A quick rundown of everything we know (and often forget) about the economy

It’s not sorcery.
It’s not sorcery.
Image: Reuters/Kacper Pempel
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The financial crisis taught economists some hard lessons. But over the last 250 or so years economists have learned a few things that still hold up.

1. Markets aren’t perfect, but they’re the best we’ve got

Indulge me a useful over simplification: the goal of economics is to determine what’s the best way to allocate a scarce number of resources. Over-simplifying again, this can either be done by a central planner deciding who gets what, or letting the market decide by determining a price based on the scarcity of any good and how much people want it. A benevolent, all-knowing, all-powerful dictator may do the best job, but no such person exists. Markets do the second best job, even if they aren’t perfect. Prices are not always right because information is wrong or people make bad decisions. But a fallible market does a better job than a fallible human, which is why free markets grow faster for longer.

But because markets aren’t perfect there exists scope for policymakers to tweak markets and help them function better. Even the most ardent free-market economists agree the government has its place. But how much and how exactly is what divides the profession.

2. The key to sustainable growth is productivity

Economies need to grow, not every year, but most years. Economic growth represents societies getting richer. It keeps people happier, more productive, and affords debt repayment. Growth comes from putting more people or capital (machines, natural resources) to work. But you can only add so much of each and keep up high growth; people and capital also are in finite supply. The key to sustainable growth is productivity, or getting more output for each person, machine, or mineral.

Gains in productivity comes from inventing new products or making existing products better. Economists have been very worried about productivity lately because technology hasn’t delivered, productivity growth has mostly been slower since the 1970s compared to the post-war era and much slower compare to the first half of the 20th century. It could be tech really has changed the economy and we don’t know how to measure productivity in the tech economy yet. Or it could be tech isn’t so great; the iPhone isn’t as revolutionary as indoor plumbing. Economists are sharply divided on this issue. We may all be dead before we know who’s right. It took almost a century for the steam engine to transform the economy.

3. Most policies create winners and losers

Markets allocate goods and services between different parties. The division may not be equitable. A CEO earns $3 million a year compared to a fry cook at McDonald’s who makes $8 an hour. Forcing the CEO give some of his earnings to the fry-cook makes the fry-cook much better off and the CEO worse off (even if the benefits mean much more to fry-cook than the loss does to the CEO). Nearly all policies that tinker with markets, no matter how just they may seem, create distortions leaving winners and losers. Anyone who tells you different is selling you something.

4. People respond to incentives

When you give or take away income or wealth it alters behavior. The change may be too small to notice. If you increase someone’s taxes from 35% to 38% of their income, they’ll probably work the same amount. But if you increase their tax rate to 95% they’ll probably change their behavior. It’s hard to know where distortions start to matter and what will happen. A higher tax rate may mean you work less because you get less reward for your work. But you might also work more because you need more money. These effects are unpredictable and vary based on occupation, income, and geography. But these effects often determine who the winners and losers are and whether a policy is good for the economy.

5. Monetary policy can’t fix structural problems

We look to the Fed to fix the economy. Since the financial crisis, it has lowered interest rates, paid interest rates on reserves, and bought long-dated bonds. The hope was that lower interest rates would get people to invest, spend more, and boost hiring. It worked; unemployment is down to 4.9%. But the number of people working still hasn’t fully recovered.

Economists can’t decide it that’s because there’s more room to juice the economy with low rates or if the remaining slack is comes from some people lacking the skills employers want. If it’s the skill problem, low rates won’t get people back to work. The only thing that will help them is retraining or maybe new infrastructure projects. The distinction between demand and skills is important because, like all policies, low rates also create distortions, winners, and losers. Keeping rates low is only worth it if it will help employment.

6. The second moment is as important as the first

Economists often say if X happens, then Y will result. But that is not quite right. It is really: if X happens a range of Ys will result. There’s a lot of unpredictability about things we can’t control: a hurricane might occur, the Chinese economy might collapse, your house might burn down, future taxes might increase. Risk and uncertainty makes investors and consumers nervous and this can dampen economic activity. Government policy can reduce risk by offering a safety net with unemployment benefits and Social Security. But it can also create uncertainty about how different policies will play out (all those countervailing incentives) or how policies will change in the future.

7. Consumption doesn’t grow an economy, savings does

You often hear that keeping the American economy afloat depends on keeping American consumers spending. But this only works in the short run. People also need to save. Saving is what fuels investment, which makes the economy grow and stay productive (though we can borrow savings from abroad, at least for now). Saving also ensures households can continue to consume when bad things happen. Savings make consumption more predictable, which reduces risk for households, investors, and employers.

Sure, you can consume too little and hold back growth, which is arguably where China is—its household saving rate is between 20 and 30%. But America is far from that—its personal saving rate is just 5.5%. When we hear about an increase in consumption we should have mixed feelings about it.