Welcome back to our examination of N. Gregory Mankiw’s textbook. Start at the beginning here.
Okay, we’re starting the section “how people interact.” It’s probably the best section.
Let’s jump into:
Principle 5: Trade can make everyone better off.
This is true and not entirely commonsensical (many people think that if, say, Japan gains from trade with us, we must be losing an equal amount from trade with them). Even better, the explanatory text is clear and reasonable, and the “can” keeps it on this side of the line between reality and dogma (trade doesn’t always make people better off).
Grade: A.
Suggested replacement principle: None.
Wow! That was so quick, let’s get ambitious and take on two at once:
Principle 6: Markets are usually a good way to organize economic activity.
And, Principle 7: Governments can sometimes improve market outcomes.
Both are true, both are important, and each is a corrective for the other. It looks like Mankiw is on a roll.
But then there’s the explanatory text. Oy, the explanatory text.
It seems okay at first. Mankiw praises the invisible hand of the free market (as he should), and then explains, rightly, that we need government both to enforce “the rules and maintain the institutions that are key to a market economy” and because markets, left to themselves, don’t always work.
And when he explains two big reasons why markets break down (externalities and market power), he’s clear and correct.
SKIP THIS PARAGRAPH IF YOU UNDERSTAND THE ABOVE CONCEPTS. If you don’t: Externalities occur when people who don’t take part in a transaction are affected. So if Georgia Pacific decides that it wants $10 more than it wants a ream of printer paper, and I want a ream of paper more than I want $10, the transaction makes us both better off, and thus society is better off because its members are. It follows that if we leave people free to choose their own transactions, everyone will do what makes them well off, and the result will be the choices that are best for society. But if GP pollutes your air while it’s making my paper, you’re worse off and society is less well off (and possibly absolutely worse off) because you’re also a member. But you had no say in the deal. At that point, the outcomes can be improved if government, say, taxes pollution. Market power matters because a free market is regulated by competition (If I run a bar and sell watery beer for $40, you’ll open a bar and sell good beer for a good price and I’ll go out of business), and this regulation is preferable to government regulation in several ways (like, no bureaucrats to enforce it). But if a company has the power to avoid competition, like if Bank of America decides to raise its fees because screw you, then the argument against government regulation evaporates. At that point, the outcomes can be improved if government, say, breaks Bank of America into tiny little competitive pieces, like an ogre crushing bones into dust, while the shareholders scream in impotent outrage and . . .
Anyway. So far there’s nothing to object to. What’s the problem?
The problem is that as Mankiw continues, it becomes clear that his understanding of the economy is just plain crude. He really seems to believe that the economy actually is a textbook-perfect free market, with the occasional exception where government can step in (otherwise government has little to do except protect property and enforce contracts). That just ain’t the case.
First off, market failure isn’t some occasional exception. We live in a world of externalities, from the plastic bags in the Pacific to the hormones and antibiotics in our food to the slow-motion environmental horror we’re just starting to taste. And we live in an economy of big corporations, not little scrappy lemonade stands, and the big corporations are big because it gives them market power (and also because it’s easier for them to externalize their costs, from pollution to dead workers).
Second, while our governments don’t do what they should to prevent or fix these problems, they’re hardly afterthoughts in the economy. As the economist Robert Heilbroner put it, “the state, both as defender and promoter of the economic realm, has played so prominent a role that even the most abstract scenarios of the system unwittingly assign it a central and indispensable place when they take as their unit of conceptual analysis the state.”
It may seem like I’m being unfair. Surely Mankiw, a Harvard econ professor, doesn’t really think that the economy is a textbook free market, right?
But what else can we think when Mankiw says “taxes adversely affect the allocation of resources, for they distort prices and thus the decisions of households and firms”? That only makes sense if the economy — the one we actually live in — is so perfectly balanced that any change is a distortion. In reality, the economy is a messy place, already distorted from the textbook ideal (so much so that it’s just a different beast); there’s no reason that a given tax automatically distorts it more.
And what are we to think when he talks about “the great harm caused by policies that directly control prices,” without a single caveat? (Medicare uses price controls and, far from causing “great harm,” works better than private insurers, who often behave like a cartel).
Heck, what else are we supposed to think, five pages into the next chapter, when Mankiw diagrams the economy and doesn’t include government in the diagram? No taxes, no government spending, just households and firms.
Or when he explains how the collapse of the Soviet Union represented a victory of market economies (“where the decisions of a central planner are replaced by the decisions of millions of households and firms”) over centrally planned ones? Really the governments of the West were mixed economies, where planning (in the US including such Stalinist horrors as Social Security, Medicare, highways, zoning laws, building codes, product quality laws, sewers, restrictions on advertising, public health programs, air and water protections, schools, banking regulations, street cleaning etc. etc. etc.) coexisted with markets.
True, everyone was talking bollocks about the unqualified triumph of capitalism over communism after the Berlin Wall fell and the Soviet Union withered away. But since then:
- Russia listened to free-market economists, adopted straight-up market economies, and got economic collapse, oligarchy, and dictatorship (in that order)
- China (where the state, flawed and corrupt as it is, kept a firm hand on the economy) blossomed, despite starting from a much lower level than Russia
- The West changed its public-private mix to be less public and more private.
- We are now many years into a depression that free-market economists said was impossible.
But lines like “many countries that once had centrally planned economies have abandoned the system and are instead developing market economies” read like they haven’t been updated for more than 20 years.
My point is not that the idea that government should protect property, enforce contracts, step in when the market has clearly failed, and do very little else is wrong. I think it is, but that’s not the problem. The problem is that it’s a political point of view, not settled fact. Once again, Mankiw has dressed up a political agenda as neutral scholarship.
Grade: C. Maybe I’m being generous, but someone who just skims the principles themselves will learn something. But if they read the explanatory text to understand why these principles are true (as any good student should) they’ll get a worldview that seems frozen at the conventional wisdom of 1991.
Suggested replacement principles:
- Markets are usually a good way to organize economic activity.
- Well-designed policy can improve market outcomes, keep markets functioning, and replace failing markets.
- Government is inextricably woven into our economy on every level, for better or worse.
That’s all of “How people interact.” Although again, we’ve barely scratched the surface of how real people interact in the real world.
Tune in tomorrow (or soon after) as we start on the next section, “How the economy as a whole works.” And hooboy. Brace yourselves. It’s here.
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