What is Economics?

The 2009 Nobel Prize in Economics was recently awarded to Elinor Ostrom and Oliver Williamson for their work on "economic governance". The official press release notes:

Economic transactions take place not only in markets, but also within firms, associations, households, and agencies. Whereas economic theory has comprehensively illuminated the virtues and limitations of markets, it has traditionally paid less attention to other institutional arrangements. The research of Elinor Ostrom and Oliver Williamson demonstrates that economic analysis can shed light on most forms of social organization.

Especially considering that Ostrom is a professor of political science, this award appears to be a recognition of fundamental economics, its method, which applies in all social studies.
The nature of this method, its basis in human experience, and its comprehensive scope were well described by Philip Wicksteed in 1910:

the general principles which regulate our conduct in business are identical with those which regulate our deliberations, our selections between alternatives, and our decisions, in all other branches of life. And this is why we not only may, but must, take our ordinary experiences as the starting point for approaching economic problems. We must regard industrial and commercial life, not as a separate and detached region of activity, but as an organic part of our whole personal and social life;

"Man himself is the beginning and end of every economy," wrote Carl Menger, when preparing notes for his ground-breaking Principles of Economics (1871) -- beginning, because aggregate economic and social phenomena (such as prices in the marketplace) do not arise except from individual men's actions (not society but man alone acts); and end, because even though each man acts on his subjective values towards his subjective goals, calling upon his subjective judgment and using his subjective skills, the rational principles that govern this individual behavior, properly understood and applied, are, miraculously, sufficient to explain not only the market process that guides the production of economic goods but in fact, the evolution of the entire social order.

Menger's essay on the Origins of Money is a splendid example of the economic method in action. He proves that differences in individuals' valuations of different goods and the absence of a co-ordination agency or mechanism (such as a government or State) are no obstacle to the natural emergence of money in any human society. In fact, differences in valuations are the reason social exchanges happen in the first place, and people realize without anyone's prompting that the most marketable goods should be accumulated for their own sake because they would be useful in future exchanges.

Man's position at the center of its method distinguishes economics from physical science as well. Only man chooses and acts, so causes and effects in human society are of a different kind than in the natural world. Ludwig von Mises, who determined to become an economist when he first read Menger, and who was recently described as "the man who predicted the Great Depression", did more than anyone to clarify the nature of economic knowledge. He says (on pg. 7 of his essay on The Ultimate Foundations of Economic Science):

in the orbit of natural events of the external world
which [the scientist] explores there is no such thing as action.

The economist does not proceed by observation and measurement to hypothesis and inference but deductively from the axiom that men consciously choose, economize and act to achieve their individual ends in the presence of relatively scarce resources, to its inevitable consequences in the marketplace and society.

Another important feature of economics is that it is positive, not normative -- it illuminates how the human world, as it is, has come to be, and does not prescribe how it should be. Economists and their models are often used by those in power as justification for the policies they wish to carry out; sometimes the economists understand this and co-operate in the project, sometimes not. How a man should live, what values he should have, what kind of society "we" should aim to construct, and how -- important as these questions are, they lie outside the scope of economics.

It is also too much to ask of economics that it should predict how specific government measures (such as the 2009 stimulus measures) will affect specific aggregate measures of the economy (such as the unemployment rate). Each event has many causes that cannot be always separated. However, the laws of economics do apply 'in the large' -- using them, Mises was able to see through the credit-induced boom of the 1920s and anticipate the bust and depression that followed. In the 1930s Mises and Hayek also worked out the main economic problem with socialism and predicted its collapse. Of course, the actual collapse of a socialist economy (like Russia) does not prove them or their theory right, and neither does the continuing success of a socialist economy like China prove their theory wrong. Economic theory is correct in the construction or not at all.

Will Prices Rise or Fall?

Over the last two years the Federal Reserve and other central banks have taken extraordinary steps to provide cash (or liquidity, or reserves) to banks and other institutions. As the economy recovers and the new money makes its way into the hands of spenders, prices may be expected to rise.

However, anybody who has used a credit card knows that cash and credit are equivalent for a purchase; it is not just the amount of cash in the economy but the total amount of money and credit available that is relevant for the overall level of prices. So if credit shrinks, prices could decrease.

That is exactly what appears to be happening: for about a year now, total consumer credit has been shrinking (the latest Fed preliminary reading shows it falling at 5.75% per year.) This reversal of a decades-long trend is already pushing prices downward, as the recent trend in the Consumer Price Index seems to indicate.

The Fed creates cash and the banks create credit, so if credit creation continues to sputter, the Fed will find itself 'pushing on a string', and might be unable to reverse a serious credit contraction and resulting deflation of prices, notwithstanding Fed Chairman Bernanke's well-known determination not to let it happen.

What is Wrong with Saving Money?

If someone saves a portion of his income rather than spend it all, the money saved ("under the mattress") does not become part of anyone else's income, and is withheld from the rest of the economy. If everyone were to start saving suddenly, businesses may start failing and will have to shrink. Eventually, the total savings of the population, instead of rising, could even start to fall because people losing income or jobs would have to stop saving as they tried to get by on less and less.

This so-called paradox of thrift is the basis for the government intervention that acolytes of Keynes (or recent converts to his way) advocate in times of crisis. When demand for goods and services falls sharply and the confidence of consumers and businessmen suddenly declines, government should offset the drop in economic activity by increasing public investment.

But why does aggregate demand suddenly fall, and how does this propensity to save come upon everyone all at once, so that each person's individually irreproachable act of saving collectively becomes such a danger?

And how would government officials know how to restore people's "animal spirits" if nobody knows why they withered in the first place?

As to the first question, the Keynesian diagnosis (if that is the right word) is that unmanaged capitalist economies are inherently unstable, probably because consumers and businessmen must always make decisions under changing conditions and with uncertain expectations of the future.

And as to the second, there is every reason to be skeptical. Despite the self-proclaimed success of the authorities in staving off economic disaster, in the matter of getting people to spend, or banks to lend, even the massive emergency policies appear not to be working. Could it be that these measures are not working because they go against the people's desire to save, however inconvenient it may be for the authorities? As Adam Smith warned in The Theory of Moral Sentiments,

[The man of system] seems to imagine that he can arrange the
different members of a great society with as much ease as the
hand arranges the different pieces upon a chess-board. He does
not consider that the pieces upon the chess-board have no other
principle of motion besides that which the hand impresses upon
them; but that, in the great chess-board of human society, every
single piece has a principle of motion of its own, altogether
different from that which the legislature might chuse to impress
upon it. If those two principles coincide and act in the same
direction, the game of human society will go on easily and
harmoniously, and is very likely to be happy and successful. If
they are opposite or different, the game will go on miserably,
and the society must be at all times in the highest degree of
disorder.

What Caused the Financial Crisis?

The financial crisis of 2008 (that we are still living through) is worse than anything we have seen in our lifetimes. There have been slumps and recessions before but nothing like the worldwide credit crunch that took hold of the international financial system in mid-2007, bringing it to the edge of implosion by September 2008, and leading the whole world into an extraordinary panic and economic collapse over the next six months.

Since the middle of 2009 conditions have improved, spectacularly in some areas, very likely owing to the emergency steps taken by authorities, but people have continued to debate vigorously in blogs, books, and magazines, both the causes of the crisis as well as public policy measures taken in response, especially as the first anniversary of the Lehman Brothers episode came around last week.

Looking at the variety of explanations being offered -- some ideological (such as free markets, laissez faire economics and capitalism) some institutional (such as under-regulation of banks) some systemic (such as securitization of mortgages, or derivatives) -- one could be forgiven for thinking that even experts are confused about the causes. Indeed, the academic failure is so severe that we need not rush to form any judgment on the matter. Instead, we can look to ongoing events, in the expectation that they will teach us more than arguments alone could.

The role of public policy in these events is likely to be huge (as Keynesian thinking makes a comeback) but will not go unquestioned. Recently, James M. Buchanan, winner of the 1986 Nobel Prize in Economics, endorsed a study that asks if the Obama administration is making Depression-era mistakes again. Similarly, the Fed's lightning moves in counteracting the crisis have been praised but its "exit strategy" is being carefully scrutinized. And won't such policies, critics of government intervention ask, ultimately lead to inflation (higher prices)?

As this large scale panorama unfolds, perhaps another question to ask is: can the right public policy always prevent a depression? Consider this message from the study Buchanan endorsed:

[T]he market depends on the aggregate consequences of millions of individual plans, responses to outside signals about what to do, based on private knowledge of what to do it with. No bureaucracy could possibly coordinate these plans, or be aware of these resources.

Once millions of individual plans have gone awry, for whatever reason, and associated resources depleted, getting the remaining resources back in line will not be easy -- and may even be impossible -- despite the best-laid plans of officials, bureaucrats and bankers, who are, after all, only individuals with bigger plans than others'.

How Did Economists Get it So Wrong?

Paul Krugman, winner of the 2008 Nobel Prize in Economics, trying to answer How Did Economists Get it So Wrong? says they mistook beauty for truth. Their models did not allow for the kind of collapse that happened last year.

A similar shattering of faith in the prevailing economic theories of the day accompanied the Great Depression of the 1930s. Then, as now, the academic discipline (so-called neoclassical economics) failed to anticipate or account for the latest financial crisis.

Cometh the hour, cometh the man, and the man of economics' darkest hour was John M. Keynes.

Keynes did not have a convincing explanation for what caused the Depression (Krugman is not much help either, saying merely that economists of tomorrow must 'face up to the inconvenient reality [of]...extraordinary delusions and the madness of crowds') but his theory recommended that governments should spend on public works in order to cure it. This caught on and held sway until about 1960 in both academics, where a distinction between micro- and macro-economics started to be made, as well as in policy-making, where the government's role in the economy grew ever larger.

In the 1960s Milton Friedman led a revival of neoclassical economics by arguing that the cause of the Great Depression was bad central bank policy, so that there was, in fact, no need for wholesale revisions to pre-depression, pro-market theories. Governments should leave economies alone, and rely on monetary policy (e.g. loosening the money supply) to counteract slumps as soon as they emerged. This 'Chicago school' has steadily gained support over ever since, and both academic and practical economics have gradually retreated away from Keynes. For example, Ben Bernanke, our recently reappointed Fed Chairman, said on Friedman's 90th birthday in 2002: 'I would like to say to Milton and Anna [Schwartz, Friedman's coauthor]: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.'

The pendulum is now swinging Keynes' way again. But did Keynes have it right? Certainly , the debate on what caused the Great Depression continues.

And then there is possibility that the economists have got it really wrong, off chasing beautiful models instead of the truth.

Read this nice summary of the important foundational tenets of economics and chew on it:

Production takes place for consumption (derived from the Scot Adam Smith), not the other way round. Value is measured not as an average but at the margin (the Englishman W. S. Jevons, the Frenchman Leon Walras, and the Austrian Carl Menger). The cost of producing a commodity or service is not the labour required (the German Karl Marx) but the commodity or service thereby lost (the Austrian Friedrich von Wieser). The instinct of man is to “truck and barter” in markets (Adam Smith). He will find ways round, under, over or through restrictions created by government (the Austrian Eugen von Böhm-Bawerk). There is no such thing as absolute demand (for education, medicine or anything else) or supply (of labour or anything else) because both vary with price (the Englishmen Alfred Marshall, Lionel Robbins and many before and since). Not least, without the signalling device of price, man cannot spontaneously and voluntarily co-operate for prosperous co-existence (the Austrian Ludwig von Mises and the Austrian-born but voluntarily-British Friedrich Hayek).