Naked Economics: Undressing the Dismal Science

Chapter 8 describes how politics, in the form of organized interests, interfere with the laws of economics. One hot-button issue that illustrates this is international trade. A poll of economists conducted by the University of Chicago, for example, showed that every single one agreed or strongly agreed with the statement that “trade with China makes most Americans better off” (183). Yet a groundswell of negative public opinion on the issue has resulted in politicians curtailing this trade. A case in point was the scrapping of the Trans-Pacific Partnership (TPP) by the Trump administration and its disavowal by some who had a hand in crafting it.

On the other hand, Congress funds projects that seem to have no economic benefit. One example Wheelan gives is a subsidy provided to farmers who raise a certain kind of goat that produces mohair. This began back in 1955, when the military wanted to ensure an ample supply of wool for its uniforms, and continued until it ended exactly 40 years later. The only problem is that the military turned to synthetic fiber for its uniforms starting around 1960. As if that weren’t bad enough, Wheelan writes, “when the rest of us turned our attention elsewhere, it came back” in the 2008 farm bill (183). What happens is that the mohair farmers lobby hard for something that means a lot to them, and in the larger scheme of things, nobody else really notices. As a share of the entire budget, the subsidies are miniscule, and the small number of such farmers helps them stay under the radar. This has led to a theory by economists. In terms of special interests in politics, small groups get better results because their interests mean a lot to them but little to most people who don’t put up much resistance.

Another famous example is ethanol, a fuel additive made from corn that is subject to a federal tax subsidy. Politicians tout its positive environmental effects and its role in reducing America’s reliance on foreign fuel. However, scientists and environmentalists disagree, saying that both are minimal. Perhaps the real reason politicians are convinced of ethanol’s benefits is that so much corn is grown in Iowa, a state that is pivotal to presidential primaries. Few politicians make it out of Iowa with a win if they don’t support ethanol subsidies.

This doesn’t really pose a problem until you consider the number of companies and special interest groups that obtain a similar benefit from government policy. Pork barrel legislation (that is, government spending for specialized, local projects managed by a representative) can get out of control as politicians support each other’s pet projects that help to bring votes in their home states. The problem is that it’s not necessarily good economics. When government protects entrenched groups through subsidies, tax breaks, and other policy, it is disrupting one of the main features of capitalism: creative destruction. This hobbles the economy.

This chapter is about what is called the “business cycle,” or the pattern of boom and bust that occurs in all modern economies. The author begins with an explanation of how to measure the size of an economy. The most important figure is real gross domestic product (GDP). This is a measurement of all the goods and services produced each year. “Real” means it is adjusted for inflation; “nominal” GDP gives the figure not accounting for inflation. Thus, real GDP, compared to previous years, measures how much an economy grew It’s also important to divide that by the total population, giving the per capita GDP, or the average income per person. The higher that number, the better off a country is, generally speaking, because that’s how much is available to purchase things or to trade.

Looking at the numbers for the United States, it’s clear that the US economy is huge and that Americans are much better off today than they were in the past. One way economists measure today’s level against the past is to compare how many work hours it would take to purchase something. This is determined by dividing the price of an item by the average wage in a given year; that way, comparing different years accounts for fluctuations in inflation. The reason for this increase in wealth is that American workers are more productive today than in the past.

GDP as a measure of well-being and progress, however, has a number of drawbacks. First, it doesn’t measure unpaid work, such as caring for children or other family members, or cleaning and maintaining a home. It also does not account for any intrinsic value of what money is spent on. For instance, $10 million spent on building an electric car factory and the same amount spent on building a prison are regarded as equal. In addition, GDP does not account for harmful environmental effects as a result of economic activity. What’s more, because GDP is an average, it offers no information on the income inequality of a country.

However one measures economic progress, a problem occurs when it becomes negative. Economists don’t know exactly why downturns happen, but Wheelan writes that they are usually triggered by some kind of shock to the system and then spread to other areas. In 2007, for example, it was the bursting of a housing bubble that spread to Wall Street investment firms. One thing led to another, and the credit market seized up. When people sense or feel a downturn, they stop spending and hold onto their money, making the economy worse. In fact, the loss of consumer confidence may be worse than the initial event that set off the downturn. The end to a recession often comes only after issues underlying the problem have been ironed out. One benefit of a downturn is that less efficient businesses go under, which improves economic growth in the long run.

Governments have two tools to help end a recession, one being fiscal policy, which deals with government spending in terms of both outlays and revenue. Because consumers are hesitant to spend, government fills the void. Spending on public projects helps keep the economy moving and increases consumer confidence. Governments can also cut taxes, leaving businesses and individuals with more money that they will, hopefully, spend. Both approaches were used in the aftermath of the 2007 crash. However, timing can limit fiscal policy’s effectiveness. First, Congress has to pass a law, which nearly always involves political wrangling and delays. Second, the money might not be spent for some time afterward, even as the economy needs an immediate influx.

The other tool for dealing with a recession is monetary policy, which can be implemented much faster. In the United States, the chair of the Federal Reserve, the nation’s central banking system, can change interest rates immediately. Lowering rates has the effect of loosening the credit system, encouraging firms and people to spend more.

Other figures and measurements can help round out the picture of how healthy an economy is, including the unemployment rate, the poverty rate, income inequality, the size of government (its spending as a ratio of GDP), any existing budget deficit or surplus, national savings rate, and demographics. In terms of income inequality, economists have created a way to measure this, called the Gini index, a scale that runs from zero (perfect equality) to 100 (complete inequality). The US had a score 45 in 2007, a number that has been rising for the previous half century.

In this chapter, Wheelan discusses the money supply and how it is controlled by the Federal Reserve System. The Reserve System consists of eight banks nationwide and is led by the Fed chair in Washington, D.C. Economists agree that the Fed chair holds great power by regulating the money supply, although they often disagree about how to wield that power. The chair must find the right balance between growing the economy and making sure it doesn’t overheat. As noted in Chapter 9, lowering interest rates has the effect of boosting the economy. That may seem good, but if the economy grows too fast, inflation results. With firms and individuals spending freely, demand outstrips supply; the only way the market can deal with that is by increasing prices. Inflation erodes purchasing power, in effect making people poorer. The optimal rate of growth before this happens seems to be about 3% per year.

The Fed’s power derives from the fact that it can control of the supply of money, which is subject to the law of supply and demand like any other commodity. When the money supply expands, commercial banks lower interest rates to attract borrowers; conversely, higher rates result when the money supply contracts. A committee in the Fed led by the chair makes these decisions, which work indirectly. The Fed sets the interest rates for banks to borrow directly from the Fed (called the discount rate) and manipulates the money supply to effectively set the rate at which banks borrow from each other (the federal funds rate). The amount of money in circulation is controlled by the Fed buying and selling government bonds.

In practice, the Fed’s job is harder than it sounds. It’s difficult to know exactly how and when people will respond to changes in interest rates. Plus, the Fed doesn’t act in a vacuum; other economic players are simultaneously doing various things. Most notably, Congress is passing budgets and may be employing fiscal policy (described in Chapter 9), which interacts with actions by the Fed. Still, what the Fed does is extremely important. One economist, for example, has concluded that moves by the Fed caused the Great Depression and, by extension, World War II.

Wheelan explains this by first discussing the nature of money, which is simply a medium of exchange for transferring assets, goods, and services. In the past, money was backed by silver or gold, meaning paper bills could be traded in for a certain amount of precious metal. In 1971, President Richard Nixon ended this policy (the US went “off the gold standard,” as economists put it). Today, paper money has no inherent value. The only thing giving it value is our belief in its power to purchase things. When this power decreases, inflation is at work, as noted earlier in the chapter (prices go up because purchasing power goes down). This is where the Fed comes in, as a smaller money supply will force prices down.

Runaway inflation wreaks havoc with an economy, as illustrated in 1920s Germany and 1980s Latin America. People spend their cash recklessly because the next day it could be worthless, and fixed-rate loans disappear. Serious inflation reduces the value of assets and redistributes wealth in favor of debtors (they repay a nominal amount of money whose purchasing power has plummeted). It also distorts the effect of taxes, which, again, must be paid on a nominal figure of income, not one adjusted for inflation. Finally, poorly run governments that have high debt may be tempted to use inflation to wipe that debt away (since debtors benefit), which has long-term negative effects not just on the economy but on the citizens’ confidence in that government. This shows the importance of an independent central banking system that is free from the meddling of politicians.

As bad as inflation can be, the opposite—when prices continuously fall—is much worse. This is called deflation. Japan is the best of example of this in recent times, as the country has endured an extended period of deflation after the end of its boom in the 1980s. Consumers put off purchases, expecting lower prices in the future. This slows economic growth, which only causes less consumer spending, and a downward spiral ensues—all the way to a recession. If people can’t repay loans and collateral for loans have lost value, banks may have trouble remaining solvent. When the central bank cuts interest rates to zero, little else can be done to stimulate spending.

Here Wheelan ties this back to the Great Depression. The Fed did not increase the money supply as it should have, intensifying the effects of the economic downturn and extending the Depression. Ben Bernanke, the Fed chair at the time of the 2008 Great Recession was a scholar of the Depression, and Wheelan argues that lessons learned from the 1930s debacle informed Bernanke’s actions and likely averted something even worse.