Economics Reimagined: Nature, Progress, and Living Standards

By Rick Teller

What goes on in the economy is important to everyone, yet often baffling. This book-Economics Reimagined: Nature, Progress, and Living Standards-explains many mysteries of economics, for example:

Is macroeconomics even a science? Why have leading economists been given so much unchecked power over our lives? Why do government price inflatio

• Language: English
• Publisher: Rick Teller
• Release date: Nov 8, 2023
• ISBN: 9798988307716

Book preview

INTRODUCTION

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WE LIKE TO THINK we have complete control over our own lives. Yet what we do for a living, how much we make, what taxes we pay, what we earn on our savings, how much we can borrow, and what interest rate we pay when we do—all these things are affected, or completely controlled, by the decisions of macroeconomists.

Knowledge of macroeconomics (macro) seems extensive. Interest rates, stock prices, government deficits, unemployment, tax policies, and other topics are regularly in the news and discussed widely.

Nevertheless, the immense power that leading economists have been given nearly everywhere in the world is barely noticed and never debated. It is universally accepted that economies need expert management by economists working at the Federal Reserve Bank (the Fed) in the US, and at the various central banks of other countries.

Without their intervention, the economy is thought certain to misbehave badly, giving us financial crashes, depressions, out-of-control inflation, rising poverty, or other disasters. Except, even with that supposedly expert management, we get all those things anyway, just not when the leading economists anticipate them.

What happens in the economy is often surprising. For more than a decade after the collapse of the US housing bubble in 2007-08, inflation indices showed barely any increases, and the Fed was constantly talking about ways to get inflation up to the 2% per year level that was and still is its goal. Then, predicted by no mainstream economist even well into 2021, including the top leaders of the Fed, prices took off. By 2022, inflation indices hit the highest rate in 40 years, more than four times the Fed’s 2% goal.

In an earlier surprise to macroeconomists, at the top of the housing bubble in 2006-07, the head of the Fed expressed confidence that house prices would not decline and, if they somehow did, it would pose no risk to the financial system. In almost no time at all, both those problems showed up in a massive way.

Why are the top economists regularly blindsided by events? If they don’t understand their field well enough to anticipate what is about to happen, why do we continue to give them so much power? Can this be fixed by replacing the current powerful batch of economists with a different batch, or is the problem deeper than that?

My answer is that mainstream macroeconomics is fundamentally flawed and cannot do what it has promised. Economists themselves are well meaning, and almost all of them are very smart, but the economy is more complex than any single one of them, or even a group of the very smartest economists, can possibly manage in a way that produces better results than if it were left to its own devices, unmanaged.

Complex doesn’t mean confusing. The basic principles are not hard to understand. Mainstream macro looks at the world using faulty ideology and flawed conceptual tools, and, as a result, gets cause and effect wrong. This book will explain why they are wrong and show you a better way to understand what happens in the economy. You won’t need an economics degree to follow along.

The other major area of study within economics is microeconomics (micro), which covers how individuals and businesses interact in the economy, including what determines prices, how people decide what to buy or where to work, how businesses decide whether to invest or hire, and what they can afford to pay workers, among other things. While people are very interested in their own and others’ experiences in their roles as consumers, employees, and/or employers, very rarely will any commentator discuss micro theory, because it is so predictable as to be not worth mentioning.

We are almost never surprised by anything related to micro, such as when a clothing store puts bathing suits on sale near the end of the summer, because we expect them to do just that. We are also never surprised that a hot new car sells at list price or even higher, because we all know that an excess of demand over supply means sellers have no reason to offer discounts.

Have you ever wondered why micro is so much more predictable than macro? The answer is that micro is a science, a very settled one, to use the popular phrase. There could be ten million clothing stores in the world, and except for ones in a country with runaway inflation, a grand total of none of them would ever raise the price of bathing suits near the end of the summer, just as no car company that has a new car selling out fast would ever slash the price.

The reason micro is predictable is that it is based on human nature. What? Isn’t human nature infinitely variable? Isn’t it very dependent upon the customs of the society in which a person lives? Even within a given society, aren’t people wildly different in many ways?

Yes, all true, but not when it comes to how we interact with each other in the economy. It doesn’t matter which society you live in, or whether you are alive now or lived thousands of years ago. When buying something, you always want to pay less for it rather than more. When selling something or getting a salary, you would always rather be paid more than less. When investing your own money, you would always prefer to invest in something you expect to provide a high return and a low risk of loss, not the other way around.

When engaging in transactions with others, the price we agree upon will reflect our sense of the balance of supply and demand, with relative increases in demand likely to move prices up and relatively more supply likely to move them down.

People universally respond to incentives and disincentives, not in a lockstep, predictable fashion, but we at least take them into consideration, which is why you are more likely to buy something when it goes on sale, and less likely to ignore the setting on your heat or air conditioning if energy prices are soaring. People, no matter where or when, obey the Law of Diminishing Returns: that someone who already has plenty of something will lose much of their desire to get more, not counting collectors looking for a complete set.

Also, people, regardless of the society in which they live, have similar hierarchies for the beneficiaries of their decisions. Working hard to benefit oneself and one’s family and friends nearly always has a higher priority than helping strangers far away.

These rules don’t all apply to every single person 100% of the time. The Law of Diminishing Returns often has exceptions, such as people who have amassed more wealth than they could possibly use or give away but who still work hard for more. Some people don’t always place themselves and their families as the most important beneficiaries of their efforts, such as soldiers with families who don’t want them harmed, yet who still fight and die for their countries.

There can be other exceptions. Some clothing stores might feel it diminishes the good name of their store or its bathing suit lines to discount, so they just pack away unsold suits at the end of the season and pray they are still in style next year. For some products where buyers are uncertain about their quality, price can sometimes convey useful information. A person might prefer to buy a more expensive wine or watch, thinking it might be better than a less expensive one. But these are trivial exceptions, and once one has chosen the wine or watch they want, no one would turn down a discount if offered.

Because of these universal characteristics, the patterns of behavior that comprise micro do not change, because human nature regarding economic choices hasn’t changed in all of human history. It is the same under any economic system or social system. It doesn’t matter who runs the government. That makes micro closer to physics and other established sciences. Predictions based on micro laws are not certain to be exactly correct, as is the case in physics, but are likely to come close.

Macro couldn’t be more different. There are no established relationships between the concepts it uses. One can’t say that an X% increase in inflation will cause a Y% change in short-term interest rates, or vice versa, or cause some change in Gross Domestic Product (GDP), employment, or anything else. The only causes of anything in the economy are human decisions. People take economic data into account, but only as one of many factors.

A person thinking of quitting their job might be concerned about a high unemployment rate. A contractor bidding on a construction job that won’t get started for a year will ponder the inflation rate. People consider interest rates, trends in the economy, and so forth, but also many other factors related to their personal situation, some rational, some emotional, some even subconscious.

An economist is not a mass mind reader and will never know the extent to which a change in inflation or any other concept in economics will affect the decisions people make. Inherently unpredictable relationships between economic concepts mean that, if a macro model of the economy seems to work for a little while (few even do that), it is more likely a matter of luck than anything else.

This is important, because every country in the world has given massive power to economists on the grounds that macro is a science and that economists are the experts at applying the science to the particulars of the economy at that time. Neither of these beliefs is true.

The main concentration of economists’ power in the US is at the Fed, which lacks any serious oversight by elected officials. It is considered impertinent for laypeople to even question their decisions. They swear they know what they are doing, and we are expected to take that on faith. We never explicitly voted to give economists so much power, nor has there ever been an election in which an issue of great importance was whether economists should be given such a dominant position in our society. They have it, and that is how it is. Very few people even ask why.

This book argues that mainstream macro is not just randomly wrong due to inability to guess how people will respond to complex and changing circumstances, but also consistently wrong to the extent that it makes false assumptions about human nature, ignores constraints of the real world, and uses inherently flawed concepts that aren’t really saying what economists think they do.

If you are not a macroeconomist, you may wonder: Who am I to judge? Actually, everyone has standing to judge. The history of ideas is full of examples where an elaborate intellectual construct was developed and widely adopted, and yet was wrong, not because of some subtle point that only the most sophisticated experts in the field eventually detected, but because one or more of the basic assumptions underlying the edifice were wrong, something that non-experts were open minded enough to notice. Think of The Emperor’s New Clothes. Such is the case with macro.

That is good news for me as the author and you as a reader. We all happen to be experts at human nature, being humans ourselves. Even those with no knowledge of economics or statistics have the skills to recognize what is wrong with an economic theory when it is based on assuming that people behave in a certain way that we all know they never have and never will.

An example exists in every civilized country of how non-experts can examine evidence, think about cause and effect, and apply what we know about human nature in order to make important decisions. And even though in doing so we make no use whatsoever of mathematics, computer models, or formulas, it is generally agreed that the decisions, while occasionally faulty, are the correct ones most of the time.

I’m referring to the court system, both civil and criminal. Adversaries show up in court with professional advocates. Each side presents evidence and testimony, which usually contradict each other on many points, or the two sides would have settled and wouldn’t be in court. Each side gets to present a narrative, a story of cause and effect that paints its own side as having the best explanation of what really happened, while pointing out the flaws in the other side’s case.

The judge or jury then considers the evidence and arguments, and more than anything else, applies what they know about human nature to understand the testimony, character, and motivations of the witnesses. They decide whose story makes the most sense. If the losing side feels strongly that justice was not done, there are appeals mechanisms that can reverse or ameliorate the outcome.

The law and the court system are both based upon the fact that any member of a jury, regardless of education level or whether they have had any formal training in psychology, is perfectly qualified by their life experiences to size people up and decide who is right, or at least more believable. The same applies to economics.

Throughout the book, I will make use of what I call mechanisms of micro. A mechanism is a series of choices people, including business owners and managers, will likely make, given their incentives and disincentives. People respond to their circumstances, and the effects of their responses sometimes change the incentives for those who haven’t yet responded.

Think of it like moves in a chess game. Each move is one ply. Better chess players can think many plies ahead; they are not certain what move their opponent will make, but can figure out what they are likely to do because that would be the most attractive move, even if, unbeknownst to the weaker opponent until too late, it will place them in a poor strategic position that will lead to their defeat.

Chess is a game with opponents, while the economy is a cooperative interaction of millions of people, so the analogy is not ideal. Still, mechanisms based on micro are reliable because one doesn’t have to consider the playing style of a specific chess opponent, who may favor surprise moves unlikely to be foreseen by their opponent. In micro, there are few surprises, so these mechanisms unfold in a predictable way, if not necessarily at a predictable pace.

Often a mechanism works through business strategy rather than the choices of consumers or workers. Macroeconomists tend to think of companies as being indistinguishable participants in the marketplace, but the smartest move for one company to make, depending upon micro factors, may be very different from the choices some of its direct competitors should make. An established company with a high market share will behave differently from a small, aggressive newcomer with nothing much to lose. Companies with high fixed costs and low variable costs will behave differently from those with the opposite cost structure.

I know something about this because, since my first summer job in the 1960s, my career was in the stock market. By the early 1970s, I worked as what was then called a stockbroker but now has various classier names. My specialty then and continuing long after I retired more than 20 years ago, was investment in micro-cap companies.

These are very small companies, in the lowest 5% or so of public companies in terms of revenues and earnings. They are all relatively unknown, with only their employees, people in their industry, and some locals near their headquarters knowing much about them. While they may be small, they are sometimes the dominant player in a lucrative niche business.

Their top officers aren’t so busy and important that they don’t have time to talk to a prospective investor, especially one with clients who, collectively, could buy a lot of stock. The officers of tiny companies often have most of their net worth tied up in the stock, so they pay attention to its price.

I’ve spoken with hundreds of managers, and one of my main interests was their competitive strategy. For the better-managed ones, it matched up to what one would expect from microeconomics. Companies with big market share in their niche are always more interested in maintaining high profit margins than sacrificing them to gain even more market share. Small outfits in bigger markets take the opposite approach. Other choices that made sense to them were exactly what one would expect, given their microeconomic characteristics.

When the Fed changes interest rates, it does so with certain goals in mind. Macro effects, to the extent they exist, operate through mechanisms in the micro world, i.e., decisions made because of changed incentives.

Nobody is ever required to do what a mechanism’s incentive or disincentive suggests they do. People will sometimes pass on some lucrative opportunity or fail to reverse doomed choices because they are unobservant, capital constrained, short of staff, or for other reasons. If so, and the underlying conditions haven’t changed, the incentive usually stays in effect until the opportunity it reveals does attract takers and disappears as a factor.

The opposite of thinking many plies ahead characterizes many popular viewpoints on economic policies. One-ply thinking considers only the immediate effect of some law or policy, not subsequent effects. This limitation plagues most discussions of the effects of automation, artificial intelligence, imports, welfare, unemployment, tax rates, and other topics.

Because macro as taught generally ignores the implications of micro and its mechanisms, you’ll probably come across many ideas in this book that are different from what you have read elsewhere or been taught. Some of them are:

Living standards, although difficult to quantify, are a much better measure than GDP of the success of the economy in providing people with whatever it is that they want. GDP is easy to quantify but counts as positives many things that reduce living standards. The economy exists to serve people—we don’t exist to maximize GDP.

Inflation figures could be very different and equally valid (or not) but are nonetheless calculated with great precision by hordes of government economists, as if the figures were not mere artifacts of arbitrary definitions.

The natural situation in free-market economies is for prices to decline over time due to business investments in R&D, staff training, and more efficient equipment, which reduces unit costs and leads to lower prices or gives customers more for their money through quality improvements at the same price. Nevertheless, our economics establishment consistently and adamantly favors steadily rising prices, which lower living standards for the poor and middle class, while adding to the wealth of the rich.

Despite the widespread belief that inequality has never been greater, and despite the massive bubble in asset prices owned by the wealthy, the fact is, in terms of living standards, inequality has rarely been less in the US than now.

The real cost of government is not just the taxes we pay, but the total cost of what it spends, however financed. Another cost of government is the higher prices we must pay for output because of government and central-bank policies. Those include deficit spending that increases demand for output more than its supply, years of artificially low interest rates and money printing that make assets very expensive, and the diversion of money to people who are well paid despite not producing output that anyone would use their own money to buy.

In addition to what the government spends, its ill-considered incentives impose an immense cost on society in the form of bad investments and wasteful spending by the private sector. The housing bubble earlier this century and the everything bubble of the last few years are good examples.

All efforts to make businesses "pay their fair share," whatever that may be, are futile. Sooner or later, every tax or cost imposition on business is converted into some combination of higher prices and/or lower pay or benefits, so these taxes and costs are paid for entirely by customers and workers, not the businesses, except briefly. There is a mechanism in micro that ensures this, and it cannot be escaped.

Taxes that directly target the rich, such as highly progressive income-tax rates, capital-gains taxes, inheritance taxes, and proposed wealth taxes, have little effect on the living standards of the wealthy, but by reducing savings and investment, especially high-risk capital for startups, they reduce productivity growth and thus diminish the future living standards of those with lower incomes.

Many of our programs to retard climate change, while reducing some of the expense that will be needed in the future to mitigate the worst effects of higher temperatures, appear likely to reduce future incomes more than they reduce future expenses, leaving our descendants worse off even though their mitigation expense may be lower.

By the end of the book, I hope you’ll see why no matter who or what the government taxes, or even if it taxes nobody, nearly the entire cost of government is paid for in the form of reduced living standards for the poor. Those who think a more powerful government, commandeering even more resources in society, will somehow lead to less inequality or higher living standards for those with lower incomes, couldn’t possibly be more wrong.

That conclusion should be disturbing to progressives, whose answer for everything is more government size and power, but equally surprised and skeptical will be conservatives, who believe that the government transfers excessive amounts of money from the well-to-do to the poor, with the latter getting close to a free ride. The idea that, in terms of living standards, the rich sacrifice very little to pay for the government and it is the poor who are exploited, will upset their worldview, too.

My main thesis therefore has no natural allies on the left or the right. That’s a good thing. In evaluating it, no one will be able to apply their standard talking points to counter the other side—they must instead consider a very different way of looking at the economy and how it operates.

You’ll have to use your imagination occasionally, comparing the world in which we live to a counterfactual world which is identical to our world except for one thing. And you’ll have to be aware of how intertwined the economy is with the government and the Fed. Disentangling them is necessary to understand cause and effect in the economy.

A convention used in this book is the word widget to refer to some product or service offered by competing companies. Output is used to mean goods and/or services—whatever it is that a business wants to sell to customers. Equity means ownership or shares in ownership, not anything about social or racial fairness. For simplicity, I will talk of the Fed, but other countries have their own central banks where the same principles apply. Since almost all of them, as far as I can tell, believe in the same mainstream macro theories, what I say about the Fed probably applies to them, too.

• SECTION ONE •

UNJUSTIFIED POWER

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WRITTEN IN THE LATE 1700s, when economists were close to nonexistent, the US Constitution makes no mention of them, nor does it authorize roles for anyone to interfere with market prices for loans (aka interest rates) or do anything else to intentionally manage the economy. Of course, governments even then affected the economy, but the purpose of taxes and tariffs was to raise money so the government could pay its bills, not to change any aspects of the economy.

Starting in the late 1800s, economics developed as a field of academic study, but its intent was to understand the economy, not control it. The Fed was established as a central bank in 1913 to be a lender of last resort, to dampen any bank runs or panics, and to enhance the efficiency of the banking system by facilitating check clearance and other prosaic tasks.

In its first decade, the Fed tiptoed cautiously. In the early 1920s, the Fed got increasingly bold in its attempts to steer the economy. It decided that its policy should be guided by what today is called inflation-rate targeting, in which rates get increased and credit is tightened when price inflation is higher than the Fed’s target, and rates are cut and credit eased when it is less.

Benjamin Strong, head of the New York branch of the Fed, which made him more powerful than the Fed’s Chair at the time, wrote in 1925 "That it was my belief, and I thought it was shared by all others in the Federal Reserve System, that our whole policy in the future, as in the past, would be directed towards the stability of prices so far as it was possible for us to influence prices."

By the mid-1920s, noticing that there was consumer price deflation, the Fed took that as an indication that the sum effect of its policies was too tight, so it loosened them accordingly.

That was the wrong interpretation because monetary policy is not the only thing that affects price levels. The 1920s were a time of mass adoption of new power and communications technologies. With newly built transmission lines, factories became increasingly electricity intensive, with efficient electrical motors replacing steam, water, and manual human power in production processes. This cut production costs, and as these advances became available to all except remotely located businesses, competition forced prices to follow costs down.

Also, the widespread adoption of telephones by businesses was a big cost saver. Managers didn’t have to travel to find things out in person. If a product was not selling well, the factory had a chance to cut production before massive excess inventory was created. This reduced risk and cost, eventually pushing prices down.

The Fed’s credit easing did little to make consumer prices rise but did encourage banks and brokers to lend more to speculators in real estate and the stock market. The relentless rise in stock prices made banks comfortable lending speculators a high percentage of the value of their portfolios. This financing-enhanced buying power pushed stock prices to unsustainable levels, and the resulting market crash and