11 Big Myths About the Economy That Are Destroying America
Continued from previous page
In the world of Econ 101, “the economy” is usually treated as a synonym for “the market.” But an enormous amount of economic activity takes place outside of competitive markets dominated by for-profit, private firms.
In the industrial nations of the OECD, government spending at all levels on average accounted for 46 percent before the Great Recession. Even in capitalist countries, the government is usually the largest employer, and the largest consumer of goods and services in areas like defense, education and infrastructure. Other non-market sectors responsible for goods and services production include the household (your chores are economic activity too, even if Econ 101 ignores them) and nonprofits like religious institutions, colleges and universities, charities and think tanks like ours. Markets, then, account for around half of a modern nation’s economic activity — maybe less, if uncounted household production is as big a part of the real economy as some have claimed.
Myth 4: Prices reflect value.
If the economy is a market, prices are what allow goods and services to be efficiently allocated. In Econ 101, because prices are set in “free markets,” the price of something must be a reflection of its real value. This principle — known as the efficient market hypothesis — was the reason why, when in the run-up to the Great Recession real house prices increased 40 percent (a more than seven-fold increase from decades prior), virtually no economist sounded the alarm, precisely because those higher prices must have reflected higher value. This is why Ben Bernanke stated in 2005 that rising home prices “largely reflect strong economic fundamentals” and Fed chairman Alan Greenspan assured us that, “It doesn’t appear likely that a national housing bubble, which could pop and send prices tumbling, will develop.” Had economists not been in the grip of the efficient market hypothesis, they would have realized that something was seriously amiss and helped rein in lending to reduce the bubble and subsequent collapse. But if they tell policymakers that prices don’t always reflect value, then the entire foundation of Econ 101 starts to crumble.
Myth 5: All profitable activities are good for the economy.
Another axiom of Econ 101 is the assumption that all profitable activities are good for the economy: After all, Adam Smith “proved” that pursuit of self-interest maximizes economic welfare. To be sure, even Econ 101 would recognize that societies use legal penalties to discourage economic transactions like prostitution and drug use that are considered immoral, to say nothing of Mafia contract killing.
But the version of Econ 101 familiar to most politicians and pundits ignores the distinction between productive activities (e.g., making useful appliances or lifesaving vaccines) and pure rents (profiting from real estate appreciation, stock manipulation or the accident of owning mineral deposits that become more valuable). If the greatest fortunes are to be made in financial arbitrage, gambling in real estate or exploiting crony-capitalist political connections, the argument that private profit-seeking maximizes economic welfare and the public good is undermined.
Myth 6: Monopolies and oligopolies are always bad because they distort prices.
In the abstract universe of Econ 101, monopolies and oligopolies are always bad because they distort prices. Here populism, often opposed to neoclassical economics, is allied with it. The neoclassical vision of the normal economy with multiple small yeoman producers resonates with Jeffersonian antitrust policy, with its suspicion that all large enterprises must be conspiracies against the public.
In the real world, things are not that simple. Academic economics includes a well-developed literature about imperfect markets. But it is reserved for advanced students and is never encountered by those who are told only the simplicities of Econ 101. In manufacturing industries with increasing returns to scale, like semiconductor or airplane production, markets characterized by a few large producers are usually more productive and innovative than ones with many small producers. The same is usually true in industries characterized by network effects, like railroads or communications infrastructures such as wired or wireless broadband. And as Joseph Schumpeter pointed out, temporary monopolies based on technological innovation are not only beneficial but are key enablers of seeding further innovation — particularly if the “innovation rents” or super-profits are funneled back into R&D.