How the Economy Works (Review and a Summary of the Book by Farmer R.E.A “How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies”)

After studying economics for many years, I still ask myself a question- why do we need to make profits and create growth in order to generate a good life? Sure, it creates more jobs, increase competitiveness, stimulate start-ups, and revolutionize products. But is that the only way economy works? This brings me to the next question: what is the real core of economics? Is it housing, finance, consumption, import, investments, finance, production? Had we known the answer, we could well have fixed economy problems without creating new problems.

  

Historically, economists strived to describe how economy works, by applying logical reasoning, simplified modeling, statistical and mathematical modeling. Technogical progress within computing greatly favored this development.

For example, In 1949, Bill Phillips (William Phillips), the father of the well-known Phillips curve, created The MONIAC (Monetary National Income Analogue Computer) also known as the Phillips Hydraulic Computer, a device that gave a ‘feel’ for economic behavior, by presenting visual (rather than numerical) results, which were accessible without prior knowledge of explicit advanced mathematics.(on the picture). 

In 1969, the first Nobel Prize within economics was awarded, thus consolidating economy as a science equal to chemistry, physics and mathematics.  However, the praise the economists received often got dwarfed decades later, as fellow peers rejected the validity of these same models and “old” economic thoughts” were abandoned.  

New understandings were formed, which influenced the politicians’ decisions

Economics is a mechanism, which cannot be defined by any model, graph or definition. However, understanding of economics is still crucial for our survival. It’s a mechanism, driven by our needs, desires, interactions, perceptions and emotions. From another side, the economy makes the final decision what life we should live. Paradoxically, the economy outcomes depend upon the actions of everyone in society, and the same time, economy dictates our actions. So, as peoples’ behavior cannot be predicted, and understood properly, neither can economics behavior.

  

So, how does economy work? After I had finished reading the book by Farmer R.E.A “How the economy works: Confidence, Crashes and Self-Fulfilling Prophecies”, I hoped I would be able to (at least partially) answer the questions I stated at the beginning of my post. Well, can I? To adjust the reader expectations, I will say from the beginning: no, I can’t answer the questions. 

Started with the introduction on the collapse of Northern Rock, it is becoming clearer to me that the book is about “how we got to that point and what we can do in the future to prevent it from happening again.” Yet again, the Financial Crisis is being a starting point and the central point of the book. A little bit disappointing, I would say. Economy is a complex system, driven by the equilibrium in labor, capital, land, production, trade, consumption, service, education, etc. Therefore, economy should not be described only around its financial aspects.

Straight after the introduction, Farmer briefly summarizes all the factors contributing to our theoretical knowledge of the economy.

In the following, I highlight the most important parts of it. Should it be boring for a reader, I may suggest jumping into conclusion part.

There are two main schools of thinking (or disagreement on how economy works), classical economics and Keynesian economics.

Classical economics

According to classical economics, unregulated markets are naturally self-stabilizing and government intervention often does more harm than good.

“In the 1920s, the classical economists saw the economy as a stable self-correcting machine. Random unpredictable events might cause a disturbance to the economy that would temporarily throw some people out of work. But hundreds of millions of selfish individuals would be guided, in the words of Adam Smith, “by an invisible hand,” to move the economy quickly back to full employment.”

According to classical economists, one of the most important economy drivers is selfish behavior, which is also a cornerstone for the belief why greed is good.

“Selfish behavior by individuals leads to an outcome that benefits everyone in society”- Smith wrote in his most important book, An Inquiry into the Nature and Causes of the Wealth of Nations, in 1776.

The classical economists believed that excessive unemployment could only occur in the short run, a temporary period needed for prices to adjust to their long-run equilibrium levels.

For that statement, Keynes famously asserted that. “In the long run we are all dead!”

Keynesian economics was born.

Keynesian economics

Keynes replaced the classical economics assumptions with the assumption that the confidence of investors is an independent driving force of business cycles that cause falls in economy.

Mass hysteria and fall in confidence simultaneously leads to a financial crisis.

Therefore, Keynes (1883 –1946) indicated that the government should borrow money and use it to stimulate economy. The market system needs a little help sometimes, because there is no self-correcting mechanism, and therefore, the high unemployment can persist forever.

The Keynesian argument is the cornerstone for creating The Monetary Fund, the Lender of Last Resort, and governmental capital injections in times of crises, and why governments choose to run fiscal deficits.

This theory of why governments should run fiscal deficits was used by President Nicolas Sarkozy in France, Chancellor of the Exchequer Alistair Darling in the UK, and Treasury Secretary Timothy Geithner in the United States to justify huge increases in public sector borrowing in these countries in 2008–2009.

The Philips Curve

The Keynesian economics was a cornerstone of Keynesian policy, which was also supported by the Philips Curve, who in 1958 argued that there is a stable relationship between inflation and unemployment. The implication of Keynesian economics, supported by the (rather primitive) econometric evidence (the Philips curve), is a fundamental base why politicians were willing to tolerate a reasonably high rate of inflation as this would lead to lower unemployment: There would be a trade-off between inflation and unemployment.

According to Keynesian economics, if private investment expenditure is too low, it must be replaced by government investment expenditure: this is the way to escape from an economic depression. This principle was followed by many governments and few questioned it until a new crisis was created: The Debt Crisis. Then, the natural rate hypothesis was born.

The natural rate hypothesis and modern economics

In 1975, the unemployment rate reached 9% and inflation peaked at 13%, a period called “stagflation”. The stagflation period dramatically failed the predictions of Keynesian economics. The economic condition of the 70’s caused a crisis in economic thinking. Correspondingly, economists introduced a new idea: “The economy gravitates toward a natural rate of unemployment that cannot be influenced by fiscal or monetary policy. “

Edmund Phelps and Milton Friedman published their work on the natural rate hypothesis in 1968. They argued in separate articles that we should not expect to see a permanent long-run relationship between inflation and unemployment. They explained this position by pointing out that the unemployment rate depends on fundamental real factors such as the productivity of workers, the preferences of households, and the time and trouble workers have in searching for jobs.

Economists and policy makers questioned the trade-off between unemployment and inflation because the factors that determine the unemployment rate have nothing to do with the quantity of money or the rate of inflation.

This was a base or a starting point for the criticism of the Keynesian economics and a significant progress in economic thought.

Rational Expectations revolution

Rational expectations economics uses sophisticated mathematics to provide an accurate foundation to classical theory. Thus, the classical ideas were updated and revised:  a path breaking revolution.

Lucas (Robert E. Lucas Jr., 1937–present) won the Nobel Prize in 1995, having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy.

“Lucas argued that policymakers cannot improve the welfare of the average citizen through monetary or fiscal policy even in the short run. His theory implied that unemployment can deviate from its natural rate only if households and firms make mistakes in their forecasts of future business conditions.”

This though let to the understanding that economic frictions, rather than monetary policies influence the economy. It also led to new-Keynesian economics. This is was a new successful way of thinking about macroeconomics.

Gérard Debreu (1921–2004)

Lucas’s work is based on developments of general equilibrium theory by a French-born Nobel Laureate and naturalized American, Gérard Debreu. He won the Nobel Prize in

1983 “for having incorporated new analytical methods into economic theory and for his rigorous reformulation of the theory of general equilibrium.”

In a slim little volume, Theory of Value, he argued “that the quantity of labor employed by firms changes over time reflects underlying changes in household preferences for leisure, shocks to the technology of production, or new people entering or leaving the labor force.”

Real Business Cycle Theory

Lucas persuaded many academic economists to stop working on Keynesian economics and to switch instead to the study of economic growth.

The most influential figure in the development of real business cycle theory is the Nobel Laureate Edward Prescott (1940–present)

Together with fellow Nobel Laureate Finn Kydland, Prescott developed the theory of real business cycles, which describes how shocks to technology can cause recessions.

Kydland and Prescott won the Nobel Prize in 2004 “for their contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles.”

Thus, the economists concentrated on believe that dynamics of employment, investment, consumption and GDP are the triggers in the changes of productivity, and thus, the factors (now called fundamentals) that impact the economy.

Afterward, the authors’ own perception on how economy should work should combine

 “the best features of classical and Keynesian economics.”

“The correct response to the crisis is to set in place, in every country in the world, an institution to control the value of national stock market wealth by targeting the rate

of growth of an index fund. Ideally, this function would be taken on by the nation’s central bank and coordinated with domestic monetary policy. Central banks should use changes in the size of their balance sheets to prevent inflation from rising too high or too low. They should use changes in the composition of their balance sheets to prevent bubbles and crashes.”

Conclusions

It is fair to note that the description of economy thoughts is written in a nice, short and easy to read and remember form. The author collects all important economy dimensions and events and its evolution in a chronological order. I believe that this general picture/order was missed when studying economics at school.

Nevertheless, the book didn’t answer my main question stated in the introduction; nor do I think the author answered his own question: how does economy work?

The book review highlights some of the important economic thoughts, good to know knowledge, so that you can to form your understanding of the economy, but there is still a huge mismatch to the reality, as these economic theories are not a true reflection of real world: They are all based on the assumptions, nicely build statistical models, etc.
 
It is also my impression that the author leaves many topics untouched, for example the role of real economy on the crisis (outsourcing of production facilities), the role of education system (the avoidance of studying finance in schools), the role of immigration on employment equilibrium. Many other economic models were also missed out (welfare model, planning model, socialistic model); even some major economist were also missed out (Kindlerberger, Shiller, Minsky).   

Not only are many of the topics left out, but also the reconciliation of the models to the real world was omitted. For example, describing the efficient allocation of recourses, I would have liked to know what institutions can actually allocate financial resources in the most efficient way: bank, governments, funds, or “invisible hand”, or maybe church.

The author calls himself a classical liberal.  However, it was not clear to me, what frameworks from classical economy does he apply at his work on a daily basis. For example, how had market equilibrium been effected by globalization, immigration and financial liberalization?

I admit I put too much weight on the title of the book, which I believe have not met my expectations.  I would rather call it the “The Development of Economic Though”, which also is not a bad thing to know.

Speaking in general, there is something wrong with economy models and how they are being applied. The avoidance of important aspects, such as manufacturing, education, art, history, and even philosophy by the economic models (not only by the author) is one of the underlying reasons why there are problems in the economy. Focusing only on some of the parts of economy mechanism, creates an illusion (for example, the focusing and managing inflation only to control unemployment in the 70’s was one the reasons for the financial crisis in that period).

I believe that today we have too much of a focusing illusion of the consumption effect on the restoring our economy. Rarely had the economic problems of recent events were analyzed in light of education, women rights, and music and art industry development.

Thus, the shift in focusing illusion (today it is consumption, and dodgy finance, in the 70’s it is inflation) make economies “incomparable”, thus, creating more uncertainty and risks for any decision making

Thus, these “trend and fashions” in economic thinking create mass focusing illusion on one aspect, omitting something else. Therefore, the world is paying the price.

I think our knowledge (or missed knowledge) of how economy works is a trigger for all the economic crises. Then it gives meaning why the book starts with the description of the latest financial crises: the outcome of the Dark Age of Economics we are living in now.

It just gave me some thoughts for my next post (here).