Errors in Economics and Their Consequences

William J. Baumol Errors in Economics and Their Consequences “ IF ALL ECONOMISTS WERE LAID END TO END, THEY WOULD NOT REACH a conclusion” is a standard witticism about my discipline and one that relates to two made in this paper. First, the witticism itself it simply wrong—a problem that is more characteristic of the field is not exces­ sive disagreement, but its opposite: the propensity ofits practitioners to agree too much. One need merely look at the standard economics texts, the subjects they encompass, the tools they utilize to analyze those subjects, and the conclusions they derive to recognize that there are no profound differences in analytic approaches. Of course, economists do disagree, sometimes passionately, primarily because their varied politi­ cal orientations, which are patently not derived from economic analy­ sis (nor are they claimed to be so derived) do frequently lead them to differ sharply in their recommendations. But that is, evidently, a very different m atter from incompatible analysis. Second, the jest can be interpreted to imply that because econo­ mists allegedly so often disagree, at least some ofthem must frequently be wrong. Of course, I can hardly deny my own errors or those of my colleagues. Indeed, I will offer a number of illustrations in the text that follows. But economists are hardly the only source of economic errors. My discipline is particularly vulnerable to mistaken ideas contributed from the outside. Unfortunately, unlike fields such as physics, economics is a subject on which even the most ill-informed of individuals are apt to feel themselves qualified to make authoritative pronouncements. social research Vol 72 : No 1 : Spring 2005 169 After all, eveiyone participates in the economy in one way or another. Moreover, where widespread misconceptions passionately held are the result, democratic government can be forced to act in accord with them. Politicians, too, frequently just assume that they understand the work­ ings of complex but common economic phenomena, and have been content to proceed to their conclusions with little evidence or analysis. In this paper, I will deal with a variety of illustrative errors, focus­ ing among others on two that are critical for policy: the notion that a budget deficit constitutes a burden for our grandchildren, and the idea that rising costs of health care and education mean that society will be increasingly incapable of financing them and that cutbacks in both of these vital services are therefore unavoidable. ECONOMIC ERRORS THAT DAMAGE THE INDIVIDUAL Sometimes it is the individual committing an economic error who alone bears the cost. An example is the investor who seeks out and follows financial analysts’advice on the purchase and sale ofstocks, despite over­ whelming statistical evidence demonstrating that, even if such advice were offered without cost, it would generally be valueless or worse. Professional recommendations on stock market purchases and sales have repeatedly been shown to be totally unreliable. Indeed, they must be so because, as the data demonstrate, the behavior of securities prices approximate what statisticians call a “random walk.” Random behavior is, by definition, inherently unpredictable even by the best-informed and most intelligent analyst. But stock market analysts’advice is even worse than this for the investor, on two scores. First, it is not costless. The inves­ tor is forced to pay for bad information and is thereby put in the posi­ tion of a bettor in a gambling casino, where the outcomes are not just random but are systematically biased to bring a predictable rake-off to the gambling house. Second, whether or not as a deliberate dereliction of duty, frequent sales and purchases of securities that benefit the stock market analysts’own firms are characteristic oftheir recommendations. These transactions multiply the investor’s total payments to these firms and, incidentally, materially increase the investor’s tax bill. 170 social research DAMAGE TO THE SOCIETY: THE CASE OF MISTAKEN COUNTERCYCLICAL POLICY As the next illustration will show, economic errors can burden many beside the individuals who make the mistake, and sometimes even soci­ ety as a whole. A notable example was the belief that an essential step in extracting an economy from recession or depression is elimination of deficit spending by the government. While...