ECONOMICS An A–Z guide MATTHEW BISHOP, a senior editor at The Economist Group, is an award-winning journalist and longtime writer. His roles at The Economist, which he joined as economics correspondent, have included business editor, Wall Street editor, globalisation editor and New York bureau chief. He is the author of several books, including Philanthrocapitalism: How Giving Can Save the World (described as “important” by President Bill Clinton) and The Road from Ruin, which set out an agenda for the reform of capitalism after the 2008 crash. He is a member of the World Economic Forum’s Global Agenda Council on Global Governance. He was the official report author of the Taskforce on Social Impact Investment established by the governments of the G8, and a member of the Advisors Group of the UN International Year of Microcredit. He co-founded and advises the #givingtuesday campaign and the Social Progress Index. He is on Twitter as @mattbish. THE ECONOMIST IN ASSOCIATION WITH PROFILE BOOKS LTD. AND PUBLICAFFAIRS Copyright © Matthew Bishop 2003, 2009, 2016 First published in 2003 by Profile Books Ltd. in Great Britain. Published in 2016 in the United States by PublicAffairs™, an imprint of Perseus Books, a division of PBG Publishing, LLC, a subsidiary of Hachette Book Group, Inc. All rights reserved. Printed in the United States of America. No part of this book may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of both the copyright owner and the publisher of this book, except in the case of brief quotations embodied in critical articles and reviews. For information, address PublicAffairs, 250 West 57th Street, 15th Floor, New York, NY 10107. The greatest care has been taken in compiling this book. 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Library of Congress Control Number: 2016937558 ISBN 978-1-61039-656-1 (PB orig) ISBN 978-1-61039-657-8 (EB) First Edition 10 9 8 7 6 5 4 3 2 1 Contents Introduction Why economics matters more than ever Rethinking macroeconomics The new microeconomics Economics with a purpose About this book A–Z Introduction Why economics matters more than ever There has never been a more exciting time for economics. Although economists themselves may be more unpopular than usual, especially those whose ideas helped bring about the financial crash of 2008 and the Great Recession that followed it, more than ever they are being turned to for insights and answers to the big questions affecting every aspect of life, including the sustainability of our planet. In this time of widespread questioning about where society is heading, and of vast and rapid change, if you want to know what is really going on, and what needs to be done, it is essential to have a working understanding of economics. Hence this book, written in the spirit of The Economist with the goal of bringing the intelligent non-economist up to speed. Let’s start with the most basic question: What is economics? “Economics is what economists do,” said Jacob Viner, a leading 20th-century economist, not very helpfully. Former US president Ronald Reagan described economists as unworldly “people, who see something work in practice and wonder if it would work in theory”. More usefully, the authors of Freakonomics note that economics, at its root, is “the study of incentives: how people get what they want, or need, especially when other people want or need the same thing”. Their recognition that people are often competing for the same things points to what is probably the best definition of economics: “the study of how society uses its scarce resources” or, more snappily, “the science of choices”. Without scarcity – of land, labour, raw materials, capital, entrepreneurial spirit, time – there would be no need to make choices about how to use those things to greatest effect, and thus no need for economics. At its best, economics helps people, individually and collectively, to make the right choices and it shows them the most efficient way to use scarce resources in the process of achieving their goals. Three aspects of economics are especially exciting today, because each of them urgently demands fresh thinking from the brightest minds in the profession. The first is macroeconomics – how best to manage an entire economy. The severity of the crash and the depth of the Great Recession came as a big surprise to most mainstream economists, though a few had given warning of impending dangers. In most countries the pace of economic recovery has been unexpectedly slow, too, surprising a conventional economic wisdom that had predicted a typical, relatively quick economic rebound. The second, following from a revolution in microeconomics based on combining traditional economics with a more realistic model of human behaviour, focuses on generating new ways to improve how people live their daily lives. This includes developing innovative business models (such as the mobile-phone apps developed by Uber and Airbnb) and improving how government works by using so-called nudges to encourage people to behave in their (and society’s) best interests in circumstances where they would otherwise make suboptimal choices. Third, the severity of the Great Recession and the growing threat of climate change, among other things, have inspired an increasingly urgent debate about the relationship between economics and social, organisational and personal purpose. If trying to maximise GDP growth simply results in people taking on more debt than they can afford, leaving them vulnerable in an economic downturn, and doing things that threaten the sustainability of our environment, shouldn’t we be using better goals to guide our economy, such as the Social Progress Index or Bhutan-style gross national happiness? Rethinking macroeconomics Macroeconomic debate is livelier today than at any time since the combination of free market laissez-faire economics and Milton Friedman’s monetarism replaced the big-government, free-spending, Keynesian orthodoxy in the late 1970s/early 1980s. The crash of 2008 and subsequent Great Recession destroyed the credibility of claims that the economy had entered a new phase of Great Moderation, with permanently low rates of inflation and unemployment. The battle is on to develop a new paradigm for macroeconomic policy. The need is urgent, especially as populist solutions touted by politicians with little grounding in the economic realities of scarcity are catching on among frustrated electorates wanting answers to today’s economic problems that do not require them to make hard choices. The crash of 2008 and the subsequent Great Recession highlighted serious flaws in the previous macroeconomic conventional wisdom. Central banks and Treasury departments, the powerhouses of macroeconomic policymaking, stuffed to the gills with economists, largely failed to spot the crash coming and underestimated the damage it would do beyond the financial sector to the rest of the economy. (Economists in the private sector hardly did better, with the exception of the occasional economic Doctor Doom who predicted macroeconomic apocalypse.) They bought into the notion of the Great Moderation. They were also reassured that the financial system was capable of managing an ever greater amount of debt thanks to its adoption of risk- management systems based on cutting-edge financial economic theories. What followed was an unprecedented meltdown in the financial system after the collapse of Lehman Brothers, an investment bank, and the deepest recession in the world economy since the Great Depression in the 1930s. Mainstream economists do deserve at least one cheer for helping governments to learn the most important lesson from the Great Depression: that they needed urgently to shore up the financial system and provide some fiscal stimulus to avoid Great Depression 2.0. Even so, there was (and remains) considerable disagreement among economists about what caused the crisis and what the appropriate policy response to it should be. (That said, when do economists ever all agree? George Bernard Shaw, an Irish playwright, famously joked that, “If all the economists were laid end to end, they would never reach a conclusion.”) Some economists argued that the best post-crash macroeconomic policy, at least in countries with high ratios of public-sector debt to GDP, was the austerity slashing of government spending and borrowing. With interest rates already close to zero in nominal terms, some central banks tried to strengthen the financial system and thus the economy by buying debt from the banks, a policy known as quantitative easing. Though this seemed to have a positive impact, at least in the short run, first in the US and later in the euro zone, its likely long-term consequences remain a topic of fierce debate among economists. Shockingly to many, brought up in a world where inflation was viewed as the biggest economic threat, the Great Recession has led to a renewed focus on the considerable dangers of falling prices, deflation and how to prevent it. The crash and Great Recession also worsened some pre-existing global macroeconomic faultlines. The European Union’s efforts to establish a new currency, the euro, for most of its member countries was always going to be tough, even before its financial system was devastated by a post-crash sovereign debt crisis and much of the euro-zone economy stopped growing. In the US, the dollar had only become established as a national single currency after a bloody civil war; in Europe, the euro was launched before the EU had agreed how to deal with some of the thornier economic and political consequences of monetary