every year. We hold doors open for strangers. We practice remarkable acts of bravery and generosity. None of this is incompatible with the basic assumption that individuals seek to make themselves as well off as possible, however they happen to define that. Nor does this assumption imply that we always make perfect—or even good—decisions. We don’t. But each of us does try to make the best possible decision given whatever information is available at the time.
So, after only a few pages, we have an answer to a profound, age-old philosophical question: Why did the chicken cross the road? Because it maximized his utility.
Bear in mind that maximizing utility is no simple proposition. Life is complex and uncertain. There are an infinite number of things that we could be doing at any time. Indeed, every decision that we make involves some kind of trade-off. We may trade off utility now against utility in the future. For example, you may derive some satisfaction from whacking your boss on the head with a canoe paddle at the annual company picnic. But that momentary burst of utility would presumably be more than offset by the disutility of spending many years in a federal prison. (But those are just my preferences.) More seriously, many of our important decisions involve balancing the value of consumption now against consumption in the future. We may spend years in graduate school eating ramen noodles because it dramatically boosts our standard of living later in life. Or, conversely, we may use a credit card to purchase a big-screen television today even though the interest on that credit card debt will lessen the amount that we can consume in the future.