Book review – ‘Economics Rules’ by Dani Rodrik

Dani Rodrik, an economist from Harvard, wrote ‘Economics rules’, a book on economics (2015). In his book, he tries to explain what economics is as a science and what it is not.

Mathematics, and sometimes difficult math, has become very important in economics, giving it a sense of an exact science. But Rodrik is  clear on this: economics is a social science, so it is not possible to come up with fundamental laws of economics, rules that are universally valid. 

In economics, one comes with a model (another term for an economic theory) that tries to describe a particular aspect of how society functions. A model is always a simplification of reality, otherwise it would be too complex and not very helpful to gain insights in this particular aspect. Simplifications are necessary, but can also be dangerous. One needs to be careful what simplifications are accepted and what are not. And, importantly, also accepting simplifications is context specific: in one context a simplification can be accepted, whereas it is not in another context. Therefore, a good economist will frequently answer “it depends on the specific situation”, when asked a general economic question. 

Another important advantage of models is clarity (or transparency). With a model, basically a set of mathematical equations, everything is clearly spelled out. Misinterpretations and moving the goalposts when defending your model is not possible. Using models also helps to think clearly and logically about the problem at stake, not only with others but also for yourself.

In my opinion, the main message of the book, however, is that economics is not a science that builds on previous research to refine the former research. So, it is not like physics where, for example, Newton came up with some universal rules which were refined centuries later by Einstein (so the new refined rules also hold for objects traveling at very high speeds, which was not the case with Newton’s laws). In economics, Rodrik explains, one doesn’t build vertically (like in physics), but horizontally, adding new models to give answers on new questions or on the same questions in a different context. Seldomly, a model is being dismissed. An example that Rodrik gives here, and that I also remember from following Paul Krugman’s blog after the financial crisis in 2008-2009, is the use of an old Keynesian model (IS-LM) to describe what was happening after the financial crisis. This macroeconomic model was much simpler than the complex models used by central banks, but was pretty adequate in forecasting the absence of inflation even though there was a relatively large stimulus being done. The old Keynsian model was not intrinsically better than the new and more complex ones, but it was better in this context. Good economics depends highly on the choice of the richt model for the specific context.

Economics as a science that adds models to explore and explain ever more aspects of society (or in different situations) also has its importance when designing and regulating markets, something governments and other public agencies do all the time. Rodrik refers to Jean Tirole, a Nobel-winning economist, who said that market regulation and design is industry-specific. Also here, it depends. Context is everything.

So, politicians should know this, and maybe they do, but they often miss to apply this wisdom. Probably this is because “it depends” is a humble and nuanced message. And with such a message, it is diffecult to incite your tribe or convince a disinterested public.

Rodrik provides a good lesson to economists to be more humble, but also to appreciate the power of economic science. A good economist has learned to think clearly and thoroughly, with the help of mathematics, about complex problems that are important for society. It reminded me of this quote by Ben Bernanke in 2013: 

Economics is a highly sophisticated field of thought that is superb at explaining to policymakers precisely why the choices they made in the past were wrong. About the future, not so much. However, careful economic analysis does have one important benefit, which is that it can help kill ideas that are completely logically inconsistent or wildly at variance with the data. This insight covers at least 90 percent of proposed economic policies.”

Don’t penalize people advocating for one kind of policy

In ‘Who Really Cares About the Poor?: A Socratic Dialogue’, Bryan Caplan, an American economist, let two characters, Glaucon and Socrates, discuss a public policy to help the poor.

Glaucon, a left-wing politician, wants to increase money transfers to the poor, paid by taxes, but was blocked by the right-wing majority. Glaucon complains about those uncaring right-wing politicians and claims that they are only voting for their self-interest.

But Socrates argues that it could well be possible that right-wing politicians just don’t believe the lift-wing policy would actually work. Maybe their opposition is genuine and not about their self-interest.

Moreover, Socrates argues that if Glaucon is sincere about the effectiveness of his proposed policy, Glaucon can still help the poor by giving away his own money to the poor. Surely, Socrates argues, it won’t cure poverty, but it will help at least some poor families.

This reasoning set out by Caplan is a classic argument against people wanting
a policy that needs extra taxes: why don’t they pay more taxes themselves? It was exactly the same argument against Warren Buffett when he said the US needs higher taxes on income from capital gains (the so-called Buffett rule): he could already do it himself.

Will Wilkinson argued against this kind of reasoning, referring to the fact we face a collective action problem: one individual giving extra money will not solve anything.

I think there is an additional argument against the reasoning of Caplan. If Caplan’s reasoning would be followed, then no one could advocate for a policy which increases taxes, without paying more taxes herself. This would impose an individual penalty on those advocating for higher taxes. Consequently, this would decrease the probability one would advocate for this kind of policies, whether the policy is good or bad.

A more striking example is the following: in Belgium, newspapers receive a lot of subsidies for physically distributing newspapers (about 400 million euro’s for a country of 11 million people, each year). Assume a newspaper is against these kind of subsidies, because they think there is no market failure that justifies the subsidy. Stopping these subsidies and, for example, lowering taxes on wages would be a much more efficient outcome.

Following Caplan’s reasoning, this newspaper could not accept the subsidies, because not accepting the subsidies would lead to lower unjustified subsidies. This would lead to lower taxes on wages, increasing overall welfare.

But not receiving those subsidies would lead to a much more expensive home-delivered newspaper compared to their competitors, putting themselves at a disadvantage. In a competitive environment, they would certainly lose market share or even go bankrupt. So following Caplan’s reasoning, not accepting subsidies would lead to fewer papers being sold that advocate for lower subsidies.

[You could also see this differently: the newspaper argues for a world where not one newspaper receives subsidies. They do not argue for a world where everybody is receiving subsidies, except one. To stretch the argument a bit: the true rational individual, but selfish position would be to argue for subsidies for oneself and for no one else. But knowing that this is never to be accepted, the second best is that no one receives subsidies.]

The goal should be to create an environment where the debate on policy is on the policy itself. For that to succeed, two conditions should be met:

  1. One point Caplan makes clear in his dialogue, is that you should not accuse political opponents of being morally inferior. Let us assume that in all political parties there will be more or less the same share of politicians who just want to make the world a better place for everybody. They just differ in the way to accomplish this.

  2. Don’t penalize people advocating for one kind of policy, because it creates a disadvantage for advocating that policy. For example, you cannot set a penalty on those wanting to increase taxes, because that would lead to less people willing to advocate for higher taxes, even though this could be the right policy.

To conclude, the political battle field should be: will your policy work the way you say? And what is your theoretical and empirical evidence to support your claim? Questions on the personal reasons why someone is arguing for a specific policy is an argument ad hominem, hindering an honest debate.