Monday, May 31, 2010

There is No Economic Magic

Magic means power beyond the laws of the material universe. Magic can invoke supernatural powers, or it can just be an effect that one believes cannot be explained by the known laws of nature. The origin of the word is Greek, magos, ironic because we think of the ancient Greeks as having originated systemic rational thought.
If one believes that there are no effects other than those that apply the laws of nature, then one does not believe in magic. Even a mysterious effect would still be caused by natural laws, even if we do not understand them. Ultimately, however, we cannot prove materialism, so it too is a religion, even if it is truth.
Many people do believe in magic. Some believe that the world is socially constructed, so that if we close our eyes and open our imaginations, we can redo the world just by visualizing something different. Many people believe in spells, incantations, and sorcery. They believe that particular individuals have psychic powers, or that priests can harness the powers of deity.
Even parents who do not believe in sorcery teach magic to their children. They tell children that there is this magical being in a red coat living in the North Pole, who rides a sleigh in the air pulled by reindeer, bringing toys to all good girls and boys. Why parents prefer not to take full credit for the toys that they give to their children is a mystery I leave to psychologists to explain. Perhaps, and I’m just guessing here, the Santa Claus myth is intended, however inadvertently, to prepare children for both religious beliefs and the magical belief in the paternal state.
I won’t here argue against magic in the physical world. It seems to me that physical laws become almost magical when practitioners of quantum mechanics report results such as particles being in two places at the same time, or forces that act instantaneously over distance.
What I do argue is that there is no magic in economics. We cannot raise our standard of living by means other than production. Just as in physics, there is no working perpetual motion machine, so too in economics, we cannot have outputs without inputs that get used up.
Yet most economists believe in economic magic. Conventional economic theory invokes magic, although non-economists, especially politicians, have an even greater belief in economic magic.
For example, many people believe that raising the legal minimum wage will help the poor and improve the economy because the poor will buy more stuff. Most economists realize that the extra payment to the working poor has to come from someplace, such as higher prices to consumers, and the higher wages would cause greater unemployment and a deadweight economic loss. The belief that higher minimum wages create more output is a belief that we can magically create output out of nothing.
Many people believe that trade barriers would increase domestic employment and output, whereas economists understand the law of comparative advantage, that trade takes place when the partners concentrate on producing those things in which they have a greater productivity relative to other products. Trade barriers act like higher transit costs that reduce the goods we can get in exchange for our exports. The belief that trade barriers can increase output is a belief that magically contradicts the law of demand; it is the magical belief that with a higher price, folks will buy more rather than less stuff.
But economists too fall under the spell of economic magic when they believe that government can improve market outcomes. They believe in market failure because they observe social problems such as unemployment, poverty, pollution, and sprawl, and jump to the conclusion that the market failed to be efficient, equitable, and sustainable. Free-market economists understand that there are severe governmental interventions that make our economy far from free, and that it is the interventions that cause the problems. The belief that more arbitrary regulation will make markets more honest, efficient, and equitable, amounts to a belief in economic magic, when the reality is regulatory capture: the regulators serve the regulated at the expense of rather than for the benefit of the public. Witness the failure of the SEC to prevent and compensate for the fraud of Ponzi schemes, or the failure of environmental regulation to prevent gigantic oil spills.
Much of conventional macroeconomics is economic magic. There is the belief that greater government spending will magically raise output, overlooking the reality that if the funds are obtained domestically, the governmental spending replaces what taxpayers and lenders would have spent privately. There is the broken window fallacy, the belief that breaking windows will increase employment from fixing the windows, overlooking the reality that the labor would have been more productively employed elsewhere. This is the magic invoked by “stimulus” spending, that we can spend the economy out of depression.
Probably the biggest piece of economic magic is the spending multiplier, the belief that if people consume more and save less, that extra consumer spending will become magically multiplied into much greater output. This implies that the income that is saved just sits there wasting away. This also implies that investment in more capital goods or in more human capital is autonomous, existing regardless of savings, whereas in reality, investment comes from savings. When one realizes that income not consumed is normally invested, the magic disappears.
Just as with the compulsion to lie to children and make them believe in a magical gift giver, a belief in economic magic, and government as gift giver, is deeply embedded in our culture. Most people are blindly culture-bound, so they are invulnerable to economic logic. Few people, even social scientists, can transcend their culture, and so pernicious cultural practices persist. Thus disasters such as war, the Great Depression, and the giant oil spill in the Gulf of Mexico.


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