Naked Economics: Undressing the Dismal Science pdfdrive com

Yet all nine white candidates go away angry, feeling that they have been
discriminated against. Loury is not necessarily a foe of affirmative action. He
merely adds nuance to a discussion that usually has none. Affirmative action can
harm the very race relations that it seeks to heal.
Or consider the periodic campaign to mandate that insurance companies cover
the cost of two nights in the hospital for women who have delivered babies,
rather than just one. President Bill Clinton found this issue sufficiently important
that he vowed in his 1998 State of the Union address to end “drive-by
deliveries.” But there is a cost to such a plan that should be made explicit. An
extra night in the hospital is not medically necessary in most cases, but it is
expensive, which is why new parents don’t pay for it themselves and insurance
companies don’t want to pay for it either. If insurance companies are forced to
offer this benefit (or any other new benefit mandated by law), then they will
recover their extra costs by raising premiums. And when premiums go up, some

---

people on the margin will no longer be able to afford any health insurance at all.
So the real policy question is: Are we willing to pass a law that will make many
women more comfortable if it means that a much smaller number of men and
women will lose coverage for basic care?
The tradeoff underlying that seemingly narrow question has enormous
resonance as America debates health care reform. The more generous a health
care system is in the benefits it guarantees, the more it is going to cost. That’s
true regardless of whether the government is operating the system or not. In fact,
the most important question related to health care reform often gets far too little
attention: Given the proliferation of fabulously expensive medical technology,
some of which produces great results and some of which doesn’t, how do we
design a system that says “yes” to procedures that justify their cost and “no” to
those that don’t?
Is economics one big advertisement for the Republican Party? Not exactly.
Even Milton Friedman, a Nobel laureate in economics and the most articulate
spokesman for free markets, would concede that unfettered markets can lead to
deeply flawed outcomes. Consider the American lust for the automobile. The
problem is not that we like cars; the problem is that we don’t have to pay the full
cost of driving them. Yes, we buy the car and then pay for maintenance,
insurance, and gasoline. But we don’t have to pay for some of the other
significant costs of our driving: the emissions we leave behind, the congestion
we cause, the wear and tear on public roads, the danger we pose to drivers in
smaller cars. The effect is a bit like a night on the town with Dad’s credit card:
We do a lot of things that we wouldn’t do if we had to pay the whole bill. We
drive huge cars, we avoid public transportation, we move to far-flung suburbs
and then commute long distances.
Individuals don’t get the bill for this behavior, but society does—in the form
of air pollution, global warming, and urban sprawl. The best way to deal with
this growing problem is not the stuff that laissez-faire conservatives usually talk
about. It is higher taxes on gasoline and cars. Only with those kinds of measures,
as we shall explore in Chapter 3, will the cost of climbing behind the wheel of a
car (or a hulking SUV) reflect the real social cost of that activity. Similarly,
larger subsidies for public transportation would properly reward those
commuters who spare the rest of us by not getting into their cars.
Meanwhile, economists have done some of the most substantive work on
social issues like discrimination. Have the world’s symphony orchestras
historically discriminated against women? Harvard economist Claudia Goldin
and Princeton economist Cecilia Rouse came up with a novel way of finding out.
In the 1950s, American orchestras began to use “blind” auditions, meaning that

---

the aspiring orchestra member would perform behind screens. Judges did not
know the identity or gender of the musician trying out. Did women do better
under this blind system than they did when judges knew their gender? Yes,
decidedly so. Once the auditions became anonymous, women were roughly 50
percent more likely to make it past the first round and several times more likely
to make the final cut.
2
Economics presents us with a powerful, and not necessarily complex, set of
analytical tools that can be used to look back and explain why events unfolded
the way they did; to look around and make sense of the world; and to look
forward so that we can anticipate the effects of major policy changes. Economics
is like gravity: Ignore it and you will be in for some rude surprises.
The demise of the investment bank Lehman Brothers, which declared
bankruptcy on September 15, 2008, ushered in “the financial crisis,” which
deserves its frequent description as the worst economic downturn since the Great
Depression. How did it happen? How did so many consumers, who are supposed
to have a rational understanding of their own well-being, end up crushed by a
housing “bubble”? Who were the knuckleheads who loaned them all that
money? Why did Wall Street create things like “CDOs” and credit-default
swaps, and why did they prove so devastating to the financial system?
Chapter 2 makes the case that most of the reckless behavior that led to the
financial crisis was predictable, given the incentives built into the system. Why
did mortgage brokers originate so many reckless loans? Because it wasn’t their
money! They were paid on commission by the banks that made the loans. More
mortgages meant more commissions, and bigger mortgages meant bigger
commissions.
So why were the banks willing to put so much of their own capital at risk
(particularly given the incentives of the mortgage brokers who were bringing
them customers)? Because banks typically “sell” most of their mortgage loans,
meaning that they get a lump sum of cash now from some third-party investor
who gets the stream of future mortgage payments in return. (You may now
recognize this situation as an adult version of “hot potato” it doesn’t matter how
bad a loan is as long as you can pass it on to someone else before the borrower
defaults.)
Okay, then who would buy these loans? That’s what Chapter 2 explains. I’ll
give you one clue now: Wall Street gets involved and it doesn’t end well.
Having written all that, I must admit that there is some soul searching going
on in the economics profession. As obvious as the financial crisis seems after the

---

fact, few economists saw it coming (with some notable exceptions). Virtually
none anticipated how severe it might be. In the fall of 2005, several prominent
economists wrote in a prestigious journal, “As of the end of 2004, our analysis
reveals little evidence of a housing bubble.”
3
Wrong. Actually the article was worse than wrong, because it was written
explicitly to refute the signs of a bubble that had become obvious to many
laypeople—which is kind of like the fire department showing up at a house with
smoke wafting from the roof and declaring, “No, that’s not a fire,” only to have
flames start leaping from the attic twenty minutes later. There was a bubble. And
it can be explained best by incorporating psychology into economics, namely the
tendency of individuals to believe that whatever is happening now is what’s
most likely to happen in the future.
Economics is evolving, like every discipline. One of the most interesting and
productive areas of inquiry is the field of behavioral economics, which explores
how individuals make decisions—sometimes in ways that aren’t as rational as
economists have traditionally theorized. We humans underestimate some risks
(obesity) and overestimate others (flying); we let emotion cloud our judgment;
we overreact to both good news and bad news (rising home prices and then
falling home prices).
Most of this was obvious to Shakespeare, but it’s relatively new to
mainstream economics. As New York Times columnist David Brooks noted,
“Economic behavior can be accurately predicted through elegant models. This
view explains a lot, but not the current financial crisis—how so many people
could be so stupid, incompetent and self-destructive all at once. The crisis has
delivered a blow to classical economics and taken a body of psychological work
that was at the edge of public policy thought and brought it to front and center.”
4
Of course, most of the old ideas are still pretty darn important. Federal
Reserve chairman Ben Bernanke was a scholar of the Great Depression before
leaving academe, a fact that has had implications far beyond the Ivory Tower.
Chapter 10 will make the case that Bernanke’s creative and aggressive
interventions at the Federal Reserve, many of which were inspired by what went
wrong in the 1930s, prevented a bad situation from getting much, much worse.
This book walks through some of the most powerful concepts in economics
while simplifying the building blocks or skipping them entirely. Each chapter
covers subjects that could be made into an entire book. Indeed, there are minor
points in every chapter that have launched and sustained entire academic careers.

---

I have glossed over or skipped much of the technical structure that forms the
backbone of the discipline. And that is exactly the point: One need not know
where to place a load-bearing wall in order to appreciate the genius of Frank
Lloyd Wright. This book is not economics for dummies; it is economics for
smart people who never studied economics (or have only a vague recollection of
doing so). Most of the great ideas in economics are intuitive when the dressings
of complexity are peeled away. That is naked economics.
Economics should not be accessible only to the experts. The ideas are too
important and too interesting. Indeed, naked economics can even be fun.

---