The Tooth-Fairy Economics of Jeff Madrick

The Tooth-Fairy Economics of Jeff Madrick

December 2, 2014

by Laurence B. Siegel

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Incentives don’t matter, tradeoffs don’t exist and there are no limits to what the government can give you. Those who believe this dogma are likely to still have faith in the tooth fairy. In Seven Bad Ideas, a critique of the neoclassical revival in economics that surrounded Milton Friedman and that affected policy and politics worldwide for more than a generation, Jeff Madrick emerges as tooth-fairy economics’ chief exponent.

Briefly, Seven Bad Ideas argues that the influence of a group of free-market economists led by Friedman over a period from the late 1960s until the 2007-2009 global financial crisis caused a worldwide turn to the political right that destroyed rewards for labor, enhanced the position of elites, hindered growth and generated a series of destructive financial-market booms and crashes.

It’s hard to overstate just how bad Seven Bad Ideas is. Most leftist rants – and that’s what this book is – express a critique of society with which almost anyone can sympathize. This one does not. It is an unsupported claim that the great defining ideas of mainstream economics – the salutary effects of open competition, the efficiency of capital markets and so forth – are flat-out wrong.

They are not wrong. They are generalizations and points of departure, not intended to reflect reality exactly. For example, tests of market efficiency often reveal that prices do not fully reflect all available information and that one can trade profitably on the inefficiencies. Such tests and trading strategies would not be possible without a null hypothesis of market efficiency. The same principle holds for political arguments in which governments are asked to remedy market imperfections: first one must ask what the market would be achieving if it worked perfectly. Only then can one weigh the costs against the benefits of a non-market (government) remedy and come up with a decision.

If you told a group of economists in the 1930s that the worst economic event in the subsequent 80 years would be a long, shallow depression during which U.S. per capita GDP did not fall below $46,795, they would have done a happy dance like no other.  (Per capita GDP in the pre-Depression peak year, 1929, was $11,324.¹  Both numbers are in 2009 dollars.) Those economists would have regarded capitalism, specifically the mixed and regulated capitalism that produced that astonishing rate of growth, as a stunning and unexpected success.

Yet, according to Jeff Madrick, the poor performance of 2008-2014 is proof that capitalism has failed. That is like saying that the internal-combustion engine has failed because motorists sometimes crash their cars. Even if per capita GDP never grows again, which is absurd, the mostly free-market system under which we live has achieved a level of consumption 17 times higher than that of the world’s richest country in 1820.²

There is a glimmer of wisdom in Jeff Madrick’s questioning of several ideas that are close to the heart of financial professionals. As Jeff Madrick argues, the stock and bond markets are not perfectly efficient. Speculative bubbles exist and often end in crashes. Economics is not a science, but a social science. If there is value in Seven Bad Ideas, it is in the sections that raise these questions.

But first, Milton Friedman was a good-hearted man with good ideas…

…not an ogre who sought to destroy the world. (I knew him slightly.) The ability of political debaters to ascribe malign motives to people with whom they disagree never ceases to astound me. In a democracy, most people in positions of power, including those few economists who do have power, do what they do because they believe it is right. Reasonable people differ on what is right. Polemicists should not sling mud, accusing opponents of only trying to please their cronies and enrich themselves and other members of their social class. Madrick plays this kind of foul ball with some regularity.

Madrick’s seven bad ideas

My review is organized along the same lines as Jeff Madrick’s book: each bad idea gets a chapter, the title of which identifies the idea that Madrick doesn’t like. They are (in my own words):

1. The invisible hand
2. Say’s law (“supply creates its own demand”)
3. The desirability of a limited social role for government
4. The desirability of low inflation
5. The impossibility or nonexistence of speculative bubbles
6. The desirability of globalization
7. The idea that economics is a science

Let’s consider each of these (except #3, because my blood pressure is high enough already).

The invisible hand

Madrick admits to having been seduced, early in life, by Adam Smith’s comment that markets, particularly the interaction of supply, demand and prices, cause resources to be deployed properly and efficiently as if “led by an invisible hand.” Jeff Madrick calls this a “beautiful idea,” but warns – rather elegantly – that it is a “source of clean economics in a dirty world.”

But theories are supposed to be generalizations! Newton’s laws are a source of clean physics in a dirty world: they predict that a feather and a brick will fall at the same rate when they do not, because they ignore air resistance. People instinctively know this and do not expect physics to make perfect predictions. The imperfections are what’s interesting and worth studying, and one must always make adjustments for them.

So it is in economics. Bankers “sell…complex securities without informing [the] buyers [of the complexities]” (p. 42). This should be against the law, but — to some people — Treasury bonds are complex, so one can debate just how the law should be written. Jeff Madrick emphasizes that people are not rational and buy stocks after they have gone up, and they follow fashion in other pernicious ways, even “buying an Hermès Birkin bag” (p. 44) from time to time. This is a familiar complaint about markets, dating back to Thorstein Veblen [1899] and beyond.

We can all agree that markets have imperfections. And we have to have a government that regulates markets in some aspects. But only a writer blinded by anti-market ideology would argue, as Jeff Madrick does, that the mere existence of imperfections invalidates the market system, while treating government as an almost unalloyed good.

Say’s Law (supply creates its own demand)

Jeff Madrick’s actual chapter title is “Say’s Law and austerity economics,” which is revealing. Austerity economics doesn’t exist. Ignoring second-order effects, governments don’t create or destroy resources, they just redistribute them (after the market has distributed them once, hence the “re” prefix). Austerity, once a meaningful word (an austerity program in World War II might have involved not eating butter so the soldiers could have more), is now code talk for “giving less of other people’s money to politically favored groups.” Stimulus – which may or may not stimulate anything – means “giving more of other people’s money to politically favored groups.”  Just making sure we understand each other, Jeff Madrick.³

But I digress.  What is Say’s Law, and what does it have to do with austerity?

Say’s Law, named after the 19th century French economist Jean-Baptiste Say (pronounced  “sigh”), is usually expressed as “supply creates its own demand,” but that statement is unclear. In plain English, Say’s Law states that if one adds up all the payments received by those whose work, raw materials, and so forth were used to produce a good, that sum is sufficient to buy the good. In other words, there is enough money around that someone can afford to buy the goods.

There is, of course, no guarantee that every single widget produced will find a buyer. There are market imperfections and waste. At the aggregate level, however, Say’s Law implies that there cannot be a general glut of goods or labor — that is, a general economic depression — because the prices of goods and other resources (such as labor) will fall until they’re all being used.

Furthermore, Say’s Law suggests that if recessions and depressions do occur, they are self-correcting. Thus, policymakers should avoid interfering with market processes, such as wage and price deflation and asset liquidation, which help to end the depression. By “austerity economics,” then, Jeff Madrick and others mean allowing these processes to happen naturally without government intervention. What is proposed as an alternative is “Keynesian” deficit spending by the government, believed by Keynes and his many followers to move the economy from a condition of depression back to “full employment” (of all resources, not just labor).

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