Richard Posner’s Economics

A review of a book that explains capitalism via psychology.

What happens in a depression, and makes it a psychological event as well as an economic and political one, is that the economic environment becomes so uncertain that people freeze.

The review is worth reading because the reviewer is the brilliant Richard Posner. He simplifies the dismal science as he confronts the arguments of the book. It is a lesson in the dismal science that is not itself dismal reading.

The idea that monetary policy–raising interest rates (and therefore reducing the amount of money in circulation, because interest is the price of putting money into circulation rather than hoarding it) to check inflation, and lowering interest rates to check economic downturns–holds the key to moderating the business cycle, and therefore to preventing depressions as well as inflations, has been falsified.

The above is Keynesian economics. A product of a liberal approach to the economy.

Posner says,

Many influential economists came to oppose deficit spending on public projects, which injects the government deep into the economy and creates a risk of inflation and high taxes in the future. Increasingly economists favored the monetarist approach, championed most famously by Milton Friedman, which teaches that the proper management of the money supply is all that is needed to avert depressions, and that it can do so painlessly.

The book under review seeks to,

…marry Keynes to “behavioral economics” and offer the resulting union as a replacement for conventional monetarist economics…

The crucial point about the book is that it, “… rejects the “rational man” model of conventional economic theory in favor of what its proponents consider a more realistic picture of human motivations and capacities. Akerlof and Shiller believe that if people were rational, there would be no depressions; but there are depressions, and so the rational model must be inadequate.”

The takeaway:

As one reads this book, one has the sense that deep down Akerlof and Shiller believe that being rational is the same as being right. That is a mistake. It prevents them from entertaining the possibility that what has now plunged the world into depression is a cascade of mistakes by rational businessmen, government officials, academic economists, consumers, and homebuyers, operating in an unexpectedly fragile economic environment…

Reason doesn’t know everything there is to know – it just thinks it does.

The complexity of a modern economy has defeated efforts to create mathematical models that would enable depressions to be predicted and would provide guidance on how to prevent them or, failing that, to recover from them. The insights of behavioral economics have not done the trick, either.

Desperately seeking answers.