What Economists Get Right
From finance to the environment to geopolitics, economic analysis has given us a way to better understand our world
Economists have come under fire of late for a laundry list of transgressions. They are said to have misread economic downturns with outdated frameworks and to be out of touch on big challenges such as climate change. Should economics be renamed Wreckonomics or are the criticisms unfair? This is one in a series of essays in which economists at Queen’s University weigh in.
Economics is the social science that people love to hate. While the field of economics has its share of failures and omissions, the haters are blinded by misconceptions regarding the scope of economic analysis and overlook what economists get right.
Though their research may be weaponized in the political arena, economists are generally not encumbered by dogma. Over the past 50 years at least, standard economic models have acknowledged that markets are not perfect. They have incorporated a range of factors that result in market failure: the risks that people are inclined to take when they believe an insurer will cover the costs of any damages; the imbalance in bargaining power between two parties; and market power, among others.
Economists have gone further and analyzed regulatory failures as well. Public choice theory, for example, applies economic analysis within bureaucracies to understand how selfish agents can lead these organizations to further their own interests rather than the public good.
Contrary to popular belief, the mechanisms that economists devise do not become part of an ideology but are critically assessed based on new empirical evidence or via a novel theoretical lens. A good example is incentive pay: At first, it was viewed as a solution to the problem of misalignment between company owners and managers, but its limitations have since been extensively studied.
The rigorous analysis of matching (between buyers and sellers, for example, or employers and employees) is yet another departure from the dated assumption that economic agents are indistinguishable. It includes the life-saving design of the New England Program for Kidney Exchange by Nobel laureate Al Roth and the use of auctions for the allocation of spectrum usage rights.
Economics beyond the economy
Economics thinking has been most evident in areas such as finance and the workings of the economy. Milton Friedman, for example, was vindicated when he predicted that there was no trade-off between inflation and unemployment in the long run; that even though these two variables are negatively correlated, any attempt by policymakers to reduce unemployment by increasing inflation would ultimately result in high unemployment and high inflation. This perspective, revolutionary at the time, explained the failure of expansionary macroeconomic policies in the 1960s and 1970s. It was nothing less than a paradigm shift that led to institutional changes and to a period of macroeconomic stability known as the Great Moderation.
But economists have shown that they do not just care about the “economy.”
They have, for example, responded to the effects of economic activity on the environment. More than half a century ago, they applied optimal control theory — a branch of mathematics that looks for the best ways to control a dynamic system — to better understand the depletion of natural resources. Even further back, the notions of externality and public goods were developed and formalized.
More recently, economists have studied the effects of various regulatory mechanisms on carbon emissions — mechanisms such as taxing pollution, subsidizing reductions in pollution and establishing markets for emission rights. In the end, such mechanisms may be useful not because of their direct effects on carbon emissions, which will likely remain minor, especially on a global scale, but because the price signals that they send will spur technological innovation and creative destruction.
Economists have also applied their tools to shed light on societal concerns. In the United States, discrimination based on race is a recurring issue. Thirty years ago, Glenn Loury pioneered work on discriminatory policies to understand whether “affirmative action” would end up eliminating negative stereotypes and warned about unintended consequences that are still poorly understood. Roland Fryer studied data regarding the use of force by police to test whether there is any bias based on the ethnicity of targeted individuals.
Economic analysis has even been applied to better understand interactions between nation-states. It is well known that game theory was used during the Cold War and might have prevented terrible outcomes. As a recent essay by Nobel laureate Roger Myerson reminds us, game theory can be more generally used to better understand relationships among nation-states, including preventing wars that could arise as an established power attempts to curtail challengers. These lessons are acutely relevant these days.
New tools for the times
Economists have long understood how to address economic and financial crises, as well as the warning indicators. The timing and the exact scenario in which a crisis unfolds are hard to predict, if only because crises that can be anticipated will be prevented. The experience of past crises, however, helps economists manage unexpected crises.
Ben Bernanke, best known for managing the Fed through the financial crisis of 2008, is a good example. Bernanke was a scholar of the Great Depression. He devoted his career to understanding the policy failures of that time, especially failures of monetary policy and banking supervision. He was also involved in the application of new tools, including the disclosure of stress tests in the banking system, to help quell the crisis and allow the economy to rebound. My own work with co-authors Matthieu Bouvard and Adolfo de Motta delineated the circumstances in which disclosing stress-test results to market participants would help restore financial stability.
Economists have also embraced new empirical methodologies such as machine learning, albeit in a limited way, that reflect the field’s focus on explaining rather than predicting outcomes. They pioneered econometric techniques to establish causal relations rather than mere correlations, embraced field experiments, including in development economics, and incorporated behavioural biases and other cognitive imperfections in their models, such as overconfidence, loss aversion, optimism, pessimism and many others.
This brief survey hardly does justice to the evolution of economics. There are, however, two key takeaways. First, the alleged failures of economics are usually failures of public policy, which may or may not use economics as a guide. Second, criticisms of the field often arise from the misperception that the tools and perspectives taught in Econ 101 account for the totality of the field.
This is not to say that the field cannot make progress. I expect it will continue to shed light on emerging issues and contribute to sound decision-making throughout society.
Pierre Chaigneau is an associate professor and Commerce ’77 Fellow of Finance at Smith School of Business.