Good Economics for Hard Times

Good Economics for Hard Times Plot Summary

Introduction

Economic debates often center on deeply entrenched myths that persist despite contradicting empirical evidence. These myths shape policy decisions with profound consequences for society, yet they remain resistant to correction even when experts present clear evidence to the contrary. The gap between economic theory and public perception has widened dramatically, with trust in economists falling below that accorded to weather forecasters. This disconnect manifests in systematic differences between professional economic consensus and public opinion on issues ranging from immigration benefits to trade policy, creating dangerous blind spots in public discourse about critical policy issues. This exploration challenges conventional economic wisdom by examining how resources move much more slowly than traditional models assume, how social context powerfully shapes preferences and behavior, and how economic policies that ignore distributional impacts or community ties often generate backlash. By placing human dignity at the center of economic analysis, we can develop approaches that acknowledge people's needs for meaningful work, community belonging, and environmental sustainability alongside material consumption. This perspective does not diminish the importance of economic analysis but enriches it by incorporating insights from psychology, sociology, and political science to create a more holistic understanding of economic challenges.

Chapter 1: The Sticky Economy: Why Markets Fail to Optimize Resources

Traditional economic theory suggests that markets efficiently allocate resources, with people and capital flowing seamlessly to their most productive uses. This elegant theory, however, collides with a messier reality that economists call "the sticky economy." In practice, resources often remain stuck in suboptimal arrangements, creating persistent inefficiencies that markets fail to correct. The evidence for this stickiness appears across multiple domains. When factories close due to international competition, workers frequently don't relocate to areas with better opportunities. Instead, they remain in declining regions, facing prolonged unemployment or accepting lower wages. This pattern emerged clearly during the "China shock" of the 1990s and 2000s, when increased Chinese imports led to manufacturing job losses in specific American communities. Contrary to economic models predicting smooth transitions, these communities experienced lasting economic damage, with depressed wages and employment rates persisting for over a decade. Housing markets demonstrate similar stickiness. Despite substantial regional differences in housing costs and economic opportunities, Americans' geographic mobility has declined by nearly 50% since the 1980s. This decline affects all demographic groups and appears unrelated to aging populations or homeownership rates. The explanation likely involves complex social factors—people value proximity to family and established community networks, making relocation psychologically costly even when economically beneficial. Labor markets exhibit stickiness through wage rigidity. During recessions, companies typically lay off workers rather than reducing wages across the board. This pattern defies standard economic logic, which suggests wage reductions would preserve jobs. Yet psychological research reveals why: workers strongly resist nominal wage cuts, viewing them as violations of implicit contracts. Employers understand this resistance and prefer layoffs to the morale damage and productivity losses that wage cuts would trigger. Financial markets also demonstrate stickiness through credit constraints. Even when interest rates fall, many businesses and households cannot access cheaper credit due to information asymmetries and institutional barriers. Small businesses particularly struggle to obtain financing during downturns, precisely when they most need it. This credit stickiness amplifies economic cycles and prevents efficient resource allocation. The sticky economy challenges fundamental assumptions about market efficiency and suggests a more nuanced approach to economic policy. Rather than assuming markets will automatically correct imbalances, effective policies must acknowledge and address the frictions that keep resources stuck in suboptimal arrangements.

Chapter 2: Identity Economics: How Social Context Shapes Economic Choices

Standard economic models treat preferences as fixed, stable attributes that individuals bring to every decision. This assumption provides analytical clarity but misses a crucial reality: our preferences are profoundly shaped by social context and are often inconsistent or malleable. Understanding how preferences form and change is essential for designing effective economic policies. Social influences on preferences begin with discrimination. Field experiments consistently reveal discrimination across various markets. Job applicants with identical qualifications receive significantly different callback rates based solely on names that signal race or ethnicity. This discrimination takes multiple forms. "Taste-based" discrimination reflects personal prejudice, while "statistical discrimination" occurs when people use group characteristics to make judgments about individuals. The latter explains why "ban the box" policies, which prevent employers from asking about criminal records on initial applications, can paradoxically increase racial discrimination—employers denied specific information resort to racial stereotypes instead. Even more troubling is self-discrimination, where individuals internalize negative stereotypes about their own group. Claude Steele's research on "stereotype threat" demonstrates how awareness of negative stereotypes can undermine performance. Black students performed worse on tests described as measuring intellectual ability, but equally well when the same test was framed as a problem-solving exercise. Similar effects appear with women in mathematics and white males when compared to Asian students. These effects create self-reinforcing cycles—people perform differently when reminded of their group identity, which reinforces stereotypes. Group identity profoundly shapes preferences in ways that can override individual interests. In experiments with Princeton undergraduates playing golf, performance varied dramatically based on whether race was made salient before the activity. When race wasn't mentioned, black and white students performed similarly. When race was highlighted, performance diverged along stereotypical lines—blacks performed worse when golf was framed as testing "sports intelligence" but better when testing "natural athletic ability." These effects appeared at Princeton University, hardly a bastion of explicit racism. Social context also influences economic preferences through network effects. People avoid those they are suspicious of and move to neighborhoods with similar demographics. This segregation affects life chances and perpetuates inequality. Children growing up in segregated neighborhoods receive different resources and opportunities, creating lasting impacts on economic mobility. Experiments with Hispanic high school students revealed they were less likely to sign up for SAT preparation when their choice might become public, fearing accusations of "acting white." The malleability of preferences extends to moral behavior. Bankers primed to think about their professional identity were more likely to cheat in experimental settings than when thinking about their personal lives. This suggests context activates different aspects of identity with different moral standards. People maintain multiple "preference sets" activated by different situations, making their economic choices highly dependent on social framing.

Chapter 3: Growth Realities: Myths and Truths About Economic Development

Economic growth has dominated policy discussions for decades, with political leaders measuring success by GDP expansion. This obsession intensified after 1973, when the extraordinary post-war growth in Western economies suddenly slowed. What caused this slowdown, and can growth return to its previous pace? The answers challenge many common assumptions about economic development. The post-war economic boom (1945-1973) represented an unprecedented period of prosperity. In the United States, GDP per person grew at 2.5% annually, allowing living standards to double every 28 years. Western Europe experienced even faster growth at 3.8% annually. This expansion was driven by rapid productivity improvements as workers became more educated and gained access to better machines and technologies. Most remarkably, total factor productivity—the efficiency with which inputs are combined—grew four times faster between 1920-1970 than in previous periods. This growth transformed daily life. The average person ate better, enjoyed more comfortable housing, consumed a greater variety of goods, and lived longer. Work weeks shortened by twenty hours, and child labor virtually disappeared in Western countries. But in 1973, coinciding with the OPEC oil embargo, growth suddenly decelerated. Despite temporary improvements in the late 1990s, productivity growth has remained significantly below its previous pace. This persistent slowdown has sparked debate among economists. Robert Gordon argues the exceptional growth of 1920-1970 represented a one-time transition that cannot be repeated. Today's innovations, he contends, simply aren't as transformative as electricity or internal combustion engines. Joel Mokyr counters that current technologies like genetic engineering and artificial intelligence will eventually drive another growth surge. Both perspectives contain insights, but history suggests predicting growth is perilous—economists have consistently failed at this task. The evidence indicates sustained growth is historically unusual. Before 1820, annual GDP growth per capita averaged just 0.14% over centuries. The 150 years of faster growth between 1820-1970 were exceptional, not normal. If Gordon is right and growth settles around 0.8% annually, we would simply be returning to historical averages. This doesn't mean faster growth cannot return, but we should recognize its historical rarity. Growth discussions often overlook measurement problems. GDP counts only marketed goods and services, missing crucial aspects of well-being. When a person takes time off work to enjoy leisure, GDP falls even though welfare rises. Some economists argue that digital technologies create substantial unmeasured value through free services like social media. However, experiments suggest these technologies may contribute less to well-being than their advocates claim. When randomly assigned to deactivate Facebook for a month, users reported being happier, not more bored, and subsequently reduced their usage.

Chapter 4: Migration and Trade: Balancing Benefits with Localized Costs

The consensus among economists about free trade's benefits stands in stark contrast to public skepticism. When asked whether tariffs on steel and aluminum would improve American welfare, every economist on the IGM Booth panel disagreed, while public opinion remained deeply divided. This disconnect reflects a fundamental reality: while economists focus on trade's aggregate benefits, the public sees both gains and pains, with many believing the costs outweigh the benefits for vulnerable workers. Trade theory, dating back to David Ricardo's concept of comparative advantage, suggests that countries should specialize in what they do relatively best, increasing total income everywhere. The Stolper-Samuelson theorem further predicts that in poor countries, trade should help workers and reduce inequality, while in rich countries, inequality might increase. However, empirical evidence often contradicts these predictions. When developing countries like Mexico, Colombia, Brazil, India, and China opened to trade, inequality increased rather than decreased, contrary to theoretical expectations. The disconnect between theory and reality stems largely from the "sticky economy" - resources don't move smoothly in response to market signals as traditional models assume. When Indian districts faced different levels of exposure to trade liberalization after 1991, those more affected by liberalization experienced slower poverty reduction. Workers rarely migrated from affected areas, and firms were slow to reallocate resources or discontinue unprofitable product lines. This stickiness means trade shocks create concentrated pockets of suffering rather than economy-wide adjustments. Migration debates similarly reveal the limitations of standard economic models. Despite enormous potential gains—migrants can triple or even sextuple their incomes by moving to wealthier countries—global migration rates remain surprisingly stable at around 3% of world population. The puzzle is not why so many people migrate but why so few do, given the potential benefits. The answer lies partly in psychological factors like loss aversion and fear of failure. Moving represents an active choice with potential for regret, which many find more painful than passive acceptance of current circumstances. For both trade and migration, the distributional effects matter enormously. The "China shock" that hit American manufacturing between 1991 and 2013 demonstrates how trade can create concentrated pockets of suffering. Regions producing goods that competed directly with Chinese imports experienced substantial manufacturing job losses without compensating gains in other sectors. Despite neighboring regions remaining relatively unaffected, workers didn't move. The clustering of industries exacerbated these problems—when a dominant industry in a region collapsed, it triggered downward spirals affecting local businesses, housing values, and public services. Addressing these challenges requires policies that acknowledge both the aggregate benefits of economic integration and its localized costs. Rather than protectionist tariffs, which create new losers without helping existing ones, better solutions would include expanded adjustment assistance, subsidies for firms employing older workers in affected regions, and policies that address both mobility barriers and the dignity of those who cannot or will not move.

Chapter 5: Inequality Origins: Policy Choices, Not Technological Inevitability

The dramatic rise in inequality since 1980 is often portrayed as an inevitable consequence of technological change and globalization. A closer examination reveals a different story: deliberate policy choices, particularly in the United States and United Kingdom, fundamentally altered the social contract and concentrated economic gains among the already wealthy. The timing is striking. In both the US and UK, the share of income going to the richest 1% reversed decades of decline precisely when Reagan and Thatcher took office. In the US, the top 1% captured about 9% of national income in 1979; by 2017, this had risen to nearly 24%, approaching levels last seen in 1928. Meanwhile, wages for the bottom 90% stagnated. For American workers without college degrees, real earnings in 2018 were 10-20% below their 1980 levels. This pattern differs markedly from continental Europe, where pre-tax inequality remained relatively stable despite similar technological changes and trade exposure. Technological change certainly played a role. Computerization eliminated many middle-skill jobs while increasing demand for highly educated workers. However, technology alone cannot explain why inequality rose so much more in Anglo-Saxon countries or why gains concentrated so dramatically at the very top. Those making between $100,000-200,000 annually saw only modest income growth, while those earning over $500,000 experienced explosive gains. This pattern suggests policy choices, not just market forces, drove inequality. Financial deregulation contributed significantly to top-end inequality. Financial sector employees now earn 50-60% more than workers with comparable skills, a premium that didn't exist before 1980. In the UK, finance professionals represented just one-fifth of the top 1% but captured 60% of the earnings growth within this group between 1998-2007. Much of this premium represents economic rents—rewards not for productivity but for positional advantage. This distorts talent allocation, drawing brilliant minds away from potentially more socially valuable pursuits. Corporate governance changes further concentrated income. CEO compensation increasingly linked to stock prices disconnected executive pay from internal wage scales. When everyone was on the same scale, CEOs had incentives to raise wages at the bottom to increase their own. With stock options, they gained incentives to suppress wages to boost short-term profits. Compensation committees using "peer benchmarking" created an upward spiral in executive pay, with finance sector salaries infecting other industries. Tax policy accelerated these trends. Top marginal tax rates fell from above 70% to around 40% in both countries. When tax rates were high, firms had little incentive to pay astronomical salaries since most would go to the government. Lower rates made ultra-high compensation attractive again. Countries that maintained higher top tax rates, like Germany and France, experienced much smaller increases in inequality. Importantly, research finds no evidence that high earners work less when tax rates increase—the primary economic argument against progressive taxation.

Chapter 6: Welfare Reimagined: Balancing Material Support with Human Dignity

Welfare policy debates often present a false dichotomy: either provide cash with no strings attached or impose strict conditions that risk humiliating recipients. This framing misses a crucial insight—effective social policy must balance material support with preserving dignity. Understanding this tension can transform how we approach poverty alleviation. Universal Basic Income (UBI) has gained prominence as an elegant welfare solution. By providing everyone a guaranteed income without conditions, UBI promises to eliminate poverty while avoiding bureaucratic intrusion. Economists from Milton Friedman to contemporary progressives have endorsed versions of this approach, arguing people know their own needs better than governments. UBI would eliminate costly screening and monitoring, which consume significant resources in traditional welfare programs—in Mexico, 34% of administrative costs go to identifying beneficiaries and 25% to monitoring compliance with conditions. Complex eligibility requirements create substantial barriers to accessing existing benefits. In Delhi, two-thirds of eligible widows don't receive pensions they're entitled to because of complicated application procedures. Experiments show that simply helping people navigate bureaucracy dramatically increases participation. In the US, automatic enrollment in free school lunch programs brought benefits to millions of additional children who were already eligible but hadn't applied. These barriers disproportionately affect the most vulnerable, precisely those welfare programs aim to help. However, UBI faces two significant challenges. First, truly universal programs are prohibitively expensive. A $1,000 monthly payment to all Americans would cost approximately $3.9 trillion annually—roughly equivalent to the entire federal budget. More targeted approaches become necessary, reintroducing the complexities UBI aims to eliminate. Second, many people, including potential recipients, worry unconditional cash would encourage dependency or wasteful spending. These concerns persist despite overwhelming evidence to the contrary. Across 119 developing countries with unconditional cash assistance programs, recipients consistently increase spending on food, education, and healthcare rather than alcohol or tobacco. Multiple experiments, from the 1970s Negative Income Tax trials to Alaska's Permanent Fund, find minimal reductions in work effort. The evidence consistently shows that poor people use cash transfers productively and continue working. The most promising approach may combine elements of different models. A modest universal ultra-basic income (UUBI) could provide a safety net accessible to anyone in need, while larger targeted transfers support the most vulnerable. Evidence from Morocco suggests that "labeled" transfers—presented as support for specific goals like education but without strict enforcement—can be as effective as conditional programs while avoiding exclusion of struggling families. This approach acknowledges that most people want to improve their lives but may need different types of support. Long-term evidence from Indonesia's PKH program, a conditional cash transfer operating since 2007, shows lasting positive effects on health and education outcomes. Children in participating villages experienced 23% less stunting and higher school completion rates. However, households weren't measurably richer despite these human capital gains, suggesting financial transfers alone may be insufficient for economic transformation.

Chapter 7: Rebuilding Trust: The Foundation for Effective Economic Policy

The erosion of trust in government represents perhaps the greatest obstacle to addressing today's economic challenges. Across developed and developing countries, citizens increasingly view government as incompetent, corrupt, or captured by special interests. Rebuilding this trust requires understanding its causes and implementing reforms that demonstrate government can effectively serve the public interest. Skepticism toward government intervention has deep historical roots but intensified during the Reagan-Thatcher era. Reagan's famous declaration that "government is not the solution to our problem, government IS the problem" reflected and reinforced a fundamental shift in public attitudes. By 2015, only 23% of Americans trusted the government "always" or "most of the time," with 59% holding negative opinions. This distrust creates a paralyzing cycle—citizens resist funding government programs they believe will be ineffective, which ensures insufficient resources for success, confirming initial skepticism. The perception of government waste and corruption drives much of this distrust. Economists have contributed to this narrative by emphasizing government failures without acknowledging comparable inefficiencies in private markets. The reality is more nuanced. Government exists partly to address problems markets cannot solve—natural disasters, healthcare for the indigent, industrial decline—making comparisons difficult. Studies from countries like India, Indonesia, and Uganda show that administrative reforms can significantly improve government effectiveness, but simple formulas like privatization rarely work. Transparency initiatives, while valuable, can create perverse incentives. When officials fear accusations of corruption, they may prioritize following procedures over achieving results. In Italy, a centralized procurement system created to prevent corruption ended up costing the government more for identical products because officials chose the officially sanctioned option rather than seeking better deals. Similarly, excessive procurement regulations in the United States discourage innovative firms from bidding on government contracts, leaving agencies dependent on specialized contractors skilled at navigating bureaucracy rather than delivering quality services. The portrayal of government officials as incompetent or corrupt creates a self-fulfilling prophecy by affecting who chooses public service. In the United States, talented graduates rarely consider government careers, creating a selection problem that reinforces negative stereotypes. Experiments in India found that students planning government careers were more likely to cheat in experimental settings, while the opposite pattern appeared in Denmark, where public service carries prestige. These contrasting results suggest institutional culture shapes who enters government and how they behave. Rebuilding trust requires demonstrating government can effectively address citizens' concerns. Latin American countries achieved this through conditional cash transfer programs that delivered measurable improvements in poverty and child welfare. By emphasizing reciprocity and subjecting programs to rigorous evaluation, they built political support across ideological lines. Mexico's Progresa program survived multiple changes in government because its effectiveness was transparently demonstrated. Tax policy represents another crucial dimension of government legitimacy. The United States collects just 27% of GDP in tax revenue, seven points below the OECD average. Even if taxes on the ultra-wealthy increased substantially, meaningful expansion of public services would require broader tax increases. The challenge is convincing citizens that higher taxes will translate to better services rather than waste. Switzerland's experience suggests this is possible—when citizens see tangible benefits from public spending, they accept higher taxation.

Summary

The fundamental insight emerging from this analysis is that effective economic policy must transcend traditional models that assume frictionless markets, fixed preferences, and purely material motivations. The evidence consistently shows that resources move much more slowly than standard theories predict, that preferences are profoundly shaped by social context, and that people value dignity and meaning alongside material consumption. These realities challenge both market fundamentalism and simplistic redistributive approaches, pointing toward more nuanced policies that acknowledge the complex interplay between economic systems and human psychology. Moving beyond economic myths requires placing human dignity at the center of policy design. This means recognizing that work provides not just income but identity and purpose, that communities offer value beyond economic efficiency, and that effective welfare programs must balance material support with opportunities for meaningful contribution. It also means acknowledging that inequality stems not from inevitable technological forces but from specific policy choices that can be reversed. By integrating insights from psychology, sociology, and political science with economic analysis, we can develop approaches that promote both prosperity and human flourishing, rebuilding trust between citizens and the institutions meant to serve them.

About Author

Loading...

Abhijit V. Banerjee

Read more